Professor DeLong, the goal of our discussion today is to get your view on “why is this time different?” We had a deep financial crisis, a deep recession, and a sluggish recovery since then. Why are we witnessing something that is so unfamiliar to us given the experience of the last 30 to 40 years?
I don't think we have a good answer why this time is different, but it certainly is. Back in the early 1990s, the interest rates on U.S. Treasury bonds were relatively high and tended to rise when you got bad news about growth. Now, that’s not the case. There is a flight to quality, a flight to safety. The fact that bad news about growth is worse news for private and other bonds seems to be creating a situation in which the treasury market strengthens, when all of our previous thoughts about how things have worked for the past two generations would make you think it ought to weaken.
This can't go on indefinitely. Sooner or later, fundamentals will make themselves felt, and treasury yields will start to rise and rise very steeply. But for the moment, that's not the world we’re in and it's not the world we’ve been in for the past five years.
Let's review the policy of the U.S. Federal Reserve in this context. The Fed’s balance sheet has exploded since the financial crisis. You could say that in the beginning it was to generate trust in the system—in effect, to say, “Lehman was an accident, but nobody else will go bankrupt.” But now, years later, we still have the policy of “quantitative easing infinity.” How does it fit together?
Well, one way to look at quantitative easing infinity is that it is a bet that sufficiently expansionary monetary policy can resolve what Richard Koo, chief economist at the Nomura Research Institute, calls a “balance sheet recession.” Whether that's true or not, we really don’t know. We are about to conduct an experiment to find out.
What should the U.S. government’s policy be? On the one hand, Nobel economist Paul Krugman argues that money is free so the government should borrow and spend to stimulate the economy. On the other, PIMCO bond manager Bill Gross says the U.S. deficit is in the same league as Spain and Greece. What’s your view?
The big difference between the U.S., on the one hand, and Spain and Greece, on the other, is that people are willing to lend to the U.S. on extraordinary terms for extraordinary lengths of time that I never thought I would see in my lifetime. So, the natural thing when people are willing to lend you money on easy terms and accept a lot of inflation and other risk for doing so, is to borrow—if you can find productive things to do with the money.
Everyone expects that the U.S. economy will grow over the next generation, not only from natural population increase and productivity growth, but also from immigration. With treasury rates at their current levels, it makes enormous sense to borrow money now and pay it back in a generation. Certainly, the U.S. government can do productive things with the money. The U.S. infrastructure is outmoded and falling apart. The country has stepped back on its commitment to education. There is a powerful argument for pulling government spending forward from the future into the present and pushing taxes from the present back into the future. And I think the U.S. government should do that until interest rates change.
Let’s turn to Europe. When you look at Europe as a whole, compared to the U.S. we are in pretty good shape. The deficit of the Eurozone countries is around 3.5 percent of GDP, compared to more than 8 percent in the U.S. And the overall debt level of the U.S. government is much higher. Why is Europe portrayed as the bad guy of the world economy? Aren’t we actually in better shape than the Americans?
There are two worries about Europe. The first is demographic. Right now, the U.S. has about 320 million people and Europe has 400 million. But everyone expects that in 50 years, the U.S. debt will be paid off by 550 million people, while Europe will still have the identical population of roughly 400 million. That makes the calculus of the debt burden and the deficit for the two economies significantly different.
The second thing is the north-south imbalance in Europe. Larry Summers likes to point out that back in the early 1990s, when Texas overinvested in shopping malls just like Spain has more recently overinvested in beachfront condominiums, the United States central government transferred 25 percent of Texas’s annual GDP to that state over three years in order to resolve the overinvestment, bankruptcy, and necessary deleveraging problems in Texas. At the time, the rest of us didn't really notice, because the United States has had a fiscal union for some 250 years now.
Europe, however, created a monetary union at Maastricht but without a fiscal union. And now, the fact that monetary union seems to imply a significant amount of fiscal union, at some level, is becoming clear. And German and other northern European taxpayers are nervous about what this entails. The fact that the fiscal transfer to deficit regions may not happen is the thing that is causing a sovereign-debt crisis in southern Europe, and that is causing the current European upset.
Summarize your view on the world economy for the next year and, say, the next five years. What are your expectations?
The main expectation has to be pretty much “more of the same”: continued extremely slow recovery; lots of bad debts in the U.S. housing market, meaning that U.S. housing construction remains depressed; continued downward fiscal pressure on public spending in the United States. Taken together, those trends mean that even very low interest rates and healthy business investment in equipment won’t pull the U.S. up to anything we’d regard as full employment or produce a situation in which there’s any upward inflationary pressure as well. So, figure a U.S. economy that grows at 3 percent per year over the next five years and a European economy that grows at 2 percent, interrupted every two years by another financial crisis that requires another assumption of long-run burdens, in one way or another, by the German taxpayer.
On the downside, there are definite risks that governments will perform significantly worse than they have over the past five years, that you will have a European crisis of some sort that causes a repeat of 2008 to 2009 in Europe, or that you will have a collapse of U.S. governance, perhaps created by congressional gridlock and the coming of the fiscal cliff, which would produce a massive increase in taxes and cuts in spending in the United States in the next six months that would then send the U.S. back into recession.
On the upside, it’s hard to see situations in which economic growth materially accelerates, and then we stop worrying about our current problems of deleveraging and debt overhangs and start worrying about the problems of inflationary pressures and the unwinding of the enormous stocks of government debt and of liquidity that have been accumulating over the past five years. Actually, it would be really nice to be able to worry about a different set of problems because it’s a lesser set of problems than what we have now. But I don't see a substantial chance of that in the next several years.
Which is good news for you, because then economic advisers will be high in demand!
Economic advisers are high in demand. But it’s embarrassing because you notice how many things you have failed to call correctly over the past five years! You think you have knowledge, but your knowledge has only enabled you to be confused and wrong at a more sophisticated level.
Well, Professor DeLong, I'm sure you didn’t confuse our viewers. Thank you very much. We look forward to continuing the discussion with you at some point in the future.
Thank you very much for inviting me. It’s been a great pleasure, and I look forward to coming back again and confessing my errors!