Christy Romer speaks on this issue at Council of Foreign Relations. She says:
In the past twenty years, we have had two periods of extended, robust growth, one from 1992 to 2000, and the other from 2002 to 2007. In both cases, aggregate output and employment grew steadily, unemployment fell to low levels, and inflation was restrained. To be sure, the two episodes had important differences: most notably, real median household income rose strongly in the 1990s but was largely stagnant in the early 2000s.
But, a key similarity was that both periods were accompanied by very large run-ups in asset prices that turned out in retrospect to be unjustified—a phenomenon that we commonly refer to as a “bubble” for short. The result was substantial overinvestment in certain sectors of the economy—high-tech in the 1990s, housing in the 2000s. More importantly, in both cases the bubble eventually burst, throwing the economy into a recession—a mild one at the end of the 1990s expansion, and as we all know, an extremely severe one in the current episode.
The subject I would like to talk about today is how we can achieve the good without the bad. Do we need asset price bubbles to get robust growth and low unemployment? Does growth inevitably create such bubbles? What can we do to ensure that the next expansion doesn’t come with a bubble of its own, planting the seeds of the next recession? As the title of my talk suggests, how do we create growth without bubbles?
She says it is possible to grow without bubbles as history has shown. However, her answer is not really as convincing. She relies on what we have read in economics text-books:
There is a natural equilibrating mechanism that ensures that aggregate demand is adequate without the presence of an asset price bubble.
If, at prevailing interest rates, the demand for the economy’s goods and services without any boost from bubble-driven investment fell short of the economy’s normal capacity, this would translate into surplus funds in credit markets. The demand for loans to finance new investment projects and purchases of durable goods would be less than the supply of funds from savers.
But, this is just another way of saying that interest rates would be above their equilibrium levels. Interest rates would fall—relatively quickly if the Fed perceived the imbalance and injected additional funds into the market, more slowly if the imbalance were not evident. The fall in interest rates would increase investment and purchases of durable goods, as well as lower the value of the dollar and raise net exports. The process would stop when demand equaled supply with the economy operating at normal capacity. This is how economies have achieved healthy bubble-free growth throughout modern history.
We all wish it was as simple as this.
She adds that first line of defence against bubbles should be market forces (as we saw in the dot com case where large number of firms failed). However, we should not rely on market forces completely as in this case. So, the policies have to be designed to prevent further bubbles.
She looks at growth prospects in the long run:
To address this question, it is helpful to recall the first (and, in some cases, the only) equation that many of us met in our study of economics: the economy’s output of goods and services equals consumption plus investment plus net exports plus government purchases of goods and services. I further want to separate the investment piece of this breakdown into housing and nonhousing investment.
This is the equation Y = C+I+G+ (X-M). She says C,G and Housing I will not add to growth. C is understood as housing wealth has declined. However, G is surprising:
The role of government purchases of goods and services in generating demand is not likely to change greatly. (Note that economists do not treat programs like Social Security and Medicare as “government purchases,” and they do not show up directly in GDP because they are effectively treated as transfer payments.) The composition of government purchases will change as our military involvements in Iraq and Afghanistan wind down and we invest in education, clean energy, and health care. This reorienting of government spending will make our economy more productive, and so will raise the path of output going forward. But, it is hard to see a big change in overall government purchases as a share of GDP, and so hard to see any substantial change in the role of those purchases in generating demand.
Very nicely she says the govt expenditure in Iraq etc would be replaced by ongoing expenditure to resurrect the economy. With most economists worried over US ballooning fiscal deficit in future, G’s role in growth should be more.
She says max growth would come from Business I and Exports. She also looks at growth over a shorter horizon and here she says G is expected to play a major role.
Interesting insights.
