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Beyond the Stimulus Package; The Rest of the Solution to the Crisis—A Commentary by James Kwak ’11

The following commentary was published in The Politic on March 19, 2009.

Beyond the Stimulus Package; The Rest of the Solution to the Crisis
By James Kwak ’11

James Kwak is a student at the Yale Law School and a co-author of The Baseline Scenario, a popular economics blog.

The Obama Administration faces a set of economic challenges perhaps more daunting than any faced by an incoming administration since 1933. We have a financial sector on life support, a plunging housing market, a large government deficit (predating the current crisis), a plunge in personal consumption, and a severe global recession. Even before the crisis, we faced a looming retirement savings shortfall, largely due to a broken and expensive health care system.

The one silver lining is that the depth of today’s problems provides a rare opportunity to take decisive action to repair the economy. And Obama’s economic team is responding with a large fiscal stimulus package, with large outlays for public infrastructure projects that would have been inconceivable in the “private sector knows best” climate of the past two decades.  

The economic justification for the stimulus is simple: given a self-reinforcing drop in personal consumption, an increase in government demand is necessary to stabilize economic activity. Backing for the stimulus comes from virtually the entire spectrum of economists, even including Martin Feldstein, the esteemed conservative economist. This is an easy choice.

However, a large blast of spending and tax cuts is only one ingredient of an economic recovery. Unless we want to repeat Japan’s “lost decade” of the 1990s, it must be accompanied by several other measures. Obama’s economic team is aware of these issues. Unfortunately, however, they require political choices that are more difficult than the stimulus.

Ending the recession

In the short term, ending the recession requires two things in addition to a stimulus program. One is a healthy banking system. Although the current crisis has reduced demand for credit, any economic recovery will increase demand for credit, and banks and the bond market have to respond to that demand. Since Lehman, bailouts of financial institutions have managed to stave off any major collapses, but the banking sector remains undercapitalized, weighed down by the toxic assets on their balance sheets, and increasingly vulnerable as the recession deepens. The sector needs more capital or some way to put a floor under the value of its toxic assets or both. However, given the way the first rounds of bailouts were conducted, the public is deeply skeptical of any further aid to the financial sector.

Second, we need inflation to return to the two percent range, where it has been for several years. We are a nation of borrowers—on the household and government levels—who borrowed money at six percent when inflation was about two percent, meaning our real interest rates were four percent. However, expected inflation over the next five years (implied by the spread between regular and inflation-indexed Treasury securities) is zero percent, making those real interest rates are more like six percent. This significantly increases our debt burden, crimping consumption. The Obama team will have to work with the Federal Reserve and Ben Bernanke to restore inflation to a moderate level; again, the idea of increasing inflation may be politically unpopular.

Finding sustainable economic growth

A large fiscal stimulus, a healthy banking sector, and expansionary monetary policy will probably get us out of this recession within the next 9-18 months. (A majority of forecasters tracked by the Wall Street Journal actually expect growth beginning in Q3 this year, but these forecasts have been consistently revised downward since the beginning of the crisis.) However, the recession will cause a lasting adjustment in the makeup of the economy, as nervous consumers adjust their consumption patterns permanently in favor of greater saving. For the last decade, economic growth has been fueled by increased consumption financed by debt. This is mainly true of households but also holds true of the Bush Administration, which fought two debt-financed wars while pushing through two of the largest tax cuts in history. In the absence of debt-financed consumption, the economy needs to find an alternative source of growth; otherwise, once the stimulus program fades away, we will be left with better roads and bridges and not much else.

First, there needs to be better regulation of the financial sector. This issue got a lot of attention in the heady days of September and October but has been put on the back burner as the real economy has worsened. The problems that evolved in the financial sector—near-predatory lending, high leverage, incentive structures that led to unhealthy degrees of risk, lack of transparency regarding derivatives and off-balance sheet vehicles, over-reliance on faulty models, and occasional outright fraud—were not simply the result of the free market. Rather, they were the result of regulatory capture, in which financial institutions gained disproportionate influence over the legislators and regulators who were supposed to be looking out for the interests of the public—best illustrated by a 2003 press conference where the head of the Office of Thrift Supervision and the Vice Chairman of the FDIC used tree shears and a chainsaw to attack a stack of bank regulations. Ironically, the financial crisis has created behemoth financial institutions that are even larger and politically more powerful than before—notably JPMorgan Chase, Bank of America, and Citigroup—and that will require regulation that is both more powerful and better adapted to today’s complex financial world.

