President Obama is in a bind. He knows that the economic recovery is fragile and dependent on continued fiscal stimulus—hence the bipartisan deal on further tax breaks he brokered in December. But he also knows that the tolerance in Washington for deficits of close to 10 percent of Gross Domestic Product is running out. In the short term, the politics of the new Congress will not allow them; and in the long term, the President’s own National Commission on Fiscal Responsibility and Reform has warned against them.
The President’s dilemma was on open display in his State of the Union address in January. It is, he said, deficit spending by government that has “broken the back of this recession”; and government-supported investment in innovation, education, and infrastructure that is needed to “win the future.” But while sending to Congress a budget that he promised will produce “countless new jobs,” the President at the same time proposed to cut the deficit by more than $400 billion over the next decade.
Overall investment and spending must be maintained by the government in order to support the economy at a time when unemployment remains at unprecedented postwar levels and a quarter of home owners owe more on their mortgages than the value of their property. The Federal Reserve has tried to stimulate the economy through a loose monetary policy, keeping interest rates very low and purchasing $600 billion in Treasury notes from big banks in an effort to make more money available to the banking system—a measure called quantitative easing. But the deficit must also be cut in order to preserve the nation’s creditworthiness.
This is the urgent challenge the President knows America is facing. Is there a way to square the circle? Part of the solution, we believe, lies in the creation of a National Investment Bank that will produce more jobs while not seriously increasing the deficit. Behind this lies solid economic theory.
The theory is Keynesian. John Maynard Keynes did not deny that market economies recovered “naturally” from slumps. He argued that their natural recovery mechanisms were too weak to bring them back to “full employment” within a “reasonable time” (say, three or four years). When private business confidence has been crushed and private investors’ appetite for risk has been curtailed by the painful experience of a recession, private spending will remain in the doldrums for a prolonged period even though output is well below capacity, resources lie idle, and people are unemployed. This is what occurred during the Great Depression, when the American economy took eight years after 1929 to regain its pre-crash peak output, and unemployment remained over 10 percent for more than a decade.
In these circumstances, Keynes argued that the government should run an increased budget deficit to support recovery, because the government is the sole agency able to prevent total spending in the economy from falling below a reasonable level of activity and employment. If private spending is depressed the government can restore “aggregate demand”—the total spending and investment in the economy—to a higher level by adding to its own spending or reducing taxes. By contrast, any attempt to reduce the fiscal deficit while large spare capacity exists will only make matters worse. If the economy is severely “underemployed,” government spending that produces a deficit will not “crowd out” private spending. It will replace private spending that is not taking place.
Few dispute that the US is not enjoying a normal recovery by recent standards. Economists talk about the persistence of the “output gap”—a theoretical concept that captures the difference between what the economy could produce if all available resources were employed and what it actually does. The Congressional Budget Office, for example, estimates in its latest assessment that the economy is still running at nearly 6 percent below potential.1
The man or woman in the street has a more direct measure of the problem: an unemployment rate close to 9 percent three years after the recession began. In the recessions of the early 1980s, 1990s, and 2000s, by this point in the recovery the total number of Americans employed was at, or above, the total number employed before the recession began. At the end of 2010, there were still more than seven million fewer Americans with jobs, full-time and part-time, than in March 2008. In this dismal situation, it is not surprising that Keynes’s diagnosis and his policy prescriptions have had a major revival, and fiscal policy throughout the OECD nations reflected this in the initial period of the global financial crisis. Fiscal stimulus in order to stabilize aggregate demand became the order of the day.
As the crisis itself recedes into the distance, however, old dogmas have reemerged. The Keynesian case for deficit spending is challenged by the theory of “expansionary fiscal contraction,” which alleges that deficit spending will, on the one hand, “crowd out” private spending by depressing consumption. This will happen as households save more to pay anticipated higher taxes that will have been increased in order to pay for deficit spending. The public deficit will also constrain investment, since interest rates will have to rise as the government borrows money to cover the deficit. On the other hand, the theory proposes that “fiscal consolidation,” or reduction of the deficit, will increase household consumption, since households no longer anticipate increased taxes, and also investment, by making credit cheaper.
