An Age of Diminished Expectations?

Kenneth Rogoff, Professor of Economics and Public Policy at Harvard University, was formerly chief economist at the IMF.

CAMBRIDGE – As the United States and European economies continue to struggle, there is rising concern that they face a Japanese-style “lost decade.” Unfortunately, far too much discussion has centered on what governments can do to stimulate demand through budget deficits and monetary policy. These are key issues in the short term, but, as every economist knows, long-run economic growth is determined mainly by improving productivity.

There is no doubt that Japan’s massive 1992 financial crisis was a hammer blow, from which it has yet to recover, and the parallels with the US and Europe today are worrisome. Both seem set for a long period of slow credit growth, owing both to necessary stricter financial regulation and to the fact that their economies remain significantly over-leveraged. There are no simple shortcuts in the healing process.

Yet, in assessing the Japanese experience and its relevance today, it is important to recognize that Japan’s fall to earth was due not only to its financial crisis. Japan also suffered a number of severe productivity shocks, which had much to do with its longer-term problems. Even if Japan had never experienced a real-estate and stock-market bubble, the meteoric rise of its giant neighbor China would have been a huge challenge.

At the dawn of the 1990’s, Japan’s dominance in export markets worldwide had already been dented somewhat by the rise of its smaller Asian neighbors, including Malaysia, Korea, Thailand, and Singapore. But China presents an entirely different challenge, one for which adjustment will take much longer.

Moreover, even if it never had a financial crisis, Japan would have been plagued by adverse demographics, as its population is both aging and shrinking. Last but not least, Japan’s hyper-growth years were built on a phenomenal rate of investment. But, because productivity ultimately must be built on innovation, not just on ever more buildings and equipment, it was inevitable that returns on investment would turn south at some point.

In principle, with a healthier financial system, Japan’s economy would have had more flexibility to meet these challenges to its productivity growth. But, one way or another, Japan’s once sky-high growth rates probably would have fallen sharply. As is usually the case, financial crisis amplified other causes of economic meltdown, rather than igniting it directly.

The US Great Depression of the 1930’s is another case in point. Again, a great deal of attention has been lavished on the ebbs and flow of fiscal and monetary policy. But New Deal economic policies, by expanding the role of the state in an often chaotic and unpredictable fashion, probably also played a role in at least temporarily impeding productivity growth.

The US today seems to be moving towards a gentler and more European-style state, with higher taxes and possibly greater regulation. Supporters of the US administration might fairly argue that it is undertaking long-deferred maintenance on issues such as income inequality. But if the US does experience slow growth over the next decade, can it all be blamed on the financial crisis?

Likewise, Europe’s latest existential identity crisis is again creating a great deal of policy uncertainty and unpredictability. In Europe, too, if there are adverse growth effects over the next decade, they cannot all be blamed on the financial crisis.

In the short term, it is important that monetary policy in the US and Europe vigilantly fight Japanese-style deflation, which would only exacerbate debt problems by lowering incomes relative to debts. In fact, as I argued at the outset of the crisis, it would be far better to have two or three years of mildly elevated inflation, deflating debts across the board, especially if the political, legal, and regulatory systems remain somewhat paralyzed in achieving the necessary write-downs.

With credit markets impaired, further quantitative easing may still be needed. As for fiscal policy, it is already in high gear and needs gradual tightening over several years, lest already troubling government-debt levels deteriorate even faster. Those who believe – often with quasi-religious conviction – that we need even more Keynesian fiscal stimulus, and should ignore government debt, seem to me to be panicking.

Last but not least, however, it is important to try to preserve dynamism in the US and European economies through productivity-enhancing measures – for example, by being vigilant about anti-trust policy, and by streamlining and simplifying tax systems.

For better or for worse, productivity trends are very difficult to extrapolate, depending as they do on hugely complex interactions of social, economic, and political forces. Nobel Prize winners Robert Solow and Paul Krugman famously once questioned whether the proliferation of computers and technology would lead to bottom-line growth. (This theme underlies the title of Krugman’s classic 1990 book “The Age of Diminished Expectations.”)

In the end, policymakers must remember that whether or not the US and Europe avoid a lost decade depends on their ability to retain productive vitality in their economies, not simply on short-term demand-stimulation measures.

Project Syndicate

Post-Crisis World Institute