This year I am on sabbatical--which means I do not teach. And I do miss it. Thus, from my perspective at least, this next hour is going to be an hour of pure fun.
I hope it will be an hour of pure fun for you all as well.
As Bob Strom said, right now in this MBA class you are transitioning from studying micro to studying macroeconomics. You are moving away from studying that part of economics where you talk about how the market system works well: how supply balances demand to make the maximum possible amount and value of win-win deals, and how people respond to the incentives they’re given to change their behavior. To the extent that things go wrong in microeconomics--to the extent that when you step back and look at the situation you say "Geewillickers! I really wish this had not happened!"--it is because you wish that you or the market system had not given people the incentives that it in fact did.
Practically everything that goes wrong in micro goes wrong because somewhere in the system some people have what we regard as the "wrong" incentives, and have responded to them. In such a situation you frantically scramble to fix it and correct it. And you do so by finding ways to change public policies so that people in fact have the right incentives.
Micro is somewhere between half and three-quarters of economics.
The other quarter or so of economics is macroeconomics.
Macro is different. Macro deals with the fact that sometimes the economy seems to have some sort of a grand mal epileptic seizure. It freezes up. Something goes mysteriously wrong--and wrong not with an individual firm, or an individual industry, or an individual sector of the labor market, but wrong with pretty much the whole thing. This happened to the US economy in 2008 and 2009.
In eighteen months, the share of American adults who had jobs suddenly and discreetly fell over a period of nine months from the then-normal of 63% to 58.5%, and it has remained at 58.5% since, for 3.5 years now, with no signs of any recovery in the share of American adults with jobs.
4.5/63--one in 14--of the proportion of people who had jobs in the summer of 2008 and should still have them today no longer had them by the fall of 2009, and do not have them now. This social waste is over and above the "normal" unemployment you see in an economy as people lose jobs, people quit jobs, people get jobs, people wait for better jobs, people change jobs, people find they lack the skills for the jobs there are right there and don’t want to move. There is "normal" "background" unemployment in the economy--that is 3% of the labor force or so. "Normal" unemployment you can say performs a social function--just as an economy has to have an inventory of goods, so it has to have an inventory of workers looking for jobs and of jobs looking for workers. But you cannot say that of this extra unemployment.
There is an argument that the aging of the baby boomers should have pushed that 63% down to 62% over the past six years. But there is an equally-strong argument that as people’s home equity retirement savings vanished in 2009 the baby boomers tried to postpone their retirement--if you don’t have the money to retire, it is hard to do so. Thus the best guess is that "normal" employment in the American economy--employment where people are neither surprised on the upside or downside in aggregate, and where there is neither upward nor downward pressure on the rate of inflation--is still the 63% it was in the mid-2000s. And at 58.5%, we are far, far below that right now.
Why did we have this collapse of employment? It’s not because we had a sudden outburst of laziness on the part of Americans. It’s not because people decided to take a great vacation. It’s not because our system of benefits all of a sudden became a lot more generous. Our system became somewhat more generous for a year and a half, as it should have: congress looked at the large numbers of people suddenly unemployed and frantically extended unemployment benefits. But that’s now coming to an end. If that were the cause of low employment, the period of low employment would have been cured by now. It hasn’t.
That is the first thing I have to say: Macroeconomics is the study of why--at times--the economy as a whole freezes up, as it has right now.
The next thing I need to say is that we macroeconomists do not know very much about it--at least, not very much that is terribly useful in providing warnings. We have a lot of egg on our faces right now. If you had asked any of us back in 2007 whether this large a grand mal seizure of the economic system was likely to happen, we would all have said: "Of course not. The share of adults with jobs isn’t going to fall from 63% to 58.5%. It might fall from 63% to 61%, perhaps, but that is as large as business cycles get these days." And we would have said that because we believed that, over the past two centuries, governments--especially central banks--have learned to how manage things in the economy to keep such grand mal seizures of the economy from happening on that large a scale.
