As Prepared for Delivery
WASHINGTON – Since joining the Treasury, I have traveled around the world attending a steady stream of G-20 meetings. The discussions at these meetings span a rich set of issues, but the particular focus is on the current and prospective performance of the global economy. While the U.S. economy continues to gain steam, with real GDP growing above trend, job creation picking up sharply, and unemployment declining, we have not yet seen strong and consistent growth across the rest of the world.
There is broad agreement in these G-20 discussions, as the Leaders have underscored, that our ultimate macroeconomic objective is strong, sustainable, and balanced global growth. Notably, however, there also is agreement that the global economy is falling short of this goal in two important ways.
First, trend growth for many countries individually, and for the global economy as a whole, has slowed in the years since the financial crisis. And potential output—that is, the productive capacity of the economy to supply goods and services—has remained below our reasonable aspirations. This observation raises important concerns about the capacity of firms to innovatively combine labor, capital, and other resources to produce output. There is clear recognition in these G-20 discussions that strengthening the supply side of our economies is essential for increasing employment, boosting productivity, and raising standards of living for future generations.
But there is also agreement that we are falling short in a second critical way. Specifically, the global economy continues to be plagued by substantial cyclical slack. Aggregate demand and spending are markedly below our now reduced estimates of the potential capacity to produce. The economic consequences of this shortfall have been significant. First, cyclical weakness has meant an inability to provide suitable jobs for many of our citizens, especially our young workers. Second, it has translated into strong disinflationary pressures and in some countries the onset of outright deflation. Third, this sustained weakness has unleashed divisive political pressures, which have at times complicated the pursuit of sound economic policies.
Thus, by my reckoning, the leading voices in the G-20 generally agree on our ultimate objectives and the challenges that we face. There is consensus that global economic performance is disappointing on both the supply-side and the demand-side. But we differ in our views as to the causes of this disappointing performance, and what policies can most effectively address the present challenges.
In the remainder of my remarks, I will address this debate. My core arguments are tailored particularly for the advanced economies, but I will also sketch out some implications for the emerging markets. The key insight that I want to emphasize is that the supply-side and the demand-side of the economy are vitally interlinked. A viable program to move the global economy forward must include reinforcing and complementary steps both to raise productive capacity and to reduce the unacceptably large cyclical slack that now prevails.
Strengthening the Supply Side
Let me begin with the supply side of the equation. As I indicated, the G-20 consensus is that the disappointing performance of the global economy has, in part, reflected a shortfall on the supply-side. This diagnosis provides a strong rationale for countries to adopt structural reforms to bolster productive capacity where needed. Examples of such reforms include measures to make labor markets more flexible by allowing firms greater scope to hire, fire, and negotiate wages; making product markets more competitive by removing barriers to entry and giving firms increased latitude to adjust their prices; and, more generally, by taking appropriate steps to streamline regulation, privatize state-owned firms, and increase openness to international trade and investment. Although mobilizing political support for such reforms can be difficult, they hold the prospect of spurring innovation, improving the climate for investment and entrepreneurship, stimulating labor supply, and making the economy more diversified, flexible, and resilient.
The urgency of structural reforms—and their prescribed mix—varies significantly from country to country, but I see the case as especially persuasive for three sets of countries.
First, several of the European peripheral countries need to make further progress in restructuring their economies. Italy is an important example. Italian unit labor costs have risen substantially relative to many other euro-area countries over the course of the past decade. Labor market reforms to raise the productivity of Italy’s workers are sorely needed to enhance competitiveness going forward. Another example is Greece, which has made progress in addressing its fiscal imbalances and bringing down its unit labor costs, but further structural reforms are needed to allow its economy to compete successfully in Europe and internationally.
A second group of countries for which structural reforms are essential is the emerging-market commodity exporters. With slowing growth in China’s demand for commodities and the more general softening of conditions in global commodity markets, countries like South Africa and Brazil have compelling incentives to diversify the structure of their economies to reduce exposure to volatile commodity prices.
