The Way Out of the Slump

Tony Dejak/AP Images
President Obama after speaking about the economy at Cuyahoga Community College, Parma, Ohio, September 8, 2010


How can the economy recover? Of the three books under review, Raghuram Rajan’s Fault Lines says almost nothing about the question. He seems mainly concerned with preventing future bubbles, going so far as to call for an immediate rise in interest rates despite the depressed state of the economy. Nouriel Roubini and Stephen Mihm warn that recovery may be very slow—but they offer no solution, instead criticizing the solutions proposed by others. Only Richard Koo has something positive to propose—but his answer appears outside the realm of political possibility.

Most of the time, we count on central banks to engineer economic recovery following a slump, much as they did after the 2001 recession. Normally, when recession strikes, the Fed, the European Central Bank, or the Bank of England cuts the short-term interest rates it controls; market-determined longer-term rates fall in sympathy; and the private sector responds by borrowing and spending more.

The sheer severity of the slump after the 2008 housing bust means, however, that this normal response falls far short of what’s needed. One way to revive the economy is to consider the so-called Taylor rule, a rule of thumb linking Fed interest rate policy to the levels of unemployment and inflation. Applying the historical Taylor rule right now, with inflation very low and unemployment very high, would mean that the Fed’s main policy rate, the overnight rate at which banks lend reserves to each other, should currently be minus 5 or 6 percent. Obviously, that’s not possible: nobody will lend at a negative interest rate, since you can always hold cash instead. So conventional monetary policy is up against the “zero lower bound”: it can do no more. We’re in the classic Keynesian liquidity trap, in which the economy is so awash in liquidity that adding more has no effect. What’s left?

One answer is fiscal policy: the government can step in to spend when the private sector will not. We’ve already argued—in the first part of this review1—that a rise in government deficits played a key role in preventing the crisis of 2008 from turning into a full replay of the Great Depression. Why not use more deficit spending to push for a full recovery?

That’s a question that deserves more serious consideration than it has received so far. Leave aside the political considerations: if you believe that deficit spending is an effective way to reduce unemployment—as, for example, Roubini and Mihm clearly do—why not advocate going all the way and spending enough to restore full employment?

Yet that is a recommendation few economists have been willing to make.2 Instead, even those with a clearly Keynesian view of how the economy works tend to balk at following that view to its logical conclusion.…

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