The True Lessons of the Recession: The West Can’t Borrow and Spend Its Way to Recovery

Foreign Affairs:

According to the conventional interpretation of the global economic recession, growth has ground to a halt in the West because demand has collapsed, a casualty of the massive amount of debt accumulated before the crisis. Households and countries are not spending because they can’t borrow the funds to do so, and the best way to revive growth, the argument goes, is to find ways to get the money flowing again. Governments that still can should run up even larger deficits, and central banks should push interest rates even lower to encourage thrifty households to buy rather than save. Leaders should worry about the accumulated debt later, once their economies have picked up again.

This narrative — the standard Keynesian line, modified for a debt crisis — is the one to which most Western officials, central bankers, and Wall Street economists subscribe today. As the United States has shown signs of recovery, Keynesian pundits have been quick to claim success for their policies, pointing to Europe’s emerging recession as proof of the folly of government austerity. But it is hard to tie recovery (or the lack of it) to specific policy interventions. Until recently, these same pundits were complaining that the stimulus packages in the United States were too small. So they could have claimed credit for Keynesian stimulus even if the recovery had not materialized, saying, “We told you to do more.” And the massive fiscal deficits in Europe, as well as the European Central Bank’s tremendous increase in lending to banks, suggest that it is not for want of government stimulus that growth is still fragile there.

In fact, today’s economic troubles are not simply the result of inadequate demand but the result, equally, of a distorted supply side. For decades before the financial crisis in 2008, advanced economies were losing their ability to grow by making useful things. But they needed to somehow replace the jobs that had been lost to technology and foreign competition and to pay for the pensions and health care of their aging populations. So in an effort to pump up growth, governments spent more than they could afford and promoted easy credit to get households to do the same. The growth that these countries engineered, with its dependence on borrowing, proved unsustainable.

Rather than attempting to return to their artificially inflated GDP numbers from before the crisis, governments need to address the underlying flaws in their economies. In the United States, that means educating or retraining the workers who are falling behind, encouraging entrepreneurship and innovation, and harnessing the power of the financial sector to do good while preventing it from going off track. In southern Europe, by contrast, it means removing the regulations that protect firms and workers from competition and shrinking the government’s presence in a number of areas, in the process eliminating unnecessary, unproductive jobs.

THE END OF EASY GROWTH

To understand what will, and won’t, work to restore sustainable growth, it helps to consider a thumbnail sketch of the economic history of the past 60 years. The 1950s and 1960s were a time of rapid economic expansion in the West and Japan. Several factors underpinned this long boom: postwar reconstruction, the resurgence of trade after the protectionist 1930s, more educated work forces, and the broader use of technologies such as electricity and the internal combustion engine. But as the economist Tyler Cowen has argued, once these low-hanging fruit had been plucked, it became much harder to keep economies humming. The era of fast growth came to a sudden end in the early 1970s, when the OPEC countries, realizing the value of their collective bargaining power, jacked up the price of oil.

As growth faltered, government spending ballooned. During the good years of the 1960s, democratic governments had been quick to expand the welfare state. But this meant that when unemployment later rose, so did government spending on benefits for the jobless, even as tax revenues shrank. For a while, central banks accommodated that spending with expansionary monetary policy. That, however, led to high inflation in the 1970s, which was exacerbated by the rise in oil prices. Such inflation, although it lowered the real value of governments’ debt, did not induce growth. Instead, stagflation eroded most economists’ and policymakers’ faith in Keynesian stimulus policies.

Central banks then changed course, making low and stable inflation their primary objective. But governments continued their deficit spending, and public debt as a share of GDP in industrial countries climbed steadily beginning in the late 1970s — this time without inflation to reduce its real value. Recognizing the need to find new sources of growth, Washington, toward the end of President Jimmy Carter’s term and then under President Ronald Reagan, deregulated many industries, such as aviation, electric power, trucking, and finance. So did Prime Minister Margaret Thatcher in the United Kingdom. Eventually, productivity began to pick up.

Whereas the United States and the United Kingdom responded to the slump of the 1970s with frenetic deregulation, continental Europe made more cosmetic reforms. The European Commission pushed deregulation in various industries, including the financial sector, but these measures were limited, especially when it came to introducing competition and dismantling generous worker protections. Perhaps as a result, while productivity growth took off once again in the United States starting in the mid-1990s, it fell to a crawl in continental Europe, especially in its poorer and less reform-minded southern periphery. In 1999, when the euro was introduced, Italy’s unemployment rate was 11 percent, Greece’s was 12 percent, and Spain’s was 16 percent. The resulting drain on government coffers made it difficult to save for future spending on health care and pensions, promises made even more onerous by rapidly aging populations.

DISRUPTING THE STATUS QUO

For the United States, the world’s largest economy, deregulation has been a mixed bag. Over the past few decades, the competition it has induced has widened the income gap between the rich and the poor and made it harder for the average American to find a stable well-paying job with good benefits. But that competition has also led to a flood of cheap consumer goods, which has meant that any income he or she gets now goes further than ever before.
During the postwar era of heavy regulation and limited competition, established firms in the United States had grown fat and happy, enjoying massive quasi-monopolistic profits. They shared these returns with their shareholders and their workers. For banks, this was the age of the “3-6-3″ formula: borrow at three percent, lend at six percent, and head off to the golf course at 3 PM. Banks were profitable, safe, and boring, and the price was paid by depositors, who got the occasional toaster instead of market interest rates. Unions fought for well-paying jobs with good benefits, and firms were happy to accommodate them to secure industrial peace — after all, there were plenty of profits to be shared.

In the 1980s and 1990s, the dismantling of regulations and trade barriers put an end to this cozy life. New entrepreneurs with better products challenged their slower-moving competitors, and the variety and quality of consumer products improved radically, altering peoples’ lives largely for the better. Personal computers, connected through the Internet, have allowed users to entertain, inform, and shop for themselves, and cell phones have let people stay in constant contact with friends (and bosses). The shipping container, meanwhile, has enabled small foreign manufacturers to ship products speedily to faraway consumers. Relative to incomes, cotton shirts and canned peaches have never been cheaper…

In countries that did reform, deregulation was not an unmitigated blessing. It did boost entrepreneurship and innovation, increase competition, and force existing firms to focus on efficiency, all of which gave consumers cheaper and better products. But it also had the unintended consequence of increasing income inequality — creating a gap that, by and large, governments dealt with not by preparing their work forces for a knowledge economy but by giving them access to cheap credit…

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