Kenneth Rogoff: The Global Economy is Still Growing Too Fast

Kenneth Rogoff says we need to raise interest rates to prevent inflation, to quit trying to stimulate the economy with fiscal policy, and allow financial institutions to fail:

The world cannot grow its way out of this slowdown, by Kenneth Rogoff, Financial Times: As the global economic crisis hits its one year anniversary, it is time to re-examine not just the strategies for dealing with it, but also the diagnosis underlying those strategies. Is it not now clear that the main macroeconomic challenges facing the world today are an excess demand for commodities and an excess supply of financial services? If so, then it is time to stop pump-priming aggregate demand while blocking consolidation and restructuring of the financial system.

The huge spike in global commodity price inflation is prima facie evidence that the global economy is still growing too fast. …

Absent a significant global recession…, it will probably take a couple years of sub-trend growth to rebalance commodity supply and demand at trend price levels (perhaps $75 per barrel in the case of oil…) In the meantime, if all regions attempt to maintain high growth through macro­economic stimulus, the main result is going to be higher commodity prices and ultimately a bigger crash in the not-too-distant future.

In the light of the experience of the 1970s, it is surprising how many leading policymakers and economic pundits believe that policy should aim to keep pushing demand up. In the US, the growth imperative has rationalised aggressive tax rebates, steep interest rate cuts and an ever-widening bail-out net for financial institutions. The Chinese leadership, after having briefly flirted with prioritising inflation…, has resumed putting growth as the clear number one priority. Most other emerging markets have followed a broadly similar approach. … Of the major regions, only … the European Central Bank has resisted joining the stimulus party… But even the ECB is coming under increasing … pressure as Europe’s growth decelerates.

Individual countries may see some short-term growth benefit to US-style macroeconomic stimulus… But if all regions try expanding demand, even the short-term benefit will be minimal. Commodity constraints will limit the real output response globally, and most of the excess demand will spill over into higher inflation.

Some central bankers argue that there is nothing to worry about as long as wage growth remains tame. … But as goods prices rise, wage pressures will eventually follow. …

What of the ever deepening financial crisis as a rationale for expansionary global macroeconomic policy? … Inflation stabilisation cannot be indefinitely compromised to support bail-out activities. However convenient it may be to … bail out homeowners and financial institutions, the gain has to be weighed against the long-run cost of re-anchoring inflation expectations later on. Nor is it obvious that the taxpayer should absorb continually rising contingent liabilities…

For a myriad reasons, both technical and political, financial market regulation is never going to be stringent enough in booms. That is why it is important to be tougher in busts, so that investors and company executives have cause to pay serious attention to risks. If poorly run financial institutions are not allowed to close their doors during recessions, when exactly are they going to be allowed to fail? …

[T]he need to introduce more banking discipline is yet another reason why the policymakers must refrain from excessively expansionary macroeconomic policy … and accept the slowdown… For most central banks, this means significantly raising interest rates to combat inflation. For Treasuries, this means maintaining fiscal discipline rather than giving in to the temptation of tax rebates and fuel subsidies. In policymaker’s zealous attempts to avoid a plain vanilla supply shock recession, they are taking excessive risks with inflation and budget discipline that may ultimately lead to a much greater and more protracted downturn.

Where I differ is on the risk of inflation over the longer run – I am more inclined toward Mark Gertler’s view – and on the fragility of the financial system. Inflation is a concern, but raising interest rates too fast risks throwing the financial sector into a tailspin, and that would bring the economy down with it, and that’s a risk I’d rather not take. We need to keep an eye out for signs that inflation is becoming embedded and self-reinforcing, but we need to be even more concerned about a domino effect taking hold in the financial sector. That danger is not yet over.

As for fiscal policy, first, I am not worried about one shot increases in spending creating the continuous increases in demand needed to fuel a long-run inflation (see here for a summary of the estimated effects of the stimulus on GDP). However, beyond that, it’s important to remember that our problems are not just from high world demand causing high commodity prices. If that was the only problem we face – it this was just a “plain vanilla supply shock recession” – I’d be inclined to agree. But we are also having a financial crisis and that requires a different response (and makes our policy needs different from countries that are not having a mortgage meltdown – our problem isn’t plain vanilla). The evaporation of credit represents a shock to demand, and unless that demand is replaced during the period when financial markets are recovering, we will have lower output and employment growth than we are able to sustain.


Originally published at Economist’s View and reproduced here with the author’s permission.

2 Responses to "Kenneth Rogoff: The Global Economy is Still Growing Too Fast"

  1. RealThink   August 6, 2008 at 4:07 pm

    Just bringing the relative price of the limited resource to “trend” is definitely not enough reason for reducing employment of labor and capital. The real reason is that oil is limited not only in the sense that its global extraction rate cannot rise as desired (hydroelectric power is also limited in that sense), but also in the sense that it is exhaustible, which implies that its global extraction rate will inevitably peak (most likely in the 2008-2013 timeframe) and relentlessly decline thereafter. Same for natural gas and coal (and high-grade mineral ores too). This fact, when viewed in conjunction with the essential roles fossil fuels play in modern society (as both energy sources and raw materials), leads to the conclusion that the only safe path forward ("safe" meaning minimizing the likelihood of catastrophic societal collapse) is to reserve fossil fuels for essential uses and start a massive program for implementing renewable energy sources (not corn ethanol!). This approach was stated by M. King Hubbert in his 1976 paper "Exponential growth as a transient phenomenon in human history": "It appears therefore that one of the foremost problems confronting humanity today is how to make the transition from the precarious state that we are now in (based on the use of fossil fuels) to this optimum future state (based on the use of renewable energy sources) by a least catastrophic progression. Our principal impediments at present are neither lack of energy or material resources nor of essential physical and biological knowledge. Our principal constraints are cultural. During the last two centuries we have known nothing but exponential growth and in parallel we have evolved what amounts to an exponential-growth culture, a culture so heavily dependent upon the continuance of exponential growth for its stability that it is incapable of reckoning with problems of nongrowth."Thirty years later, however, the world does face physical constraints: as shown in a recent article by David Cohen, one of the sharpest Hubbert’s Peak-aware analysts, today a wind farm construction plan of the scale recently proposed by Al Gore is simply unfeasible because of PHYSICAL constraints, those of steel production being the foremost. Should society then keep wasting time and directing those resources to further construction of suburban McMansions? (*)And there is a simple model for the current situation: the case of Easter Island, majority view (i.e. not that of Professor Terry Hunt, who thinks that deforestation was caused mainly by rats and not human activity). And an important difference to keep in mind is that in Easter Island they had the chance to restrain tree cutting to match the reforestation rate, whereas now we don’t have that possibility with fossil fuels.And the graph from a recent model for the case of Easter Island itself speaks louder than a thousand words: http://www.physorg.com/printnews.php?newsid=121959198(*) Particularly since construction of more suburban, energy-inefficient McMansions is just digging further in the already deep hole most of the US population is in, as higher fuel prices will turn those homes into traps for their occupants.