The conditions needed to validate this theory are highly unreal, and there is negligible empirical evidence to support it.2 But the vague air of moral rectitude that surrounds policies of austerity has reexerted a powerful influence over financial markets, and in its name, most OECD countries have now agreed on four- or five-year plans to liquidate deficits. “Fiscal consolidation” has become the new orthodoxy.
The US is no exception. The Simpson-Bowles commission on the deficit has confirmed that the US faces larger long-term fiscal challenges than most other countries, and that major reform is needed. The Republican majority in the House of Representatives has placed cutting government expenditure at the heart of the political agenda for both parties. For the time being at least, the ideological winds have changed, and the President knows that it would be unrealistic to expect any further help from direct fiscal stimulus, despite the lethargic pace of the recovery.
So the situation the President faces can be summarized as follows. Aggregate demand is not recovering sufficiently, and continues to need stimulus in order to restore employment to a reasonable level within an acceptable span of time. But it has become politically impossible to increase the government deficit; and even the extraordinarily loose monetary policy we have mentioned is not proving sufficiently effective to produce a full recovery. The tall order facing President Obama, then, is to find policies that can maintain demand without expanding the deficit. The creation of a National Investment Bank should be at the top of his list. A National Investment Bank could achieve two goals simultaneously: it could improve the long-term prospects of the US economy for growth by improving its facilities for energy, transportation, water supply, and much else, while offsetting the contractionary effects of orthodox fiscal policy.
The first goal is likely to be the least controversial. After all, it was on these grounds that a National Infrastructure Reinvestment Bank was proposed in Congress in 2007 and 2009. On March 15 of this year a bipartisan group of senators headed by John Kerry proposed an infrastructure bank on exactly these grounds. The traditional case for public development banks is that they can incorporate national policy objectives into their lending strategies—and by doing so, avoid short-term “market failures” in private capital markets—failures that result in the lack of funding for projects of long-term value to the national economy. Unlike a commercial bank, a National Investment Bank would appraise such projects for financing not only on the basis of their profitability—though this would still be a necessary condition for approval—but also on the basis of their contribution to national policy objectives—such as the promotion of exports, the repair and development of infrastructure, and the efficient reduction of carbon emissions. Such an appraisal would thus take into account the benefits that such projects would bring to the broader economy.
This traditional rationale for such a National Investment Bank is a powerful one in the contemporary United States economy. The administration has acknowledged that the financial crisis and its aftermath have exposed the needs for fundamental restructuring of the economy. As the President put it in his State of the Union address, “to win the future, we’ll need to take on challenges that have been decades in the making.”
Rebalancing the economy toward exports is one example of what is needed. The twenty-five-year credit boom that began in the mid-1980s generated an unbalanced economy, in which domestic sectors such as construction and real estate grew at an excessive rate, while exporting industries such as manufacturing lagged behind. America’s foreign trade was roughly in balance in the 1970s; in the two years leading up to the recession, the current account deficit in foreign trade averaged 6.5 percent of GDP. To reverse the trade imbalance, the administration has stated its ambition to double exports by 2015. A National Investment Bank could support the President’s National Export Initiative by giving priority to new export industries because of the real economic benefits they would bring in reducing America’s dependence on borrowing from abroad to pay for foreign products.
Another example of the structural economic challenges that a National Investment Bank could help meet is the deterioration of American infrastructure. Investment in America’s transport, energy, and water systems has been allowed to fall to critically low levels over the past four decades. In 2009, the American Society of Civil Engineers estimated investment needs over the next five years alone of $2.2 trillion. Its “Report Card” gave a D or D–rating to the country’s current facilities for aviation, energy, hazardous waste, roads, levees, schools, and transit, among others.
But infrastructure is a prime example of a sector in which the benefits of a project to the broader economy are larger than the private financial return to the owner, with the result that private capital markets, left to their own devices, tend to fund less infrastructure investment than is optimal for the economy as a whole. What is more, the current system of allocating public money to such investment is hopelessly politicized, subject to the pressures of state and local governments and the individual demands of congressmen and senators. As Felix Rohatyn and Everett Erlich proposed in these pages before the crisis struck, a National Investment Bank is the ideal vehicle for solving both these problems.3
The traditional arguments for a public development bank strongly apply in the fields of energy and the environment. The development of new technologies in renewable energy production to help meet America’s energy security and environmental challenges is a national priority. Because such energy resources require long lead times, critical levels of volume, and an effective regulatory policy, private capital markets will tend to fall short of America’s needs. A National Investment Bank could take the lead in financing green technologies such as wind and geothermal power by evaluating and incorporating into its appraisals the value of their benefits to the broader economy.
