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Needed: More Aggregate Demand: The Keynesian Cure

J. Bradford DeLong (2008), "The Keynesian Cure," for Project Syndicate: BERKELEY -- It is not yet foredoomed that the world economy will undergo a substantial recession in the next three years or so: we might still escape. But governments should play it safe by starting to take more steps now to cushion, soften, and shorten the period of high unemployment and slow or negative growth that now looks very likely.

It is a fact of nature – human nature, at least – that prudent and appropriate policies now will later seem excessive. At some point, the world economy will begin expanding rapidly again. But it would be most imprudent to assume that the turning point is right now, and that things are as bad as they will get.

Perhaps the best way to look at the situation is to recall that three locomotives have driven the world economy over the past 15 years. The first was heavy investment, centered in the United States, owing to the information technology revolution. The second was investment in buildings, once again centered in the US, driven by the housing boom. The third was manufacturing investment elsewhere in the world – predominantly in Asia – as the US became the world economy’s importer of last resort.

For 15 years, these three locomotives kept the world economy near full employment and growing rapidly. When the high-tech boom ended in 2000, the Federal Reserve orchestrated its replacement by the housing boom, while investment in Asia to supply the US market was chugging along at an increasing pace.

Many today are complaining about Alan Greenspan’s monetary stewardship, which kept these three locomotives stoked: “serial bubble-blower” is the most polite phrase that I have heard. But would the world economy really be better off today under an alternative monetary policy that kept unemployment in America at an average rate of 7% rather than 5%? Would it really be better off today if some $300 billion per year of US demand for the manufactures of Europe, Asia, and Latin America had simply gone missing?

The first locomotive, however, ran out of fuel seven years ago, and there is no clear technology-driven alternative leading sector, like biotechnology, that can inspire similar exuberance, rational or otherwise. The second locomotive began sucking fumes two years ago, and is now coasting to a halt, which means that the third – the US as importer of last resort – is losing speed as well: the weak dollar accompanying the housing finance crash makes it unprofitable to export to the US.

The world economy, as John Maynard Keynes put it 75 years ago, is developing magneto trouble. What it needs is a push – more aggregate demand. In the US, the weak dollar will be a powerful boost to net exports, and thus to aggregate demand. But, from the perspective of the world as a whole, net exports are a zero-sum game. So we will have to rely on other sources of aggregate demand.

The first source is the government. Fiscal prudence is as important as ever over the medium and long term. But for the next three years, governments should lower taxes – especially for the poor, who are most likely to spend – and spend more.

The second source is private investment. The world’s central banks are already cutting interest rates on safe assets, and will cut them more as the proximity and magnitude of the likely global slump becomes clear.

But low interest rates are entirely compatible with stagnation or depression if risk premia remain large – as the world learned in the 1930’s, and as Japan relearned in the 1990’s. The most challenging task for governments is to boost the private sector’s effective risk-bearing capacity so that businesses have access to capital on terms that tempt them to expand.