Rajan presented a paper titled “Has Financial Innovation Made the World Riskier?” His answer, put simply, was “Yes.” He was dismissed by the assembled masters of the universe. “Misguided,” said Larry Summers. But Rajan was right.
In this month’s Foreign Affairs, Rajan is back with another warning. “The industrial countries have a choice,” he writes. “They can act as if all is well except that their consumers are in a funk and so what John Maynard Keynes called ‘animal spirits’ must be revived through stimulus measures. Or they can treat the crisis as a wake-up call and move to fix all that has been papered over in the last few decades and thus put themselves in a better position to take advantage of coming opportunities.”
This time, Rajan’s comments are being received more favorably. Greg Mankiw, the Harvard economist who advises Mitt Romney, called the essay “wise.” Tyler Cowen, the George Mason University economist who runs the popular blog Marginal Revolution, was even more direct: “Rajan nails it,” he wrote.
But he is once again on the opposite side of the issue from Summers. This time, however, there has been an unusual role reversal: It is Summers who is trying to rouse an economics profession that has settled into a kind of complacency, and Rajan whose argument is more comfortable to much of the political and economic establishment.
Rajan’s commentary is perhaps the clearest manifesto yet from the school of post-recession thought that I’ve come to think of as “the long-termers.” The long-termers don’t deny the enormous and ongoing human suffering caused by the recession. They don’t argue that the best course is passivity. Rather, they argue that there’s not much that we can or should do in the short run, and so we may as well focus on long-run issues such as the design of the tax code and the quality of our schools. (For another example of long-termism, see today’s David Brooks column.)
But as Summers sees it, the short run has a nasty tendency to become the long run. “The evidence is that cyclical problems harden into structural problems,” he says, “because people who have been out of work for a year lose their ability to work.”
The longer you’ve been unemployed, the harder it is to get back into the labor force. “If you’ve been unemployed for a few weeks, your chance of finding a job is 30 or 40 percent,” says Michael Reich, an economist at the University of California at Berkeley. “If you’ve been unemployed for six months, it’s 10 percent.”
Since the recession began, the “labor participation rate” has fallen to levels not seen since 1981. Some of that is older workers retiring. But much of it is discouraged workers giving up on searching for new jobs.
Fewer workers, of course, means less economic growth and lower tax revenue. In a recent study, Summers, alongside Berkeley’s Brad DeLong, showed that in a depressed economy, stimulus measures could pay for themselves if they worked to prevent these kinds of long-term labor crises.
Rajan, of course, agrees that it would be good to address these problems if we could. He thinks it would be great to employ more workers rebuilding the nation’s infrastructure, but he doesn’t think we can get those projects up and running fast enough to make a difference. He thinks it would make sense to write down much of the housing debt in the parts of the nation that have been hit hardest by the economic crisis, but he doesn’t think the politics will permit that. He thinks that as long as the housing market is choking on foreclosures, there’s not much that monetary policy can do, as it mainly works through stimulating demand for housing.
“I don’t see great short-term solutions,” he says. “When people say austerity is not the answer, fine; if you have great things to spend on, let us know what they are.”
To Summers, though, this fatalism is sober-sounding nonsense. “Surely we can have public employment grow as rapidly as it did during George W. Bush or Bill Clinton’s presidency,” he says. “Surely we can have classes across America be as small as they were five years ago. Surely if you put more money into the hands of lower-income people they will spend a substantial fraction of it.”
In a reversal from their earlier debates, it is now Rajan’s argument that is easier for the political class to embrace: Proposing more stimulus, or more expansionary Federal Reserve policy, is politically dangerous in a way that calling for education reform simply isn’t. But unlike before, we don’t have to choose between the two sides.
We could spend more on teachers and classroom repairs now while passing budget cuts and tax increases that really kick in after unemployment has dropped to, say, 7 percent. We could rebuild the nation’s infrastructure while doubling down on our education reforms. We could, in other words, make both the short term and long term better. But we’re doing neither. And Summers and Rajan, in case you’re curious, both oppose that course of inaction.