When I look at the sequence of processes that got us here, I find my batting average over the past six years to be low. First, I thought that the subprime mortgages that became the problem were too small a potential problem to pose any systemic risk--too small to take down the US economy. Second, I thought that after the bankruptcy of Bear Stearns the Federal Reserve had the situation under control. Third, I thought that big banks would be much more aggressive in spending their money once the Federal Reserve had implicitly guaranteed their debt by making whole the creditors of Bear Stearns. Thus I thought, fourth, that we would have higher inflation long before now, and that that would induce people to spend their cash and that would return employment to normal levels. Fifth, I thought the Federal Reserve would make boosting unemployment its highest priority and would extend itself much more than it has--try all kinds of untried policies--in order to make that happen. Sixth, I thought the Obama administration would apply the lessons that the Bush and the Clinton administrations had applied at the start of the 1990s with the S&L crisis, and fix the banks and the mortgage market. Seventh, I thought that even if congress proved dysfunctional, the Obama administration would focus on getting people back to work and would push the limits of its powers to make sure that it did so.
I was wrong. All of these processes leave us with serious and global economic challenges, for it is not just the US but the world economy as a whole that is depressed. When I talk to my friends in the White House, I tend to yell at them. Their response tends to be: "Look: we’re doing much, much better than Europe.At least in the United States, the unemployment rate has fallen by 2.5 percentage points, from 10% to 7.5%, over the past two years. In Europe, the unemployment has gone up by 2 percentage points. God knows what’s going on with the European banking system right now, but it isn’t good." All that is true. Nevertheless, it does not make me a happy camper.
So with that warning against your presuming that I have especially good judgment, let me move on to the third thing I have to say: that in order to understand why this catastrophic and prolonged collapse of employment has happened to us, we should start with a detour through economic history. Let us back up to the very start of the 19th century, back to the birth of the market economy, and to the birth of economics.
18th century northwestern Europe had an economy where 70% of households were farmer. Most farmers grew their own food. Most households spun their own thread, wove their own cloth, sewed their own clothes. The market economy--where people made of things for sale and consumed what they bought--was still more the exception than the rule. But this was about to change. By 1850 not 70% but only 20% made most of what they consumed and consumed most of what they made. And today? Nobody.
As the 19th century began, people saw this transformation coming. People worried about it. People wondered if it would, somehow, all go wrong. Could the farmer grow the crops but be unable to sell the crops because the weaver had no money because she couldn't sell her cloth to the blacksmith whose tools were still unsold because the farmer did not have the cash?
Back at the start of the nineteenth century, back at the beginning of economics, most of the first economists believed that such an outcome was logically impossible. The lead spokesman was a French economist, Jean-Baptiste Say. Nobody, Say argued, produces for sale without planning to buy. Thus, by metaphysical necessity, you could not create supply on the market without creating the equivalent amount of demand. And was it possible that the wealth would be there but the cash purchasing power--the money--was absent? Say said "No." Say said merchants knew how to create credit and how to gve credit to those who were productive and solvent but strapped for cash, and those who weren't productive and solvent weren't sources of supply.
An economy could find itself in a situation in which there was high unemployment, Say argued, but then the problem was not that demand was scarce but that supply was in the wrong sector. it’s actually a sectoral shift. There are then too many people producing in one sector and too few people producing in another, where the demand is: too many construction workers, too few psychotherapists, and unemployment because it is hard to retrain construction workers to be good therapists.
Say (and David Ricardo, and many other economists) were counterbalanced by Thomas Robert Malthus. Malthus said that Say (and Ricardo) sounded good in theory, but not so good in practice. Malthus saw huge numbers of unemployed textile workers, but no industries with high demand that were growing fast enough to be a plausible balance.
1825 saw the collapse of the British canal boom, a steep fall in stock values, and a severe depression. In its aftermath, Jean-Baptiste Say changed his mind. He went over to Malthus's side in his analysis. The young economist John Stuart Mill put his finger on how to resolve the Say-Malthus debate in 1829. Mill pointed out that people who make and sell may want not to purchase other goods and services but to purchase and hold cash. An excess demand for cash will then go with an excess supply of currently-produced goods and services--you can have a "general glut" of commodities if there is a scarcity of cash.
What happens if there is a scarcity of cash? What if people just want to hold on to more cash? And what if the reason that they want to hold on to more cash is that they don’t trust the private credit system? Then either the government--or some other outside agency--has to show up with the cash, or else. If the government doesn't, there is depression: everyone tries to spend less than their income to build up their cash holdings, but for the economy as a whole everybody's income must come from someone else's spending. The result is that production falls and unemployment rises until the unemployment rate has risen high enough that people no longer dare try to build up cash, and so economy-wide spending equals income.
