Is the economy in a dangerous downward spiral, or is this a painful but ultimately healthy adjustment leading to a sustainable growth path?
Misdiagnosing this recession could lead to bad economic policy, with devastating consequences. If we're in a self-perpetuating spiral but don't respond with massive stimulus spending, the economy could fall into a trough that would rival the Great Depression. If, on the other hand, the economy is naturally finding a bottom, heavy spending could jack up inflation dangerously and saddle future generations with a huge debt burden.
With the unemployment rate at a 26-year high of 8.1% and hopes for a second-half recovery waning, Congress is deeply split over how to interpret and cope with the crisis. On Mar. 10, House Speaker Nancy Pelosi (D-Calif.) said "we have to leave the door open" to even more spending than is in the Obama Administration's newly passed $787 billion stimulus plan. But Senate Minority Whip Jon Kyl (R-Ariz.) warned the same day against wasteful government spending. Kyl earlier accused President Barack Obama of "rather casually throwing out some careless language" after the President warned Congress that failure to pass the original stimulus bill would jeopardize the nation's economy.
Unfortunately, economists aren't much help in this debate. They're tussling over stimulus like rival surgeons battling for the scalpel in an operating room. Nobel laureates took opposite sides in BusinessWeek interviews. Robert M. Solow of Massachusetts Institute of Technology (Nobel 1987) says the only thing wrong with the Administration's fiscal stimulus is that it's too small. In contrast, Edward C. Prescott of Arizona State University (Nobel 2004) argued that Obama's stimulus measures "are depressing the economy."
Most economic forecasters, who are judged on accuracy rather than academic rigor, seem to think stimulus is necessary. (Of course, they've been wrong before.)
The median forecast of a broad range of Wall Street economists surveyed by The Wall Street Journal in February was that the Obama stimulus plan would save about a million jobs over the next year.
That irks the stimulus skeptics, who doubt the wisdom of heavy-handed government intervention. About 250 economists, including Prescott and two other Nobel laureates, signed an open letter to Obama sponsored by the libertarian Cato Institute that said "it is a triumph of hope over experience to believe that more government spending will help the U.S. today." They favor cuts in tax rates and a rollback of regulation to promote long-term growth.
The dispute over spiral vs. stability goes back 75 years to the Great Depression and British economist John Maynard Keynes. Before Keynes, most economists believed that economies naturally tended toward full employment. But Keynes argued that an industrialized economy can spiral downward when job reductions depress consumer spending, causing businesses to cut more jobs and decrease investment, and so on. Only government can break that spiral by spending to lift demand, he contended.
Keynesian views held sway well into the 1960s. But academia's fear of economic instability began to ebb in the 1970s as a new wave of economists argued that consumers and businesses are rational and farseeing, and not likely to be stampeded into recession. What's more, the argument went, government can't spend its way out of a recession because consumers realize that extra government spending now will necessitate higher taxes in the future. They'll save more to prepare for that day, offsetting the stimulus.
DEALING WITH ANIMAL SPIRITS
The current crisis has revived the debate, in intense form. Economists who advocate active government intervention to break a downward spiral have become much louder. George A. Akerlof of the University of California at Berkeley (Nobel 2001) and Irrational Exuberance author Robert J. Shiller of Yale University call for "truly aggressive measures" to deal with the current crisis in Animal Spirits, their new book reviewed in this issue.
In contrast, the most extreme academic opponents of stimulus say that unemployment is mostly a case of workers asking for too much money—and will solve itself if wages are allowed to fall. Arizona State's Prescott, who has a reputation for being outspoken, is at least partly in that camp. "People are getting a little more hungry for jobs," he says. "It's great that I can get...some work done on my house." John H. Cochrane of the University of Chicago Booth School of Business agrees that "in the past, credit crunches like this when left alone have led to a sharp decline in output that did fairly quickly rebound." Cochrane opposes the Obama stimulus, while favoring careful interventions to get securitized lending flowing again.
The country can't wait for economists to agree. Right now, the risk of doing too little to stop the downturn probably outweighs the risk of doing too much, because if the economy gets too deep in a hole, it will be hard to climb out. There will be time for fights over theory when the crisis is past.