The economic policy debate in Washington has come down to a boxing match between two opposing remedies – with “stimulus” in one corner and “austerity” in the other. Unfortunately, considering each so-called solution in isolation has hampered both analysis and decision-making. The proponents of stimulus argue that the losses in aggregate demand following the global financial crisis must be reversed. Their opponents say that austerity is needed to restore fiscal sustainability. But to understand how elements of each fit together, a different approach is needed, one that “connects the dots” and integrates the sets of economic logic and data employed by the two sides.
The problems of the financial crisis and economic downturn are a case in point. Leading up to the crisis, market participants and policymakers failed to understand the interconnections within the “shadow banking” system. The ensuing freeze in the repo financing markets – particularly after Lehman Brothers’ bankruptcy – had severe adverse effects on credit demand and supply, and employment. But the US economy’s structural problems predated the financial crisis. Public policy and the financial system were geared to promote excessive reliance on consumption, with inadequate support for business investment and exports. Making the right connections would have exposed this imbalance, and the role of leverage in propping up economic growth that looked solid on the surface.
Understanding these links provides a clear direction to restart growth. The US economy must shift toward promoting investment and exports. This requires a return of confidence. Businesses need a shock to “animal spirits” to promote investment, and the incentives to investment should be substantial. At the same time, debt-service burdens are constraining households’ ability to respond to policy actions. Consumers need to feel more secure about their net worth. Policies should facilitate these adjustments, and offer a foundation for growth and wealth appreciation.