And About Those Structural Imbalances

I think Matt Yglesias is closing in on a crucial difference between two sides in this debate about how to get out of our current economic mess, a difference that doesn’t divide neatly along a right-versus-left axis.

On the one hand are people who say: we’re in a funk because of a massive hit to aggregate demand. What caused that hit – presumably the massive financial crisis triggered by the fall in housing prices – is less important than the fact of the hit. Monetary policy has the tools to reduce the attractiveness of holding money. If money is less attractive, then goods and services become relatively more attractive, so aggregate demand goes up. So the Fed should use those tools to dig us all the way out of the recession, all the way back to full employment. Then we can talk about structural stuff, ways to make the economy more efficient as well as ways to better distribute the gains from increased efficiency.

On the other hand are people who say: we’re in a funk because of a massive hit to aggregate demand, but the cause of that hit needs to be fully understood so that we can solve the problem correctly. The proximate cause of the hit to demand was the banking crisis. The proximate cause of the banking crisis was a drop in housing values. But the broader cause of the crisis was that consumption growth in the 2000s was overwhelmingly driven by rising consumer debt. Consumer debt was rising because wages were not keeping up with the rising cost of living. The large gains in global productivity in the 2000s, to the extent that they accrued to the United States, were captured as what amount to rents by the health and financial sectors.

Yglesias says:

The way this story goes is that we had steady productivity gains going back 10-15 years, related both to Asian manufacturing and to technological change. This freed up workers to go do other things. But instead of putting the workers to productive uses, they went off to toil in an unsustainable boom in housebuilding. When this boom collapsed, what we were left with was not 1-2 years of productivity growth but an entire decade’s worth of displaced labor. The entire growth experience of the aughts wasn’t so much wiped out in the recession as revealed to have been an illusion in the first place. Now we need to essentially start over, and restructure the American economy to find useful ways to employ people.

But the illusion wasn’t that we engaged in a binge of housebuilding. It’s that we engineered a massive speculative bubble in land, and then borrowed against those appreciated values to finance current consumption. That was the illusion.

The structural change that didn’t happen was moving American labor up the value chain so that American workers (not just Chinese workers) were seeing rising productivity, which would be more likely to drive rising American wages, and combating the financialization of American industry that wasn’t just driving more income into the hands of the already wealthy but, more specifically, seeing finance capture a larger and larger percentage of aggregate American profits.

Both of these are hard tasks. China still has a whole lot of low-hanging fruit to pluck. (As do India, Indonesia, Vietnam, Brazil, Turkey, Nigeria . . . it’s a big world out there.) Their productivity gains are doing wonderful things for world wealth, but China is going to capture the lion’s share of those gains. And the impact on the United States and other developed countries will be brutal if we don’t figure out how to make our service sectors more productive and move up the value chain ahead of these rising economic powers. And financialization is easy to diagnose but difficult to combat in a world of globalized finance. The countries that have done the best at it are relatively small economies (like Canada) that aren’t particularly good models for a country like the United States.

These problems, already manifesting themselves in the 1990s, were completely unaddressed in the 2000s. If anything, they were exacerbated. But we still saw a recovery in demand because of rising housing values.

That was the illusion. When the illusion went away, ordinary Americans experienced a sharp shock to their expectations of future wealth. In aggregate, they did not believe they could consume at the level that they had been – because their previous consumption was financed by debt backed by an asset that was now depreciating, not appreciating.

To combat the recession, yes, we need to avoid falling into outright deflation. But once we’ve achieved price stability, monetary policy has done its job. And that won’t solve the whole problem. It didn’t after the last, much milder recession – inflation was already picking up in 2004, and yet unemployment had barely budged. What brought down unemployment after that was the debt-fueled rise in consumption. That’s the experience we don’t want to repeat.

The amount of inflation it would take to get out from under the mountain of consumer debt we have accumulated is not to be contemplated. The amount of savings it would take is similarly not to be contemplated; that huge spike in savings is what is prolonging the recession. To get out from under the debt will require clearing the market, which in turn means government intervention in the housing finance market. Those tools exist; we should use them, even if it means we have to bail out the banks again.

But we’d still have to convince people that they can rationally expect higher wages in the future. And I really do believe that the only way to do this is to tackle some of the structural problems in our economy as outlined above. I’m open to what are considered right-wing and what are considered left-wing approaches to achieving those goals – as, I believe, is the Obama Administration, though I don’t think they’ve put a whole lot of energy behind any of them.

That’s the fundamental divide between myself and those who advocate a policy of “boost aggregate demand now and worry about the fundamentals later.” I think we need to understand why we had such a big hit to aggregate demand in order to boost it without causing a bigger problem down the road. It’s not a left-versus-right debate. I count on my side of the debate Jeffrey Sachs, Paul Volcker, Joseph Stiglitz and, it appears, President Barack Obama. If anything, it’s mainly a debate within the left.