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Home Opinion Spurring growth in an era of constraints
Growth • Debt • Politics

Spurring growth in an era of constraints

Menzie Chinn - 22 May 2013

The developed countries have been struggling since 2008 to recover from the Great Recession, yet many of these have the ability to quickly repair their economies. All that is needed is the political will

For over four years, the economies of the Euro zone, the UK, US and Japan have been mired in a slow and hesitating recovery from the deepest recession since the Great Depression.  In the beginning, policymakers responded aggressively to both the illiquidity and insolvency problems in the financial systems, and the collapse in aggregate demand. However, in many instances, efforts to stimulate the economy were too soon withdrawn, or severely curtailed, despite the enormous amount of slack in these economies. In the United States, Republicans stalled any substantial increments to the 2009 stimulus legislation; in the Euro zone, the absence of a centralised fiscal authority prevented an effective response to the sovereign debt problems that arose in the periphery countries. Can we stimulate growth at a time when traditional macro-economic management tools are restricted because of seemingly unsustainable national deficits?
 
I believe it is possible to accelerate growth in these hard-hit economies, now that the nostrums of expansionary fiscal contraction have been discredited, except all but the most ideologically blindered. However, doing so requires making some difficult choices. The first step is to realise that countries that have their own currency have considerably more latitude in terms of sovereign debt borrowing than the countries of the Euro zone periphery. And those that borrow in their own currency – such as the United States, the UK, and Japan – have more latitude in terms of the amount of government debt that can be accumulated without worry of a sovereign debt crisis. Finally, countries that run current account surpluses yet again have the ability to borrow greater amounts without repercussions. In other words, a considerable number of countries have the ability to more quickly repair their economies. All that is needed is the political will.

Given that key developed countries outside of the Euro zone (and several within) have some “fiscal space” – that is room to accumulate additional debt – what should be done? In my view, policymakers need to undertake the following measures: Implement conditional inflation targeting; Expand fiscal stimulus by way of the balanced budget multiplier; and spend smartly.

1.    Conditional inflation targeting

The advanced economies have been undergoing a prolonged process of debt deleveraging, by way of default and reduced household consumption spending. The way to get private sector agents to accelerate spending is to increase the rate of inflation. As Jeffry Frieden and I have argued, this task can be accomplished by committing to conditional inflation targeting, wherein the monetary authority commits to a higher inflation target than the conventional 2% until such time as economic activity re-attains normal levels. In the United States, the Federal Reserve has done something like this, while Japan is moving to a higher inflation target than previously in place. However, the euro zone and the UK remain recalcitrant, and so much remains to be done.

Why would higher inflation result in faster growth? In conventional  macroeconomic models, higher inflation with interest rates at near zero leads to negative real interest rates, which tend to spur borrowing. Further, under these conditions, inflation-adjusted debt loads will be eroded over time. If asset prices (house values, stock prices) rise along with inflation, then collateral constraints will be loosened, and lending will resume. As lending and borrowing rises, more rapid growth will resume, shaving the debt-to-GDP ratio.

2.    Exploiting the balanced budget multiplier
For countries that face tight constraints on sovereign borrowing, it’s still possible to spur the economy with fiscal policy. As long as tax revenues rise with spending dollar for dollar (or euro for euro), then increases in spending will increase aggregate demand, while not worsening the budget deficit. In fact, this approach is more likely to reduce the pace of debt accumulation than the austerity approach implemented in, for instance, Greece.

In fact, over the longer term, spending of this sort will likely more than pay for itself, particularly when government borrowing costs are near zero.  Brad DeLong and Larry Summers have recently shown  that insofar as expansionary fiscal policies mitigate long term unemployment and sustain higher levels of capital investment, potential GDP (and hence output) will be higher than in the counterfactual of fiscal retrenchment.

3.    Spending smartly
In order to maximise the benefits of the expenditure of scarce resources, it’s clear that not any government spending will do. Rather one has to think of both the demand side and supply side effects. For instance, spending on defense might have a high multiplier for aggregate demand, the long term effects are likely to be minimal. On the other hand, spending on infrastructure and education, if wisely done, can provide a much needed long term boost to output. In the United States, it’s well known that infrastructure – roads, railways, bridges, inland waterways, and water distribution and treatment systems – are all in a poor state, meriting a rating of D+ from the nation’s civil engineering society. Unfortunately, the allocation of infrastructure spending has not always been aimed its most productive uses. The idea of a national infrastructure bank (more accurately a fund), if implemented effectively, can help attain that objective. Proposals in the United States envision a government owned corporation that would analyse projects and leverage private resources to fund investments that localities and states would find difficult to finance.

While underinvestment in infrastructure is a well-known problem in the United States, it is also an issue in economies that thus far have done relatively well, including Germany.  That leads back to the possibility of government-led growth, emanating from the countries within the Euro zone that do not face constraints on government borrowing and spending.

Taken together, these measures do not constitute a panacea for the ills besetting the advanced economies. However, they do constitute a feasible pathway toward the resumption of sustainable growth.

Menzie D. Chinn is professor of public affairs and economics at the University of Wisconsin, Madison, and a senior economist on the President’s Council of Economic Advisers, 2000-01.

This article forms part of a series of 30 'Memos to the Left' entitled 'Progressive Governance: The Politics of Growth, Stability and Reform'.

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