That was John Stuart Mill’s 1829 diagnosis. From it, two possible solutions to the problem of depression follow immediately. First, when the private sector is spending less than its income, the government can fix the problem and put people to work by spending more than its income. This policy has biblical blessing: the story in Genesis of Joseph and Pharaoh's dream. Pharaoh dreamed that there would be seven years of plenty followed by seven years of dearth. Joseph advised Pharaoh to save and fill the storehouses during the years of plenty, and then run a large deficit during the years of dearth.
We did some of that during the Great Depression under FDR. Germany did a good deal more of that under Adolf Hitler in the 1930s--that was one of the sources of Hitler's persistent popularity.
Second, if the problem is that people don’t have enough cash--well, then, find some organization, a Bank of England, a Federal Reserve--and have it print cash until people no longer think they should spend less than their income to build up their cash. Flood the economy with money until people no longer want to hoard more cash than they currently have.
We saw that panicked scramble for cash happen at the end of 2008 and the beginning of 2009. Look at the interest rate on two kinds of corporate bonds: the BBB bond--a reasonable bond--and the CCC bond--a junk bond, a company that looks like it may be on the edge of bankruptcy in a year or two. In the mid-2000s the economy was cruising along. A BBB compan had to pay about 6%/year to borrow money. A CCC company had to pay 12%/year to borrow mone--better than you’ll get a the check cashing and payday loan shops down Wornall, but far from great for a business.
By the fall of 2008 people with cash are no longer willing to lend it out. Businesses find themselves in real trouble as the interest rate on CCC loans hits a peak of 45%, and even the BBB rate goes above 10% for a month or two.
In late 2008 early 2009 we saw again what John Stuart Mill had seen in 1825 and theorized about in 1829: a sudden scramble for cash on the part of the economy as a whole, as everybody scrambles to get more cash, and an excess demand for cash carries with it a deficiency in demand for currently-produced goods, services, and labor. That’s what pushed the unemployment rate up to 10%, and the employment to population ratio down from 63% to 58.5%.
Between 2000 and 2008, the level of total spending in the American economy at current prices rose smoothly from $9.8 trillion/year up to $14.4 trillion/year. then the pace of spending fell off a cliff. It still hasn’t caught up to its pre-2008 trend. A lot of prices even today and a lot of expectations and plans formed five or ten years ago were set assuming that the pace of spending would be on trend, on track. The fact that spending isn't on track means that we do not have the spending to support full employment at current wage and price levels. So we don't have anything like normal levels of employment: our adult employment-to-population ratio is and is stuck at 58.5%, where it has been for nearly four years, rather than at the 63% where it should be.
Jean-Baptiste Say gave up his theory of structural maladjustments and structural shifts--of excess supply of workers and for commodities in one sector counterbalanced by excess demand in another sector--in 1829, when he took a look back at 1825-6 in Britain and recognized that he had been wrong in what he had written back in 1803. But even though he abandoned his theory 188 years ago, it is back--like some strange zombie of economic theory.
This time this alternative theory that you will hear--the theory that isn’t the John Stuart Mill shortage of cash causing an epileptic seizure, a freezing up of the economy theory--is built on the housing bubble. There was a big housing boom in the 2000s. In some sense, we built too many houses. Because we built too many houses, we had to shift lots of workers out of construction into other activities. And, the story goes, workers and housing construction really aren’t qualified to do that much else--and so, the story goes, we then wound up with a big structural unemployment problem because our construction workers are unproductive elsewhere: are "zero marginal product workers".
Indeed we did have a housing boom. Indeed we did have a housing bubble. We had a housing bubble on a scale that we had never seen before. Before we had had, perhaps, 20% fluctuations in housing prices in the past. We had a big downward fluctuation in housing prices in the 1920s--perhaps because people saw that United States government was going to cut off immigration. we had an upward jump in housing prices in the 1940s, when after World War II it turned out everyone wanted to buy a house especially since cars were now cheap. But we had nothing like the 2000s: nothing like housing prices nationwide rising by something like 70% at their peak.
