A Debate in Foreign Affairs: Stimulus or Reform

From an exchange in the September/October issue of Foreign Affairs, with Raghuram Rajan, Karl Smith and myself. I write in my comment:

In “The True Lessons of the Recession” (May/June 2012), Raghuram Rajan sketches a structuralist interpretation of the Great Recession’s causes and aftermath and draws out the resulting policy implications. Although he gets much right about the causes of the crisis, the reforms he recommends for ending it are misguided. In an environment of insufficient demand, a strategy that relies solely on getting rid of regulations, investing in human capital, and spurring entrepreneurship is doomed to end in sorrow. These types of policies are better thought of as complements to, rather than substitutes for, aggressive tactics aimed at boosting demand.

Professor Rajan responds:

In criticizing work, it is often easier to
caricature it, because caricatures are
easier to attack. Both Menzie Chinn
and Karl Smith have yielded somewhat
to this temptation. The main point of
my essay was that demand was bloated
in the years before the Great Recession,
thanks to unsustainable borrowing by
governments, households, and the financial
sector, with the importance of each
varying by country. Bloated demand also
distorted the supply side, which fed back
into demand. In the United S tates, as
more people bought houses financed
with easy credit, home prices increased,
and people borrowed against their homes
to buy washing machines and cars.

I disagree with Chinn and S mith
on several other issues. Chinn grossly
misinterprets my argument when he
writes that I claim that globalization
and technological innovation “resulted
in involuntary unemployment.” In fact,
my main point was that the lost middleclass
jobs were replaced by low-end jobs,
including in construction, before the crisis.
Unemployment increased after the
crisis, but disproportionately at the lower
end. The scenario he sketches of advances
in innovation and productivity being
“counterproductive in the short run if they
drive prices down” may be theoretically
possible, but it is extremely unlikely. More
innovation and productivity will raise
workers wages in real terms and expand
investment, contributing to sustainable
growth in demand. To argue that these
changes will lead to spiraling debt deflation
in today’s world strains credulity.

The entire set of responses and rejoinders is here.


22 thoughts on “A Debate in Foreign Affairs: Stimulus or Reform

  1. DS

    So if he’s saying that demand was bloated previously, that would seem to imply that he sees current demand as a return to normal and therefore, in essence, what we should learn to live with.
    Is our demand level currently a return to mean and does it make sense with population increases?
    What is a sufficient level of demand and can the private sector achieve it on its own or does it require a certain level of government demand to be maintained?

  2. ppcm

    The persistence in setting the banks on the front line of the causes of the crisis,is not injustice (profits do not tolerate a moral concept)but a mistake. A mistake,as the governments administrations programed the financials modus operanti,not willing to write so is to discard their past role and to shift the whole burden of rebalancing the destroyed markets equilibrium on the private sector. This crisis was financially driven and the role of the central banks was conducive.

  3. 2slugbaits

    More innovation and productivity will raise workers wages in real terms and expand investment, contributing to sustainable growth in demand. To argue that these changes will lead to spiraling debt deflation in today’s world strains credulity.
    Huh? That is no doubt true in a normal world with a positive Wicksellian interest rate, but right now we don’t live in that world. A lot business investment has been of the non-Hicksian non-neutral “labor augmenting” variety, and that does not necessarily guarantee an increase in wages and higher employment. For example, a recent Center for Economic Studies (Dept of Commerce/Census Bureau) paper concludes that with a: “CES production function with labor augmenting differences…Non neutral technical improvements will result in higher stocks of capital but not necessarily more hiring of labor.

  4. Jiamingsoh

    I think it is a contradiction for Professor Rajan when he suggested “a strategy that relies solely on getting rid of regulations…” but at the same time acknowledged the cause of the crisis as financial deregulation. Besides, I think Prof Rajan’s ideas of supply-side policy will be more effective in increasing the Long run supply curve but the trickle-down effect of increasing the real wage may take a long time to manifest itself among the workers especially amidst this high unemployment rate. More importantly, I think a more serious question is Who should we depend on to invest in his technology innovation and globalization( if not the government) especially amidst this massive uncertainty (as claimed by Baker et al http://www.epi.org/files/2011/PolicyUncertainty.pdf) which most likely will rule out the private sectors from taking these initiative.

