The Short Run and the Long Run: Savings Gluts, Investment Shortfalls, too-Low Inflation Targets, Reduced Risk-Bearing Capacity, and the Failures of Our Public Sphere...: Monday Focus
Back in 2007 and before I taught my students that the United States was a flexible economy. It had employers who would be willing to gamble and hire when they saw workers who would be productive without work. It had workers who would be willing to move to opportunity, or to try something new in order to get a job. And as these processes took place--as entrepreneurial workers and bosses took a chance--supply would indeed create its own demand. Adverse shocks to spending could indeed create mass unemployment and idle capacity, but their effects would be limited it to one, two, or at most three years. The way to bet, I told my students back in 2007 and before, was that the United States economy would recover roughly 40% of the ground between its current situation and its full employment potential and each year after the initial downturn had come to an end. 022 years, I said, was the domain of the Keynesian (and monetarist) short run. When analyzing events at a 3-7 year horizon, I taught, you were safe assuming a "classical" model--one in which the economy would return to full employment, and in which changes in economic policy and in the economic environment would change the distribution but not the level of spending, production, and employment. And beyond seven years was the domain of economic growth and economic institutions.
All of this is now revealed to be wrong for today.
We will argue over whether it was always wrong, and my sect of economists were foolish, or whether we were right for the past but the world has changed and so we were wrong for the present and the future. But the example of Japan since the start of the 1990s provides us with very strong evidence that the short run can last for decades, and even after decades be followed not by a return to the old normal, but rather by a transition to a new normal in which the Keynesian short run of economic depression casts a very long shadow indeed.
The default framework for thinking about these questions is a very old one: the market-and-natural interest-rate framework of Knute Wicksell's *Geldzins und Guterpreis*. In every economy, the argument goes, there is a market interest rate determined by the financial system, and there is a natural interest rate--in value of the interest rate at which desired savings at full employment is just equal to desired investment at full employment, and at which the economy as a whole desires neither to leverage nor to deleverage. If the economy as a whole desires to leverage up, then we have an inflationary boom. If the economy as a whole desires to deleverage, then we have a depression. It is then the business of the Central Bank to intervene in the banking system in order to push the market interest rate to the natural interest rate, and so balance the economy at full employment without excess inflation.
In this framework, the problem right now is that the natural interest rate--the liquid safe nominal interest rate on short-term Treasury securities, that is--is less than zero. Thus the Central Bnk cannot push the market interest rate there, and until something happens to raise the natural interest rate we are stuck with a depressed economy. Some blame a global savings glut for this state of affairs, and call for less thrift--but if we were at full employment we would recognize the world is still in impoverished with mammoth growth opportunities, and to sacrifice the growth of the future for the well-being of the present is a second-best at best. Some blame a global investment shortfall driven by an exhaustion of technological opportunities for this state of affairs, but in my eyes at least this is a caste of thought that springs up in every deep depression rather than a clear-eyed view at our world. Some say if only we had a 5% per year inflation target rather than our current 2% per year inflation target the problem would resolve itself, for the loss of 5% of the real purchasing power that people board in cash each year would induce the boost in real investment we need. I think they are probably right, but both Paul Volker and Alan Greenspan would warn us that a 5% per year inflation target is ultimately unsustainable: people can be happy with a stable 2% per year inflation target--that is too low to notice--but 5% per year would eventually become 10% per year, and 10% per year would eventually become 20% per year, and then we face either another deep recession like 1982 or even more unpleasant alternatives. And then there is a fourth group of economists today, centered around Ricardo Caballero of MIT, it seems the problem as a global shortage of safe assets, or perhaps a global absence of risk-bearing capacity to be happy holding the market portfolio with the limited stock of safe assets outstanding. This train of thought leads to policies to better mobilize the financial risk-bearing capacity of society, and calls for clever thought to figure out how to use the public sector to outwit the forces of time and ignorance that curb the willingness to engage in risky investments.
Four theories. All four advocated by smart, thoughtful, and hard-working economists were giving it their best shot. In a good world we would have a vibrant public sphere in which a sophisticated debate among these four points of view too place--a debate which would then inform economic policy.
We do not.
And the fact that we do not is, perhaps, the root cause of the unfortunate circumstance that we are now looking at not one but two or more lost decades of economic growth.