J. Bradford DeLong: Growth and Structural Change...!
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Growth and Structural Change in the Global Economy After the Crisis World Economic Outlook Talk for Fall 2010
J. Bradford DeLong U.C. Berkeley October 4, 2010
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J. Bradford DeLong: Growth and Structural Change...!
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The Global Savings Glut and the Housing Boom ................................................3 The Housing Crash and Its Consequences ..........................................................4 Back to 1825 .........................................................................................................4 Types of General Gluts .........................................................................................6 Our Current Situation ..........................................................................................7
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THE GLOBAL SAVINGS GLUT AND THE HOUSING BOOM In 2007 the world economy had about five million excess houses that should not have been built. The collapse of the Silicon Valley dotcom bubble—the recognition that while modern computing and communications technologies are wonderful things, that competition in the is so fierce and protection of intellectual property so difficult that it is difficult to make a lot of money off of investments in them—had greatly shrunk the supply of new savings vehicles that people all over the world used to carry their purchasing power into the future. But the economic rise of Asia had produced a greatly-increased demand for savings vehicles, both as private citizens in Asia had not yet learned how to spend the extra income rising productivity provided and because governments in Asia sought to save a good chunk of their resources in the world economy’s North Atlantic core as a byproduct of their highlysuccessful export-led manufacturing development strategy. The result on the supply and demand side was what Ben Bernanke calls the “global savings glut.” The natural response to a savings glut is a structural shift: move labor and capital into making extremely durable goods like houses that can back the long-run savings vehicles that financial markets want. The natural response was a housing boom. And, of course, the housing boom went too far. Some financiers underestimated risks. Others overestimated their ability to manage risks. Still others left their proper business of encouraging enterprise by finding savers who can and wish to bear risks, and entered the business of making money by finding savers who did not understand the risks and convincing them to bear them. The result was that by 2007 we had, collectively, built five million excess houses—largely but not exclusively in the American desert between Los Angeles and Albuquerque. And the world’s savers thought that they had about $100,000 in mortgage wealth invested in those houses than they did: on average $100,000 of mortgage debt on each of those houses was not going to be paid back because, after all, the desert between Los Angeles and Albuquerque is not that nice a place to live and houses locate there are not that valuable. 3
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THE HOUSING CRASH AND ITS CONSEQUENCES In 2006-2008 the world’s savers recognized that the five million excess houses should not have been built. And they recognized that the world economy had a $500 billion loss to allocate. This loss, however, should not have been a big problem. This should not have been the cause of a major economic downturn. The collapse of the dot-com bubble a decade before had led to fundamental losses six times as large as those of the housing crash. Yet the recession that followed was small in the United States and barely noticeable worldwide. This time, however, was different. The $500B of losses were on assets that had been widely regarded as safe—it was not just a loss of wealth, but a loss of that wealth that savers had regarded as safe. And it was a shrinkage of places perceived to be safe—places where you could put your wealth and be confident it would still be there when you came back. Moreover, many assets widely regarded as safe had been in large part held as capital by highly-leveraged financial institutions. When the music stopped and the question of who was it to whom the big banks had sold derivatives who had not understood the risks that they were bearing was answered, the answer turned out to be the highly-leveraged big North Atlantic banks themselves. Thus the unsoundness of these assets put all the liabilities of highly-leveraged financial institutions into jeopardy. The market response was a “flight to quality”: nearly everybody wanted to sell the risky assets that they could no longer evaluate and put their wealth into safe assets instead. That yearlong flight to quality wiped $20T off of global asset values, as investors everywhere sought more safety in their portfolios. That financial accelerator of 40 meant that the global financial system had not a $500 billion-of-missing-wealth problem but a $20-trillion-of-missing-wealth problem. And this market response to the housing crash produced an enormous excess demand for safety, an enormous demand for the limited global supply of high-quality safe financial assets
BACK TO 1825 But why should it matter for the rest of us if financiers and savers panic, if all of a sudden their appetite for bearing risk vanishes, and they buy and sell and so push up the price of safe and down the price of risky financial instruments? Some of them lose a great deal of money, yes. 4
