Rethinking Macroeconomics

Macroeconomics is still a very young science. It began when John Maynard Keynes, who recognized the existence of fallacy-of-composition problems in the macroeconomy, conceived the concept of aggregate demand in the 1930s. Only 90 years old, it is like a toddler when compared with centuries-old disciplines such as physics and chemistry. Nicolaus Copernicus deciphered the workings of the solar system in 1530, and Isaac Newton discovered the universal law of gravity in 1687. These monumental discoveries took place 250 to 400 years before Keynes developed the concept of aggregate demand in 1936. As a young science, economics has been able to explain only a limited range of economic phenomena. Its youth also makes it prone to fads and influences.

The profession's immaturity was amply demonstrated when only a handful of economists saw the post-2008 Great Recession coming, and even fewer predicted how long it would take to recover from it. Most also failed to anticipate that zero interest rates, massive quantitative easing (QE), and inflation targeting would fail to bring about inflation within the forecast time.

These fundamental failures stem from the fact that most macroeconomic theories and models developed during the last 90 years assumed that private-sector agents always seek to maximize profits. For that to be true, it was implicitly assumed that attractive investment opportunities would always be plentiful and that private-sector balance sheets would always be clean. From those two assumptions, it follows that profit-maximizing firms will always be willing to borrow if only the central bank lowers real interest rates far enough. Although these two assumptions are valid throughout most of the golden era, when economies are typically in Case 1 or 2, economists have not realized that most advanced economies today are not only in the pursued phase, but are also experiencing balance sheet recessions, that is, that they are squarely in Cases 3 and 4.

Before realizing that an economy could be in Case 3 or 4, where the private sector may be minimizing debt, economists had to come up with a variety of explanations for phenomena they could not explain with the conventional framework, which assumes a profit-maximizing private sector. Phenomena that eluded explanation included prolonged periods of economic stagnation and unemployment despite record-low interest rates and pump-priming via fiscal stimulus.

The explanations put forward to explain them included allusions to structural problems, deflationary expectations, secular stagnation, the cost of rewriting menus (i.e., the high cost of changing prices), and “external shocks.” These are similar to the explanations that astronomers gave for the movements of the planets before Copernicus realized it was the earth that was circling the sun and not the other way around.

Structural or Balance Sheet Problems?

Allusions to structural problems are a common refuge for economists whose conventional macroeconomic policy prescriptions fail to produce the expected results. Too often, they revert to structural explanations without realizing that other factors—such as balance sheet problems or a lack of investment opportunities—can also produce a similar predicament.

Economists started to fall back on structural explanations after Ronald Reagan and Margaret Thatcher made the public aware of the importance of structural or supply-side issues in the 1980s. In contrast, balance sheet problems or shortages of investment opportunities were never discussed in economics departments or business schools until quite recently.

A large number of economists and policy makers therefore jumped onto the structural reform bandwagon in both post-1990 Japan and post-2008 Europe, arguing that there could be no economic recovery without such reforms. But the Reagan and Thatcher era in the United States and United Kingdom could not be more different from the post-bubble period in Japan and Europe.

At the time of Reagan and Thatcher, both the United States and the United Kingdom were facing high inflation and interest rates, incessant labor disputes, and large trade deficits. In present-day Japan and Europe, inflation and interest rates are both extremely low, labor disputes are rare, and trade accounts are deeply in surplus, at least before the pandemic and energy shortage. Moreover, both economies were responding well to conventional macroeconomic policies before 1990 in Japan and before 2008 in Europe. That makes it difficult to argue that the economies suddenly lost steam and are stagnating because of age-old structural issues.

But because of mainstream pundits' near-exclusive focus on structural reforms, Japan has wasted a tremendous amount of time and resources on such policies over the last 30 years, as has Europe for the last 15. In the United States, meanwhile, policy makers understood within the first two years of the global financial crisis (GFC) that the country was suffering from balance sheet problems, not structural issues. As a result, it was the only country that did not fall into the structural reform “trap,” even though many of its economists had been arrogantly lecturing the Japanese on the need for such reforms only a few years earlier. The United States was doing much better than Japan or Europe because it did not waste any time debating structural reform policies.

Structural Reforms Require a Correct Narrative

The lack of investment opportunities typical of countries in the pursued phase is indeed an argument for structural reform. This is because deregulation and other structural reforms are needed to raise the return on capital at home. What must be made clear, however, is that structural policies are needed to address problems that existed before the economy fell into a balance sheet recession. In other words, structural reforms are necessary, even in the United States, but they are not the answer to the sudden deceleration of these economies after the bubble burst in 2008. For these much more urgent balance sheet problems, it is fiscal stimulus and not structural reform that is required.

The policy makers and economists who peddled structural solutions for the post-2008 stagnation lost credibility with the public when their policies failed to produce a recovery within the expected timeframe. Their loss of credibility allowed outsiders and far-right political parties to make substantial political gains, especially in Europe.

In Japan, former Prime Minister Junichiro Koizumi's favorite slogan—“no economic recovery without structural reform”—and his opposition to fiscal stimulus were totally inappropriate for a country that was suffering from massive balance sheet problems. During his five-year tenure from 2001 to 2006, Japan's private sector was saving an average of 9.26 percent of GDP in spite of zero interest rates. Not surprisingly, the economy continued to stagnate during and after his structural reform efforts.

Seventeen years have passed since the end of the Koizumi administration, and Japan's private sector has finally repaired its balance sheet. The remaining challenge for the nation is to fend off pursuers from behind, which is indeed a structural reform issue. The problem is that the public was told two decades ago that structural reforms would lead to economic recovery, but the promised recovery never materialized. Feeling betrayed, people are now rightfully skeptical of any structural reform proposals—including the “third arrow” of Abenomics, which was all about structural reforms. Many are tired of hearing the term itself. Economists may keep their teaching jobs in universities even if their predictions and prescriptions turned out to be wrong, but they have lost credibility, and not just for themselves but for the entire establishment.

What Japan needs now, therefore, is a proper narrative starting with an admission that the earlier emphasis on structural reform was premature and mistaken because at that time, the problem was rooted in balance sheets. The new narrative must indicate that balance sheet problems have been resolved and that structural reforms are now needed to increase the return on capital at home to attract investment and fend off pursuers from behind. It must also explain that, because the private sector is still a huge net saver, fiscal stimulus must continue until private-sector borrowers return.

A similar distinction also needs to be made in Europe, where extreme-right parties have made considerable gains amid economic weakness. It must be emphasized that while structural reforms are necessary to increase the return on capital at home and fend off pursuers from behind, such measures are no substitute for the fiscal stimulus needed to counter the balance sheet recessions engulfing the region since 2008.

Summers's Secular Stagnation Thesis

When Larry Summers first used the term secular stagnation in 2013,¹ the United States was in the midst of a balance sheet recession in which the private sector was saving nearly 7 percent of GDP at zero interest rates. He subsequently noted² that returns on capital in the West had begun falling in the 1970s, long before the GFC erupted in 2008.

It should be obvious that Western economies have experienced a sudden loss of economic momentum since 2008 because they are suffering from serious balance sheet recessions following the collapse of the housing bubble. Alvin Hansen, who first coined the term secular stagnation in 1938, also did so at a time when the United States was in the midst of the greatest balance sheet recession of all, the Great Depression, and the unemployment rate was 19 percent.