During the bubble, there were three factions of economists. There were economists who said the price rise was 100% an irrational bubble--that housing prices were going up because they were going up and because people were watching flippers grow rich on cable TV, that this was a process that worked only as long as the cable TV audience was growing, and that when the cable TV audience stopped growing there would an extravagant crash. There were economists saying it was partly fundamentals--saying that we are not building more commuter superhighways, that the population is growing, and that the price of energy is going up as the world runs out of oil. You combine increased congestion with higher energy costs that means that houses located in reasonable places are going to become a lot more expensive--and so we should expect housing prices to go up.
Then you had a third faction--me and a bunch of other people--who said that the fundamental effects were large enough to account for perhaps a 30% rise in housing prices but not large enough to account for a 70% rise. 30% a permanent rise in fundamentals, 40% a bubble that is probably going to deflate gradually over decades--that is what we thought. We thought we were smarter than group 1. We were not.
As a result of the housing bubble we did build 600,000 extra houses--100,000 of them in the swamps of Florida, 500,000 in the desert between Los Angeles and Albuquerque. And we did indeed face, in 2006, the task of moving people out of the housing construction industry and dealing with the fact that we had, by then, 600,000 more houses than would be occupied by normal demand.
This graph shows four big components of total economy-wide spending--exports, how much we sell abroad; how much businesses buy in terms of machines to install in their factories; what the government buys; and how much we build in the way of houses and apartment buildings. I’ve moved these four lines up and down so that they all intersect at the start of 2007--this graph shows changes since the start of 2007.
On this graph we can see the housing boom, and the peak of housing construction. We can see the creation of the 600,000 extra houses over and above trend. And we can see the subsequent crash of housing spending--and we can see that, since housing construction reached its bottom, it’s been flatlining.
The housing boom is this triangle of extra building here before 2007. It is only about a quarter of the size of this very large period afterwards during which we are not building houses at anything like the trend level. It is simply not the case that we built extra houses for a while, and then stopped until population and household formation will have caught up. Instead, we built extra houses for a while Then we stopped. Now we are three million houses short of trend. But the housing market is still depressed because there are four million fewer households than there should be--we have four million extra families living in their sister’s basement and getting increasingly crabby and anxious. Each year the lobbyists for the real estate industry says this is the year that people will have had enough and will finally say: "I don’t care how risky the job market is, I’m sick of living in my sister’s basement, I’m going to move out and buy or rent something." It hasn’t happened yet, right.
That is the first argument against the "sectoral shift" theory. We did indeed have a sector where we overbuilt. But by now we have far more than wiped out any economic drag that might have been created by that period of overbuilding.
The second argument against the "sectoral shift" theory takes a look at what happened between the peak of housing prices at the end of 2005 and the bad year of 2008. What you see over 2005-2008 is a smooth rebalancing of the economy that takes place with the economy at full employment. Yes, a huge amount of resources move out of housing construction. But the consequence is not recession. The consequence is not high unemployment. We also see huge growth in exports and substantial growth in business investment. Why? Because the market economy is successfully rebalancing. Housing prices fall in response to the fall in demand for houses. There are fewer construction companies wanting to borrow money from banks. That opens up finance for businesses to borrow more to buy more machines. That opens up a switch in demand as those foreigners who formerly invested in mortgage-backed securities buy U.S. exports instead.
So from 2005 through the start of 2008 we see a sectoral rebalancing--excess supply of construction workers here, excess demand for exports and for machinery there--but the process of dealing with this rebalancing is not one of high or rising unemployment. People manage to move smoothly from construction jobs into other jobs, and people move from other jobs into still other jobs, and people move from still other jobs into export jobs and into manufacturing equipment jobs. This process went on so smoothly that at the start of 2008 the six economists with the National Bureau of Economic Research appoints to try to say whether the economy is in recession or not were worried about the collapse of the housing boom, but believed that the collapse of the housing boom was not going to cause even a small recession.
And come 2008-2009 everything collapsed. Construction collapsed, business investment collapsed--that’s what the spike in interest rates did. Exports collapsed as trade financing collapsed. Those drove the US economy into recession, and those pushed the employment-to-adult-population ratio down from 63% to 58.5%.
