No Way Out

Ever since Keynes wrote The General Theory in the 30s economists have understood the mechanism for escaping the sort of slump the economy faced in the Great Depression. The key point was to generate demand. The government had to do something – anything – that would increase demand for goods and services.

This depression problem was the exact opposite of the normal economic problem of scarcity, the problem created by insufficient supply of resources like land, labor and capital. The problem of scarcity is in principle difficult – we have to either take something from someone to make anyone better off or find some way to make the economy as a whole more efficient. However, the problem of lack of demand should be simple: we just have to increase demand in aggregate. This is possible without making anyone worse off.

Remarkably, even though we know how to solve the problem of inadequate demand, the United States appears unable to do it because all the potential routes for increasing demand are blocked politically. As a result, the country seems destined to repeat the suffering of the Great Depression, although on a smaller scale, even though we know better this time around.

The most simple and obvious way for the government to increase demand is to simply spend money. This is very straightforward. The government simply runs a larger deficit by either increasing spending and/or cutting taxes as was done in the stimulus package approved by the U.S. Congress last year.

This stimulus package was a good first step that prevented the recession from being worse; however, it was nowhere near large enough. The package passed last year was officially $787 billion. However, about $80 billion was a technical change to the tax code that had no stimulatory effect since this change is put in place every year. About $100 billion of the stimulus is projected to be spent in 2011 and later, leaving a bit more than $600 billion to be spent in 2009 and 2010, or $300 billion a year.

This is a bit more than 2 percent of GDP. But even this figure overstates the extent of the stimulus from the public sector. State and local governments face large budget shortfalls as a result of the recession and have been forced to cut back their spending and or raise their taxes. These cutbacks offset more than 1/3rd of the two-year stimulus and close to half in 2010. Given that the output gap that needs to be filled was at least $1.7 trillion, or 12 percent of GDP, it should have been evident that the stimulus is nowhere near large enough.

In principle, Congress could simply add to the stimulus thereby further boosting demand, but politics in the United States make any substantial addition to the stimulus virtually impossible. Deficits have become an over-riding concern even as the unemployment rate hovers in the double-digits, just as was the case in the Great Depression. Politicians think that we are somehow helping our children by leaving their parents out of work rather than issuing more government debt. This is especially ironic since money spent today can better the infrastructure; support research and development; improve education; or in other ways enrich the economy for our children and grandchildren.

If it is politically impossible to increase the deficit, then monetary policy provides a second potential tool for boosting demand. The Federal Reserve Board can go beyond its quantitative easing program to a policy of explicitly targeting a moderate rate of inflation (e.g. 3-4 percent) thereby making the real rate of interest negative. This would also have the benefit of reducing the huge burden of mortgage debt facing tens of millions of homeowners as a result of the collapse of the housing bubble.

Unfortunately, inflation targeted of this sort also appears to have been ruled out for political reasons. Federal Reserve Board Chairman Ben Bernanke has repeatedly stated his commitment to combat inflation, even though inflation is nowhere in sight.

A third potential channel for boosting demand is through trade. This could come from a lower valued dollar. This is not quite the classic “beggar thy neighbor” policy of the 30s. The United States went into the downturn with a large trade deficit in large part because China and several other countries deliberately held down the value of their currency against the dollar in order to develop an export market in the United States. This was one of the imbalances that helped lay the basis for the housing bubble and the subsequent crash.

The United States was willing to accept this imbalance before the crisis, but there is no reason that it should continue to accept it when the price is mass unemployment. It could force the issue with its trading partners – for example by setting an official exchange value for the dollar that is substantially lower than its current value.

Unfortunately, this path has been ruled out also. The Obama Administration has committed itself to a “strong dollar.” In politics, it is apparently better to have a strong dollar and weak economy. At least, the unemployed workers can take pride in the strength of the dollar when they lose their homes.

Politics has even obstructed the most obvious measure to adjust to below-capacity GDP: work-sharing. In Germany and the Netherlands, the unemployment rate has not risen in this downturn because the governments provide tax subsidies to companies that reduce work hours rather than lay off workers. This route has been ruled out in the United States by Larry Summers, the head of President Obama’s National Economic Council, because it is not the American Way.

As a result, it looks like America’s workers will get to enjoy America’s Way for several more years to come in the form of high unemployment and massive rates of foreclosure. We know better, but that doesn’t matter. Given today’s politics, we would be in largely the same position if Keynes never bothered to lay out the basic economics for us.

DEAN BAKER is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of Plunder and Blunder: The Rise and Fall of the Bubble Economy and False Profits: Recoverying From the Bubble Economy.

This column was originally published by The Guardian.


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Dean Baker is a macroeconomist and co-director of the Center for Economic and Policy Research in Washington, DC. He previously worked as a senior economist at the Economic Policy Institute and an assistant professor at Bucknell University.

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