At the time of Hansen's speech, however, nobody in Germany was talking about secular stagnation. Speedy, sustained, and substantial fiscal stimulus to fight the balance sheet recession had completely eradicated the German recession and brought the unemployment rate down to just 2 percent in 1938 from a high of 28 percent in 1933. And Hansen’s secular stagnation suddenly ended when the U.S. government started the massive military procurement effort to fight World War II. The fact that both Hansen and Summers raised the issue of secular stagnation during balance sheet recessions, and that Germany—which had overcome its own balance sheet recession by 1938—was not suffering from such stagnation, suggests that balance sheet recessions is the main driver of “secular stagnation.”

The post-1970 decline in the return on capital, however, is likely due to the fact that by then Western economies were all entering the pursued phase, when Japan started chasing them. From that point onward, a growing number of manufacturers in those countries found that the return on capital was higher abroad than at home. Many of them decided to buy from or invest in the pursuing economies themselves. Shrinking capital investment in the advanced countries led to slower growth in productivity and wages.

This pattern—of emerging economies taking away investment opportunities from the developed countries—will continue until all economies have long passed their Lewis Turning Points (LTP) and the return on capital has more or less equalized. Although China has passed the LTP already, India and many other economies have a long way to go. The current transition is therefore likely to continue for many years to come.

This process can be explained using the framework of Figure 3.1 applied in a global context. Most countries can reach their EQ level of wages in Figure 3.1 for ordinary workers in a relatively straightforward fashion if they follow the correct policies for economic growth. But for wages to grow beyond that level, wages in all other countries must also reach their EQ levels so that businesses no longer have the option of using cheaper workers abroad.

This means workers in individual countries can look forward to rising incomes until wages reach their EQ levels, but that then effectively becomes the global ED level of wages in Figure 3.1 applied to global context. These countries must wait until all slack in other labor markets is eliminated for wages to start rising again. Since that could take decades, workers in the pursued countries should start honing their individual skills immediately instead of waiting for the global economy to reach that point.

Beware of Fake “External Shocks”

Economists are also fond of using the term external shock to describe what happened after 2008. This implies that the event originated outside the economy and therefore could not have been predicted (hence the “shock”). The author would agree that the recessions triggered by the COVID-19 pandemic, the Russian invasion of Ukraine, and 9/11 were good examples of external shocks. Indeed, the author himself was shocked to find himself, along with many members of the National Association of Business Economists, in the World Trade Center in New York City on the morning of the September 11 attack. But to call the Lehman Brothers bankruptcy and the subsequent GFC an external shock is preposterous.

For years before Lehman's failure, the existence of a housing bubble financed with collateralized debt obligations (CDOs) containing subprime mortgages but carrying outrageously high ratings from corrupt rating agencies was well known. Once the bubble burst, the overwhelming amount of leverage in the system meant that economies had to fall into balance sheet recessions. In that sense, what happened after 2008 was largely endogenous to the system: it was not caused by unpredictable external factors.

As the crisis unfolded, economists, including former Fed Chairman Alan Greenspan, argued that it was a “once-in-a-hundred-year event” that could not have been predicted. Others called it a “perfect storm” or an “external shock.” These terms all imply that economists should not be blamed for failing to predict it.

A young but brilliant Brazilian investor who incurred heavy losses in 2008 decided to leave the field altogether when he heard such statements from prominent economists. He thought that if the financial world contains dangers that even Alan Greenspan (“the Maestro”) and other famous economists could not anticipate, he would rather take up a different profession that did not expose him to such unpredictable perils.

After wondering for several months what profession to pursue, it occurred to him that if there was one person on this earth who had seen the crisis coming, then 2008 had not been a perfect storm. It simply meant the big names in economics were working off the wrong models. After conducting the kind of extensive research that he was known for, he did find a few who had seen it coming, and the author was honored to be included in his list. That the list was so short is testimony to the fact that the economics profession has gone badly wrong for too long.

The point here is that the state of the economy prior to the “shock” is absolutely critical in understanding how it will subsequently respond to various policy actions. The nature of the shock itself is also important in predicting what follows.

In the event of a purely external shock, such as 9/11 in the United States or 3/11 in Japan,³ the economy may need a few years to recover. For a global shock such as the COVID-19 pandemic, it may take a little longer. But an economy suffering from the collapse of a debt-financed bubble will invariably require years, or even decades, to recover. This is because millions of underwater private-sector balance sheets must be repaired, and a fallacy-of-composition problem makes the process even more difficult when everyone tries to repair them at the same time. Although the collapse itself may be triggered by some external event, the long and painful balance sheet recession that follows is no shock at all. Apart from truly unpredictable events such as 9/11 and COVID-19, economists should not use the term external shock to brush over their ignorance of the problems that were happening in the economy prior to the shock.

Beware of Fake Allusions to “Expectations”

There is a great deal of economics literature on expectations, and especially inflation expectations. Indeed, those who are pushing for continued monetary stimulus in the face of central banks' repeated failures to reach inflation targets argue that such efforts are still needed to “anchor expectations.” But people's expectations are fundamentally based on what they see happening and what they have experienced in the past.

In post-bubble Japan, where commercial real estate prices fell 87 percent nationwide (Figure 2.1), the typical CEO was busy repairing his firm's balance sheet by using cash flow to pay down debt (Figure 2.2). He was also aware that most other CEOs in the country were doing the same thing. With no borrowers to take funds out of the financial sector and inject them into the real economy, it was obvious to these executives that no amount of central bank liquidity injections would increase the money circulating in the economy. And with no way to increase the money circulating in the economy, it was clear to them that monetary easing could not boost economic growth or inflation rates.

In this environment, the announcement of a 2-percent inflation target by the central bank will have no impact because these CEOs are unable to change their debt-minimizing behavior. The escape from negative equity is a matter of survival for businesses, and CEOs have no choice but to continue deleveraging until their balance sheets are repaired. But if they continue to deleverage, there will be no credit growth and no inflation. Nor are banks allowed to lend money to businesses with underwater balance sheets. The resultant undershooting of inflation targets by the central bank then reinforces CEOs' expectations of no inflation while undermining the credibility of central banks and the economists who pushed for the targets.

In such a world, the announcement that the central bank has raised its inflation target from 2 percent to 4 percent does not lead to expectations of lower real interest rates because the original 2 percent target was not credible to begin with. This is the reality, and it has nothing to do with expectations. Anyone who cared to ask CEOs why they were deleveraging when the central bank had announced a 2-percent inflation target would have received this answer.⁴

This also means that there is a disconnect between central bankers—and their economist friends, along with some of the market participants that are noted in Chapter 2—who are still operating on the assumption that the economy is in Case 1 or 2, and the rest of the population, whose actions are keeping the economy in Case 3 or 4. And it is the CEOs and the general public who have the correct model of the economy in their heads, not the central bankers and economists.

When the economy was in a golden era (in Cases 1 and 2), in contrast, the economy was moving along the upward-sloping labor supply curve KP in Figure 3.1, meaning there was constant upward pressure on wages. Facing ever-rising wages accompanied by ever-increasing demand for their products, most CEOs were busy borrowing funds to carry out additional productivity- and capacity-enhancing investments. Financial institutions were also lending out all available funds, raising the money multiplier to its maximum value. In other words, there was a real macroeconomic foundation for inflation expectations in the golden era of the 1960s and 1970s: they did not emerge out of thin air.