Third, a number of other emerging-market economies, most prominently China, have remained far too reliant on export-led growth. This has perpetuated the risks associated with global imbalances and blunted our mutual efforts to achieve strong, sustainable, and balanced growth. In addition, with sluggish global demand and with world trade now growing at a much slower rate, export-led growth strategies are less viable for the countries themselves and more prone to zero-sum competition for market share than in the past. In countries that are overly reliant on export-led growth, reforms are needed to shift resources toward the non-tradables sectors and to rebalance the economy toward stronger domestic demand. Achieving these policy objectives will require efforts to open the financial sector, allow increased exchange rate flexibility, and strengthen safety nets.
Notably, the G-20 work program appropriately reflects the importance of structural reforms. The so-called Growth Strategies Initiative, endorsed by the Leaders in Brisbane, seeks to raise the collective GDP of the G-20 countries by at least 2 percent (or $2 trillion) relative to baseline by 2018. In pursuit of this objective, countries have put forward a range of reforms to support investment (particularly in infrastructure), job creation, and further steps to open trade and spur global integration.
The United States has been a pacesetter in this effort. Historically, the U.S. economy has been distinguished by structural flexibility in its labor and product markets, clear property rights, commitment to the rule of law, and openness to foreign trade and investment. In the years since the financial crisis, the United States has moved aggressively to implement financial sector reforms to make intermediation more reliable and efficient, as well as to ensure the integrity of our financial markets and reduce vulnerabilities to future crises. Looking forward, the Administration’s structural reform agenda includes reforming the business tax system and strengthening the framework for immigration. We are also actively engaged in pursuing the Administration’s trade agenda through high-standard agreements such as the Trans-Pacific Partnership, which will expand opportunities and drive further integration with key trading partners. Together, these measures will support the competitiveness of American businesses and promote growth and stability—both globally and here at home.
The Limits of Structural Reforms
Well-designed structural reforms are clearly needed to enhance the productive capacity of the global economy. But a related point also bears emphasis. While structural reforms are necessary to ensure that global economic performance is vibrant in the medium to long run, as a general matter they do not address the urgent problems of underutilized labor resources and disappointing growth that the global economy faces today. These challenges instead reflect softness in global demand. Structural reforms come in many types and varieties, but my reading of the empirical evidence is that they tend to have neutral or, particularly for labor market reforms, contractionary effects in the near term.
It is sometimes argued that the announcement of structural reforms will unleash a powerful dose of confidence that provides immediate stimulus to the economy. While such scenarios cannot be ruled out, the early stages of intensive structural reform programs often bring stark economic adjustments. Less competitive firms tend to lose market share; inefficient sectors may be squeezed by increased competition; wages in sheltered industries are often pushed down and their work force reduced; and privatization may bring downsizing and rationalization of state-owned firms. Such developments lay the groundwork for stronger performance over time; in the near term, however, the uncertainties and transition costs may be intense and sometimes contractionary.
To be concrete, consider the recent experience of Spain. As displayed in the first chart, over the past few years, Spain has made remarkable progress in reforming its economy: Its unit labor costs have fallen sharply relative to those of other euro-area countries, indicating that Spanish labor is now more competitive; its exports have been on a rising trajectory; and real GDP growth has moved solidly into positive territory.
Given these favorable outcomes, Spain is appropriately singled out as a successful euro-area reformer. But make no mistake, the past years have not been easy. The country’s unemployment rate surged from 8 percent in the first half of 2007 to a peak of over 26 percent in 2013. Even now, the unemployment rate remains very high, at over 23 percent. As an alternative metric of these adjustment costs, Spain’s economy in early 2011 began ten consecutive quarters of economic contraction, and real GDP is still down 5 percent from its peak before the global financial crisis.
While the reforms undertaken by Spain (and other euro-area peripherals) have been necessary, it is worth considering whether a more stimulative calibration of macroeconomic policies in the euro area as a whole would have allowed this adjustment to be less difficult for Spanish workers and the country’s economy more broadly. With this question in mind, I now highlight the necessity of demand-side policies in supporting economic activity through times of transition or stress, as well as the vital role of these policies in fostering strong, sustainable, and balanced growth over the longer-term.