Thus this downturn is not a Ricardo-Say downturn. It is not a "excess supply here, excess demand there, and unemployment rises because it is very difficult to retrain workers to be productive in the high-demand sectors." There was excess supply here and excess demand there in 2006-2008 but the economy adjusted smoothly without higher unemployment--the magic of the market, you know. Then came 2008, which was a John Stuart Millian process: surprising losses in finance, a panic, everybody tries to run and shift their portfolio into something cashlike--into safe and liquid financial assets like cash or U.S. Treasury bonds--and high unemployment as an unsatisfied excess demand for financial assets that are liquid, secure, and safe produces an excess supply of goods, services, and labor.
After the collapse of employment in 2008-2009 came what may well be my worst call in my life as a professional economist.
I had run a lot of statistical studies of the business cycle in the United States. I had found that, since World War II, on average, it takes 15 months for the economy to get hallway back to normal after a downturn reaches its trough. You don’t know how big a downturn will be. You don’t know how low the employment-to-adult-population ratio will go. But you do--or you did--know tha,t once things start back up, it will take about 15 months for you to get halfway back to normal, and then another 15 months to get another halfway back to normal--a total of 3/4--and after 45 months you are 7/8 back to normal and can no longer see the effects of the downturn.
It was this belief--that the American market economy is flexible and adaptive and mean-reverting--that led people like me to advise President Obama that 2009, 2010, and even 2011 would be bad years, but that by 2012 and certainly by 2013 the economy would be fixed. We said that there were indeed very powerful reasons to try to "stimulate" the economy to boost production in 2009 and 2010, but that the stimulus should then ebb and should be turned off by the end of his first term. This was, we said, the way things had been since World War II. The market economy, we said, is a wonderful, resilient thing. There are lots of workers who need jobs and have skills. There are businesses. And if the workers are without jobs the businesses will find them and employ them within a few years.
Thus in mid-2009 President Obama was convinced that the economy was on its way toward recovery, and so turned his attention to doing other things--like healthcare reform--rather than continuing to focus on macroeconomic recovery.
Really bad call.
Really, really bad call.
We did have a recovery in exports. We did have a substantial recovery of business investment--albeit not all the way back to where it was.
But we had never fixed the mortgage system. We still have huge numbers of foreclosed houses, and houses people think will soon be in foreclosure and hence offered for sale at fire-sale prices. So very few people want to build houses. Construction is still flatlined.
State worries about the fact that their tax revenues were declining sharply and that their debt is increasing have meant that government purchases started to fall off a cliff at the end of 2009, and are still falling. With housing construction flatlined, and government purchases still on a steep downward trajectory, the fall in government purchases has more or less offset the rise in exports. The consequence has been our weak and anemic recovery. The Federal Reserve has pushed the interest rates it controls down to zero, has said it’s going to keep them there for quite a while, and hopes that this promise of sustained hyper-low interest rates is going to induce businesses to borrow more and buy more machines and households to try to save less and spend more on consumer goods and services, and that this shift in demand away from people's trying to build up their holdings of cash and Treasury bonds and toward buying currently-produced goods and services will get us out of this mess. The Federal Reserve is doing all that it can: once it is pushed interest rates down to zero, it really cannot do much more to incentivize businesses to spend more in buying machines or households to save less.
The Federal Reserve has been trying to follow John Stuart Mill's implicit advice--that if the economy gets wedged with high unemployment because there is an excess demand for safe, secure, liquid assets like cash, you cure the high unemployment by getting people the cash they need so there is no longer an excess demand for cash and no longer an excess supply of currently-produced goods and services.
The US economy was running along fine with $800B of Federal Reserve provided cash in 2008 or so, a number that had been growing very smoothly. Even September 11, 2001 had little effect on demands for cash--and that day was a very big deal, especially in New York where most of the cash reserve is kept. At the end of 2008 the Federal Reserve decided it would double the cash supply. That probably kept unemployment from going above 10%. But that wasn’t enough to return unemployment to normal.
So, a year later, the Federal Reserve raises cash from $1600 billion of cash to $2 trillion. That didn’t seem to do much to boost the economy. Then they raised the cash supply to $2.7T. Now the dominant faction on the Federal Reserve is going to keep adding $80 billion a month to cash--over protests from our own Esther George, President of the Federal Reserve Bank of Kansas City up there in Crown Center, who says:"Wait a minute! We’re stuffing these banks full of cash, and yet we have no control and no knowledge over what they’re doing with it. They are likely to be running excessive risks with it. We should find some other way." And she is joined by Federal Reserve Governor Jeremy Stein, who shares her worries, as do at least three other Federal Reserve bank presidents.