In such a world, a central bank could also contain inflation by limiting the supply of reserves because the availability of reserves was a constraint on money and credit growth. This is why the three lines in Figures 2.2 to 2.14 and 2.17 moved together before 2008 in the West and before 1990 in Japan. Central banks that succeeded in containing inflation enjoyed high credibility because they were able to deliver on their promises. But that is not the environment central banks in advanced countries find themselves in today.

There are many economists, including some at the Fed, who still fear that the fall in inflationary expectations will lead to the kind of economic stagnation that Japan has experienced. Their view is that if inappropriate inflationary expectations can be eradicated with drastic monetary tightening measures, like those implemented by Paul Volcker in October 1979, then today's inappropriate deflationary expectations can also be eradicated with drastic monetary easing.

But the post-1990 Japanese and post-2008 Western economies stagnated not because of deflationary expectations due to inappropriate monetary policies, but because there were real reasons for people not to borrow money—namely, private-sector balance sheet problems and inferior returns on capital. These two problems have nothing to do with expectations. But the economy will stagnate if people are still saving money while fewer are borrowing and spending those savings. With the economy moving along the flat global labor supply curve PQ in Figure 3.1 and businesses not borrowing money at home, there are real macroeconomic reasons for people not to expect inflation. Without addressing these two real issues with fiscal and structural actions, no amount of monetary easing will improve the economy or the public's expectations of the future. The absence of inflationary expectations in pursued economies does not emerge out of thin air.

Instead of treating “expectations” as some sort of policy objective that a central bank can change, economists should ask why people are behaving the way they are. Japanese CEOs ignored the Bank of Japan (BOJ)'s monetary accommodation not because they had somehow come to expect deflation, but because they knew from their own debt-minimizing actions that there was no reason why monetary accommodation should work. If economists only understood these fundamental drivers of behavior, they would make far fewer allusions to expectations.

Where the Analysis Begins Is Important

Some mainstream economists have recently come around in favor of more active fiscal policy given today's low interest rates. Olivier Blanchard, former International Monetary Fund (IMF) chief economist, argued that when interest rates are lower than the economy's growth rate, the government can administer more fiscal stimulus without causing a deterioration of debt-to-GDP ratios. That is arithmetically true, of course, and the author welcomes the fact that some economists have finally found a reason to make greater use of fiscal policy.

The problem is that their analysis starts from the premise of low interest rates without bothering to explain why they are so low. Blanchard, for example, uses just five words to elucidate the causes of today's low interest rates: “savings, investment, risk aversion, and liquidity.” This is no different from the economists who pushed for more monetary accommodation to fight deflation without explaining why economies were suffering from deflation in the first place. Paul Krugman, a Nobel laureate, even argued that how a country fell into deflation was not important as long as it implemented sufficient monetary easing to overcome it.

But without a full understanding of the drivers of observed phenomena, policies implemented to address them will be thrown off course by even slight changes in those phenomena. If fiscal stimulus is premised on low interest rates, for example, it will have to be abandoned when interest rates shoot up, as happened during the taper tantrum of 2013.

But if fiscal stimulus is implemented based on the understanding that it is needed to fight a recession caused by the private sector's minimization of debt to repair damaged balance sheets, it will not be discontinued until private-sector is back borrowing money again. If policy makers are also aware that private-sector deleveraging is the fundamental driver of low interest rates, they will not be concerned about occasional bouts of interest rate volatility until the deleveraging process itself comes to an end.

The same problem appeared when monetary easing was used to fight deflation. Despite astronomical amounts of QE and zero or negative interest rates, central banks failed to reach their inflation targets because the deflation was driven by private-sector balance sheet problems and inferior returns on capital. Neither of those problems responds well to monetary policy easing. The point is that policy makers should be wary of economists peddling quick fixes to a problem without being able to explain how the problem started.

Conventional Models Have Trouble Dealing with Abrupt Reversals

Economists also assumed, mostly unconsciously, that the responses of economic agents to changes in prices and other external factors are always continuous and in the same direction. As Brendan Markey-Towler of the University of Queensland pointed out, traditional economics is based on the implied principle of universal substitutability, which means a change in relative prices will always prompt a reaction in the economy.⁵ For example, if the price of good A rises relative to the price of substitute good B, a certain number of consumers will stop buying A and start buying B. From this perspective, which assumes that changes in prices—including interest rates and exchange rates—always lead to corresponding changes in the economy, it is natural to assume that a decline in real interest rates, if large enough, will always encourage willing borrowers to step forward.

It was this kind of thinking that led economist Krugman to argue that the monetary authorities should opt for a 4-percent inflation target if a 2-percent target was not working. Similar thinking also led some central bankers to conclude that if zero interest rates were not adequate, rates should be taken into negative territory. The assumption here, of course, is that in a world of universal substitutability there should be at least some response to their policy actions.

But when businesses and households face the threat of insolvency, their responses are highly discontinuous as they shift abruptly from profit maximization to debt minimization. Debt minimization is also an urgent matter because a technically insolvent business faces extinction unless it can quickly emerge from that state of negative equity. If the true state of the company's finances becomes known, no supplier will do business with it unless it pays in cash given the imminent possibility that it will seek bankruptcy protection. Banks are also prevented by law from lending money or rolling over loans to insolvent borrowers in order to protect depositors. And the best employees of such a firm might also seek employment elsewhere.

This means the principle of universal substitutability does not apply when individuals and businesses face insolvency because they not only abruptly stop borrowing but also start paying down debt, which is the opposite of borrowing. And this abrupt reversal happens regardless of how low the central bank takes interest rates.

The problem is that economists who were trained under the assumption of universal substitutability are unable to comprehend such disconnects and abrupt reversals in human behavior. As a result, their theories and models are often incapable of incorporating sudden shifts and reversals in private-sector behavior, rendering them useless when such reversals happen.

Obsession with Mathematics Is Killing Macroeconomics' Credibility

Although noneconomist readers may find the preceding discussion hard to believe, the reliance on universal substitutability became essential when mathematical modeling became an obsession for mainstream economists. Today, many in the profession would not consider anything that is not expressed in mathematical terms (such as this book) to be serious economics. But for mathematical equations to be useful (i.e., continuously differentiable), models must assume that the behavioral changes of economic agents are smooth, continuous, and always in the same direction. That, in turn, makes these models useless when households and businesses are forced to make abrupt changes or even reverse their behavior. That was why they failed to predict the post-2008 Great Recession.

Economists such as Gauti Eggertsson and Krugman (2012)⁶ have argued that their models still indicate that monetary easing is effective even in a “Fisher-Minsky-Koo” environment, and that inflation targeting and QE should work. The fact that Krugman himself admitted three years later that these policies have failed to be a “game changer”⁷ in the real world suggests that their models and equations did not fully incorporate the possibility of abrupt reversals following a bubble collapse.

The inability of most mathematical models to handle abrupt reversals is a sad betrayal of the very spirit of macroeconomics. After all, the discipline was born in the midst of the Great Depression, the most abrupt shift to debt minimization in history. The fact that only a few economists were able to predict the Great Recession and its long and unpleasant aftermath says a lot about the usefulness of mathematical tools in understanding the economy.

The advanced mathematics used in astrophysics succeeded in landing a man on the moon. The advanced mathematics used in economics (and the professors who ply the trade) failed to predict not only the biggest macroeconomic event since the Great Depression but also the substantial changes to the effectiveness of monetary and fiscal policy that occurred after 2008.