The Necessary Role of Demand-Side Policies
As I noted at the outset, there is broad agreement across the G-20 that the global economy continues to be plagued by cyclical slack. Current levels of aggregate demand and spending have been insufficient to close the sometimes large prevailing gaps in output and employment (relative to their potential levels) that many economies have faced. In other words, the supply-side of the global economy has fallen short of expectations, but the demand-side has been weaker still. On this point, the G-20 Leaders pointedly observed in their Brisbane communique: “The global economy is being held back by a shortfall in demand …”
Economic history highlights that during periods of cyclical weakness the global economy is more vulnerable to destabilizing shocks and to ill-advised policy choices, such as excessive dependence on external demand, protectionism, and reliance on the exchange rate as a tool for fueling growth. Let me note, on exchange rate issues in particular, we have made progress urging key partners to move toward market-determined exchange rates. Such actions, coupled with these economies’ ongoing reform efforts (for example, to rebalance toward sustainable domestic spending), represent meaningful steps in our pursuit of a level global playing field.
But another question, on which there is still division within G-20 circles, is how macroeconomic policies should respond to the shortfall in global demand. As is well known, we at the U.S. Treasury have argued for countries to forcefully employ strong stimulative policies to address this situation. Such stimulus can include monetary measures, where inflation is well contained, and fiscal measures, where the government has put its house in order and has sufficient budget space.
As an analytical matter, our position in favor of meaningful demand-side stimulus rests on five core observations. First, demand-side policies have been powerful in the United States. In the years following the eruption of the financial crisis, the United States took forceful action to stimulate demand, fully employing both monetary and fiscal tools. The Federal Reserve slashed policy rates, injected liquidity, and bolstered demand through unconventional balance sheet policies. Fiscal policy provided critical stimulus during the crisis by temporarily boosting expenditures and extending unemployment benefits, as well as through supportive tax cuts and efforts to stabilize the housing market. Such measures helped prevent an even more severe downturn and have fueled a recovery that has outpaced those of many other advanced economies, and which now appears to be gaining steam.
One concern expressed about these stimulative policies was that they would stoke an outbreak of inflationary pressures. But this has not been the case. These policies have limited deflationary risks, while both inflation and inflation expectations have remained quiescent. The important conclusion is that in an environment with substantial slack in resource utilization and with a track-record of subdued inflation expectations, macroeconomic policy has meaningful scope to pursue counter-cyclical measures.
Second, there are vital links between the demand-side and the supply-side. Policies to support near-term demand have sometimes been dismissed as “sugar stimulus.” According to this line of thinking, such stimulus provides only a temporary boost to the economy, with the effects quickly dissipating. But this overlooks an important point: Resources that are not being utilized tend to depreciate and become less productive. This is true of machines and structures, which rust and decay, but it is also true of labor and expertise. As our experience of recent years attests, people who are out of work today find it harder to secure employment tomorrow. Periods of high cyclical unemployment can leave long-lasting scars on labor market conditions. Macroeconomists have labeled these important links between the performance of the economy today and the capacity to produce in the future as “hysteresis.”
Newly established firms, which are important drivers of job creation, may be especially vulnerable to these hysteresis effects. Specifically, a prolonged deterioration in cyclical conditions would likely push many otherwise efficient and competitive firms into bankruptcy, reducing employment and the economy’s productive capacity even after a recovery has taken hold. Young firms and entrepreneurs, often lacking the deep pockets and financial resources of their older counterparts, are likely to be more adversely affected. Hence, demand-side policies offer the added dividend of shielding these firms during periods of downturn.
Third, an argument sometimes lodged against stimulative fiscal policies is that they increase the public debt burden to be shouldered by future generations. But my reading of the empirical evidence is markedly different. The appropriate gauge for assessing the burden of the debt is not the amount of debt that is owed but, rather, the amount that is owed relative to the capacity to repay. In other words, the denominator of the debt-to-GDP ratio is as important as the numerator. Given my previous arguments that periods of cyclical weakness can scar the economy’s productive capacity, a lagging policy response may adversely affect future debt sustainability. Specifically, prolonged periods of cyclical weakness impede the economy’s capacity to generate tax revenues and, more generally, limit the resources available to service the debt.
The next charts provide some evidence bearing on this point. As is well known, Japan in recent decades has seen the ratio of its general government debt to GDP grow sharply relative to that of other countries. But the difference has not been a faster accumulation of debt – the numerator of the ratio. Indeed, both Japan and other G-7 countries have seen their debt levels expand significantly. Rather, the remarkable difference has been in the growth of nominal GDP – the denominator of the ratio. In other G7 countries, nominal GDP has expanded steadily, while in Japan the sustained failure to defeat deflation contributed to a stagnation of nominal GDP. The key point is that the important objective of medium-term fiscal sustainability depends not only on the evolution of the budget balance, but also hinges crucially on the achievement of growth and price stability objectives.
