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CAMBRIDGE – As the US economy limps toward the second anniversary of the Lehman Brothers bankruptcy, anemic growth has left unemployment mired near 10%, with little prospect of significant improvement anytime soon. Little wonder that, with mid-term congressional elections coming in November, Americans are angrily asking why the government’s hyper-aggressive stimulus policies have not turned things around. What more, if anything, can be done?
The honest answer – but one that few voters want to hear – is that there is no magic bullet. It took more than a decade to dig today’s hole, and climbing out of it will take a while, too. As Carmen Reinhart and I warned in our 2009 book on the 800-year history of financial crises (with the ironic title “This Time is Different”), slow, protracted recovery with sustained high unemployment is the norm in the aftermath of a deep financial crisis.
Why is it so tough to boost employment rapidly after a financial crisis? One reason, of course, is that the financial system takes time to heal – and thus for credit to begin flowing properly again. Pumping vast taxpayer funds into financial behemoths does not solve the deeper problem of deflating an overleveraged society. Americans borrowed and shopped until they were blue in the face, thinking that an ever-rising housing price market would wash away all financial sins. The rest of the world poured money into the US, making it seem as if life was one big free lunch.
Even now, many Americans believe that the simple solution to the nation’s problem is just to cut taxes and goose up private consumption. Cutting taxes is certainly not bad in principle, especially for supporting long-term investment and growth. But there are several problems with the gospel of lower taxes.
First, total public-sector debt (including state and local debt) is already nearing the 119%-of-GDP peak reached after World War II. Some argue passionately that now is no time to worry about future debt problems, but, in my view, any realistic assessment of the medium-term risks does not permit us simply to dismiss such concerns.
A second problem with tax cuts is that they might well have only a limited impact on demand in the short run, with the private sector hoarding a significant share of the funds to repair badly over-leveraged balance sheets.
Last but not least, there is a fairness issue. By some measures, nearly half of all Americans do not pay any income tax already, so cutting taxes skews an already very unequal income distribution. Deferred maintenance on income equality is one of many imbalances that built up in the US economy during the pre-crisis boom. If allowed to fester, the political consequences could be severe, including trade protectionism and perhaps even social unrest.
Those who think that the government should take up the slack in private spending point out that there is an abundance of growth-enhancing projects – a point that should be obvious to anyone familiar with America’s fraying infrastructure. Likewise, transfers to state and local governments, which have limited constitutional scope to borrow, would help slow down wrenching layoffs of teachers, firefighters, and police. Lastly, extending unemployment insurance in the wake of a once-in-a-half-century crisis should be a no-brainer.
But, unfortunately, Keynesian demand management is no panacea, either. Nor can the government always be the employer of last resort. While tax cuts enhance long-term productivity, expanding the government sector is hardly a recipe for economic vitality. There are surely many useful activities for the government to undertake in a market economy, but a frenzied orgy of stimulus spending is not conducive to rational discussion of what they should be. And of course, there again is the matter of the soaring national debt.
All in all, the G-20’s policy of aiming for gradual stabilization of growth in government debt, bringing it into line with national-income growth by 2016, seems a reasonable approach to balancing short-term stimulus against longer-term financial risks, even at the cost of lingering unemployment.
While America is facing the limits of fiscal policy, monetary policy can do more, as Federal Reserve Chairman Ben Bernanke detailed in a recent speech in Jackson Hole, Wyoming. With credit markets impaired, the Fed could buy more government bonds or private-sector debt. Bernanke also noted the possibility of temporarily raising the Fed’s medium-term inflation target (a policy that I suggested in this column in December 2008).
Given the massive deleveraging of public- and private-sector debt that lies ahead, and my continuing cynicism about the US political and legal system’s capacity to facilitate workouts, two or three years of slightly elevated inflation strikes me as the best of many very bad options, and far preferable to deflation. While the Fed is still reluctant to compromise its long-term independence, I suspect that before this is over it will use most, if not all, of the tools outlined by Bernanke.
The bottom line is that Americans will have to be patient for many years as the financial sector regains its health and the economy climbs slowly out of its hole. The government can certainly help, but beware of pied pipers touting quick fixes.
Kenneth Rogoff is Professor of Economics and Public Policy at Harvard University, and was formerly chief economist at the IMF.
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