Astrophysicists could send a person to the moon because the moon does not change direction abruptly. Physicists won the respect of others by finding a mathematical formula that accurately predicted where the moon would be or when the next high tide would come, matters that affect our daily lives. In addition to mathematical tools, these predictions required long years of observation and hard work to find the correct mathematical equations to fit the data.

Economists failed to predict the Great Recession because people react to events and change direction all the time. Economists failed precisely because their mathematical models did not allow households and businesses to change their behavior. By relying on mathematics as their primary tool, economists treat human beings as they would treat planetary objects like the moon or Mars, and not as thinking and reacting individuals.

Economists may have latched on to mathematics because of what George Soros called “physics envy.”⁸ Indeed, Soros has been arguing for decades with his theory of reflexivity that economists need to regard businesses and households as thinking and reacting entities.

Power of Plain Language in Economics

The ultimate goal of any scientific discipline, including economics and physics, is to find the truth. On that score, economists have one huge advantage over physicists: they are analyzing the behavior of people just like themselves. As Alfred Marshall said, economics is the science of everyday life.⁹ Economists are themselves workers, consumers, savers, and investors. Economists even have the luxury of directly asking households and businesses why they are doing what they are doing. They could, for example, have asked Japanese CEOs why they were deleveraging at a time of zero interest rates. Unfortunately, few did.

Economists could have examined what businesses were doing with their financial assets and liabilities by looking at the statistics shown in Figures 2.2 and 4.2. If they had, they would have noticed that businesses were minimizing debt. Again, not many did. But that is like an astrophysicist trying to predict the motion of a planet without looking at the data.

Because economic phenomena are the result of human beings interacting with each other, nothing in economics is outside human cognitive experience. That means that everything in economics, including the behavior of households and businesses, must be explainable in plain language. This is the opposite of physics, which cannot describe the movement of comets or electrons without using mathematical tools. Physicists also get nowhere by asking a comet or an electron why it does what it does.

It should be possible, therefore, to spell out in plain language the assumed or expected behavior of individual consumers or businesses in any economic theory or model, mathematical, or otherwise. That exercise should help determine whether the model is treating people as planetary objects or as thinking and reacting beings. The problem is that once the elegant mathematical models have been deciphered and translated into plain language, it will be found that many of them do indeed treat human beings as planets and comets.

When the author took part in a debate on trade frictions in Japan with a professor known for his elegant mathematical models, the professor inadvertently spelled out in plain language what was happening in his model. He revealed that a worker in his model who had lost his job due to imports would immediately find another equally well-paying job. But if that were the case, there would be no trade frictions to start with.

Trade frictions exist because people in importing countries are losing jobs and income. In real life, a worker who loses his job to imports will have to go through years of often painful retraining to regain the income he enjoyed earlier. In many cases, his income may never recover fully. It is this loss of income that causes trade frictions. The professor's model, however, was saying there should be no trade frictions because there are no income losses. This “discovery” effectively ended the debate.

Practitioners of economics should constantly check to see what their models expect households and businesses to do. Students of economics should always ask professors to explain in plain language what is happening to households and businesses in their mathematical models. Only then can they judge for themselves whether the model makes any sense.

Because of the discipline's half-century-long infatuation with mathematics and the belief that mathematically formulated economics is the only “legitimate” form of economics, important phenomena falling outside its assumptions—such as balance sheet recessions and a shortfall of domestic investment opportunities—have been completely overlooked. The economics taught at universities therefore applies only to nonbubble, largely closed economies in a golden era where balance sheet problems and a shortage of investment opportunities do not exist.

But under those conditions, who needs economists? Economists are needed when an economy is in Case 3 or 4, that is, when it is plagued by the counterintuitive fallacy-of-composition problems that are noted in Chapter 1 that only trained economists can see through and analyze. These are also the times when the economy is suffering from slow growth or worse. Unfortunately, most economists today are only trained to look at economies in Cases 1 and 2 (or their models only work in those cases). Hence, the public's ongoing disappointment with economists and their friends in the establishment.

Economists Should Learn from Medical Science, Not Physics

If economists are to an economy what medical doctors are to the human body, then the former have much to learn from the latter. Even though medical science has made great strides in improving human health, no medical scientist in his right mind would try to come up with a mathematical model of the human body before finding a cure for an ailment. This is not only because building a mathematical model of the human body is a ridiculously roundabout way of getting to the solution, but also because it should be possible with careful observation and deductive reasoning to isolate the cause of an ailment in specific viruses, bacteria, genes, or chemical compounds. Once the cause of the ailment is identified, a remedy can be developed to help patients fight the disease.

The same is true in economics. With millions of thinking and reacting households and businesses who are changing their minds all the time, building a mathematical model to find a solution to an economic ailment is terribly inefficient. On the other hand, just as in medical science, careful observation and deductive reasoning can go a long way to helping the economy recover.

When Japan was suffering from economic stagnation and banking problems in the mid-1990s, many economists, especially those in the West, argued that the government must tackle the banking crisis first because it was the cause of the economy's poor performance. But if that were true, a number of other phenomena should also have been observed. For example, foreign banks that were not affected by the bursting of Japan's bubble in 1990 should have been increasing their market share in the country. Similarly, the corporate bond market, which is a good proxy for bank lending to large companies, should have been booming. The spread between the lending rate and banks' funding rate should also have been widening if there were plenty of borrowers but a lack of capital kept bankers from lending.

None of these three phenomena typically observed in a banking crisis were reported in Japan. Instead, foreign banks were leaving the country, the corporate bond market was shrinking, and the interest rate spread was narrowing. This suggests that even though there was a banking crisis, it was not the main reason for Japan's economic stagnation.

The deductive reasoning from the preceding observations suggests that the primary reason for the slump was that borrowers, whose balance sheets were badly damaged after the bubble burst, disappeared faster than lenders. And this can be confirmed by comparing the BOJ's Tankan survey of borrowers with their actual borrowings, as shown in Figure 8.6. Although borrowers in the survey indicated that banks were willing lenders, they were not borrowing. The correct treatment for economic stagnation driven by a lack of borrowers, therefore, is for the government to act as borrower of last resort. The banking crisis must be addressed, but its resolution will not lead to economic recovery until the absence of borrowers is addressed.

Similarly, when the private sector abruptly shifts to deleveraging after a bubble bursts—in spite of zero or negative interest rates—as happened in the West after 2008, economists should suspect that its balance sheet is in trouble instead of assuming that it suffers from “deflationary expectations” or “structural problems.” This is because both of those issues take years to manifest themselves and cannot explain an abrupt slowdown in the economy.

Medical science is not as precise as physics because of the complexity of the human body, which consists of billions of live and interacting cells. But medical scientists still command great respect because they have been able to improve human health in so many ways. Economists should put aside their physics envy and embrace the methods of medical science so that they can contribute to human welfare in the same way that medical scientists have contributed to human health.

Economics Has No Meaningful Theory of Growth

By presuming that there are always willing borrowers, economists have also unwittingly assumed away the two most critical challenges to economic growth: the availability of domestic investment opportunities worth borrowing for and the presence of businesses with clean balance sheets. While the public is desperately waiting for economists to come up with policy recommendations to get the economy growing again, that is, to pull it out of Cases 3 and 4 and push it back into Cases 1 and 2, economists themselves have largely assumed away the problem of growth because their models take it for granted that the economy is already in Case 1 or 2.