But could a National Investment Bank also help with the urgent problem of the weak recovery and the exhaustion of the current policy options? We believe that it could.
Keynes was skeptical that economies can stage spontaneous recoveries from major slumps because he recognized the central importance of confidence in a market system. The destruction of confidence caused by a severe recession leads to a collapse in investment, which leads to further deterioration in confidence, and hence to further reduction in investment. In a slump, there is no shortage of savings and liquidity in the economy (and this is why further increasing liquidity, for example by quantitative easing, does little good). The problem is that private businesses do not want to borrow and invest—regardless of how low interest rates on borrowing are—because the future is particularly uncertain and they see no clear prospects for future demand.
The current situation in the US conforms closely to Keynes’s analysis. There is no shortage of savings—the proportion of disposable income that American households save has jumped from below 2 percent immediately before the crisis to over 5 percent today, and US banks are sitting on record levels of cash. But there is a chronic shortage of confidence in future demand—so these savings are sitting in the most riskless of places—in short-term Treasury bills, and in banks’ accounts at the Federal Reserve.
Keynes’s summary of the situation in 1932 still makes sense today, though in less extreme degree:
It may still be the case that the lender, with his confidence shattered by his experience, will continue to ask for new enterprise rates of interest which the borrower cannot expect to earn…. If this proves to be so, there will be no means of escape from prolonged and perhaps interminable depression except by state intervention to promote and subsidise new investment.
The central challenge is to restore confidence on the one hand and on the other to find a way of deploying idle cash to finance the resulting investments. Keynes argued for the direct solution: let the government do both. By increasing fiscal expenditure, it will support demand now and bolster confidence for the future; and by issuing bonds to finance the resulting deficit, it will put the savings currently hiding in cash and Treasury bills to work. In effect, expenditures sponsored by government would substitute for the lost confidence of the private sector until business regains the confidence needed for future investment.
For the time being such a policy is politically impossible, as President Obama has made clear. But the creation of a National Investment Bank provides an alternative solution—and one that has the cardinal virtue, in the current political situation, of not requiring the government to increase its borrowing significantly. As in the classical Keynesian solution, the federal government can revive confidence by making clear its support for large-scale, long-term investment programs—programs that will involve tens of billions of dollars of investment and generate hundreds of thousands of jobs. But unlike in the classical solution, the investments will be made by the private sector or by local governments, and the idle cash to fund these investments will be borrowed and deployed not by the federal government but by the National Investment Bank.
Of course, the creation of a National Investment Bank cannot be a fiscal free lunch. Congress would need to appropriate sufficient funds to inject the initial capital of the bank. But the essence of banking is the ability to make loans up to a multiple of several times initial capital. For every dollar of initial capital from Congress, the National Investment Bank would be able to finance investment up to a sizable multiple of this initial capital by borrowing the extra dollars now languishing in the private capital markets. It would operate in two main ways. In some cases, the bank would offer a partial or full guarantee of repayment on bonds issued directly by investment projects themselves, thereby assuming some or all of the risk of the projects, and so reducing their cost of funding. But for the most part, the bank itself would lend to finance investment projects, and raise funds for lending from the capital markets by issuing long-term bonds carrying a modest premium over the interest rate on government securities. Such National Investment Bank bonds would likely be attractive assets for pension funds and other long-term investors.
Such are the principles of our proposal, but what about the practicalities? Could a National Investment Bank operate on a scale that would make a material difference to aggregate demand and employment? And how would the bank operate in practice?
A useful example of the scale of what our proposal could achieve is provided by the European Investment Bank (EIB). The European Union has an economy of a similar size and level of development to the US—in 2010 the GDP of the EU was around $16 trillion, and of the US around $15 trillion—and the EIB is its public development bank. The EU governments that own the EIB have contributed approximately $50 billion of capital to it; and the bank currently borrows a further $420 billion from the private capital markets to finance a total lending portfolio of some $470 billion. In other words, for a fiscal outlay of $50 billion, the EU governments are able to finance investments worth more than $470 billion. The EIB has funded major infrastructure projects throughout Europe, from the port of Barcelona to the Warsaw beltway, and from France’s famous TGV network to Britain’s new, world-leading offshore wind industry. In doing so, it has consistently turned a profit and maintained negligible delinquencies over five decades.