Fourth, the burdens of the prolonged downturn have fallen disproportionately on the young. As shown in the final chart, this has particularly been the case for the euro-area periphery. Spain and Greece face a major challenge—their youth unemployment rates (that is, for workers younger than 25 years old) have remained over 50 percent through the past few years. In Italy and Portugal, the situation is only a little less severe. Conditions in the United Kingdom and the United States are better, but rates are still unacceptably high. Only in Germany is this rate below 10 percent.
These data highlight a striking irony. Those who oppose calibrated stimulus measures in the name of not leaving debt for future generations may inadvertently be intensifying headwinds facing the younger workers they aim to protect. This outcome is particularly concerning given the rapidly aging populations in many countries. As baby boomers reach retirement, today’s young workers are quickly becoming the heart and soul of the workforce. Such high unemployment rates raise serious questions as to whether these workers will have the skills they need to drive economic growth in the decades ahead.
Fifth, strong demand is the ultimate driver of confidence. Those who question the advisability of stimulative macroeconomic policies often couch their arguments in terms of the need to restore confidence in the business community. This is a worthy and important goal. But these arguments fail to recognize that nothing is likely to jumpstart business confidence (and, for that matter, consumer confidence) more powerfully than evidence of rising demand and stronger real GDP growth. Indeed, a benchmark theory of investment—the so-called “accelerator model”—links business investment directly to the rate of economic growth. In this sense, businesses tend to strike a Missouri-like “Show Me” stance: They boost their levels of investment once they actually see evidence of stronger demand for their products.
My bottom line is that sound economic policies must seek to appropriately balance supply-side and demand-side considerations. Measures to stimulate demand during periods of weakness are necessary both to ensure favorable economic growth today and to safeguard the vibrancy of the economy and its capacity to produce tomorrow. This is especially the case during times of high unemployment.
Structural reforms can have powerful effects on growth over the medium to long term, but they are not a substitute for appropriate measures to stimulate demand in the near term. Instead, structural reforms and macroeconomic stimulus have the capacity to play complementary roles. For example, to the extent that labor market reforms exert contractionary effects in the near term, well-designed macro stimulus can buffer adverse effects on the economy. This, in turn, helps ensure that the reforms proceed in an environment that is as supportive as possible. Conversely, macro stimulus is likely to be most effective when the supply-side of the economy is strong.
Finally, the arguments that I have made are not only important for individual countries as they seek to frame their economic policies, but they are also the key to realizing the G-20’s goal of lifting global growth. As policymakers take appropriate steps to support demand in their own economies, positive spillovers flow to the rest of the world. These spillovers serve both to limit the depth of cyclical downturns elsewhere and to create a global environment that is supportive of countries’ structural reform efforts. For these reasons, an ongoing commitment to strong domestic-demand-led measures is central to catalyzing a productive, resilient, and balanced global economy in the years to come.
See, for example, Lusine Lusinyan and Dirk Muir, “Assessing the Macroeconomic Impact of Structural Reforms: The Case of Italy,” IMF Working Paper, 2013; Jan Babecky and Tomas Havranek, “Structural Reforms and Economic Growth: A Meta-Analysis,” Czech National Bank Working Papers, 2013. Notably, the literature suggests that across the gamut of structural reforms, tax reform and the liberalization of land use may have the most immediate positive effects.
Remarks of Secretary Jacob Lew at The Economic Club of New York, June 11, 2014; Ben Bernanke, “Recent Developments in the Labor Market,” March 26, 2012; and see also David Reifschneider, William Wascher, and David Wilcox, “Aggregate Supply in the United States: Recent Developments and Implications for the Conduct of Monetary Policy,” Federal Reserve Finance and Economics Discussion Series, 2013. Teresa Fort, John Haltiwanger, Ron Jarmin, and Javier Miranda, “How Firms Respond to Business Cycles: The Role of Firm Age and Firm Size,” IMF Economic Review, 2013; John Haltiwanger, Ron Jarmin, and Javier Miranda, “Who Creates Jobs? Small versus Large versus Young,” The Review of Economics and Statistics, 2013.