Moreover, most economists simply assume a rate of long-term “potential” growth that is based on trend growth in capital, labor, and productivity. They then argue that policy makers should strive to bring the economy back to that trajectory. But such “potential growth rates” mean absolutely nothing when businesspeople are either unable (because of balance sheet concerns) or unwilling (because of a lack of investment opportunities) to borrow money and invest it at home. Indeed, extrapolating trends observed during the golden era into the pursued era makes no sense whatsoever. This means conventional economics has no meaningful theory of economic growth because economists have assumed away all the relevant questions on growth that the public expects them to answer.

An Existential Issue for Economics Profession

The biggest concern for the economics profession at this juncture should be that the parents, students, and taxpayers who pay for or subsidize college tuition may eventually realize that what passes as “economics” in universities has little to do with reality. Of all the social sciences, economics would probably win the prize for straying the farthest from reality. When the public realizes that the vast majority of economics professors had no clue about the Great Recession, which lasted nearly 10 years in many countries and cost eight million jobs on both sides of the Atlantic, it may understandably want to cut the funding for university economics departments.

New groups such as the World Economic Association and the Institute of New Economic Thinking are keenly aware of this deficiency in the profession and are working hard to make the discipline relevant for society again. Professor Takamitsu Sawa¹⁰ of Kyoto University has also issued warnings that the funding for university economics departments might be cut by the Japanese Ministry of Education¹¹ if the profession's unrealistic obsession with mathematics is not rectified.

Unfortunately, many if not most economics professors continue to teach the same old material, as if 2008 had never happened and another golden era is just around the corner. This means the profession as a whole needs to reinvent itself before the public realizes what is actually happening.

Economics: A History of Changing Fads

Young disciplines, like young people, are easily influenced by fads. When macroeconomics was in its formative years in the 1940s and 1950s, most Western economies had passed the LTP and were in their golden eras with no one chasing them. New products were continually being invented, and people were optimistic about the future. Balance sheets were also strong thanks to massive government spending during the war, which had repaired the balance sheet damage wrought by the Great Crash of 1929. With strong demand for borrowings from the corporate sector, the economy was squarely in Case 1 or 2.

At the same time, the extraordinary effectiveness of fiscal policy in lifting economies out of the Great Depression during World War II was obvious for everyone to see. The tragedy was that Keynes, who had argued for such policies, never realized that fiscal stimulus should be used only when the private sector is minimizing debt, that is, when the economy is in Case 3 or 4. Because of this monumental omission on his and his followers' part, the postwar fad among economists was to believe that fiscal policy could solve most problems.

Since private-sector balance sheets had already been repaired, the government's attempt to fine-tune the economy with fiscal policy in the 1950s and 1960s only resulted in more inflation, higher interest rates, and a general misallocation of resources. These were the undesirable results of an overreliance on fiscal policy when the economy is in Case 1 or 2. These outcomes lie at the opposite end of the spectrum from the pernicious cycle of bubbles and balance sheet recessions that results from an overreliance on monetary policy when the economy is in Case 3 or 4, as is discussed in Chapter 4.

Even though the postwar economy had already returned to Case 1, it still took Americans another 14 years after 1945 to overcome their debt trauma (long- and short-term U.S. interest rates did not return to the average levels of the 1920s until 1959, as shown in Figure 2.22). But with the advanced economies in their golden era, inflation was becoming an ever-larger problem. By the early 1970s, inflation had caused a significant loss of credibility for Keynesian economics and its emphasis on fiscal policy.

When inflation reached double-digit levels and became a national concern in the late 1970s, the pendulum shifted to the opposite extreme, with neoliberals led by Milton Friedman arguing that monetary policy and smaller government were the answer to most problems. They claimed that central banks should be able to control inflation by controlling the money supply, and the Fed actually adopted a policy of targeting the money supply in October 1979. Although that policy did not work as smoothly as expected, the enthusiasm for monetary policy among academic economists was such that some even tried to rewrite history, arguing that the Great Depression could have been avoided with better use of monetary policy by the Fed.¹²

The tragedy was that Friedman, who had argued for such policies, never realized that monetary stimulus should be used only when the private sector is maximizing profits, that is, when the economy is in Case 1 or 2. Because of this monumental omission on his and his followers' part, the fad among economists was to believe that monetary policy could solve most problems—including what would later become known as balance sheet recessions.

When the private sector subsequently lost its head in a bubble and sustained massive balance sheet damage, first in Japan in 1990 and then in the West in 2008, the advanced economies were already in the pursued phase, with falling demand for borrowings from businesses. The economics profession, however, was still beholden to the golden era neoliberal mindset centered on small government and monetary policy. Although nearly all advanced economies were squarely in Case 3 or 4 by 2008, many economists argued for ever more radical monetary accommodation—even though fiscal policy is the only tool that can address a recession caused by a disappearance of borrowers.

Fiscal policy was mobilized soon after Lehman's failure at an emergency G20 meeting held in Washington, D.C., in November 2008. Although that fiscal package succeeded in preventing an immediate meltdown of the global economy, the golden-era orthodoxy had regained its grip on power by 2010. At the G20 summit held in Toronto that year, participating countries pledged to halve their fiscal deficits by 2013,¹³ even though the private sectors in nearly all of these countries were still engaged in massive deleveraging to repair their badly damaged balance sheets. That summit effectively threw the global economy into reverse.

Policy makers who realized soon afterward that the Toronto agreement had been a mistake, including former Fed Chairs Ben Bernanke and Janet Yellen, issued stern warnings about the “fiscal cliff” to encourage the U.S. government to continue serving as borrower of last resort, which helped keep the U.S. economy from contracting. Japanese Finance Minister Taro Aso also recognized this danger and incorporated fiscal stimulus as the second “arrow” of Abenomics, which was unveiled late in 2012. Their actions provided essential support for the U.S. and Japanese economies.

In the Eurozone, however, no such understanding emerged in policy circles. As a result, millions have suffered from unemployment and deprivation because the Stability and Growth Pact (SGP), which never considered Cases 3 and 4, requires member governments to do the opposite of what is needed to fight a balance sheet recession.

It is deeply ironic that the Germans are imposing this fiscal straitjacket on all the countries in the Eurozone. After all, it was they who suffered the most from the fiscal straitjacket imposed on the country by the Allied powers prior to 1933, and it was they who were the first to discover the effectiveness of fiscal policy in fighting balance sheet recessions after 1933. If anyone should understand the horrible economic and political risks of not administering fiscal stimulus when it is needed, it should be the Germans. This was famously noted by Joan Robinson, a British economist and contemporary of Keynes, when she said, “I do not regard the Keynesian revolution as a great intellectual triumph. On the contrary, it was a tragedy because it came so late. Hitler had already found how to cure unemployment before Keynes had finished explaining why it occurred.”¹⁴

Keynes was definitely trying to understand the economy in Cases 3 and 4 when he wrote the General Theory in the midst of the Depression in 1936. But he could not free himself from the established notion in economics that the private sector always seeks to maximize profits. As a result, he and his followers had to come up with highly convoluted explanations for why the Great Depression was so severe.

It took the post-1990 Japanese experience 60 years later for people to realize that the private sector can shift its priority from profit maximization to debt minimization when faced with daunting balance sheet challenges. That shift, in turn, can trigger the $1,000–$900–$810–$730 deflationary spiral that leads to depression if left unattended.

