As we enter a new decade, the economic debate is dominated by a conviction that policymakers need to find new tools to spur growth. This is especially true for monetary policy—both the US Federal Reserve System (the Fed) and the European Central Bank (ECB) have launched official reviews of their respective monetary-policy frameworks. On the fiscal side, the debate centers on whether governments should do more with the same old instruments, largely government spending. Economists are also debating whether monetary policy should play a more direct role in enabling more government spending.
The world economy has started to experience some profound structural shifts. Technological innovation is reshaping entire sectors, demand for skills and global supply chains. The rise of emerging markets has upended the old balance of economic power across countries.
These changes have challenged our ability to understand the economic environment. For example, economists have not found a convincing explanation for why consumer inflation in both the United States and the eurozone has remained dormant, even as their economies have grown above potential and unemployment rates have fallen substantially (in economics, the “potential growth rate” is the pace at which an economy can grow in a sustainable way over the long term. It depends, broadly speaking, on its level of capital, the available technology, and the size and skills of its labor force). The sharp deceleration in global trade has had much less of an impact on global growth than was originally feared. Policymakers are right to redouble their efforts to better understand the new economic dynamics and design more appropriate policy responses—including efforts to upgrade data and statistics because some of our lack of understanding stems from the fact that traditional economic measurements are no longer adequate.
The current policy debate, however, is characterized by an inordinate pessimism and by an excessive—almost exclusive—focus on demand-side measures.
The pessimism is typified by the “secular stagnation” theory1Larry Summers (2016) “The Age of secular Stagnation”, Foreign Affairs. : the idea that structurally lower productivity growth and population aging have condemned advanced economies to a low-growth future. Economists such as Northwestern University’s Robert Gordon argue2Robert Gordon (2012), “Is US Economic Growth Over?” VOXEU. that the latest technological innovations cannot match the growth-enhancing power of the First Industrial Revolution. Artificial intelligence (AI), robotics and the internet of things (IoT), in this view, cannot boost economic efficiency the way that electricity and the steam engine did—productivity growth is destined to languish at the dismal pace of the past few years.
The only solution, in this line of thinking, lies in greater government spending to boost aggregate demand.
How should greater government spending be financed? A growing number of economists believe that we have entered a period of permanently lower interest rates; they argue that governments should run up higher debt levels, since the cost of servicing it will remain low3Jason Furman and Larry Summers (2019) “Who’s Afraid of Budget Deficits?” . Others suggest that central banks should play a more direct role in supporting fiscal expansions, either through coordinated quantitative easing—QE (for example, purchases of government bonds on the market)—or through direct monetary financing of fiscal deficits.
Modern Monetary Theory (MMT) provides an extreme version of this view: its proponents state that a government does not face a budget constraint since it can always issue more currency to finance its spending obligations4Modern Monetary Theory Explained by Stephanie Kelton, CNBC Video. . According to this view, the only limit to public spending becomes inflation—but since inflation is now considered extinct, there is no binding budget constraint. (When faced with the objection that this strategy has not worked well for countries such as Venezuela and Zimbabwe, MMT proponents argue that it’s different for the United States since the US dollar is the global reserve currency. This ignores the fact that the US dollar remains the global reserve currency, not by divine right but because it has historically been backed by prudent macro policies as well as a strong economy.)
Central banks, disappointingly, are letting themselves be lured into the trap. Major central banks played a crucial role in responding to the global financial crisis (GFC) and averting the specter of a prolonged deep global recession. They kindled an economic recovery that, while slow-burning, has delivered impressive results. The current economic expansion in the US is now the longest on record; US unemployment sits at a 50-year low, and while wage growth has remained moderate, it easily outpaces inflation, with the benefits of a strong labor market extending to most sections of the population. Europe enjoyed four years of growth well above potential between 2015 and 2018, with a significant reduction in unemployment rates.
Central banks, however, have not normalized monetary policy—far from it. The ECB keeps policy interest rates in negative territory, and late last year, it launched a new round of monetary expansion. The Fed, which had been raising interest rates, reversed course under market pressure and cut them three times last year; faced with unexpected stress in repo markets last September, it also revamped its asset-purchase program, expanding its balance sheet by some $400 billion as of January—thereby reversing more than half of the balance-sheet unwind it had undertaken.
Both the Fed and the ECB have initiated formal reviews of their monetary-policy frameworks to identify potential new measures that could (i) raise inflation above current levels and (ii) provide an effective response to the next economic downturn. Both priorities are underpinned by the twin beliefs that (a) inflation remains dangerously low and (b) we have entered a new era of lower equilibrium real interest rates; together these imply that nominal interest rates will remain uncomfortably closer to the zero bound, leaving central banks with limited room for action to counter a downturn.
