The Dangers of Insufficient Stimulus

David Leonhardt 

My basic argument is that the current macro policy discussion is mostly missing the point. Our situation (in the U.K., the U.S., and arguably in most of the major Western economies) is one where policy makers face a long uphill battle, in which monetary ease has an ongoing role to play, even if it may not deliver recovery on its own. Insufficient monetary action risks turning sustained low growth and near deflation into a self-fulfilling prophecy. This happened in Japan in the 1990s, and in U.S. and Europe in the 1930s. I don’t think things will be “that bad” in the sense of an outright depression, but we face a real risk of long-term stagnation with some distracting upward blips and slowly eroding capacity.

There are not finely balanced risks between overheating on inflation and a double dip. That’s the fine-tuning thinking of the past decade, and certainly is wrong now. The danger is the 1930s mistake, not the 1970s one. Wage growth in the private sector is well below productivity growth, and public sector wages and employment will be cut substantially for the next few years. It seems impossible to have an upward wage-price spiral under such circumstances.

Instead, we need to recognize that if we engage in insufficient stimulus, then aggregate supply and productivity will get worse — not only through the evident worsening of labor market matching, but through banks cutting off loans to new and small businesses, and R.&D. being cut. The short-term blips in the economy are no way to judge whether we are coming out of this state of the world. We saw similar starts and stops in the Great Depression and in Japan. We would have had to see inflationary pressures and rising interest rates to indicate we were in a different kind of recovery than the bad kind, and we haven’t.

In terms of how to do more, there has been too much obsession with the scale of central bank balance sheets. It is backward logic to say that because central banks have bought more assets than ever before, we must have done a lot or our efforts must be fruitless. That is like saying, “that fire must be out because we’ve already pumped more water than for any previous fire we’ve fought before.”

The likely reason monetary stimulus will be insufficient on its own to bring sustained recovery is the ongoing fragility of the financial system limiting lending to new and small business. Having some day-to-day financial stability due to guarantees is not the same as having a fully functional banking system – the proof of functionality is in lending, not stress tests.

Ultimately, doing more monetary stimulus is the right move for the long term – this is not about impatiently preventing a double dip. Doing more would prevent erosion of our productivity and work force, and forestall (I hope) falling into a self-fulfilling trap. It also is an important insurance policy against political illiberalism and protectionism arising. It is just as important to future generations that we deliver them an intact democratic system and liberal world economy, as to consider the commonly spoken debt-burden concerns.