What sort of crisis is the West living through now? Has the response to the crisis been correct? The answer to the second question depends heavily on the answer to the first question. If there's been a misdiagnosis of the type of crisis it is likely that the response to the crisis will not be appropriate, because different remedies apply to different crises.
One way of looking at the problem is to say there are short business cycles and long structural cycles. Short cycle recession could be self-correcting; it is much easier when there is genuinely non-discriminatory state regulation to protect market freedoms. Short cycle recession can also be amenable to limited low-risk tinkering with the levers that government has at its disposal (preferably these would be predictable rules-based monetary and fiscal policy, public investment projects that pass true cost-benefit tests, automatic stabilisers of the safety-net variety, and even a bailout or two in exceptional cases).
But there is a danger of misdiagnosis when symptoms or surface phenomena are treated in practice as though they were the underlying causes. Policy makers might be led to believe that by tackling the highly visible and most painful symptoms in isolation they will quickly solve the problem. Examples include housing bubbles, bank insolvency or illiquidity, stock market and price fluctuations, unemployment, or depressing changes in total output and consumption.
Any such analysis is complicated even further by the fact that multiple kinds of cycles exist at the same time. Short business cycles overlap and get tangled up with longer structural cycles. In these situations, and especially across so many types of fluctuation, only a few basic rules will usefully apply to a solution.
The long-run 'structural cycle' transformation would typically be one or all of the following:
1. a fundamental change or failure to change the competitiveness or comparative advantage of a country.
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2. a radical mismatch between economic change and the existing institutional forms.
3. a cluster of basic technological evolution influencing the surface indices such as employment and prices.
Sometimes, external factors -- such as climate change (whether perceived or real), resource depletion, or major war -- will create or intensify a structural cycle.
Jeffrey Sachs has recently made points similar to these with considerable force - here, here, and here. He expresses his profound disillusionment with large parts of the economics profession for failing to appreciate that the current crisis is not a short run cyclical phenomenon treatable with temporary tax or transfer measures on the back of debt and stimulus. Instead, argues Sachs, policy should confront the outcomes and causes of long run technological change and competitiveness, which build up over decades and require attention to, or at least full appreciation of, a confluence of factors including demographics, social structure, education, infrastructure.
Sachs gives particular attention to globalization as a primary driver of the underlying cycle in advanced countries. I would add that globalization is a change in competitiveness and comparative advantage. As such, it is also the element influencing the rate and quality of innovation. The impact on the United States economy of globalization is -- one could therefore say -- a change in the conditions of competitive innovation. Like it or not, process innovation -- broadly inclusive of domestic institutional, organizational, or political adaptations -- plays a big role in China’s growth.
Tyler Cowen made similar arguments in his influential book, The Great Stagnation. Cowen placed more emphasis than Sachs on the relative decline of effective innovation with positive economy-wide effects in the United States. Cowen also pays greater attention to sociological or attitudinal factors which gave populations a quite dangerously false sense of security (“invulnerability”) in the face of (hidden) risks and (under-recognised) challenges of structural change.
By linking long structural cycles to the large-scale evolution of technology and competitive advantage, both Sachs and Cowen are, I think, following in the footsteps of Joseph Schumpeter. He regarded innovation -- the result of competition -- as “the root of cyclical fluctuations” in both long- and short-span cycles. “Definite innovatory processes in industry and trade” are always associated with the “big crises”, said Schumpeter.
Each cycle does pass through an inevitable trough of stagnation when innovation exhausts itself. But the vulnerable underbelly of great stagnations is the adjustment which social systems and education systems are forced to make as they restore innovation potential. Long cycles of economic change “break up and create new positions of power, civilizations, valuations, beliefs, and policies”, Schumpeter pointed out. The latest book authored by Sachs is quite appropriately titled The Price of Civilization. Social, attitudinal and institutional transformations, and external factors like climate, war, or resource constraints, act-in-reverse upon changes in economic structure, affecting the whole pace and direction of long cycles. The causality goes both ways.
I was struck by what Sachs said at the conclusion of his polemic last week against crude Keynesianism, which, Sachs alleges, focuses on recession or depression as a short cycle of demand deficiency treatable merely by “turning the dial” on public debt and short term stimulus:
“We really need to focus [on] understanding long term structural change. This is what makes our field [economics] hard. If we were really in a stationary economy, meaning that the probability distributions were relatively unchanging over time, we'd figure this out. My view is that what makes this hard is not only the complexity, which makes statistical identification [and] counterfactuals hard; but that the underpinning, the substrate of the economy, is changing over time. So our equations are never right. Structure is the deepest part of our change over a period of ten or twenty years. If we don't understand in a more substantive way the idea that business cycles are simply overlaid on this [then] the stationary theory of business cycles is also wrong. My interpretation is that we're living in a mix of these two different temporal experiences -- the longer term and the short term overlaid and interacting with each other.”
Schumpeter, in Business Cycles, elaborately emphasized the existence of “many simultaneous cycles superimposed on each other”, and the unreality of the stationary state in any but the most primitive economies. Schumpeter told us to look for the “fundamental mechanisms”, and not waste valuable time and resources messing about with “surface phenomena”. They only deceive us by hiding the underlying processes.
I was surprised to see that Sachs is full of Schumpeter. It’s rare and applaudable at the present time. Yet, rest assured, fashions in economics and policy are cyclical. Be prepared; soon enough it will again be fashionable to say, in an impressively hardline way -- the big crises are always structural in the real world. Big ones, long ones, are never a problem of aggregate demand, even when they seem to be in a modeled laboratory world.
