Sunday, 1 February 2009
Making the Most of a Recovery
The U.S. economy will recover. It won’t recover anytime soon. It is likely to get significantly worse over the course of 2009, no matter what President Barack Obama and Congress do. And resolving the financial crisis will require both aggressiveness and creativity. In fact, the main lesson from other crises of the past century is that governments tend to err on the side of too much caution - of taking the punch bowl away before the party has truly started up again.
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Making the Most of a Recovery
By David Leonhardt
30 January 2009
The U.S. economy will recover. It won’t recover anytime soon. It is likely to get significantly worse over the course of 2009, no matter what President Barack Obama and Congress do. And resolving the financial crisis will require both aggressiveness and creativity. In fact, the main lesson from other crises of the past century is that governments tend to err on the side of too much caution - of taking the punch bowl away before the party has truly started up again.
“The mistake the United States made during the Depression and the Japanese made during the ‘90s was too much start-stop in their policies,” Timothy Geithner said when I went to visit him in his transition office a few weeks ago, before he became the U.S. Treasury secretary. Japan announced stimulus measures even as it was cutting other government spending. Franklin D. Roosevelt flirted with fiscal discipline midway through the New Deal, and the country slipped back into decline.
Geithner arguably made a similar miscalculation himself last year as a top Federal Reserve official who was part of a team that allowed Lehman Brothers to fail. But he insisted that the Obama administration had learned history’s lesson.
“We’re just not going to make that mistake,” Geithner said. “We’re not going to do that. We’ll keep at it until it’s done, whatever it takes.”
Once governments finally decide to use the enormous resources at their disposal, they have typically been able to shock an economy back to life. They can put to work the people, money and equipment sitting idle, until the private sector is willing to begin using them again.
But while Washington has been preoccupied with stimulus and bailouts, another, equally important issue has received far less attention - and the resolution of it is far more uncertain. What will happen once the paddles have been applied and the economy’s heart starts beating again? How should the American economy be remade? Above all, how fast will it grow?
That last question may sound abstract, even technical, compared with the current crisis. Yet the consequences of a country’s growth rate are not abstract at all. Slow growth makes almost all problems worse. Fast growth helps solve them. As Paul Romer, an economist at Stanford University, has said, the choices that determine a country’s growth rate “dwarf all other economic-policy concerns.”
Growth is the only way for a government to pay off its debts in a relatively quick and painless fashion, allowing tax revenue to increase without having to raise tax rates. That is essentially what happened in the years after World War II. When the war ended, the U.S. government’s debt equaled 120 percent of the gross domestic product (more than twice as high as its likely level by the end of next year). The rapid economic growth of the 1950s and 1960s - more than 4 percent a year, compared with 2.5 percent in this decade - quickly whittled that debt away. Over the coming 25 years, if growth could be lifted by just one-tenth of a percentage point a year, the extra tax revenue would completely pay for an $800 billion stimulus package.
Yet there are real concerns that the U.S. economy will not grow enough to pay off its debts easily and ensure rising living standards, as happened in the postwar decades, because two of the economy’s most powerful recent engines have been exposed as a mirage: the explosion in consumer debt and spending, which lifted short-term growth at the expense of future growth, and the great Wall Street boom, which depended partly on activities that had very little real value.
Richard Freeman, a Harvard economist, argues that the U.S. bubble economy had something in common with the old Soviet economy. The Soviet Union’s growth was artificially raised by huge industrial output that ended up having little use. America’s was artificially raised by mortgage-backed securities, collateralized debt obligations and even the occasional Ponzi scheme.
Where will new, real sources of growth come from? Not from Wall Street, probably. Nor, obviously, from Detroit. Nor from Silicon Valley, at least not by itself. Well before the housing bubble burst, the big productivity gains brought about by the 1990s technology boom seemed to be petering out.
So for the first time in more than 70 years, the epicenter of the U.S. economy can be placed in Washington. And Washington won’t merely be given the task of pulling the economy out of the immediate crisis. It will also have to figure out how to put it on a more sustainable path - to help it achieve fast, broadly shared growth and do so without the benefit of a bubble. Obama said as much in his inauguration speech when he pledged to overhaul Washington’s approach to education, health care, science and infrastructure, all in an effort to “lay a new foundation for growth.”