Second, some other part of the economy needs to grow. From 1998 to 2005, the financial services industry contributed fully 50 percent of all growth in corporate profits in the United States because of the boom in lending. The big question is where economic growth will come from in the future. Some on the left wing of the administration may push for an explicit industrial policy, in which the government backs specific industry sectors as engines of growth, but the centrists who make up most of Obama’s economic team are unlikely to adopt this approach.

Progress in a capitalist economy comes from the forces of innovation and reallocation, as Daron Acemoglu outlined in The Crisis of 2008: Structural Lessons for and from Economics. Over the last twenty years, growth of the U.S. economy has been largely driven by innovation, some of it in the financial sector, but largely in real technology—computers, the Internet, pharmaceuticals, medical care, and so on. While it may be unwise for the government to dictate what the next engine of economic growth will be, it does make sense for the government to establish policies that promote technological innovation in general. From an economic standpoint, basic research and development (R&D) has positive externalities—general benefits that escape the control of the party that is conducting the research—and therefore businesses left to themselves will underinvest in R&D relative to the socially optimal level. Historically, the government has played a near-legendary role in the development of basic technologies that have led to practical innovation, from the Manhattan Project to the Internet (originally a project of the Defense Advanced Research Projects Agency). Investment in the raw materials of innovation—education and basic research—will be necessary to ensure that our economy continually finds new areas of growth in the future.

There is at least one sector where targeted government investment is warranted: sustainable energy. Again, the economic rationale is one of externalities. Fossil fuels have negative externalities—both environmental and geopolitical—that lead to overconsumption relative to the socially optimal level. Research incentives and outright (temporary) subsidies for sustainable energy are appropriate means to coax our economy onto alternative energy sources. And because of the technology-intensive nature of this sector, this could provide a major source of innovation and growth for our economy.

Promoting innovation is relatively uncontroversial (except for the issue of cost); promoting reallocation, however, is controversial. Reallocation means that capital and labor should shift from relatively unproductive to relatively productive sectors—for example, from industries where we have little advantage over foreign, lower-cost competitors, to industries where we do have advantages in technology, design, and marketing.

The controversy is evident in the debate over the auto industry and whether it should be bailed out and on what terms. While there are strong arguments that the industry should not be allowed to collapse in an uncontrolled way, especially in the midst of a severe recession, in the long term it would be even more harmful to prop up an uncompetitive automotive sector indefinitely, thereby deterring capital and labor from shifting to more productive uses. For reasons of politics and short-term economics, the Obama Administration will need to give the Big 3 auto manufacturers one more chance to become sustainable, profitable companies (and there is no inherent reason why the U.S. should not be able to have one or more globally competitive car companies); but this cannot become an open-ended commitment to protect jobs at any cost or a campaign to protect U.S. companies from foreign competition. The example of Pittsburgh shows that an entire region can successfully shift out of one dominant sector—in this case, from steel to education, health care, and technology—and even New York was once a manufacturing center.

Long-term fiscal sustainability

Obama’s economic team intends to take bold measures to restore the economy to growth. But, critics worry, how are they going to pay for all of this? While the conventional wisdom is that it is appropriate to run large deficits in order to get out of a recession, the folly, in hindsight, was running large deficits—padded by major tax cuts—during the recent boom, thereby limiting the government’s freedom of action, now when it needs it most.

But while the current deficits are large, they will decline when the economy resumes growth, and are only a small fraction of the anticipated multi-trillion-dollar shortfalls in funding for Social Security and Medicare. In the long term, the government’s ability to borrow money at low rates depends on investors’ confidence that it can address those shortfalls. And because multi-decade projections are highly sensitive to assumptions about economic growth, one of the most important things the government can do to bolster that confidence is restore the economy to long-term growth in productivity and output. If we can achieve robust economic growth, our other challenges—including ensuring retirement security—all become a little less daunting.