  5. Bryce

    The way to think about this is to contrast the Keynesian macro way of looking at capital: aggregated, lumps of homogeneous Play-Doh, that only needs a lot of money thrown at consumption spending to supposedly “stimulate” the economy — versus micro foundations: disaggregated, individual sets of LEGOs that have to fit together like a bunch of little locks & keys to foster productive economic expansion. The only way that the latter can happen is for government to get the hell out of the way, in terms of regulations, taxes, spending, etc.
    Government “stimulus” programs of consumption spending actually engender economic lethargy.

  6. Menzie Chinn

    aaron: Thanks, fixed.

    Bryce: Indeed, I believe unemployment insurance, TANF, and particularly SNAP (food stamps) do promote lethargy. Are there no poorhouses?! Oh for the days of Dickensian England. If only we could return to those halcyon times!

  7. Bryce

    Your mocking comments are non sequiturs. They have nothing to do with what I averred.
    But what else are you to do when you disagree with allowing honest prices communicate real supply and demand? And thereby efficiently allocate resources.

  8. The Rage

    Demand was only “bloated” in terms of credit creation. That meant we were already in a demand crisis.
    Rajan doesn’t want to admit globalism has failed due to capital’s decadence. Now capital is weak.

  9. 2slugbaits

    Bryce allowing honest prices communicate real supply and demand?
    So are you claiming that Says’ Law holds always and everywhere? Are you claiming that the Wickellian clearing interest rate can never be negative? Do you believe that demand and supply must always move towards one and only one equilibrium position? You seem to be saying just those things. I understand that you do not accept the concept of “aggregate demand” in macroeconomics, but even micro guys would not go as far as you seem to be going.

  10. Bryce

    I subscribe to the concept of the interest rate being determined by interplay of the supply of savings & the demand to borrow those savings. We live in a world where it is impossible to know what the supply of savings is. For central banks may “create” new “savings” with the click of a mouse without any consumer having to refrain from consuming. To wit, without anyone doing any saving.
    You often allude to Knut Wicksell. He & I aren’t that far apart.
    My central point had to do with the importance of the heterogeneity of capital as an explanation of why all the money printing & deficit spending haven’t worked.
    If he burgeoning Food Stamp & Disability systems–being games like crazy–are your idea of something positive, we must be from different planets. This is what you want to talk about?
    Okay, yes, programs that let people get something for nothing do promote lethargy. There is little doubt that this could be measured by an econ study. In fact, I’m pretty sure it has been measured with regard to length of unemployment insurance, tho’ I don’t mean to demean reasonable unemployment ins. by mentioning it. But this is all peripheral to the issues of having undistorted market prices & reasonable regulation instead of what we have.

  11. 2slugbaits

    Bryce I hardly know where to begin. Sigh! First, you are confusing stocks and flows. The Fed creates a stock variable called reserves, or as you call it “savings.” The IS side of the curve refers to “saving” (not savings), which is a flow variable. The Fed simply tries to adjust the interest rate such that planned investment equals desired saving for any given income level. The Fed does not create the flow variable “saving.” Second, when the Fed sets the interest rate, it does not do so in the way that you seem to believe. As best I can tell you believe the Fed sets the interest by announcing: Thus spake Ben: “The risk free interest rate shall be x.xx%. So it is written, so let it be done.” In fact, what actually happens is the following: Thus spake Ben: “I hereby command the FOMC to adjust the supply of money and bonds such that the loanable funds market will settle on an interest rate of x.xx%. So it is written, so let it be done.” See the difference? One is transactional and the other is not. Third, it’s not just central banks who can create money. Money creation comes about through a fractional reserve system, and unless you are advocating the abolition of fractional reserves, money will always be created somewhere, somehow, by somebody. Finally, you completely ignore the issue of what happens when desired saving exceeds investment demand. Today’s problem is not one of the Fed having to artificially create “saving” because consumers and businesses are not doing enough private saving. That’s completely ludicrous. Today’s problem is that consumers and private businesses are wanting to save too much relative to investment demand because we’re in a balance sheet recession. In fact, there is so much saving as consumers and businesses repair balance sheets relative to investment assets, that the natural interest rate should be negative. You seem to have it in your head that the solution today’s problems is increased saving. Wrong. There is no doubt that consumers and businesses want to save more and should save more because that’s what a balance sheet recession is all about. But if consumers and businesses all want to save, then some other entity has to borrow. And that entity really has to be the government.

