I’ve been fairly critical of European approaches to macroeconomic stimulus, but some pushback I’ve received forces me to acknowledge that there are real limits to what Europe can do in this regard given the institutional set-up and the ex ante debt/GDP ratios some of the major players are facing. In retrospect, the European Union’s institutional set-up involves an implicit assumption that there just can’t be a gigantic global depression. And yet there can! Given the realistic alternatives, I’m not sure that it looks like a mistake even in retrospect (which says more about the realistic alternatives than anything else) but it’s really far from optimal. Consequently, the hopes for recovery—even in Europe—largely focus on the United States. The American consumer has been the motor of demand growth over the past ten years, and the hope is that the machine can be made to work again by turning the motor back on.
Unfortunately, that seems completely unrealistic to me. If you go back in time 18 months, even people who didn’t have the foggiest inkling of what the near-future held in store for us could have told you that US consumption growth could not continue at the same pace. What wasn’t known was how, exactly, the unsustainable path was going to change. But now we know. And though one certainly hopes that confidence and consumer demand can be restored somewhat beyond the low point we’re currently facing, to actually return to the pre-crash level and trend of demand growth is hard to imagine. After all, back then people were consuming by going into debt, debt that creditors were offering them on the assumption that they owned valuable assets. Now it turns out that our assets aren’t actually worth as much as people thought. And given that reality, consumption has to track income, not fantasy asset-accumulation.
I think this leaves us, somewhat disconcertingly, with the conclusion that the fate of the world rests largely on the shoulders of China. We’ve seen over the past ten years that China has the right combination of good-enough institutions and a low-enough starting point to experience really rapid growth in productive capacity. The way the world is supposed to work is that in rich countries people already have a lot of stuff and the prospects for future growth are only middling. Consequently, people save. Those savings, in turn, ought to become investments in poor-but-growing countries where the prospects for very rapid growth (and thus a high rate of return) look better. And since there’s an inflow of investment money, the residents of the poor country, who have many more objective material needs than those of us in rich countries do, can borrow funds to increase consumption.
There’s sound theoretical reasons to think that the world should work this way. Empirically, we underwent a span from the Asian crisis through to the subprime crisis when the world did not, in fact, work like that. The underlying cause seemed to be a belief in Asia that the lesson of the earlier crisis was that you need to stockpile vast reserves. But the theory behind the “money flows uphill” period was always less clear. Now that it’s unraveled, though, we can see that it came down to the (preposterous) idea that real estate values in the United States and a few other countries (Spain, Ireland, UK) could keep rising faster than incomes forever. That was wrong. And now the question, on some level, is whether or not we can get the money flowing downhill again. Right now it’s just sort of clumping up in pools doing nothing.