World economy needs intellectual revolution to get out of low-growth trap

A decade ago, we thought the banking crisis was over and the expansion already visible in emerging economies would spread to the industrialized world. There’s been a recovery, but a frustratingly slow one. The International Monetary Fund just lowered its estimate of world growth both this year and next. Every data release seems to bring gloomy news. If the problem before the crisis was too much borrowing and too much spending, then the problem today is too much borrowing and too little spending.

The world economy is stuck in a low-growth trap. The question is why.

The Great Depression was followed by political upheaval and, in economics, an intellectual revolution. This time around, we’ve got the political turmoil but no comparable questioning of the ideas underpinning economic policy. That needs to change.

Modern policy makers operate in a world of radical uncertainty. They simply do not know what might happen next — and under these conditions, economic models need to be seen in a new light. The question isn’t whether the models are right or wrong, but whether they’re helpful or unhelpful. Today, the key features of standard models lead us astray in judging how to get the world economy out of its low-growth trap, and how to prepare for the next financial crisis.

Six years ago, Larry Summers reintroduced the concept of “secular stagnation” to economic debate. Conventional wisdom attributes this persistent slow growth — call it the Great Stagnation — largely to supply factors. This seems to fit because the underlying growth of productivity appears to have fallen. But the supply-side story is also suspiciously convenient, because the alternative — demand-led secular stagnation — sits uncomfortably with our prevailing model of monetary policy. This model finds it hard to accept that the investment required to stimulate production might be held back by extreme uncertainty. As a result, it accepts too readily that market economies are self-stabilizing.

Escaping from a low-growth trap sprung by radical uncertainty isn’t like climbing out of a Keynesian downturn, with temporary monetary or fiscal stimulus restoring demand to its trend path. It requires instead a reallocation of resources from one component of demand to another, from one economic sector to another, and from one company to another.

In some cases, the world has invested too much. China and Germany, for instance, have overinvested in manufacturing for export. Elsewhere, investment has been insufficient — in the infrastructure of many advanced economies, for example. Also, asset values in many places will need to be written down to more realistic levels, and some financial intermediaries will have to be recapitalized. These are structural weaknesses. Unless they’re attended to, there’s a risk of another financial crisis. The remedy isn’t monetary policy, but measures to support the needed reallocation of resources. Exchange rates, supply-side reforms and policies to correct unsustainable national saving rates need to be part of the mix.

Consider Europe. Further monetary easing and a weaker euro might help recovery in the south but would further distort the structure of economies in the north. Until France and Germany can resolve their differences over structural reforms to the monetary union, monetary stimulus on an even larger scale is not just papering over the cracks but also widening them. I am tempted to say that the best advice to the new president of the European Central Bank is to stay in Washington.

New thinking is also needed when it comes to dealing with financial crisis. The last one led to the Great Stagnation and was obviously costly in terms of lost output, but it was also expensive in financial terms. A recent IMF study found that the cost of interventions, including guarantees, to support financial institutions between 2007 and 2017 in 37 countries amounted to $3.5 trillion. Unprecedented injections of liquidity — the financial equivalent of overwhelming force — became a guiding principle of crisis management.

If potentially all debt issued by the financial sector must be guaranteed by the government in a crisis, the issue is not whether the Fed or other central banks would be able to provide such guarantees; it’s to devise a political settlement under which limits to private-sector maturity transformation are accepted in return. In effect, I am arguing for a tax on maturity transformation.

My book “The End of Alchemy” argued for a system of pre-positioned collateral related to the maturity transformation of the individual financial institution. Whatever the details, the imperative is to establish an ex ante framework for the provision of central bank liquidity. This is because it’s impossible to know when a small fire that should be allowed to burn and destroy one or more institutions might turn into a conflagration that threatens the entire system. Once a crisis has struck, it’s too late to create political legitimacy for the necessary emergency response.

Congress has curbed the ability of the Treasury and the Fed to fight the next crisis. This shouldn’t be surprising, because the actions taken during the crisis were not part of a system Congress agreed to beforehand. As former Fed and other officials have said, these restrictions are undesirable — but they’ll be removed only in the context of a clear ex ante framework that makes banks, and other maturity-transforming institutions, part of an insurance system that is accepted as fair. The political economy of “bailing out” banks would be much improved if it were clear that banks had subscribed in good times to an insurance system that entitled them to borrow in bad times.

In addition, radical uncertainty means that the liquidity of particular assets in some future crisis is unknown. This too argues for an insurance system — one that ensures that all runnable liabilities are covered — rather than on regulation to assure that liquidity is adequate. The response to the crisis combined excessively detailed regulation with a plea for greater freedoms for firefighters. This is ill-advised. Complex regulation imposes unnecessary costs of compliance and gives a false sense of security. And the absence of an agreed upon ex ante framework demands almost unlimited resources without the appropriate political authority.

The Fed and other central banks need to help legislators to see just how vulnerable financial systems will be in the event of a future crisis. Next time, Congress will be confronted with a choice between financial Armageddon and suspending the rules it introduced after the last crisis to limit the Fed’s ability to lend. Avoiding that choice demands radical new thinking about the lender of last resort — preferably before the last resort becomes a reality. This article is based on the 2019 Per Jacobsson Lecture at the International Monetary Fund.