Paul Krugman, 2008 Nobel Economics Prize Winner, chiefly for contributions to ‘New Trade Theory’, and well known New York Times columnist and blogger, under the rubric ‘Conscience of a Liberal,’ was in Shanghai last week delivering a speech on the present international financial crisis at Jiao Tong University. The event attracted wide media coverage in addition to over 1,000 people in the immediate audience. For those able to read Chinese a full account, including on specific issues to deal with the China, can be found here. As I was on the panel with Krugman discussing his talk afterwards it was an excellent opportunity to clarify issues with someone who is now one of the most influential economic voices in the US.
Krugman’s sincerity, good intentions, and factual knowledge were beyond dispute. He bluntly contrasted the new situation for rational discussion under the Obama administrations, in comparison to George W. Bush's, as the ‘difference between light and darkness’. Krugman’s overall economic perspective, with a major exception discussed below, was rather realistic - the format of a nearly one hour talk, followed by two hours of panel discussion and audience questions, giving considerably greater opportunity for detailed clarification than newspaper columns.
Krugman outlined his view that ‘probably’ the world economy would escape a 1930s type depression – noting that the fact he had to use the word ‘probably’ showed how serious the situation was. What he however considered possible, and feared, was a prolonged economic stagnation, or anaemic recovery, similar to the 1990s ‘lost decade’ in Japan. In such a perspective there would not be a 1929 type collapse in production but only a weak and protracted US recovery – i.e. a prolonged period of US economic stagnation. According to the latest survey by the Wall Street Journal such a perspective has now become the dominant view among US economists of diverse theoretical outlooks.
Krugman’s own argumentation for such a perspective was Keynesian – he restated Keynes was his ’god’. The present blog, in contrast, would not agree with such a line of reasoning - and would stress supply side factors rather than those rooted in demand stressed by Keynes. The reasons for this are that additions to effective demand are ineffectual rather than raising output, or merely produce inflation, if the appropriate conditions for increasing production do not exist on the supply side of the economy. This is not merely the case under the well known condition that spare capacity does not exist in the economy, in which case evidently increased demand cannot translate into increased output, but, in a private sector dominated economy, under conditions in which profitable increases in output cannot be undertaken. Nevertheless, analysing the supply side, then provided rational economic policies are adopted a 1929 style collapse, if not a significant period of relative economic stagnation in the US and Europe, should be avoidable.
The reason for this lies in the different state of the world economy today compared to 1929. In 1929 the US was not only the world’s largest economy but also its most dynamic. When the US financial system imploded in that year there was therefore no backstop to prevent the whole world economy being dragged downwards.
Today the world’s most rapidly growing economies are in Asia not in the US. India has the second most rapidly expanding economy in the world and is coming through the international financial crisis with a slow down in the rate of growth in GDP but no contraction of the type seen in the US and Europe. China’s savings, i.e. its finance available for investment, are as large as those of the US in absolute terms. Some other South East Asian states are continuing to grow – although a number, such as Singapore and Hong Kong, have suffered severely from the financial crisis. In short there is today an economic and financial backstop to the US, unlike in 1929.
These economically more dynamic Asian states are not large enough by themselves to propel strong overall world economic growth. China, India and the economies of the other South East Asian states taken together are still somewhat smaller than the US economy. But they are large enough, provided rational economic policies are pursued elsewhere, to prevent an international 1929 type collapse. Relative stagnation in the US and Europe, accompanied by growth in major parts of Asia, is therefore a realistic perspective for the world economy - even if the present author would arrive at that conclusion via a rather different perspective than Paul Krugman - Krugman did not outline his specific perspective for Asia. The proviso, however, is provided ‘rational’ policies are pursued and this is where the differences with Krugman developed in the debate.
Relative economic stagnation in the US and Europe, accompanied by still relatively strong economic growth in China and India, necessarily means a further shift in the economic relation of forces in favour of the latter two countries. From the point of view of the world economy and its recovery, or of increasing the standard of living of the two and a half billion people in these countries, of course, this is no problem. But it is for those who approach the financial crisis not via the angle of what is good for the world economy but from that of how to maintain the dominance of the US in the world. It is this which produces the danger of policies being pursued that are not economically rational.
