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.
1 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. ↩
2 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. ↩
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. ↩