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Contra Raghu Rajan: Economic Stimulus Has Not Failed, It Has Not Been Tried (on a Large Enough Scale)

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Perhaps the most fundamental truth of monetary economics that the government can always boost (or reduce) the flow of spending, and in a sticky-price world thus drive the flow of production and employment wherever it wants. As Ben Bernanke said, as a last resort to increase production and employment the government can simply throw money out of helicopters--less picturesquely, cut taxes and print cash to fill the resulting deficit, or to get a little more umph buy extra stuff and thus put some extra unemployed people to work in the process of getting the money out into the economy. Expansionary fiscal and expansionary monetary policy together trigger a rise in the circular flow of nominal spending, and unless price expectations are unanchored and prices flexible enough that 100% of that rise shows up as higher inflation, the greater circular flow puts more people to work making more stuff.

Economists fight over what happens when you do one of the two--when you just do a monetary expansion buying government bonds for cash (because people might not spend their extra cash but hoard it as a savings vehicle), or when you just do a fiscal expansion buying stuff or cutting taxes and paying for it not by printing money but by selling bonds (because purchases of government bonds that crowd-out purchases of private bonds simply shift demand away from private investment). Economists fight over what share of the increase in the nominal circular flow will show up as higher prices as opposed to higher output--over what the natural rate of unemployment is, and how it was affected by the crisis.

But back in 2007 I would have said that every macroeconomist who has done any homework at all believes that coordinated monetary and fiscal expansion together increase at least the flow of nominal GDP.

Now comes the very smart Raghu Rajan to say, apparently, not so:

Why Stimulus Has Failed: Two fundamental beliefs have driven economic policy around the world in recent years… the world suffers from a shortage of aggregate demand… [and] monetary and fiscal stimulus will close the gap. Is it possible that the diagnosis is right, but that the remedy is wrong?…

High levels of involuntary unemployment throughout the advanced economies suggest that demand lags behind potential supply…. What if the problem is the assumption that all demand is created equal?… When borrowing becomes easier… the increase [in demand] comes from poorer and younger families whose needs and dreams far outpace their incomes…. Moreover, the goods that are easiest to buy are those that are easy to post as collateral – houses and cars, rather than perishables…. [D]ebt-fueled demand emanates from particular households in particular regions for particular goods…. [A]s lending dries up, borrowing households can no longer spend, and demand for certain goods changes disproportionately, especially in areas that boomed earlier….

It is [then] easy to see why a general stimulus… may be ineffective…. The general stimulus goes to everyone, not just the former borrowers… the older, wealthier household buys jewelry from Tiffany, rather than a car from General Motors…. Indeed, because the pattern of demand that is expressible has shifted with the change in access to borrowing, the pace at which the economy can grow without inflation may also fall…. 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…. [I think] only sustainable solution is to allow the supply side to adjust to more normal and sustainable sources of demand – to ease the way for construction workers and autoworkers to retrain for faster-growing industries. The worst thing that governments can do is to stand in the way by propping up unviable firms or by sustaining demand in unviable industries through easy credit. Supply-side adjustments take time…. But continued misdiagnosis will have lasting effects…

From my perspective, what Raghu is doing is saying that if we were to undertake more aggressive coordinated monetary and fiscal expansion we would hit the inflation wall sooner than I think likely--that the difficulties of retraining and readjustment mean that the division of the increase in the flow of spending would soon shift to 100% inflation, 0% extra production. Perhaps it will. But we have not gotten there yet. We are still in a world where the flow of nominal GDP in the North Atlantic is some six percentage points below its pre-2008 trend.

Fix that trend of nominal GDP first via coordinated monetary and fiscal expansion, and then we will examine the division at the margin of PY into P and Y, and talk…