The unresolved crisis

Five Nobel winners assess the global economy in the birthday issue of F&D.
Paul Krugman

Midway into the second decade of the 21st century, the biggest problem facing the world economy—or at least its relatively rich countries—is a problem many economists never thought we’d see. For the first time since the 1930s, the world appears to be suffering from a persistent lack of adequate demand; people just aren’t spending enough to make use of the productive capacity we have. This was supposed to be a solved problem, one that may have bedeviled our grandfathers but wasn’t going to come back. But it did, and answers remain elusive.

Let me offer some crude summary numbers. If we take the IMF’s “advanced economies” aggregate from its World Economic Outlook (WEO) database, we find that the combined real GDP of these economies grew 18 percent between 2000 and 2007. Projections made at the time called for a continuation of growth at similar rates over the medium term. In fact, however, it now appears that the advanced economies will have grown only about 6 per cent between 2007 and 2014, implying a 10 per cent shortfall relative to what we used to think was the trend.

True, it’s widely argued that the actual amount of economic slack is much less than this; the WEO database estimate of the current output gap for the advanced economy aggregate is only 2.2 percent. But it would be very wrong to take a low estimate of the output gap as a sign that policy isn’t failing that badly, after all, for two reasons.

First, we don’t really know how far below capacity we are operating. Are the large declines in U.S. labor force participation or British productivity secular—that is, long term—or cyclical, the result of workers dropping out because they don’t see job opportunities? Is the stability of inflation at a low level evidence that the economy is operating close to capacity or caused by the unwillingness of workers to accept wage cuts, which makes the Phillips curve—the historically inverse relationship between rates of unemployment and corresponding rates of inflation—flat at low inflation? Nobody knows—and it would be tragic to accept low output and high unemployment as inevitable when they might be simply reflections of insufficient demand.

Second, to the extent that growth of productive potential has in fact dropped as much as estimates suggest, this is evidence of powerful long-run effects of supposedly short-run economic troubles: allowing a deep global recession to take hold seems to have led, over time, to a huge deterioration in longer-term economic prospects. This in turn implies that sustaining adequate demand is hugely important, not just for the short run, but for the long run too.

Either way, then, increasing demand should be an urgent priority. Unfortunately, what we have learned since 2007 is that our economic policymaking institutions are not at all well suited to coping with large, sustained demand shortfalls.

During the Great Moderation—as American economists James Stock and Mark Watson called the reduction in U.S. macreoeconomic volatility during the mid-1980s—we thought we had macroeconomic policymaking under control. Demand management was assigned to technocrats at independent central banks while fiscal policy focused on long-run issues. In the face of large, sustained shocks, however, it turns out that this system breaks down. On one side, central banks are constrained both by the zero lower bound—the fact that interest rates can’t go negative—and by concerns over the size of their balance sheets. On the other, fiscal policy, far from helping, quickly began making things worse. It has been hobbled both by asymmetry between debtors and creditors—the former forced to cut, while the latter have no obligation to expand—and by political infighting. I sometimes joke that Europe and the United States are in a competition over who can respond worse to the ongoing crisis; Europe is currently winning, but not by much.

It would be nice to believe that these problems are transitory, and maybe they are. But the stability of the Great Moderation was, we now realize, predicated on both ever-growing household debt and by relatively rapid growth in the working-age population, neither of which are coming back, and there are few signs of a policy turnaround.

So inadequate demand is still a very big problem, and looks likely to remain so for a long time to come. We need to find a way to deal with this situation.

This is an extract from ‘Looming ahead’, published in the IMF’s quarterly magazine, Finance and Development, September 2014, vol. 51, no. 3, wherein five Nobel Prize winners discuss what they each see as the biggest problem facing the global economy of the future. Read the other contributions by George A. Akerlof (on global warming), Robert Solow (secular stagnation), Michael Spence (inclusiveness), and Joseph E. Stiglitz (inequality) in F&D's 50th birthday edition.


Suggested citation
Krugman, Paul, 'The unresolved crisis', Evatt Journal, Vol. 13, No. 6, August 2014.<>