ECONOMIC AFFAIRS: by Colin TeeseNews Weekly
Harvard economist re-thinks free-market orthodoxy
, February 15, 2014
Outside academic economic circles the United States economist Lawrence H. “Larry” Summers is perhaps not widely known in Australia.
He is, however, a major and influential figure in the U.S. — both in academia and government. A graduate of the Massachusetts Institute of Technology, he has been, among other things, Treasury Secretary under President Bill Clinton, economic advisor to President Barack Obama and a president of Harvard University.
Summers, it is to be assumed, retains a broad commitment to the virtues of the free-market economies as sustained by 19th-century economic thinking. What seems less certain is whether he maintains his belief in the capacity of free markets to find automatic stability at full employment. If he has abandoned that belief, it would be a major shift in position and it may take some of his influential colleagues with him.
Professor Lawrence H. Summers.
As the British cop shows would have it, Larry Summers has form. During his time with President Clinton, Summers was prominent among those who persuaded the U.S. President to repeal the Glass-Steagall Act of 1933. This had been the principal regulatory instrument for controlling U.S. banks since the depths of the 1930s Great Depression. The act provided for a separation of banking activities in order to prohibit banks, inside the same institution, from conducting conventional banking operations alongside financial speculation.
In a well-publicised push towards further financial deregulation, Summers and Alan Greenspan (the then chairman of the Federal Reserve) in 1999 persuaded President Clinton to repeal the Glass-Steagall Act. Such was Summers’ commitment to financial deregulation that he described those who wanted to retain Glass-Steagall as “Luddites”.
The U.S. economy bathed in what Summers and Greenspan believed would be permanent prosperity. However, neither economist recognised that this was an illusion. The economy was actually being propped up by asset bubbles in U.S. shares and real estate.
What commentators mistook for real economic growth was in fact a burst of consumption spending financed by ballooning private debt. By 2007, such debt exceeded the proportions reached in the run-up to the October 1929 Wall Street crash.
In 2007, the U.S. economy experienced the subprime mortgage crisis, which destroyed major financial institutions and crippled the U.S. economy. The U.S. financial crisis thereupon metastasised into the 2007/08 global financial crisis (GFC), which brought the world economy to its knees.
Notwithstanding his earlier poor judgement, Summers was subsequently able to redeem himself — at least in the eyes of President Obama. It is said that Summers was the President’s first choice to replace Ben Bernanke as chairman of the Federal Reserve, but that proved impossible.
Summers could legitimately claim he was not entirely to blame for what happened between 1999 and 2007/08. Mainstream economic opinion supported him every inch of the way.
To his great credit, Summers did not sit idle, lamenting his misfortune. He has used the intervening years to try to make sense of what happened and why — regardless of how this might disturb his cherished economic beliefs. He has concluded, and made public, his view that what earlier was widely believed to be growth may well have been an illusion.
Addressing the International Monetary Fund’s 14th Annual Research Conference on the Economic Crisis in November 2013, Summers told his stunned audience that the absence of real growth could have been masked by a combination of asset “bubbles” and debt-funded consumer spending from the late 1990s to 2007/08.
Once the bubble burst and debt-burdened consumers were compelled to rebalance their budgets, overall spending collapsed and the illusion was exposed, revealing a state which Summers called “secular stagnation” — or, to use plain language, no real growth.
Summers went on to express the startling view that the U.S. economy could possibly have been bogged in this state for more than 30 years. He was not completely sure why but advanced two possible reasons: first, that the rate of population growth in the U.S. had slowed significantly over that period; and, second, that a slowdown in innovation had possibly stalled productivity growth.
If Summers is right about there being a direct connection between population growth rates and economic growth, then he may have uncovered an important truth — which could have serious consequences for the future well-being of most of the Western capitalist economies. Significantly, one of Summers’ closest academic colleagues and friends, Nobel prize-winning economist Paul Krugman, has enthusiastically supported Summers’ conclusions.
Those with long memories, and scores to settle with Summers, haven’t missed the irony that one so closely associated with the onset of the crisis should now be admitting that the good years were, after all, an illusion. Some of them, moreover, observe that Summers is telling us nothing new: U.S. economist Alvin Hansen (1887-1975) — who was often referred to as “the American Keynes” — said the same some 75 years ago.
