Larry Summers

October 14, 2012

If the global economy was in trouble before the annual World Bank and IMF meetings in Tokyo last week, it is hard to believe that it is now smooth sailing. Indeed, apart from the modest stimulus provided to the Japanese economy by all the official visitors and the wealthy financial sector hangers on, it is difficult to see what of immediate value was accomplished.

The US still peers over a fiscal cliff, Europe staggers forward trying to prevent crises King Canute-style with no compelling growth strategy, and Japan remains stagnant and content if it can grow at all.

The Bric countries, meanwhile, are each unhappy stories in their own way. On the one hand, they are constrained by deep problems of corruption and financial imbalances that are impeding growth, while at the same time demographic trends cast doubt on their long-term prospects.

In much of the industrial world, what started as a financial problem is becoming a structural one. If growth in the US and Europe had been maintained at its average rate from 1990 to 2007, gross domestic product would have been between 10 and 15 per cent higher today and more than 15 per cent higher by 2015 on credible projections. Of course, this calculation may be misleading because global GDP in 2007 was inflated by the same factors that created financial bubbles. However, even if GDP was artificially inflated by 5 percentage points in 2007, output is still about $1tn short of what could have been expected in the US and EU. This works out to more than $12,000 for the average family.

There is some validity to this view. Domestic political constraints and imperatives do interfere with necessary actions in much of the world. US politics have been dysfunctional in the run-up to the 2012 election. The EU sometimes makes the US Congress look like a model of crisp efficiency in making decisions. In Russia and China, authoritarian leaders who lack legitimacy struggle to drive economic reform, but so do those with democratic mandates in India and Brazil.

Concern about politics and the processes of international co-operation is warranted but the best one can hope for from politics in any country is that it will drive rational responses to serious problems. If there is no consensus on the causes or solutions to serious problems, it is unreasonable to ask a political system to implement forceful actions in a sustained way. Unfortunately, this is to an important extent the case with respect to current economic difficulties, especially in the industrial world.

While there is agreement on the need for more growth and job creation in the short run and on containing the accumulation of debt in the long run, there are deep differences of opinion both within and across countries as to how this can be accomplished. What might be labelled the “orthodox view” attributes much of our current difficulty to excess borrowing by the public and private sectors, emphasizes the need to contain debt, puts a premium on credibly austere fiscal and monetary policies, and stresses the need for long-term structural measures rather than short-term demand-oriented steps to promote growth.

The alternative “demand support view” also recognizes the need to contain debt accumulation and avoid high inflation, but it pushes for steps to increase demand in the short run as a means of jump-starting economic growth and setting off a virtuous circle in which income growth, job creation and financial strengthening are mutually reinforcing.

International economic dialogue has vacillated between these two viewpoints in recent years. At moments of particularly acute concern about growth, such as in spring 2009 and now, the IMF and many but not all monetary and fiscal authorities tend to emphasize demand-support views. But the moment clouds start to lift, orthodoxy reasserts itself and attention shifts to fiscal contraction and long-run financial hygiene.

This is a dangerous cycle whatever your economic beliefs. Doctors who prescribe antibiotics warn their patients that they must complete the full course even if they feel much better quickly. Otherwise they risk a recurrence of illness and worse yet the development of more antibiotic resistance. So too with economic policy. Advocates of orthodoxy prize consistency. Those like me whose economic thinking emphasizes promoting demand worry that expansionary policies carried out for too short a time will prove insufficient to kick-start growth while at the same time discrediting their own efficacy and reducing confidence.

The Tokyo meetings may not have had immediate impact. But the IMF’s emphasis on the need to sustain demand and its recognition of the importance of avoiding lurches to austerity can be very important for the medium term only if it is sustained through the next round of economic fluctuations.