Barack Obama and Mitt Romney agree on at least one thing: that this election is “a choice between two different paths for America,” as the president put it. Yet when it comes to the economy, many of the basic reasons for our sluggish recovery and the ideas needed to address it have been missing from the debate. Instead, we have been given a choice between the clearly mistaken supply-side tax cuts and deregulation championed by Romney, on the one hand, and the well-meaning but timid proposals of Obama, on the other. Here are five economic ideas that should be at the center of the election debate but are not.
§ Let’s begin with a key point about today’s crisis: we are in what economists call a “balance-sheet recession.” This is the only way to explain why, despite repeated doses of monetary stimulus and large budget deficits, the economy is essentially stalled, producing well below potential with continued high unemployment. The two textbook cases of a balance-sheet recession are the Great Depression and Japan’s “Lost Decade,” which began in 1990. Like those two cases, our recent recession followed a financial crisis involving the bursting of a major asset bubble—in this case, the housing and credit bubble. When it collapsed in 2007, housing and other asset values fell, leaving many households with unsustainable levels of debt. Accordingly, they have had no choice but to cut spending and increase savings in order to pay down debt, thus reducing consumer demand. And with weak consumer demand, businesses quickly followed suit by curtailing investment and cutting the workforce.
The overall effect has been a huge shortfall in demand, which has been worsened by an even more worrying debt and institutional crisis in Europe, and now by a potentially serious economic slowdown in China. The only way the government has avoided depression has been by borrowing and spending to offset the falloff in the private sector.
The problem is that balance-sheet recessions can drag on for years—in this case, until the household sector (about 70 percent of the US economy) has repaired its balance sheet or some major new source of demand emerges in the world economy. By most estimates, we are less than halfway through this deleveraging process. (Household debt as a percentage of GDP has declined from a peak of 97.5 percent in 2009 to 83 percent today, but is still considerably above its pre-bubble level of 65 percent.) And the world economic slowdown will probably continue to weigh on the United States for some time.
The bottom line is that Washington has no choice but to borrow and spend for the foreseeable future. The question is how large this borrowing and spending should be, and what form it should take. But that is not the debate the presidential campaign is giving us. Instead, both parties are trying to impress us with their commitment to cutting the deficit. But even modest steps to reduce the deficit in the short to medium term will bring about the kind of premature fiscal consolidation that prolonged the Great Depression when FDR decided to cut spending and raise taxes in 1937.
§ We need to create “good deficits” by replenishing America’s capital stock. The federal government has been running large deficits; the problem is that they are what some economists call “bad deficits.” Take the fiscal year 2012 shortfall, projected to be $1.1 trillion. That sounds large, yet it is not the result of government spending on things that will make us richer and more productive or put more people to work (such as infrastructure, research and development, and human capital). Rather, the deficit is mostly the result of weak tax revenues arising from slack economic growth; supply-side tax cuts (originating in the Bush era but extended ever since) that reward wealthy Americans but have little stimulative effect; and the lingering costs of two wars of occupation, which have done little to promote economic activity at home. In fact, if one includes state and local government spending, total government investment has actually declined over the past four years—in part because Republicans in Congress have blocked even the administration’s modest proposals in this area.