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What sort of crisis is the West living through now? Has the response to the crisis been correct? The answer to the second question depends heavily on the answer to the first question. If there's been a misdiagnosis of the type of crisis it is likely that the response to the crisis will not be appropriate, because different remedies apply to different crises.
One way of looking at the problem is to say there are short business cycles and long structural cycles. Short cycle recession could be self-correcting; it is much easier when there is genuinely non-discriminatory state regulation to protect market freedoms. Short cycle recession can also be amenable to limited low-risk tinkering with the levers that government has at its disposal (preferably these would be predictable rules-based monetary and fiscal policy, public investment projects that pass true cost-benefit tests, automatic stabilisers of the safety-net variety, and even a bailout or two in exceptional cases).
But there is a danger of misdiagnosis when symptoms or surface phenomena are treated in practice as though they were the underlying causes. Policy makers might be led to believe that by tackling the highly visible and most painful symptoms in isolation they will quickly solve the problem. Examples include housing bubbles, bank insolvency or illiquidity, stock market and price fluctuations, unemployment, or depressing changes in total output and consumption.
Any such analysis is complicated even further by the fact that multiple kinds of cycles exist at the same time. Short business cycles overlap and get tangled up with longer structural cycles. In these situations, and especially across so many types of fluctuation, only a few basic rules will usefully apply to a solution.
The long-run 'structural cycle' transformation would typically be one or all of the following:
1. a fundamental change or failure to change the competitiveness or comparative advantage of a country.
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Access every new PS commentary, our entire On Point suite of subscriber-exclusive content – including Longer Reads, Insider Interviews, Big Picture/Big Question, and Say More – and the full PS archive.
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2. a radical mismatch between economic change and the existing institutional forms.
3. a cluster of basic technological evolution influencing the surface indices such as employment and prices.
Sometimes, external factors -- such as climate change (whether perceived or real), resource depletion, or major war -- will create or intensify a structural cycle.
Jeffrey Sachs has recently made points similar to these with considerable force - here, here, and here. He expresses his profound disillusionment with large parts of the economics profession for failing to appreciate that the current crisis is not a short run cyclical phenomenon treatable with temporary tax or transfer measures on the back of debt and stimulus. Instead, argues Sachs, policy should confront the outcomes and causes of long run technological change and competitiveness, which build up over decades and require attention to, or at least full appreciation of, a confluence of factors including demographics, social structure, education, infrastructure.
Sachs gives particular attention to globalization as a primary driver of the underlying cycle in advanced countries. I would add that globalization is a change in competitiveness and comparative advantage. As such, it is also the element influencing the rate and quality of innovation. The impact on the United States economy of globalization is -- one could therefore say -- a change in the conditions of competitive innovation. Like it or not, process innovation -- broadly inclusive of domestic institutional, organizational, or political adaptations -- plays a big role in China’s growth.
Tyler Cowen made similar arguments in his influential book, The Great Stagnation. Cowen placed more emphasis than Sachs on the relative decline of effective innovation with positive economy-wide effects in the United States. Cowen also pays greater attention to sociological or attitudinal factors which gave populations a quite dangerously false sense of security (“invulnerability”) in the face of (hidden) risks and (under-recognised) challenges of structural change.
By linking long structural cycles to the large-scale evolution of technology and competitive advantage, both Sachs and Cowen are, I think, following in the footsteps of Joseph Schumpeter. He regarded innovation -- the result of competition -- as “the root of cyclical fluctuations” in both long- and short-span cycles. “Definite innovatory processes in industry and trade” are always associated with the “big crises”, said Schumpeter.
Each cycle does pass through an inevitable trough of stagnation when innovation exhausts itself. But the vulnerable underbelly of great stagnations is the adjustment which social systems and education systems are forced to make as they restore innovation potential. Long cycles of economic change “break up and create new positions of power, civilizations, valuations, beliefs, and policies”, Schumpeter pointed out. The latest book authored by Sachs is quite appropriately titled The Price of Civilization. Social, attitudinal and institutional transformations, and external factors like climate, war, or resource constraints, act-in-reverse upon changes in economic structure, affecting the whole pace and direction of long cycles. The causality goes both ways.
I was struck by what Sachs said at the conclusion of his polemic last week against crude Keynesianism, which, Sachs alleges, focuses on recession or depression as a short cycle of demand deficiency treatable merely by “turning the dial” on public debt and short term stimulus:
“We really need to focus [on] understanding long term structural change. This is what makes our field [economics] hard. If we were really in a stationary economy, meaning that the probability distributions were relatively unchanging over time, we'd figure this out. My view is that what makes this hard is not only the complexity, which makes statistical identification [and] counterfactuals hard; but that the underpinning, the substrate of the economy, is changing over time. So our equations are never right. Structure is the deepest part of our change over a period of ten or twenty years. If we don't understand in a more substantive way the idea that business cycles are simply overlaid on this [then] the stationary theory of business cycles is also wrong. My interpretation is that we're living in a mix of these two different temporal experiences -- the longer term and the short term overlaid and interacting with each other.”
Schumpeter, in Business Cycles, elaborately emphasized the existence of “many simultaneous cycles superimposed on each other”, and the unreality of the stationary state in any but the most primitive economies. Schumpeter told us to look for the “fundamental mechanisms”, and not waste valuable time and resources messing about with “surface phenomena”. They only deceive us by hiding the underlying processes.
I was surprised to see that Sachs is full of Schumpeter. It’s rare and applaudable at the present time. Yet, rest assured, fashions in economics and policy are cyclical. Be prepared; soon enough it will again be fashionable to say, in an impressively hardline way -- the big crises are always structural in the real world. Big ones, long ones, are never a problem of aggregate demand, even when they seem to be in a modeled laboratory world.