All of this seems rather pointless. Summers appears to have recognised at last what he may have missed before. So what if he is reinforcing what Hansen said, apparently to deaf ears, 70-odd years ago?
Back then, Hansen thought that structural or secular stagnation had two causes: 1) a fall in the rate of population growth (he was right there, and it is still going on), and 2) a petering out of innovation.
Summers has identified the same two issues. There will be debate in economic circles about whether the point about innovation holds true, but few will deny there is something to the population issue.
This appears to hold also for those economists who, unlike Summers, don’t always accept that unregulated markets necessarily deliver optimum outcomes in terms of output and employment. Yet many of that group stand behind what Summers is contending: that growth is stalled and its absence has been covered up by debt-fuelled consumption housing and share-price bubbles.
Australian economist Steve Keen, author of the book Debunking Economics: The Naked Emperor of the Social Sciences (2001), is one of those who support Summers — which is surprising.
Keen is not, and never has been, a supporter of the economic theory that Summers and Krugman endorse. Keen believes they are mistaken in believing that the marketplace automatically finds equilibrium at maximum output and full employment. He believes that orthodox economics has an imperfect understanding of how markets work. Keen holds that sometimes disturbances like recessions disrupt markets. In those circumstances, the marketplace doesn’t automatically rebalance without the helping hand of government intervention.
Summers, it is now possible to conclude, is saying much the same thing. He appears ready to accept that a slowing rate of population growth may be directly related to why the U.S. economy has been in a state of what he calls “secular stagnation” for the past 30 years. In other words, ordinarily, economic growth is heavily dependent on a growing rate of population increase. Without that, some other kind of growth stimulus is needed.
He is probably right, but there is perhaps a further dimension. There is evidence that the rapid economic growth of China, despite its enormously beneficial effect on the Chinese economy and people, has been a disruptive influence on world markets.
The U.S. since World War II granted Taiwan, Japan and South Korea generous access to its internal market, and thereby helped transform these countries into effectively self-sustaining market economies. How then could the same experiment, when it was tried with China, go so badly wrong?
The time and context were factors, as was China’s commitment to chart its own course. But the overwhelming problem may have been a matter of China’s sheer size.
Basic statistics suggest that the sheer volume of cheap Chinese exports overwhelmed the U.S. economy. The Congressional Budget Committee estimates that over U.S.$1 trillion in output and as many as 8 million jobs were lost to China.
This and a slowing in the rate of America’s population growth could, in the short term, be covered up by resorting to debt-driven consumption and, ultimately, a bubble in share prices and real estate.
Profits from U.S. firms manufacturing in China flowed back to the U.S. and certainly fuelled these fires. These profits, unable to find investment opportunities in productive activities, instead were used to sustain speculative investment in shares and real estate.
If Summers is reading the signs correctly, then the problem he has exposed is very grave. This is especially so if we discover that the same problem might also be afflicting other important Western economies.
More Western leaders should perhaps be troubled by this possibility, more than appears to be so. (For the record, there is no evidence that Summers’ view, despite his personal standing as an economist and his record in academia and government, has had much impact on official thinking, even in the United States — still less in other Western governments).
In one sense, this is hardly surprising. Most Western governments are grappling with economic and financial problems of greater or lesser gravity within a frame of reference bounded by orthodox economics.
Summers’ observations introduce a further complication beyond that framework which, at least for now, they would rather not confront.
This is all the more so because the solution Summers has put forward is that if consumer numbers are not growing at a pace needed to sustain economic growth at a level needed to maximise output and employment, then it may be necessary for permanent levels of government financial injections to be introduced into economies to achieve that end.
This proposal by Summers, despite the prestige and influence that stand behind it, is for the moment likely to go unconsidered. Most policy-making bodies of most Western governments are thinking about diametrically opposite remedies.
Their overwhelming priority is to reduce government debt: economies, they are convinced, will achieve maximum growth only under that stimulus — and jobs will follow.
For the sake of our future economic prospects, let us hope that governments have got it right and that Summers is wrong.
Colin Teese is a former deputy secretary of the Department of Trade.