We should take a more critical look at these arguments. There is evidence that consumer inflation has been kept down by technological innovations (through cost reductions and fiercer online competition, for example) and globalization. There is no guarantee that these forces will continue to exert the same disinflationary impact—in fact, globalization is already in retreat. Moreover, there is scant evidence that low inflation has had any undesirable effects so far: even during the 2009 recession and the 2012-13 European debt crisis, the US and the eurozone avoided deflation; and below-target inflation has not prevented the robust economic growth discussed above.
Similarly, some of the trends that created a “global savings glut” and depressed bond yields are already in retreat: China’s current-account surplus has narrowed considerably, and the accumulation of reserves by energy-exporting countries has been curbed by lower commodity prices. Central banks say that they are worried about low bond yields, but their own permanently loose monetary policies play a major part in keeping them low.
The cautious and dovish attitudes of central banks are easy to understand: with inflation low and stable, they feel no urge to tighten policy, and they would rather not be blamed for an economic slowdown or plunge in equity prices.
But their loose monetary stances carry risks, and so do the strategy reviews now underway. The Fed appears to be considering a shift to some form of average-inflation targeting: after a period of below-target inflation, the bank would be committed to letting inflation run above target for some time. The purpose would be to give people greater confidence that the Fed will maintain a loose monetary stance for longer, supporting inflation expectations. This seems hardly necessary: the Fed has already established strong credibility as an extremely dovish central bank. More importantly, deliberately allowing inflation to run above target might have unforeseen and undesirable effects on inflation expectations.
Across the Atlantic, new ECB President Christine Lagarde has stated that fighting climate change is “mission critical” for the bank and will feature prominently in its strategic review. Potential actions could include forcing banks to build climate-change impact into their risk assessments or applying differential treatment to “green” versus “polluting” financial assets in its purchase programs and repo operations.
Climate change is an important issue. But the ECB already struggles to meet its existing objectives: it has systematically missed its inflation target; it is trying to support economic growth in a mosaic of countries with uncoordinated fiscal policies and unresolved structural issues; it needs to supervise a fragmented banking system with significant vulnerabilities; and it must monitor macro financial risks emanating from high-debt countries such as Italy. Adding another goal to the list, one on which the ECB can have at most a marginal impact, appears unwise. It also risks making the ECB even more vulnerable to political pressures.
As central banks continue to play a bigger role, come up with new instruments and take on new responsibilities, markets and politicians will increasingly expect that nearly any problem can be addressed through monetary easing—with fiscal easing taking care of the rest.
Meanwhile, supply-side measures receive little to no attention. Across eurozone countries, almost no progress has been made on structural reforms to further liberalize labor markets and service sectors, lighten regulatory burdens and reduce taxation. Detailed studies on measures needed to improve the business environment are gathering dust on the shelves of governments’ offices. Japan has done little to improve corporate governance. Only the United States has taken significant steps to deregulate its economy, with an immediate positive impact on business confidence and growth. Even when governments have raised spending, they have focused more on current expenditures than on much-needed infrastructure upgrades.
Neglecting the supply side represents a massive wasted opportunity. Contrary to the rearview-mirror pessimism of economists, the latest technological innovations have already demonstrated tremendous potential. Additive manufacturing, also known as three-dimensional (3D) printing, is accelerating the prototype-test-production cycle in manufacturing and allows companies to build lighter and more robust parts at lower costs. Artificial intelligence accelerates new-materials discovery. Digital-industrial innovations are enabling greater efficiency across most industries.
Reaping the whole benefits of this technological revolution will take time. New technologies need to get embedded into the capital stock at scale, and this requires greater investment. Companies need to reorganize their processes, adapt management strategies and upgrade their workforce skills. It’s a complex process that could be facilitated through policies targeted at upgrading infrastructure, revamping education and training, and spurring investment through tax incentives and improvements in the business environment.
Innovation and investment in new technologies, infrastructure, education and lifelong learning are the best ways to boost productivity and long-term economic growth in a sustainable way. They should be supported by prudent macro policies that limit credit leverage and financial risks, incentivizing the efficient allocation of resources in the economy.
Policies to fuel aggregate demand without commensurate efforts on the supply side can have at best only limited and temporary success, and they have a significant risk of backfiring: credit bubbles cause resource misallocations that have a prolonged negative impact on productivity growth.
The global economy faces a new set of complex and daunting challenges. Luckily, innovation has brought on line a new wave of technologies that can help us reboot economic growth and sustain broad-based improvements in living standards for many decades into the future. But we need to accept that there is no free lunch; there are no easy fixes, no painless cures. Budget constraints are real. We need to switch our focus from the demand side to the supply side.