Recently, the faddish pendulum of economics seems to have swung to the opposite extreme again. Even though the author was the first to bring up the importance of debt and deleveraging in economics with the concept of balance sheet recessions in the late 1990s, many in the profession are now running about issuing warnings about excessive debt in the system, citing ever-increasing debt numbers. In so doing, they are forgetting the two fundamental laws of macroeconomics mentioned in Chapter 1—namely, for debt to grow, someone must be saving, and if someone is saving, someone else must borrow and spend those savings to keep the economy going. If both the public and private sectors borrow less and save more, as urged by these economists, the economy will fall into the $1,000–$900–$810–$730 deflationary spiral in a race toward depression.

A mere emphasis on the size of the debt is also absolutely meaningless without looking at what is on the other side of it. If the debt was incurred to finance investments expected to yield a return in excess of debt servicing costs, there is absolutely no problem with it, no matter how large. And most private-sector debt meets this condition (except during bubbles, when businesses and households lose their heads). Moreover, borrowing allows businesses and households to over-stretch, which is essential for economic growth.

The fact that the private sectors of most advanced countries are running a financial surplus despite record low interest rates suggests there is actually too little borrowing relative to savings. Indeed, interest rates are so low precisely because there are too few borrowers in the real economy.

The fact that economists can get away with statements like “everyone should borrow less and save more” shows how little they understand the interactive nature of the macroeconomy. They have forgotten that macroeconomics is a science of feedback loops. It also shows how easily the young profession can be corrupted by fads.

Better Data Are Needed

Medical science received a huge boost from advances in scanning technology, such as magnetic resonance imaging (MRIs), that allowed doctors to visualize problems with ever-greater clarity and precision. Economic science could also use better data to help reveal the core of the problems it faces.

In particular, the economics profession should demand that central banks in all countries gather data from borrowers similar to those collected by the BOJ in its quarterly Tankan survey (top of Figure 8.6). Many central banks collect data from lenders, one example being the Fed's Senior Loan Officer Survey, but not enough collect data from borrowers. Information about how borrowers view lenders makes it possible to visualize whether the constraint to economic growth is on the borrowers' or the lenders' side. If such surveys indicate that lenders are willing to lend but borrowers are not borrowing, then it can be inferred that the problem rests with the latter.

By supplementing such surveys with interest rate and flow-of-funds data like those shown in Figures 2.5 to 2.7 as well as Figures 7.1 to 7.8, economists can see what borrowers are doing with their financial assets and liabilities. Indeed flow of funds data is the MRI of macroeconomics as it allows the public to visualize not only balance sheet recessions (charts previously mentioned) but also banking problems (Figures 8.7 to 8.11).

If borrowers are not borrowing or are actually paying down debt despite low lending rates, they are likely to be suffering from balance sheet problems, and the economy is probably in Case 3. In such cases, the government must act as borrower of last resort to overcome the constraint on growth.

If the borrower survey indicates that lenders are unwilling to lend, it can be concluded that the problem lies with the lenders. By supplementing this information with data on interest rate spreads and flow-of-funds data for the financial sector, as shown in Figures 8.7 to 8.11, economists can determine whether banks are trying to expand lending or economize on capital. If lending rates are high (even if policy rates are low) but lending is still growing slowly or contracting, the problem probably rests with the lenders. In that case, monetary easing and capital injections or other bank rescue policies should be implemented to remove the constraint to growth.

The economics profession should also demand that governments and central banks improve the accuracy and timeliness of their flow-of-funds data. In some countries, such as China, the Netherlands, and Austria, these data are only released once a year. In other countries, such as Taiwan, the data come out too late to be of any use. And in the United States and Germany, they are subject to huge revisions.

As explained in the author's previous book,¹⁵ compiling flow-of-funds data is a massive and costly undertaking with much room for improvement. In spite of all the resources governments have invested in compiling these data, most economists still appear unable or unwilling to use them. And that is probably because they never anticipated borrower-side problems—after all, economics has traditionally assumed that economies were always in Case 1 or 2. Now that the existence of borrower-side problems has been recognized, economists will have a better appreciation of the role of these data in identifying whether growth is being held back by lenders or by borrowers.

Last but not least, it is essential to have data indicating the amount of borrowing that is earmarked for real investment—and therefore adds to GDP—as distinct from money borrowed to finance purchases of existing assets. To use the leasing industry terminology that is suggested in Chapter 6, the two types of borrowing may be referred to as “operating loans” and “financing loans,” respectively. Data on operating loans will be a good indicator of economic activity going forward because it can indicate over-stretching by businesses, which is essential for economic growth. Data on financing loans, meanwhile, may be a useful indicator of asset prices going forward.

Typical lenders do not care whether the borrowed money is used to build new factories or to buy back shares, as long as the borrower appears willing and able to pay back the debt. But for economists, the distinction is critically important. The government should collect these data not only from banks but also from the capital markets.

The share of financing loans appears to increase relative to the share of operating loans as the economy moves from the golden era to the pursued era. And that is because there is less demand for operating loans in pursued economies.

Political Implications of Dysfunctional Economics

The economic profession's overreliance on monetary policy when advanced economies have already entered the pursued era has not only created pernicious cycles of bubbles and balance sheet recessions, but has also worsened inequality between the haves and the have-nots by pushing asset prices higher. That, in turn, exacerbated political divisions. This is because monetary easing in Case 3 works mostly through the mechanism of rising asset prices in a process known as the portfolio rebalancing effect.

Specifically, bond prices rise when the central bank buys government bonds under the policy of QE. The higher bond prices then push investors into other asset classes, such as equities, that are still cheap relative to bonds. The resultant overall increase in asset prices is then expected to boost consumption by the holders of those assets, who are feeling richer than before. Although there is reason to believe that such a policy may have some positive impact on consumption, it definitely and directly benefits the rich who hold the assets.

Today, economic inequality in the United States has reached the point where 50 percent of people under the age of 38 say they would prefer to live in a socialist system. To the extent that asset price gains over the past three decades have been driven by an overreliance on monetary policy, often called the “central bank put,” central banks should be especially careful when using monetary easing going forward.

These social and political problems have been aggravated by the years of inaction on trade imbalances perpetuated by economists' incomplete understanding of free trade and free flows of capital. In particular, economists have overlooked the possibility that those who consider themselves losers from free trade might eventually outnumber the winners if large trade deficits are allowed to continue for too long. By November 2016, the losers from free trade, together with other disgruntled groups, amassed enough votes to elect an openly protectionist Donald Trump as president. In the process, traditional center-right Republicans who had championed free trade and globalization were squeezed out as the Trump faction hijacked their party.

To be sure, many of Trump's economic policies, including tax cuts and deregulation, were the correct responses for a pursued economy in Case 3, and the U.S. unemployment rate fell to a 50-year low of 3.5 percent just before the onset of the pandemic. That allowed people at the bottom of U.S. society to obtain good jobs for the first time in decades. Unfortunately, Trump's utter failure to understand the social and educational challenges facing the pursued U.S. economy, together with his botched and unscientific response to the COVID-19 pandemic, left the country in a dangerous state of disarray.

President Joe Biden is pushing for infrastructure spending, which is also the right thing to do in a Case 3 economy where the private sector is still saving 7 percent of GDP despite very low interest rates (Figure 1.1). Given the truly sorry state of infrastructure in the country, it should also be easy to find public works projects that have social rates of return in excess of low U.S. government bond yields. The same is true in Europe, including Germany, where additional spending can go a long way in reviving its aging infrastructure. It is hoped that the Europeans and Japanese will also come to appreciate the importance of fiscal policy when the economy is in Case 3.