The underlying problem in the world economy at present is that at its current rate of investment in GDP the US cannot compete, at anything like its present exchange rate, with the rising Asian economies. This is the cause of the well known US balance of payments deficit. US consumption has therefore been kept higher than its production via a massive borrowing from abroad that is ultimately unsustainable. The only way stabilisation can be achieved is therefore through a reduction in US consumption. This, in turn, can only take place through means that are either extremely painful for the US population in terms of reduced living standards (a reduction in the share of household consumption in GDP) or by means which probably involve reductions in US military spending (that is if a reduction in government consumption is not to take place in the fields of health and education). In short, to adapt the old phrase, the US can afford butter or guns but it can no longer afford both.
The attempts by the Obama administration to avoid this choice between butter and guns, that is to maintain both the high level of household consumption in US GDP, together with spending on health and education, while simultaneously refusing to cut the military budget has only been achieved through a radical reduction in US investment. But such a strategy is not viable in anything other than the short run as it undermines further the competivity of the US economy – the original cause of the crisis. The inescapable choice between butter and guns therefore still lies ahead for the US.
Paul Krugman, when questioned, however would not accept the importance of the low US investment rate. He also argued that in any case he could see no policy which could reverse this. He also stated the further decline in US investment was only due to the fall in residential investment under the impact of the sub-prime mortgage crisis.
First these statements are factually incorrect. While the decline in US investment certainly started in the residential sector, under the impact of the sub-prime mortgage crisis, the largest fall in US investment since the financial crisis started in September 2008 has been in non-residential investment. Between the third quarter of 2008 and the first quarter of 2009 US residential investment fell by 0.6% of GDP but non-residential investment fell by 1.6% of GDP i.e since the beginning of the international financial crisis 72% of the decline in the proportion of US GDP devoted to investment has been caused by a decline in non-residential investment and only 28% is due to a decline in residential investment.
These trends are shown in Figure 1, which graphs the decline in the components of US GDP as a percentage of total GDP since the third quarter of 2008, and in Figure 2 – which shows the decline in residential and non-residential US investment as a percentage of GDP over the same period. These trends make it clear that since the financial crisis broke out it is the decline in non-residential US investment, not in residential investment, that has been the driving force of the economic downturn.
Second, however, a decline in residential investment is by itself destabilising. It both reduces overall demand in the US economy and will be a contributory factor to macro-economic destabilisation created by future house price bubbles – such bubbles are due not only to excessive demand, due to excessively lax monetary policy, but to shortages in supply due to lack of investment in housing stock. This is clear from the experience of countries such as the UK, where house price bubbles have been worsened by shortage of supply, particularly in specific areas of the country such as London.
Third, contrary to Paul Krugman’s reply, it is evident that there are policies which could raise US investment. Shortage in US savings, accompanied by a balance of payments deficit, is simply another way of saying that the US is consuming more than it produces. Increased investment, financed from within the US, requires that the share of consumption in US GDP must be cut. As noted above that can either be done by reducing living standards, that is reducing household consumption, which presumably Paul Krugman would not want, or by reducing government consumption. Releasing resources in these ways would stimulate investment both via indirect means, ending the excessive calls on available resources leading to a reduction in interest rates, or via direct ones, the government for example increasing tax breaks for investment, or both. Therefore it is simply not true that there are no policies which would increase US investment.
What is true, however, is that such policies would require a change in the shape of the US economy. However that is precisely what is required - as it is the present unsustainable excess of US consumption over US production that led to the financial crisis. Maintenance of the present structure of the US economy merely means that the crisis will reappear even if the most immediate wounds are bandaged up through the financial stabilisation packages.
In short, the error of Paul Krugman’s perspective was that it underestimates the reshaping of the US economy that is required. This error is in line with the present policies of the Obama administration which, as discussed on previous posts on this blog, are also essentially maintaining the existing pre-crisis structure of the US economy. Whether or not the immediate US government packages stabilise financial markets, which remains to be decided, the fact that the underlying distortions of the US economy have not been resolved means that in the medium term, and possibly in the short term, various symptoms of the crisis will reappear.
The discussion with Paul Krugman in Shanghai was therefore enlightening not only from the point of view of its discussion of China but from the point of view of analysis of the US economy. It revealed Paul Krugman, together with the Obama administration, underestimates the scale of transformation which is required in the US economy.This misunderstanding by the Obama administration will doubtless have significant consequences in the months to come. Altogether a clarificatory event.