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Financial Crisis or Innovation Crisis? Both!

NEW YORK  Former world chess champion and political activist Garry Kasparov and internet entrepreneur Peter Thiel, squared off with Harvard economist Kenneth Rogoff on the question whether advanced economies experience a financial crisis or an innovation crisis.

Mr Rogoff, who authored This Time is Different: Eight Centuries of Financial Folly (2009) with Carmen Reinhart, argues that the systemic financial crisis is the root cause of the prolonged economic slump in the western world. In their research, Mr Rogoff and Ms Reinhart found economic growth following a systemic financial crisis to be about a full percentage point below trend growth.

Mr Kasparov and Mr Thiel, on the other side, disavow Mr Rogoff’s claim that the collapse of advanced-country growth is the result of the financial crisis. In their view, the flailing western economies reflect stagnating technological development and innovation, and without radical changes in innovation policy, advanced economies are unlikely to see any prolonged pickup in productivity growth.

Robert Gordon of Northwestern University espouses in Is U.S. Economic Growth Over? an even more dire view, suggesting that the 250 years of rapid technological progress that followed the Industrial Revolution may prove to be the exception, rather than the rule.

A synthesis of the positions held by Mr Rogoff and Mr Kasparov and Mr Thiel is rather obvious. Most advanced economies are indeed suffering from a full-blown balance sheet recession in the aftermath of the worst systemic financial crisis since the Great Depression. Households, all too often saddled with mortgage debt exceeding the value of their home, are desperate to pay down debt and reluctant to spend money, let alone take out new loans.

In order to meet the requirements of the new regulatory environment, banks are assiduously trying to raise capital and hesitant to lend money to businesses. Both the lack of consumer demand and the credit contraction harms business activity in the western world, resulting in what may be a decade or more of subpar economic growth.

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On the other hand, speculative bubbles in the housing market come with Dutch disease-like symptoms. The term ‘Dutch disease’ was coined 35 years ago by The Economist, and describes the observed relationship between the exploitation of natural resources and the decline of the industrial sector in a country.

The primary mechanism of deindustrialization is that a natural resources bonanza will lead to the appreciation of a nation’s currency, resulting in the nation’s other exports becoming more expensive for other countries to buy, thereby making the manufacturing sector internationally less competitive.

The other mechanism through which (indirect) deindustrialization takes place, is the so-called spending effect. As revenues from a natural resources boom are spent domestically, the demand for labor in the non-tradable sector increases, luring workers away from the tradable sector. We see something similar happening during a housing boom.

With residential housing prices on the rise, homeowners feel wealthier and are inclined to spend more, often with the help of a second or third mortgage. This in turn inflates the non-tradable sector. Since technological growth in the non-tradable sector is generally lower, compared with the tradable sector, a speculative bubble in the housing market harms innovation and technological growth.

The deindustrialization resulting from a housing boom could well explain the lack of technological progress and innovation in western economies, as observed by Mr Kasparov and Mr Thiel.

The Rogoff-Kasparov-Thiel synthesis is not compatible with the Keynesian view that the Great Recession is merely about a shortfall in demand, ie, that it is cyclical rather than structural. Through its adverse effect on the tradable sector, a housing boom does structural damage to an economy.

It is not a coincidence that Germany, the only western country that saw real housing prices decrease over the past decade, turned itself from the sick man of Europe at the end of the 1990s into one of the few advanced economies that seem globalization-proof.

The Dutch disease can’t account for Robert Gordon’s more pessimistic view that the era of rapid technological progress has come to an end altogether. But as the rise of China, India and other emerging economies poses tremendous challenges in terms of climate, food and other natural resources, I doubt his sobering outlook will prove true.