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But why should the rest of us care? Well, back before 1825 or so, the rest of us did not. Back before 1825, the major savings vehicles in the world economy were (a) relatively safe hoards of cash, (b) relatively safe pieces of land, and (c) relatively risky financial instruments that were backed by goods in transit from places where they were made and cheap to places where they were scarce and expensive. If you want a less risky portfolio, you simply tell the trading company that you want to liquidate your shares and that they should sell the trade goods in the London market rather than sending them around the Cape of Good Hope. A demand from finance for a less risky—less leveraged—economy can be easily and quickly met by deleveraging the real economy that backs finance. But come 1825—well, we we had had three successive Abraham Darbys at Colbrookdale. Because of them we had coke rather than charcoal-fueled blast furnaces. We had iron cylinders for steam engines. We had iron bridges. By 1825 the real economic backing of the financial instruments that were the economy’s savings vehicles were increasingly steam engines, canals, cotton mills, and were about to become iron rails, locomotives, and railroad cars. When the financial sector demands deleveraging, the real economy can no longer respond. You can turn capital in the form of trade goods on a ship—oranges from Seville, say—back into consumption goods quickly and easily. You cannot eat a railroad’s roadbed. Did this rise of fixed capital as a major component of the economy matter? Some of the first economists said that it did not. Most prominent was the French economist Jean-Baptiste Say. He had been special assistant to France’s Treasury Minister Etienne Claviere in the early stages of the French Revolution. Claviere was purged, arrested, charged, convicted, imprisoned, and committed suicide the night before his scheduled execution, Say decided civil service life and political office was too dangerous. He descended from heaven, and took up a life as a rural landlord and intellectual. 5
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In 1803 Say laid out his argument that even with fixed capital there was no reason to fear that the workings of a market economy might produce a “general glut” of mass unemployment and idle factories. As he put it, nobody makes without intending to use or sell. And nobody sells without intending to buy. Thus supply—the decision to produce and sell on the market—creates an equal amount of demand. Now, Say admitted, there is no guarantee that the planned sales and purchases will be all of the same things. But the market system will solve these problems quickly. If there is an excess supply of houses there will be an excess demand for the services of nurses, and there are great profits to be made from expanding the health care sector and figuring out how to retrain construction workers to be hospital orderlies. By 1829, however, Say had changed his mind. Say acknowledged that somehow the coming of large-scale fixed capital had made things different—that a “general glut,” widespread unemployment and idle capacity not just in a few but in pretty much all industries producing goods and services was possible. But he was not entirely sure how. The answer was provided by English economist John Stuart Mill. Mill pointed out you could have general deficient demand for goods and services if you had general excess demand for financial assets.
TYPES OF GENERAL GLUTS When there is excess supply of construction workers and an excess demand for health-care workers the economy adjusts as employers fire construction workers and other employers hire health-care workers. But when there is an excess supply of construction workers and of health-care workers, employers fire them and hire... what, exactly? How do you hire people in the creating-safe-financial-assets industry? It is not clear. In a small open economy with a large share of world trade in production you can let the value of your currency fall. Then foreigners with money will be whatever you make with their money. You 6
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and so you can enter the financial assetsproducing industry by going to work in an export industry and then selling what you produce abroad. But that does not work for the world as a whole, or if the trade share of production is small. Safe, liquid, long-duration financial assets—they are created not by individual workers but by governments, and by the confidence of the market in the soundness of the promises-to-pay of financiers. There is no obvious process by which un employed workers and idle factories can set themselves to work improving market confidence in the promises-to-pay of financiers or making the money issued by the government more plentiful. Right now we seem to have a different problem than either Milton Friedman or John Maynard Keynes focused on. In a monetarist downturn the problem is a shortage of cash—and so the prices of all other financial assets will be low, their interest rates will be high, as savers try to dump them for cash. In a Keynesian downturn the problem is too much savings chasing too few bonds— and so the prices of long-duration bonds will be high, their interest rates will be low. Right now it seems that the price of longduration safe government bonds is extremely high, but the prices of all risky assets are low. The problem is an excess demand for “safety.” How do we resolve that?
