Raghuram Rajan has an interesting post now up on Project Syndicate. The overall tone of it has an Austrian feel as it stresses the failure of stimulus to allow developed economies to attain higher GDP growth a full five years after a financial crisis because of supply side problems. I would like to add a few comments to what Rajan says.
Here’s the part I think encapsulates Rajan’s argument:
the bust that follows years of a debt-fueled boom leaves behind an economy that supplies too much of the wrong kind of good relative to the changed demand. Unlike a normal cyclical recession, in which demand falls across the board and recovery requires merely rehiring laid-off workers to resume their old jobs, economic recovery following a lending bust typically requires workers to move across industries and to new locations.
There is thus a subtle but important difference between my debt-driven demand view and the neo-Keynesian explanation that deleveraging (saving by chastened borrowers) or debt overhang (the inability of debt-laden borrowers to spend) is responsible for slow post-crisis growth. Both views accept that the central source of weak aggregate demand is the disappearance of demand from former borrowers. But they differ on solutions.
The neo-Keynesian economist wants to boost demand generally. But if we believe that debt-driven demand is different, demand stimulus will at best be a palliative. Writing down former borrowers’ debt may be slightly more effective in producing the old pattern of demand, but it will probably not restore it to the pre-crisis level. In any case, do we really want the former borrowers to borrow themselves into trouble again?
The only sustainable solution is to allow the supply side to adjust to more normal and sustainable sources of demand
I agree with the thrust of this post. I would put it this way:
Richard Koo is right; private debt is the problem now in developed economies generally as it was in Japan twenty years ago following Japan’s housing bust. And Koo’s thesis that the private sector undergoes a balance sheet recession because of this debt problem has been borne out via the post-financial crisis economic paths in the most troubled economies. All of these countries have struggled with private deleveraging, defaults, and the resulting shortfall of capital and insolvency in the financial sector.
More importantly, however, the balance sheet recession paradigm has been validated by the unusually large declines in GDP growth we have witnessed in the euro zone periphery as austerity has been applied as the solution to what ails those economies. The IMF has admitted it got things wrong when it recommended front-loaded austerity regimes in Portugal, Ireland, Italy, Greece, and Spain. They had expected government cuts to be partially offset by additions in the private sector, when, in fact, an understanding of an economy’s sectoral balances would dictate that government cuts would engender additional private cuts due to the need of the debt-laden private sector to net save. So the economic reaction to austerity that was anticipated as 50 cents on the euro was actually as high as 170 cents on the euro. And please note, the IMF is still saying that this policy response will be effective.
So, it’s clear that Europe got it wrong. But while austerity makes the situation worse, it is not clear that stimulus ‘works’. Why? If private debt is still inhibiting demand due to private balance sheet issues, the need for deleveraging tells us that stimulus geared to debt-laden sectors of the economy won’t be as additive to GDP as thought by advocates of stimulus. These sectors are relatively ‘over-supplied’ given the relationship between asset values and the high levels of debt secured by those assets. In countries like Ireland, Spain, the US and the UK, for example, household debt is still high largely because of mortgage debt. Yet, house prices are still well below their apogee in 2006 and 2007. Any stimulus directed to those sectors is going to induce a larger than expected net savings in the household sector as households continue to repair balance sheets.
Moreover, as Rajan nots in his essay, general stimulus also suffers from the same effect in that much of the stimulative effect will go toward repairing balance sheets geared to assets in the sectors suffering over-indebtedness. In the absence of supply side efforts, I see stimulus as a socialisation of losses, then. It is a gearing up of the public balance sheet as a means of maintaining demand and gearing down private balance sheets.
Japan is the furthest along of the developed economies in this effort – and we can see the results: modest deflation, anemic GDP growth, short and shallow business cycles, rising poverty, high fiscal deficits, and large public sector indebtedness. Right now, most everyone seems to believe the euro crisis is over and the US is in full recovery. I don’t believe either of these things. With Japan as a guide, I believe that we are poised for more problems if and when government stimulus recedes because the private indebtedness related to encumbered assets is still high in the crisis countries. And when the next round of crisis hits, disinflation turning to deflation will be the problem that exacerbates the situation via increasing real interest rates and the knock-on effects of housing-related problems and renewed focus on the currency wars as a panacea.
As I wrote about Japan over three years ago when we were beginning on this path of emulating the Japanese, “stimulus without reform leads to a policy cul de sac“. Demand side solutions can only go so far. The Austrians use the term “malinvestment” to describe why you need to work on the supply side. And I think their focus on the supply side has merit. If we want to move beyond the balance sheet recession paradigm quickly, the supply side has to be addressed too. Japan continues to focus on the demand side, and twenty years later, they are still in a world of hurt.
Source: Project Syndicate