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It has finally dawned on left-leaning economists like Paul Krugman and Larry Summers that the U.S. economy is not suffering from a temporary lull in demand but rather from a structural problem that yields slower growth from a permanently lower base. If this economic outlook is correct, and there is plenty of evidence that it is, there is little reason for Keynesian stimulus, which sacrifices long-term growth to avoid permanent damage from a temporary lull in demand. When a slowdown is structural, as it is today, the damage from economic displacement is unavoidable. If government spending could permanently grow an economy, Europe, especially Southern Europe, would have proven to be one of the faster growing economies in the world, rather than the opposite.
Paul Krugman correctly notes that savings now outstrip the need for investment, but mistakenly attributes the reason to slowing population growth. The notion that all investment waits for growing demand is extreme. Today, innovation drives growth. Investments in innovation create value independent of population growth and force competitors to respond in kind in order to avoid losses and preserve their profits.
More likely than Krugman’s theory is that the economy now recognizes something it never should have forgotten — banks are inherently unstable. Eight hundred years of financial history has proven this to be true. Without a significant U.S. run on the banks since the Great Depression, we naively came to believe we had solved this problem. But the 30-percent drop in real estate prices between August of 2007 and the first quarter of 2009 set us straight. The private sector has permanently dialed back risk-taking in all its forms to compensate for this now-recognized risk. As a result, growth has slowed and savings sit idle.
To bring the supply and demand for savings back into balance, Krugman calls for negative interest rates via increased price inflation-presumably, permanently negative real rates given what he now sees as the permanent nature of the problem. It is true that when savings sit idle, neither consumed nor invested, as they do today, growth slows, unemployment rises and wages fall. While negative interest rates discourage savings, they are unlikely to work as a permanent solution. Paying people to borrow money would grossly distort lending and would be unsustainable.
Nor is it likely the Fed can engineer a bout of price inflation to drive down real interest rates without slowing growth further. The Fed has printed $2 trillion of money over the past five years with little, if any, sign of growth or price inflation. That is because price inflation requires both excess liquidity and tight capacity utilization. Monetary inflation cannot deliver price inflation until the economy recovers, i.e., when price inflation and low interest rates are no longer needed. In effect, monetary inflation hands the Fed the ability to redistribute wealth from lenders to borrowers when capacity finally tightens. Because of this, inflating the money supply only adds uncertainty and produces little, if any, gain. At a time when the growth of the economy is constrained by its willingness to take risk, such policies only hinder growth.
What are we to do?
We must recognize that we do not have a surplus of savings; we have a surplus of risk-averse savings and a shortage of equity.
Risk-averse savers demand the right to withdraw their funds on-demand. They deposit their money in banks, money market funds and repurchase agreements (repos). If these savers panic and run en masse to withdraw their money, as they did when real estate prices fell, they destabilize the economy. Investments funded with bank loans take years to pay back and cannot be liquidated overnight to fund withdrawals.
To grow our economy faster and more stably, we need more equity — wealth that is willing to bear losses — relative to the amount of risk-averse savings that can be withdrawn at the first sign of loss. This is especially true in our innovation-based economy, which depends on prudent risk-taking and the willingness of investors to bear losses to produce growth. Successful innovation, and the risk-taking that produces it, creates more equity, which in turn expands our capacity to underwrite more risk.
More equity is also needed to put risk-averse savings to work. We need equity holders to use their equity as collateral to borrow risk-averse savings and reinvest the proceeds of their borrowing to produce more innovation. Equity holders do not borrow risk-averse savings and take risks because of slightly lower interest rates. They borrow and take risks because they see opportunities and have enough wealth to feel comfortable bearing the possible losses.
A shortage of equity slows innovation and leaves risk-averse savings sitting on the sidelines unused. Taxing, redistributing and consuming the returns to successful risk-takers slows the accumulation of equity, which ultimately slows growth. In the face of permanent structural problems, short-term gimmicks like price inflation and negative interest rates or government spending funded by higher taxes on successful entrepreneurs will not grow our economy faster, quite the contrary. Without a temporary lull in demand, we have to grow the old fashion way — by earning it.
Edward Conard, a former Managing Director at Bain Capital, is a Visiting Scholar at the American Enterprise Institute (AEI). He is also the author of Unintended Consequences: Why Everything You’ve Been Told About The Economy Is Wrong.
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