O UR C URRENT S ITUATION So what does this mean for our current 7
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situation? Our current problem was made in the United States. Perhaps if we look at the United States we will be able to see our way clearer. Some people claim that the problem of excess demand for financial assets and excess supply of currently-produced goods and services in the United States has already been resolved, and what we now have is a problem of “structural” unemployment. But in that case would we not see some occupations, industries, and regions in which unemployment was low and wages were rising as employers sought extra skilled workers? We do not see any such occupations, industries, and regions. Instead, we see depressed employment pretty much everywhere in the U.S. economy Other people say that the problem is structural in a different sense: that we overinvested in risky capital—that the economy now just has too many risky assets and too few safe ones, and so will be depressed until that overhang of excess risky capital is worked off. The problem with this is that the American housing construction bust since 2006 has been so great that there is now no overinvestment in risky housing capital left. Housing construction has been so far below trend over the past three and a half years that all of the boom-time excess supply of housing in the United States is gone. But even though the fundamental structural underpinnings of the excess supply of risky assets are now gone, that has not led to a rapid economic recovery in the United States. The downturn continues at its maximum depth. Things are no longer getting worse. But things are no longer better. Still, the observation that the excess production of risky housing assets has already been worked off is what leads Assistant to the President for Economic Policy Lawrence Summers to claim to be optimistic about the future: young Americans cannot live with their parents in their parents’ houses forever, can they? And when they decide to move out the spending to reemploy America’s construction sector will be there, won’t they?
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I am not so confident. Downturns provoked by monetarist excess demands for liquid cash money—the orange arrows on the slide—are very quickly resolved with the normal tools of central banking. Increase the money stock in response to the downturn, and your recovery is almost as fast as your decline. Your recession has the shape of a “V.” Since 1990, however, the United States has had three recessions that are not the result of a monetarist excess demand for liquid cash money. The early 1990s episode was the result of a small financial crisis in the Savings-and-Loan industry followed by a credit crunch as savers lost confidence in the security of the promisesto-pay of the financial sector. The early 2000s recession was the result of a Keynesian excess demand for savings vehicles. Those two episodes look like an “L” rather than a “V.” And it seems that our current episode is following the same pattern. Perhaps it should. We do, after all, know how to increase the economy’s money stock. But when the problem is that the promises-to-pay of financiers are no longer trusted—that there are no longer enough safe assets out there in the economy—when that is the source of the excess demand in finance that drives the excess supply of currently-produced goods and services, that is not a disequilibrium that will be resolved quickly or by itself. And this has powerful implications for the entire world. The United States now looks to be trapped in a jobless recovery for the next several years at least. And the U.S. is too big a part of the world’s production for slow growth and high unemployment in the United States to be easily compatible with rapid growth in the world as a whole. “Decoupling” will be very difficult to accomplish. There is, however, a possible policy solution. It appears that the root problem is that there is still a global shortage of demand for currently-produced goods and services because there is still—even after the working-off of excess risky housing investment—a global shortage of and so excess de-
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mand for safe and high-quality financial assets. The natural solution would be a global government-financed infrastructure boom. Governments that borrow by doing so can create more of the safe, highquality financial assets that savers want— as long as the government’s own finances are trusted, at least. And governments that then use their borrowing to spend can put people and businesses to work directly. Stepping back, if these were normal times we could point to the very large interest rate spreads between safe and risky assets and call upon well-capitalized commercial banks and investment banks with good judgment to undertake financial engineering projects to raise the supply of safe assets. But these are not normal times, are they? Nobody trusts the globes investment banks and commercial banks to create the kind of reliable promises-to-pay that savers so desperately want. Thus in these times it is governments in whose finances investors have confidence, and only those governments, that can cure our “jobless recovery” problem. Unfortunately, the political prospects for such an expansion of government’s role in supporting demand appear dim, at least in the North Atlantic. There are some governments that have no credibility and cannot create more reliable promises-topay. There are some governments—Germany and Britain—that could, but that are about to start contracting their fiscal policies. There are other countries—largely Japan and the United States— that are half-heartedly in the middle. And there are a few countries, some of them very large, that are being effectively even if not ideologically interventionist is pick10
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ing up the slack. If I am right: China is likely to boom Latin America is likely to grow, unless its currencies appreciate too rapidly Japan and the U.S. are likely to stagger along Northern Europe is likely to go into a double dip—unless the euro weakens, transferring demand from Asia and America to Europe • Southern Europe looks bleak indeed. • • • •
I may, however, well be wrong. We have not seen a financial crisis on this scale for 75 years, and our analyses of it may be off-base. What does seem likely is that we are losing an opportunity here. The world needs a general reorientation from a consumption to an investment-heavy growth path—dealing with the puzzles to be generated by global climate change alone will call for investments on a scale that we have never before undertaken. Yet I hear hints that when in the fall of 2009 the Obama administration economists—fearful of a jobless recovery—attempted to reorient government policy toward debt-financed infrastructure investment, in order to diminish the excess demand for safe assets, to put the unemployed to work, and to boost productivity growth in the United States, they could not obtain traction either with congress or even consensus within the executive branch.
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