Why is the U.S. economy — or for that matter, most other advanced economies — failing to thrive? This topic of a global malaise has generated intense debate among economists. Their explanations are very technical, but worth considering for an understanding of elite thinking about the issue — and its limitations. Dominating the discussion is Larry Summers’ reintroduction of economist Alvin Hansen’s 1938 term “secular stagnation.” In the contemporary formulation, “SecStag” means “that negative real interest rates are needed to equate saving and investment with full employment.” That is, the U.S. and other afflicted countries are trapped because traditional monetary policy can no longer bring the economy back to vibrancy.
Summers’ analysis is largely a story of inadequate demand, and an excess of savings over investment. There are other interpretations of “SecStag” and diagnosis of why economic growth has been so anaemic since the financial crisis. However, a complete analysis must also consider that the U.S. is suffering from more than just a post-crisis malaise: productivity in the U.S. started slowing down in the mid-2000s, during the height of the boom, long before the bust. A 2014 Federal Reserve Bank of San Francisco economic letter noted, “the sluggish output growth since 2007 reflects poor productivity trends that predate the recession.” (italics in original). That is, productivity growth in the U.S. has been sluggish for a long time — and no one knows why.
A “neo-Austrian” explanation
There is a very different explanation of what ails the U.S. and other advanced economies. What if the boom itself, rather than just the bust that followed, led to the current stagnation? This possibility is completely lacking from the conventional SecStag debate. Though this concept also lacks an agreed upon name, it is reminiscent of Austrian School of Economics thinking. To use Austrian style terminology, the recent boom caused “mal-investment” (or in more neutral language, “misallocations in investment” or “mis-investment”) to low productivity sectors.
The idea that booms themselves, rather than busts afterwards, are inherently damaging to productivity is less straightforward than it may appear. There is no obvious mechanism that explains why a surge in credit should lead to misinvestment in low productivity sectors. But here is one possible avenue in the U.S.: real estate.
The boom in the U.S., in the years before the crisis, from the late 1990s onwards, was essentially a housing boom. Construction increased by over 225 percent in the early 2000s. House prices spiked too: the Case-Shiller 10-City Composite Home Price Index tripled during the decade before the crisis. Consumers borrowed to buy bigger and bigger houses, leading to more and more home construction. But this wasn’t the end of the story: they also used the rising value of their houses to finance additional consumption — of expensive trips, new clothes, new services. Though there was no dramatic increase in productivity, the American dream finally seemed in reach for many. The bust revealed the true facts.
There is more to the story: residential home construction is a less productive investment, at the margin, than investment in non-real estate sectors such as manufacturing, infrastructure, or human capital. The return to investing in housing, even including its additional social benefits, is only 55 percent compared to investments in non-housing capital stock. In this sense during the boom, investment was misallocated: primarily to housing but also to related sectors such as retail and wholesale trade, and community and personal services. While less productive sectors of the economy boomed, the trade-able (export) sector languished. Manufacturing was outsourced to China, which was able to “learn by doing” and came to dominate important industries. But it didn’t matter, U.S. incomes rose, consumer demand rose. All that didn’t rise was productivity.
The U.S., during the boom, in some ways resembled an extremely large version of the “peripheral countries” of southern Europe. These countries too misallocated investment. Like the U.S., they experienced huge capital inflows, which weren’t used to develop highly productive or skill based sectors but instead were spent on consumption and housing booms. The result was huge trade deficits, an increase in wages not accompanied by any increase in productivity, and a decline in competitiveness. Once the boom was over, the economy was left high and dry. Even though the U.S. is no longer in a real estate boom, the damage has been done — and continues with the U.S. hamstrung by high household debt and ongoing credit misallocation to low productivity sectors.
These differing analytical frameworks of what is wrong with the U.S. economy call for differing policy responses. Again, according to SecStag, the central policy challenge is the inability of monetary policy to restore growth today, given the zero lower bound on nominal interest rates. Policy makers must search for alternatives, such as reducing real rates through quantitative easing, or using fiscal policy instead.
If the problem instead is years of misinvestment (and real estate is merely one example, there are many other mechanisms and sectors involved) that has resulted in low productivity growth, the solution is less obvious: the challenge is deeper than just finding a way around constraints on traditional monetary policy. Instead, policymaker must fix the “real” economy. How to successfully improve productivity in an advanced economy is not an area where economics has been able to provide a lot of value-add.
Beyond the standard calls for “more education” or “invest in infrastructure” — the usual silver bullets — there are some more interesting and novel policy ideas. For instance, increased RD in manufacturing, aided by tax credits has been shown to increase firms’ competitiveness. Or the U.S. could establish a widespread apprenticeship program in manufacturing akin to Germany’s. Ultimately the U.S. should consider the very non-Austrian idea of a domestic Marshall plan to improve productivity.
At the very least, the danger of malinvestment is is yet another reason to avoid financial booms and real estate booms in particular. When faced with a productivity shortfall, the U.S. must stop relying on credit bubbles — and Central Bank adventurism — as the primary fix.