For centuries, people have worried that economic growth had limits - that the only way for one group to prosper was at the expense of another. The pessimists, from Malthus and the Luddites and on, have been proved wrong again and again. Growth is not finite. But it is also not inevitable. It requires a strategy.
The upside of a downturn
Two weeks after the election, Rahm Emanuel, Obama’s chief of staff, appeared before an audience of business executives and laid out an idea that Lawrence Summers, Obama’s top economic adviser, later described to me as Rahm’s Doctrine. “You never want a serious crisis to go to waste,” Emanuel said. “What I mean by that is that it’s an opportunity to do things you could not do before.”
In part, the idea is standard political maneuvering. Obama had an ambitious agenda - on health care, energy and taxes - before the economy took a turn for the worse in the autumn, and he has an interest in connecting the financial crisis to his pre-existing plans. “Things we had postponed for too long, that were long term, are now immediate and must be dealt with,” Emanuel said in November.
Of course, the existence of the crisis does not require the Obama administration to deal with education or health care. But the fact that the economy appears to be mired in its worst recession in a generation may well allow the administration to confront problems that have festered for years.
The counter-argument is hardly trivial - namely, that the financial crisis is so serious that the administration should not distract itself with other matters. That is a risk, as is the additional piling on of debt for investments that might not bear fruit for a long while. But Obama may not have the luxury of trying to deal with the problems separately. This crisis may be his one chance to begin transforming the economy and avoid future crises.
In the early 1980s, an economist named Mancur Olson developed a theory that could fairly be called the academic version of Rahm’s Doctrine. Olson, a University of Maryland professor who died in 1998, is one of those academics little known to the public but famous among his peers. His seminal work, “The Rise and Decline of Nations,” published in 1982, helped explain how stable, affluent societies tend to get in trouble. The book turns out to be a surprisingly useful guide to the current crisis.
In Olson’s telling, successful countries give rise to interest groups that accumulate more and more influence over time. Eventually, the groups become powerful enough to win government favors, in the form of new laws or friendly regulators. These favors allow the groups to benefit at the expense of everyone else; they not only end up with a larger piece of the economy’s pie but also do so in a way that keeps the pie from growing as much as it otherwise would. Trade barriers and tariffs are the classic example. They help the domestic manufacturer of a product at the expense of millions of consumers, who must pay high prices and choose from a limited selection of goods.
Olson’s book was short but sprawling, touching on everything from the Great Depression to the caste system in India. His primary case study was Britain in the decades after World War II. As an economic and military giant for more than two centuries, it had accumulated one of history’s great collections of interest groups - miners, financial traders and farmers, among others. These interest groups had so shackled Britain’s economy by the 1970s that its high unemployment and slow growth came to be known as “British disease.”
Germany and Japan, on the other hand, had to rebuild their economies and political systems after the war. Their interest groups were wiped away by the defeat. “In a crisis, there is an opportunity to rearrange things, because the status quo is blown up,” Frank Levy, an economist at the Massachusetts Institute of Technology and an Olson admirer, told me recently. Olson’s insight was that the defeated countries of World War II didn’t rise despite crisis. They rose because of it.
The parallels to the modern-day United States, though not exact, are plain enough. America’s long period of economic pre-eminence has produced a set of interest groups that, in Olson’s words, “reduce efficiency and aggregate income.” Home builders and real estate agents pushed for housing subsidies, which made many of them rich but made the real estate bubble possible. Doctors, drug makers and other medical companies persuaded the U.S. government to pay for expensive treatments that had scant evidence of being effective. Those treatments are the primary reason the United States spends so much more than any other on medicine. In these cases, and in others, interest groups successfully lobbied for actions that benefited them and hurt the larger economy.
Surely no interest group fits Olson’s thesis as well as Wall Street. It used an enormous amount of leverage - debt - to grow to unprecedented size.
In good times - or good-enough times - the political will to beat back such policies doesn’t exist. Their costs are too diffuse, and their benefits too concentrated. A crisis changes the dynamic. It’s an opportunity to do things you could not do before.