What is going on now is in some ways going to be a test of John Stuart Mills’ theory in 1829--that all you had to do to fix a downturn was to feed the economy enough cash, and people would be happy. If $4 trillion of government cash in an economy that normally runs on $800B of government cash isn’t enough to make people happy, then it’s hard to know what could be the right number.
How does the government get the cash it makes into people's hands? If you deal with the Federal Reserve, you get cash by selling something to the Federal Reserve. At the moment, the Federal Reserve has an open invitation to the people to tender 80 billion a month of long term Treasury bonds or mortgage bonds guaranteed by Fannie Mae or Freddie Mac. We are not doing what the George W. Bush administration did in 2001--simply mailing out extra checks to people to get the money in their hands.
There are economists who are saying that that is exactly what we should be doing, and I agree: Matthew Yglesias, who writes for Slate Magazine had such a column today; Miles Kimball at the University of Michigan has a different idea that the government ought to get cash into people's hands by entering the payday loan business--but charging people 3% interest rate rather than a 30% interest rate because the government can use the IRS to collect the principal and interest on payday loans, while it is actually very expensive for private payday loan companies to collect, and so this is a business that the government really can do more efficiently. It's not that hard to hide from a payday loan company. It is hard to hide from the IRS for long--you have to move to the hills of northwestern Arkansas and become an extra in "Winter’s Bone."
Why didn't the Obama administration mail out more checks? It did spend an extra $700 billion or so in 2009-10 via the stimulus bill, the Recovery Act--$200 billion or so in tax cuts to rich people who aren't going to spend much of it, about $200 billion in infrastructure, about $150 billion to keep states spending on teachers and police officers and so forth, and about $150 billion on other things. But at the start of 2009 it was my friend Christina Romer who was was sitting in the hot seat, and it was her judgment that people were sufficiently scared that they wouldn’t spend a large enough proportion of the money if you just sent out checks--that you would do much, much better in booting spending via cutting checks to state and local governments to keep them from firing teachers and police officers, and investing a good deal in infrastructure. The idea was--and I agreed--to get the money out quickly because we thought the downturn would be relatively short.
Yes, I know that was a bad call.
What should we do next? The Federal Reserve has flooded the economy with cash to try to incentivize households and businesses to spend more to put people back to work, and does not think it can do much more. Since the summer of 2010, the Republican Party has been terrified of the rising national debt and unwilling to support any proposals that the government spend more to put people back to work. Large factions inside the Obama administration agree. Obama is basically a sound-finance guy. He doesn’t believe that the government should spend a lot of money, when it has no plans for how to pay it back.
Now, when you look at what’s happened to the government’s debt since 2008, you can indeed freak. When World War II ended, our debt was something like 120% of a year's GDP. Economic growth and budget surpluses gradually pushed that down to low of 22% of GDP under the Ford administration. Then Ronald Reagan came in, said what the US economy really needs is tax cuts, and that pushed the debt up by a lot. So when Bill Clinton came into office, people like me who worked for Clinton were genuinely scared of the long-term consequences of rising debt and so made it our first priority to cut spending and raise taxes to put the debt on a downward trajectory, which we did--better performance than even under Dwight Eisenhower, that flint-eyed Kansas person extremely careful with the wallet (except for nuclear weapons and superhighways).
We, by the way, got absolutely no help from anybody in the Republican Party in our task.
Then George W. Bush comes in. All progress in reducing the debt stops. George W. Bush, Tom Delay, Denny Hastert, Bill Frist, Mitch McConnell, Paul Ryan, and company casually break all of our Clinton-administration work in getting the government's budget balanced. And they do this without getting a protesting peep out of their economic advisors--Glenn Hubbard, Greg Mankiw, Eddie Lazear, John Taylor, and company. And for that and for the Republican economic advisors' refusal to even hint that they are sorry for not having made any of a fuss, we economists who work for the Clinton administration have a very hard time forgiving them--or, indeed, taking any economist who worked for the George W. Bush administration seriously.
Then the crash comes. Tax revenue collapses as unemployment rises and people without incomes cannot pay taxes. Spending rises as people collect unemployment insurance and food stamps. The debt starts rising and keeps rising and will push itself up to 76% of GDP before stabilizing next year.