If a US National Investment Bank were established on a similar scale, the investment spending it could therefore finance over ten years at a direct cost of around $50 billion could more than offset the $400 billion of expenditure cuts promised by President Obama in his State of the Union Address and proposed in his recent budget over the same period. The bank would achieve a more than $400 billion increase in aggregate demand in return for a $50 billion increase in the federal government’s debt. But the real return would be much greater. By making clear a national commitment to a coherent and rigorously appraised program of economic restructuring and the investment necessary to support it, the bank would also revive confidence in demand and so provide the basis for a self-sustaining private sector recovery.
As for the details of the bank’s operations and governance, there is a wealth of successful precedents, from the German Kreditanstalt fur Wiederafbau (KfW) in Europe, to the Korea Development Bank (KDB) and the Development Bank of Japan (DBJ) in Asia. The common features are government ownership, a conservative ratio of lending to capital, and a clear mandate to support long-term national economic priorities. It is important that the bank should function as a professional organization with political independence in its daily operations, in order to ensure that the projects would be rigorously appraised according to the needs for infrastructure they would fulfill and for their future profitability.
The Federal Reserve provides an existing and well-accepted model for how political accountability can be combined with operational independence. The National Investment Bank could follow the same model for the appointment of its chief executive and supervisory board. As with the Fed, the chief executive and Board of Governors could be appointed by the President and confirmed by the Senate. It would be audited by an inspector-general and the Government Accountability Office.
In fact, the US government is no stranger to running development banks as a result of its existing involvement in the World Bank and the European Bank for Reconstruction and Development, in both of which it is a major shareholder, and in which US citizens hold many senior executive positions. (It is worth remembering that a number of distinguished bankers and businessmen have been willing to preside over the World Bank, from Eugene Meyer and John McCloy in its early years to James Wolfensohn in the last decade.) There is now an opportunity for America to put to work the expertise it has accumulated in these institutions in meeting its own economic challenges.
The creation of a National Investment Bank would also have a final benefit that would be peripheral to its main purpose but might in the long run be its most important. The financial crisis has left the impression that the main purpose of the banking sector is to enrich a tiny elite at the expense of taxpayers. Adair Turner, the chairman of the UK Financial Services Authority, expressed a widespread sentiment when he said in a review of the past decade of financial innovation that much of it was “socially useless..”4 In fact, the public understands that a well-functioning financial system is essential to the US economy; and in the light of recent experience, many also understand that extensive changes in behavior are required to bring such a system into being. Apart from the Dodd-Frank bill passed in July 2010, further regulatory reform for existing banks is clearly necessary, as the recent findings of the Financial Crisis Inquiry Commission, under Phil Angelides, have made clear. But such comprehensive efforts will be complex, and new regulatory regimes in particular take time to become established.
A National Investment Bank, by contrast, would be able to adopt stricter rules from its inception, and thus demonstrate the social value of the financial sector to a quite justifiably disenchanted public. It could restore confidence, not only in future demand, but in banks and in banking itself.
—March 30, 2011
The CBO estimated the output gap at 5.7 percent of potential GDP in its Budget and Economic Outlook: Fiscal Years 2011 to 2021 of January 2011. ↩
For the theory of expansionary fiscal contraction, and evidence, see Rosaria Rita Canale, Pasquale Foresti, Ugo Marani, and Oreste Napolitano, “On Keynesian Effects of (Apparent) Non-Keynesian Fiscal Policies,” Discussion Paper No. 8, 2007, Department of Economic Studies, University of Naples ‘Parthenope.’ The authors conclude that fiscal contraction may be consistent with expansion of aggregate demand if monetary policy leads to a devaluation at the same time. But it is the monetary loosening, not the fiscal contraction, that has this effect. These findings are corroborated in the IMF’s latest study of the issue in Chapter 3 of its October 2010 World Economic Outlook. The theory of expansionary fiscal contraction confuses a correlation with a cause. ↩
“How to Tame Global Finance,” Prospect, August 2009. ↩