President Biden's push for more union jobs and higher taxes, on the other hand, is not appropriate for pursued economies. Such policies may actually sap the economy's forward momentum by reducing the return on capital at home in manufacturing. Instead, he should strengthen the social safety net and improve education and retraining opportunities for workers so that the labor market itself will remain flexible.

In Europe, far-right political parties have gained ground because the economists who created the SGP never considered Cases 3 and 4 and prevented member governments from using fiscal policy to help those who have been hurt by the post-2008 balance sheet recessions. The pact has effectively put many Eurozone countries in the same position the Germans found themselves in back in 1930, when the center-left and center-right establishment parties were both beholden to the Treaty of Versailles and were unable to rescue the economy. Against this dire political background, the European Union (EU)'s decision in 2020 to issue its own bonds to help economies pummeled by the pandemic was a step in the right direction.

A few percent of the people in any country may hold xenophobic, far-right, anti-immigration views. But when economic hardships continue, those who have lost jobs or businesses will become increasingly desperate. Some may even backtrack on progress made on civil rights if they feel a Nazi-like government is the only way to break through a policy orthodoxy that is destroying their lives. The ability of politicians espousing such views to garner significant support from voters in the United States, the United Kingdom, and France—countries that have traditionally been champions of democracy and human rights—underscores voters' unhappiness with orthodox thinking. With the credibility of established center-right and center-left parties eroding, it is urgent that the public be made aware that their economies are in Case 3, the pursued phase, which requires appropriate fiscal, structural, and educational policies. And that has to happen before the next Hitler makes his appearance.

Difficulty of Maintaining Fiscal Stimulus in Peacetime Democracies

Until universities start explicitly teaching students about economies in Case 3, central banks and their financial market counterparts must inform policy makers that there is indeed a dearth of borrowers for real investments even with interest rates near zero, and that the economy is not in Case 1 as assumed by most economists. As Ben Bernanke and Janet Yellen did with the expression “fiscal cliff,” they must tell the public that the government needs to borrow and spend to stabilize the economy when the private sector is a net saver despite very low interest rates.

The central bank needs to point this out because it will be difficult for elected leaders to convince the public that the economy is actually in the other half and that the government must act as borrower of last resort to keep it going. It is difficult because the economics taught to the public is based on golden era economies that disparaged fiscal stimulus. As a result, most elected officials will not even try to convince the public because the risk of being labeled a pork-barrel politician is too great. History also shows that administering speedy, sustained, and sufficient fiscal stimulus is extremely difficult in a democracy—except during wartime, when the nation is under military threat.

During peacetime, even leaders who understand the need for speedy, substantial, and sustained fiscal stimulus will only propose it when the economy is in desperate shape. Most will simply choose the path of least resistance, which means going along with the usual anti-deficit chorus until the economy's pain threshold is reached. But by then the medical cost of restoring economic health will be many times higher than if the disease had been treated when it first appeared.

Another political pitfall is that, because government spending, unlike monetary easing, always adds to gross domestic product (GDP), the economy will react quickly and positively to such expenditures even if the private sector is still deleveraging. Those initial positive signs, however, will trigger a pushback from the anti-fiscal-policy chorus. Since the economy is already recovering, they will argue, it is time for fiscal consolidation. But if the private sector is still deleveraging, a withdrawal of fiscal stimulus will tip the economy back into a balance sheet recession. That may prompt another round of fiscal stimulus, only to be aborted again when the economy shows fresh signs of life.

Japan lost more than two decades after 1990 because of this sort of stop-and-go fiscal stimulus that was nowhere near sufficient to pull the economy out of the balance sheet recession. And because the economy remained stagnant, many argued that not only monetary but also fiscal policy did not work. But one or two years of pump-priming fiscal stimulus was far from sufficient to repair the hole in private sector balance sheets brought about by an 87 percent decline in commercial real estate prices.

Fortunately, there were enough pork-barrel politicians in Japan to sustain the minimum level of government spending needed to prevent GDP from falling below the bubble peak. That was quite an achievement for fiscal policy in the country that lost wealth equivalent to three years' worth of GDP. Many in Europe and elsewhere were not so lucky. Their misfortune lengthened the recession and led to a loss of public confidence in established political parties and economists.

To prevent such an outcome, central bankers and financial market participants who face a lack of borrowers for real investment on a daily basis must speak out. They need to do so because most academic economists remain totally unaware that there is a shortage of borrowers even at zero interest rates. It is also hoped that universities will begin teaching students about the possibility of economies in Case 3 so that democratically elected leaders can apply fiscal stimulus as soon as it is needed.

Krugman, who fully understood the need for fiscal stimulus from the outset in the post-2008 West, correctly realized early on that there was no political appetite in Washington, D.C., for additional fiscal stimulus beyond the initial $787 billion package unveiled in early 2009. He then went on to argue for more monetary stimulus as a second-best solution.

A lack of political appetite for fiscal stimulus was also apparent in Japan in 1997. At that time, the whole country was obsessed with the need for fiscal consolidation when its public debt as a percentage of GDP passed that of Italy and became the highest among the G7 nations. Both the IMF and the Organisation for Economic Co-operation and Development (OECD) also put strong pressure on Japan to cut its fiscal deficit.

When the author and his assistant, Shigeru Fujita, became the only two economists in Japan¹⁶ to warn publicly that fiscal consolidation would destroy the economic recovery, it was an extremely unpopular and politically untenable stance to take (the only other person who openly opposed fiscal consolidation in Japan was U.S. Treasury Secretary Larry Summers). But when our prediction came true and the economy collapsed, policy makers were able to change direction quickly because an alternative road map had already been provided by the author and Mr. Fujita. The point is that economists must continue telling the public what is needed even if there is no political appetite for it. If their predictions come true, the public will change its mind, and that is the best an economist can hope for.

Krugman also expressed his disbelief at the author's adamant opposition to additional monetary stimulus when there was no obvious harm to such policy. But the author was flabbergasted by the fact that 80 to 90 percent of the policy debate after 2009 was focused on monetary easing, when 80 to 90 percent of the problem originated from a lack of borrowers, which monetary easing is ill-equipped to handle. The author was worried that not only would precious time be lost debating ineffective policies, but the credibility of the government and the central bank could also be undermined when monetary accommodation failed to produce the expected results.

Danger Posed by the Half-Educated

Chinese philosopher and educator Ku Hung-Ming once said it is not the educated or uneducated who cause problems, but rather the presence of a large number of “half-educated” people.¹⁷ By half-educated, he meant people who think they know something but, in fact, do not. Naturally, not everyone can be educated on all issues at all times. The problem arises when a policy maker turns out to be only half-educated in his or her area of responsibility.

The author was a panelist at a 2017 conference held in Europe when a central bank governor said, “If Mr. Koo's argument is correct, then Italy and France should be the champions of economic growth because they both have large public sectors.” He knew about the author's recommendation for fiscal stimulus but missed the central point of the author's argument—that such a policy should be used only when the economy is in Case 3 or 4, that is, when the private sector is minimizing debt.