Britain’s crisis was the Winter of Discontent, in 1978-79, when strikes paralyzed the country and many public services shut down. The resulting furor helped elect Margaret Thatcher as prime minister and allowed her to sweep away some of the old economic order. Her laissez-faire reforms were flawed in some important ways - taken to an extreme, they helped create the current financial crisis - and they were not the only reason for England’s turnaround. But they made a difference. In the 30 years since her election, Britain has grown faster than Germany or Japan.
The investment gap
One good way to understand the current growth slowdown is to think of the debt-fueled consumer-spending spree of the past 20 years as a symbol of an even larger problem. As a country, the United States has been spending too much on the present and not enough on the future. Americans have been consuming rather than investing. They are suffering from investment-deficit disorder.
You can find examples of this disorder in just about any realm of American life. Walk into a doctor’s office and you will be asked to fill out a long form with the most basic kinds of information that you have provided dozens of times before. Walk into a doctor’s office in many other developed countries and that information - as well as your medical history - will be stored in computers. These electronic records not only reduce hassle; they also reduce medical errors. Yet Americans cannot avail themselves of this innovation even though the United States spends far more on health care, per person, than any other country. Americans are spending their money to consume medical treatments, many of which have only marginal health benefits, rather than to invest it in ways that would eventually have far broader benefits.
Along similar lines, Americans are indefatigable buyers of consumer electronics, yet a smaller share of households in the United States has broadband Internet service than in Canada, Japan, Britain, South Korea and about a dozen other countries. Then there is education: America once led the world in educational attainment by a wide margin. It no longer does. And transportation: A trip from Boston to Washington, on the fastest train in the country, takes six and a half hours. A trip from Paris to Marseille, roughly the same distance, takes three hours - a result of the French government’s commitment to infrastructure.
Tucked away in the many statistical tables at the Commerce Department are numbers on how much the U.S. government and the private sector spend on investment and research - on highways, software, medical research and other things likely to yield future benefits. Spending by the private sector has not changed much over time. It was equal to 17 percent of GDP 50 years ago, and it is about 17 percent now. But spending by the government - federal, state and local - has changed. It has dropped from about 7 percent of GDP in the 1950s to about 4 percent now.
Governments have a unique role to play in making investments for two main reasons. Some activities, like mass transportation and pollution reduction, have social benefits but not necessarily financial ones, and the private sector simply won’t undertake them. And while many other kinds of investments do bring big financial returns, only a fraction of those returns go to the original investor. This makes the private sector reluctant to jump in. As a result, economists say, the private sector tends to spend less on research and investment than is economically ideal.
Historically, the government has stepped into the void. In the 1950s and 1960s, the GI Bill created a generation of college graduates, while the Interstate System of highways made the entire economy more productive. Later, the Defense Department developed the Internet, which spawned AOL, Google and the rest.
The idea that the government would be playing a much larger role in promoting economic growth would have sounded radical, even among Democrats, until just a few months ago. After all, the European countries that have tried guiding huge swaths of their economies - that have kept their arms around the “commanding heights,” in Lenin’s enduring phrase - have grown even more slowly than the United States in recent years.
But the credit crunch and the deepening recession have changed the discussion. The U.S. government now seems as if it was doing too little to take advantage of the U.S. economy’s enormous assets: its size, its openness and its mobile, risk-taking work force. The government is also one of the few large entities today able to borrow at a low interest rate. It alone can raise the capital that could transform the economy in the kind of fundamental ways that Olson described.
“This recession is a critical economic problem - it is a crisis,” Summers told me recently. “But a moment when there are millions of people who are unemployed, when the federal government can borrow money over the long term at under 3 percent and when we face long-run fiscal problems is also a moment of great opportunity to make investments in the future of the country that have lagged for a long time.”
He then told a story that John F. Kennedy liked to tell, about an early-20th-century French marshal named Hubert Lyautey. “The guy says to his gardener, ‘Could you plant a tree?’?” Summers said. “The gardener says, ‘Come on, it’s going to take 50 years before you see anything out of that tree.’ The guy says, ‘It’s going to take 50 years? Really? Then plant it this morning.”‘
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