October 27, 2008
Events as well as ideas shape policy choices in democracies. Who would have predicted a year ago that a Republican ad-ministration would demand that Congress make the largest set of investments in public companies in US peacetime history? Would anyone have supposed that President George W. Bush would convene a global effort to renew Bretton Woods through strengthened international financial regulation? It reminds us that in the economic sphere, as in the national security sphere, dramatic events can make the inconceivable become inevitable.
Discussions of the policy implications of the crisis have primarily focused on the immediate economic demands. The need to ensure the capital adequacy of financial institutions, maintain important credit flows, support the housing sector and the real economy, contain international spill-overs and reform regulation to prevent any recurrence of the crisis have rightly been the priority. In all these areas there will be many crucial policy choices to make in the months ahead.
However, policies that contain the crisis, support the economy and generate recovery are not sufficient to meet the historic challenge of this moment. Even with the best conceivable fiscal, monetary, financial and regulatory policies, economic performance depends on deeper and more structural policy choices. Nations cannot fine tune their way to delivering a prosperity that is more broadly based. In important ways, then, the crisis creates space to address longer standing problems. Just as patients hear advice regarding diet and exercise differently after a heart attack, so recent events should make it possible for the next US administration to accomplish more than might previously have been thought possible.
These broader goals depend on achieving the rapid and sustained growth that restores business confidence and generates the resources for investment. Economists do not understand what drives productivity growth very well. However, we know these facts: productivity grew rapidly after the second world war and then sometime between the late 1960s and mid-1970s it slowed dramatically only to re-accelerate to record levels in the mid-1990s. Unfortunately, even before the downturn, underlying productivity growth appeared to be slowing.
The most plausible explanation is that an array of transforming investments and technologies -the interstate highway system, widespread air travel and the expansion of electronics – were spurs to growth during the postwar period. Eventually their impact dissipated and, as energy costs rose, growth slowed until the information technology revolution kicked in during the 1990s. Unfortunately, the IT supply shock that powered the economy in the 1990s and early part of this decade appears to be diminishing.
So there is a need to ensure that the pressure to increase spending is directed at areas where it will have the most transformational impact. We need to identify those investments that stimulate demand in the short run and have a positive impact on productivity. These include renewable energy technologies and the infrastructure to support them, the broader application of biotechnologies and expanding broadband connectivity, an area where the US has fallen behind.
The crisis has also reminded us of the lessons of the technology bubble, Japan’s experience in the 1990s and of the US Great Depression – that finance-led growth is problematic. The wealth and income gains from the easy availability of credit were highly concentrated in the hands of a fortunate few. The benefits also proved temporary. In retrospect, the fact that 40 per cent of American corporate profits in 2006 went to the financial sector, and the closely related outcome – a doubling of the share of income going to the top 1 per cent of the population – should have been signs something was amiss.
Therefore we need to reform tax incentives that encourage financial risk taking, regulate leverage and prevent government policies that give rise to a toxic combination of privatised gains and socialised losses. This offers the prospect of a prosperity that is more firmly grounded and more inclusive. More fundamentally, short and longer-term imperatives come together with respect to policies that seek to ensure that any future prosperity is inclusive. The policies that are most effective in helping to support demand are those that help households struggling either because of low incomes or because they have recently lost part of their income. Recent events also remind us that individuals can become impoverished or lose health insurance through no fault of their own. This reinforces the need for people to have basic health and retirement security protection regardless of what happens to their employers.
All of these considerations suggest that the pendulum will swing – and should swing – towards an enhanced role for government in saving the market system from its excesses and inadequacies. Policymakers need to be attentive to potential government flaws as well. For example, they need to recognise that, even as events compel larger deficits in the short run, they reinforce the need for longer-term measures to keep government finances on a sound footing. They must also be wary of measures that have a short-term superficial appeal, yet have adverse long-term consequences.
It is said in all presidential election years that the choices made by the next president are uniquely important. This time the cliché is true. The gravity of our situation is matched only by the opportunity it presents.
The writer is the Charles W. Eliot university professor at Harvard and managing director of D.E. Shaw & Co
Copyright The Financial Times Limited 2012.