(Originally published here.)
Michael Kinsley has received a great deal of grief for an essay in The New Republic about fiscal policy. The piece was predicated on a mistaken set of beliefs about the nature of government debt that have been rightly criticized. However, several people have overreacted to this passage:
I don’t think suffering is good, but I do believe that we have to pay a price for past sins, and the longer we put it off, the higher the price will be. And future sufferers are not necessarily different people than the past and present sinners. That’s too easy.
The interesting question isn’t whether we can avoid pain but how it should be distributed. Paul Krugman acknowledged as much in a useful post describing the U.K. in the years after World War II. (Forced to choose, Krugman prefers a world of rationing and rapid inflation to one with mass unemployment.)
Consider the two back-to-back orgies of wasteful investment the U.S. has recently experienced. Between the beginning of 1996 and the middle of 2000, overly optimistic predictions about the potential for information technology fueled a surge in business spending: Real nonresidential private investment increased at an annualized rate of more than 12 percent. That wouldn’t have been a problem if IT had lived up to the hype. Unfortunately, the investments weren’t as worthwhile as advertised. Those capital expenditures saddled many businesses with unneeded capacity. Investment spending subsequently plunged by more than 20 percent and didn’t return to its pre-recession level until the beginning of 2005.
As I noted in a previous post, the years following the tech bust were characterized by deeply depressed levels of private employment and stagnant median incomes. The irrational exuberance of the 1990s led directly to those unpleasant outcomes, despite the fact that the Federal Reserve was desperately trying to “boost asset prices in order to stimulate demand,” as Donald Kohn put it in a meeting on March 16, 2004, and despite large tax cuts that raised the take-home incomes of many Americans. Reasonable people can disagree how we could have distributed the pain of the tech bust better. I struggle, however, to imagine a scenario in which no one suffered after all that waste.
It’s even harder to imagine how we could have prevented anyone from feeling pain as a result of the second wave of excessive investment. From the beginning of 2002 through the middle of 2005, real residential construction spending grew at an annualized rate of 7.4 percent. That compares to a long-term average growth rate of just 1.9 percent. Even excluding the data since the end of 2000, the long-term average growth rate in real residential construction spending is still only 3.1 percent. Remember that this average includes the years when houses were being built in record numbers to accommodate the postwar “baby boom.” Easy credit boosted housing prices, which in turn financed about $1.25 trillion in additional consumer spending.
We are still living with the consequences of the excessive private borrowing of the go-go years: joblessness, poverty, and falling real incomes for middle-class Americans. This pain could not have been avoided — the historical record is unambiguous when it comes to the aftermath of rapid credit expansions. The suffering could have been distributed very differently, however. In its infinite wisdom, the U.S. government saw fit to insulate bank creditors and many bank employees from the consequences of their imprudent risk-taking, even as it did next to nothing useful to assist regular borrowers. Many people, including me, think that we could have done much better.
The problem isn’t that we chose to tolerate unnecessary pain — it’s that we dealt with the pain badly. (It’s a small consolation prize that we have, so far, done a better job of things than the Europeans.) Faster inflation, private debt forgiveness and more aggressive fiscal stimulus all would have been helpful additions to the policy mix. I also think the government failed to demonstrate its commitment to the rule of law by declining to punish anyone responsible for what happened.
It all makes me think of Michael Pettis’s latest research note, which was ably summarized by Kate Mackenzie over at FT Alphaville. Pettis argues that cultural norms and legal institutions affect the extent to which societies can turn physical capital and natural resources into real wealth. I worry that the policy choices of the past several years may have reduced our long-term growth potential by undermining these values and institutions. This is the passage that stuck out at me:
The institutional framework around the writing down of overvalued assets, and the liquidation process itself, is an important part of how efficiently an economy is able to absorb the benefits of capital stock. A formalized bankruptcy process that takes assets away from inefficient users, writes them down to a fair market value, and reintroduces them into the economy, creates a much more efficient economic system than one in which bad loans are not recognized, effectively bankrupt companies are allowed to continue in value-destroying activity, and the use of assets is not systematically transferred from the less efficient to the more efficient user.
In fact an efficient and relatively rapid bankruptcy process is, I would argue, of fundamental importance to the ability of an economy to exploit capital stock efficiently. Even very advanced countries without a formal process to transfer resources quickly can have a hard time exploiting its capital and labor factors, especially after a period in which a great deal of labor and capital were directed into unproductive uses. I think Japan’s twenty years of nearly zero growth may be explained in part by the very slow process in Japan by which resources were transferred from “losers” to “winners” after the investment orgy of the 1980s.
Wouldn’t it be ironic if our unwillingness to punish reckless lenders for their sins crippled our economy for a generation?