  12. don

    The crisis of demand is also one of its global distribution. China and Germany are huge net savers, taking AD from other countries. China does this with capital controls and huge currency interventions. Germany does it by arranging to keep its currency undervalued through membership in the euro. China should be forced to relinquish its dollar peg, and Germany should leave the euro.

  13. Bryce

    I appreciate your effort in trying to educate me. I’m cognizant of fractional reserve banking as building on the money creation of their Mother, the Fed. If we had free market provision of money & banking, they would expand credit with infinitely more care than they do [before FDIC, banks advertised that they maintained >20% capital, twice today's lever--not to imply that this was a time of free market banking but a smidgen closer than now]. These banks are essentially mere amplifiers of what the Fed wants [well, granted not so much when they are scared to death]. But that is why I abbreviated & left them out. But at least agree that they could not have created the credit bubbles of 2000 & 2007 without the seed sewn–the monetary base– by the Fed & other central banks.
    Bernanke enforces his decree by purchasing bonds with freshly created money. He is lending money that has not been saved but created out of thin air. That’s pretty simple.
    I submit to you that the measurement of savings is not so simple. The entire world is much, much poorer than it thinks presently. It suffers an illusion, enabled by fiat money, that it is richer because it doesn’t recognize that vast sums of debt, currently seen as good, will never be paid back & is therefore bad. The US, Europe, Japan, the provinces of China…none of these will honor their liabilities. Nor will many US pension funds. So much of what you might measure as wealth today will vanish.

  14. Menzie Chinn

    Bryce: Hmm. Consider Head Start. Kids get free breakfasts. Would it have been better for them to starve a bit and have less protein during those critical years of brain development? Maybe. Perhaps it serves their parents right for not being sufficiently attentive. After all, as Governor Romney said, the best thing for getting into a good school is to have rich parents. My guess is starving before lunch promotes lethargy. Your guess I suspect differs. In which case, go poorhouses!

  15. Bryce

    Chinn the mocker. What a talent you have. Unrelated to what I asserted.
    But on your tangent, I must wonder how anyone ever survived to adulthood & even thrived in those days of yore before Head Start.

  16. 2slugbaits

    Bryce For someone who manages to get himself so exercised about “honest” prices, you seem strangely silent about the dishonest prices of risk that came from the Big Three risk assessors that deliberately overstated the quality of what were really toxic assets. All brought to you by the miracle healing powers of the unregulated free market.

  17. Bryce

    In the brilliance of your pedagogic technique of sarcasm, I’m sure you’ve have dealt with the Keynesian flaw of assumption of homogeneous capital somehow. But alas, it is sarchasm to me.

  18. Menzie Chinn

    Bryce: You made the data free assertion about lethargy. And the policy prescription for “government to get the hell out of the way.” If you use language like that, your comments are to me eminently mockable. There is so much to work with.

  19. Bryce

    The mis-regulation of the rating agencies is responsible for the perverse way in which they are paid. Govt caused the rating agencies to be paid by the bond-issuers rather than the buyers. The market would never have produced that stupid a set up. That is why there assessments were worse than worthless.
    Well, I see where you are coming from at least. What I cared about in my statement was the mistake Keynesianism makes with regard to the heterogenicity of capital. If I had said less hyperbolically, that the efficient deployment of these various resources requires govt to regulate more reasonably, to quit subsidizing various companies, to refrain from distorting market prices, etc–would I have gotten different answers?

  20. sherparick

    Bryce: “Okay, yes, programs that let people get something for nothing do promote lethargy. There is little doubt that this could be measured by an econ study. In fact, I’m pretty sure it has been measured with regard to length of unemployment insurance, tho’ I don’t mean to demean reasonable unemployment ins. by mentioning it.”
    Actually, salt water economists have tried to measure it and found it insignificant, since being without a job at 55% of one’s old wages with debts to pay means a drastic cut in one’s standard of living. http://www.brookings.edu/~/media/Files/Programs/ES/BPEA/2011_fall_bpea_papers/2011_fall_bpea_conference_rothstein.pdf
    But for Freshwater economists like Bryce and Casey Mulligan, “incentives” and “moral hazard” only apply to the lower orders of society (I don’t see them organizing for the abolition of tenure and introducing a 1 year annual auction for economic professor positions).

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