Here’s a recent post by Raghuram Rajan:
With the world’s industrial democracies in crisis, two competing narratives of its sources – and appropriate remedies – are emerging.
The first, better-known diagnosis is that demand has collapsed because of high debt accumulated prior to the crisis. Households (and countries) that were most prone to spend cannot borrow any more. To revive growth, others must be encouraged to spend – governments that can still borrow should run larger deficits and rock-bottom interest rates should discourage thrifty households from saving.
Under these circumstances, budgetary recklessness is a virtue, at least in the short term. In the medium term, once growth revives, debt can be paid down and the financial sector curbed so that it does not inflict another crisis on the world.
This narrative – the standard Keynesian line, modified for a debt crisis – is the one to which most government officials, central bankers and Wall Street economists have subscribed, and needs little elaboration. Its virtue is that it gives policymakers something clear to do, with promised returns that match the political cycle.
Unfortunately, despite past stimulus, growth is still tepid, and it is increasingly difficult to find sensible new spending that can pay off in the short run.
THE SECOND NARRATIVE
Attention is therefore shifting to the second narrative, which suggests that the advanced economies’ fundamental capacity to grow by making useful things has been declining for decades, a trend that was masked by debt-fuelled spending. More such spending will not return these countries to a sustainable growth path. Instead, they must improve the environment for growth.
That’s pretty depressing reading if you are a market monetarist. The first “competing narrative” is simply inexplicable to me. The recession was not caused by too much debt, and if it was the solution would not be more “budgetary recklessness.”
The second is slightly closer to the truth. Growth has slowed slightly in recent decades, and my hunch is that it will slow further in future decades. But this growth slowdown was certainly not “masked by debt-fueled-spending.” Either we have the capacity to produce houses, or we don’t. Whether those houses are purchased for cash or with mortgages tells us NOTHING about an economy’s PPF. It’s impossible for an economy to produce more than it’s owners and workers can afford. (But it certainly can consume more than its citizen’s can afford.)
There is a different argument that Rajan could have made, which would be slightly more plausible (although wrong.) He could have argued that the slowdown in growth was masked by policies that boosted AD, pushing the economy’s output beyond the LRAS curve (i.e. above the ‘natural rate’ of output.) But there are very good reasons why he didn’t make that argument. It would imply that inflation should have been accelerating in recent decades, and it has actually been decelerating in recent decades.
It’s discouraging that the most plausible narrative, the one consistent with elite macro theory over the past 25 years, isn’t even a contender. I’m referring of course to a monetary policy that let NGDP fall 9% below trend between mid-2008 and mid-2009, and which since then has grown at an agonizingly slow pace. That’s the obvious explanation, and according to Rajan it’s not even one of the competing narratives.
We’ve got lots more work to do.
HT: Tyler Cowen