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Why America Isn’t Working

CAMBRIDGE – As the US economy limps toward the second anniversary of the Lehman Brothers bankruptcy, anemic growth has left unemployment mired near 10%, with little prospect of significant improvement anytime soon. Little wonder that, with mid-term congressional elections coming in November, Americans are angrily asking why the government’s hyper-aggressive stimulus policies have not turned things around. What more, if anything, can be done?

The honest answer – but one that few voters want to hear – is that there is no magic bullet. It took more than a decade to dig today’s hole, and climbing out of it will take a while, too. As Carmen Reinhart and I warned in our 2009 book on the 800-year history of financial crises (with the ironic title “This Time is Different”), slow, protracted recovery with sustained high unemployment is the norm in the aftermath of a deep financial crisis.

Why is it so tough to boost employment rapidly after a financial crisis? One reason, of course, is that the financial system takes time to heal – and thus for credit to begin flowing properly again. Pumping vast taxpayer funds into financial behemoths does not solve the deeper problem of deflating an overleveraged society. Americans borrowed and shopped until they were blue in the face, thinking that an ever-rising housing price market would wash away all financial sins. The rest of the world poured money into the US, making it seem as if life was one big free lunch.

Even now, many Americans believe that the simple solution to the nation’s problem is just to cut taxes and goose up private consumption. Cutting taxes is certainly not bad in principle, especially for supporting long-term investment and growth. But there are several problems with the gospel of lower taxes.