The view from the International Monetary Fund at least has been that this big increase in debt has been a good thing for the United States--at least, that's what they conclude when they look at Europe. They say those European countries that have worked very hard not to run deficits have seen absolutely awful performance over the past several years. Those European countries, Germany that have let their deficits rise over the past five years have done much better. For each extra euro a European government has spent, it and its neighbors have gotten an extra euro 1.50 in increased private spending. The people whom the government puts to work then spend more money, and that spending puts even more people to work, and so on and so forth. So spending more looks like it has helped a good job over the past several years.
This case is reinforced when you think that if it is indeed the case that Europe-wide an extra euro of government spending boosts total incomes by euro 2.50, in Europe such an increase in incomes boosts tax revenues by euro 0.90--that a extra euro of spending pushes up European governments' debts by only 0.10. In terms of higher-spending-and-employment-to-debt-increase multipliers, that's a multiplier of 25.
So what is the reason for the government not to be spending more right now and not to postpone worrying about budget balance until employment comes back to norma? Well the reason not to spend more would be that perhaps people will become scared that you’ve spent too much and have no plans for paying it back. Then people will fear future inflation and bid up interest rates--as we saw when people in the 1970s feared inflation in response to the increases in oil prices in that decade. So ever since 2008, as we watched this sharply rising national debt, we have been watching for signs that people will start demanding higher interest rates for holding treasury bonds out of fears of inflation.
It hasn’t happened.
Interest rates continue to fall.
Interest rates continue to be well below what you would regard as normal levels even three or four years ago.
That suggests that there’s an opportunity here. Right now the US government can borrow at unbelievably good terms. So there’s a strong argument that right now the US government and state governments should be pulling forward every piece of spending they’re planning to do over the next 15 years into the present, and also pushing taxes back from the present into the future to leave more money into people’s hands. And they should keep doing this in order to boost employment and production, at least until the bond market starts holding up a red stop sign in the form of rising interest rates.
Indeed, as Christina Romer said to Barack Obama in the Oval Office in… I think it was July 2009… when he asked her when would this plan of hers to extend stimulus 1 with stimulus 2 and so on reach a natural end, her response was; "The bond market will tell us when it is time to stop. It will be very clear when it does."
There are other economists who tend to say that the bond market is irrational, and everything could be fine until some Tuesday--at which point the bond market will freak out, and we cannot risk the bond market's suddenly freaking out. That is, I think, still the dominant view in Washington DC. But the current situation continuing with very large gap between what we think is the normal unemployment level of the American economy and the level at which we have settled is not a risk, but a huge problem. We paid off a national debt of 120% of annual GDP after World War II with no problems at all--the 1950s were a good economic time. Britain paid off a debt of 300% of a year's GDP in the early 19th century after beating Napoleon--that was called the Industrial Revolution, and it was a time of previously unprecedented economic growth.
Maybe we cannot follow Britain's Napoleonic War example and run our debt up to 300% of a year's GDP before running into problems, but there does not seem to me any reason why we could not run it up to 120%--and right now we are only at 75% or so. It looks to me like there is plenty of fiscal headroom.
But, given the politics, we are not going to use it.
It is depressing. We cannot expect to see much more of an increase in exports. It would be nice that businesses were to spend more money buying equipment, but as long as the economy is depressed they have excess capacity--they think, rightly, they have more than enough machines for now. State governments and now the federal government are slashing spending, most recently with the start-of-March sequester. Construction continues to flatline. There is little desire inside the government to actually take steps to make it easier for all the people living in their sister's basement to buy or rent houses or apartments. We are still building only 400,000 houses per year when we normally build a million--I have a hard time following why not.
The bright side of this, if you are an investor or employer, is that with employment so low if you want to hire people they’re willing for little. Thus profits are at record levels. But this is not because the economy is doing well. It is because the downturn has redistributed a huge amount of wealth from labor to capital.
That brings me to the end of my "current macroeconomic situation" talk.
I wish it were less depressing.
I wish we could give more shape to the risks of rising national debt--what are they, are they near, are they far away, what might they do to us if things go south in some way in the bond market. But the US economy is in a place it hasn’t been before, and so we’re reduced to arguing by theory and by analogy and not by experience, and and theory and analogy are relatively weak reeds to rely on.
This is called "The Dismal Science" for a reason.