The size of the public sector or public debt before the economy fell into a balance sheet recession is therefore irrelevant to the discussion of post-2008 economies. The high level of government spending and debt in France and Italy was probably harmful to those economies before 2008, when they were in Cases 1 and 2. But it was a mistake for France and Italy to reduce their deficits to satisfy SGP criteria after 2008, when their private sectors had shifted from profit maximization to debt minimization despite near-zero interest rates. From this encounter, the author received the impression that the central bank governor was only half-educated on the subject of balance sheet recessions.

Summary of Appropriate Policy Mix in Different Stages of Economic Development

The stages of economic development, which can be divided into the pre-LTP urbanizing era, the post-LTP golden era, and the pursued era, have huge influences on the behavior of economic agents and on inflation, growth, and the effectiveness of monetary or fiscal policy. Economies in the golden era are fundamentally inflationary because wages are increasing along the upward-sloping labor supply curve of Figure 3.1, resulting in increased consumption and increased corporate borrowing for productivity- and capacity-enhancing investments. This means that economies are in Case 1 or 2 and that central banks must be vigilant against inflation to ensure price stability and maximum sustainable growth.

In the pursued era, however, economies are fundamentally non-inflationary because wages are stagnant, consumers are fastidious, inexpensive imports are flooding the market, and businesses are cutting back on productivity- and capacity-enhancing investments at home. With households saving but businesses not borrowing to finance real investments, the economy is likely to be in, or close to, Case 3. If private-sector demand for borrowings falls below the level of savings even at very low interest rates, the government must mobilize fiscal policy and act as borrower of last resort to keep the economy away from a deflationary spiral.

The economy can also move from Case 1 to Case 3 or 4 very quickly after a bubble bursts. Even though the government and central bank have the tools needed to nudge the economy from Case 4 to Case 3 (or from Case 2 to Case 1) in a year or two, it may take years, if not decades, for an economy in Case 3 to return to Case 1. Only fiscal policy can support an economy in Case 3 or 4, and it must be kept in place until the private sector is ready to borrow again.

Although the public debt is already large in most advanced countries, government bond yields fall to extremely low levels when an economy is in Case 3 because the private sector is a net saver and government is the only borrower remaining. Those low yields are the market's way of telling the government that if any public works projects are needed for the nation's future, the time to implement them is now. Many public works projects also become self-financing at such low bond yields.

Indeed, the most important task for policy makers in Case 3 and 4 economies is to (1) inform the public that there is an excess savings problem in the private sector even with zero interest rates, and (2) assign their best and brightest to an independent commission to identify and implement public works projects capable of earning a social rate of return in excess of these extremely low government bond yields. Such projects will increase the national debt, but they will not increase the burden on future taxpayers because they are self-financing. This policy option is not available when the economy is in Cases 1 and 2, when interest rates are high and self-financing public works projects are more difficult to find.

This commission will have to continue identifying self-financing projects until private-sector borrowers return. Instead of the independent central bank, which played a key role in stabilizing the economy during the golden era, it is the as-yet-to-be-created independent fiscal commission that will be critical in stabilizing the economy during the pursued era.

In terms of monetary policy, the authorities should recognize that monetary policy in the pursued phase is not as effective as it was during the golden era, but the economy itself is also fundamentally non-inflationary. In this environment, central banks' all-out efforts to meet golden-era-inspired inflation targets using such tools as QE and negative interest rates have not only failed to achieve their targets, but have also increased inequality and pushed these economies into unproductive cycles of bubbles and balance sheet recessions. The QE policies that have been implemented since 2008 to attain those targets have also left the authorities with the daunting task of draining excess liquidity when the inflation returned with energy shortages and supply chain disruptions. Because trying to rekindle inflation in a fundamentally non-inflationary environment does more harm than good, central banks should distance themselves from inflation targets and other legacies of the golden era.

The increased destruction brought about by climate change is forcing the whole world to move away from its reliance on fossil fuels and embrace renewable sources of energy. But all the new investment required for this endeavor, together with higher energy prices, could create strong inflationary pressures for years. Central banks should therefore finish normalizing monetary policy as soon as practical in order to prepare for this new energy-driven era. It is even possible that the sheer volume of new investment required will push economies back into Case 1, in which case the central bank will really have to worry about demand-driven inflation.

For all advanced countries facing an absence of borrowers due to a lack of worthwhile investment opportunities at home, the government must not only implement (self-financing) fiscal stimulus to stabilize the economy, but also carry out supply-side reforms in the tax and regulatory regimes to maximize domestic investment opportunities. It must enhance labor market flexibility so that businesses can take evasive action when being pursued. It must also revamp the educational system to meet much larger human capital requirements of the pursued era compared with the golden era.

Supply-side policies are needed because for an economy to grow, someone must over-stretch, either by borrowing money or withdrawing savings. For businesses to over-stretch, profitable investment opportunities that can more than pay for themselves are needed. Investment opportunities at home must also offer an expected (country-risk-adjusted) return on capital that is higher than that available abroad. In addition, businesses must have presentable balance sheets to even contemplate over-stretching.

Most of the conditions previously noted were met during the golden era, which ended for the West in the 1980s and for Japan in the 1990s. In the pursued phase that followed, however, the return on capital was often higher in emerging economies than at home. Private-sector balance sheets were also badly damaged after the bubble burst in Japan in 1990 and in the West in 2008.

In this new and challenging environment, policy makers must recognize that tax and regulatory regimes that were not a noticeable economic drag in the golden era, when there was a surfeit of domestic investment opportunities, may weigh heavily on growth when those opportunities have been exhausted and the country must come up with new products and services to stay ahead of its pursuers. That means they should review every tax and regulation and ask whether it is serving to maximize the nation's creative and innovative potential. This includes minimizing the time people waste on crafting tax avoidance schemes that distort resource allocation in the economy.

Policy makers should also ensure that the educational system is encouraging students to think critically and independently so they can support businesses pursuing Strategy A with new ideas and products. Investment in education is also far more important in the pursued era where most good jobs are in knowledge-based areas. The fact that workers are on their own in the pursued phase also means they must have continued access to education if they want to improve their living standards. Education is also one of the few areas where policy makers can address pursued economies' inherent tendency to worsen inequality.

Conclusions

During the golden era, when private-sector investment opportunities were plentiful and interest rates were high, economists rightfully focused on strengthening monetary policy's ability to curb inflation while disparaging profligate fiscal policy. But that era ended in the 1980s for the West and in the 1990s for Japan.

The effectiveness of monetary and fiscal policy is reversed once an economy is in the pursued phase and the private sector often becomes a net saver in spite of very low interest rates. In particular, once the government becomes the last borrower standing, the effectiveness of monetary policy comes to depend on the size of government borrowing, because government is the only entity able and willing to borrow money and inject it into the real economy. Policy makers must therefore shift their focus from easing monetary policy to building an independent commission to seek out self-financing infrastructure projects so that the government can, in good conscience, continue to serve as borrower of last resort.

Policy makers should also recognize that multipliers and elasticities estimated in an earlier stage of economic development may be useless during the pursued phase. These parameters can even change—sometimes drastically—within the same phase depending on whether the economy is in Cases 1 and 2 or in Cases 3 and 4. For example, while an economy might fundamentally be in a golden era, the collapse of an asset price bubble could push it into Case 3 or 4 as private-sector borrowers disappear. That is basically what happened to the United States during the Great Depression and to Asian countries during the currency crisis of 1997.

At the global level, it must be recognized that the number of Americans who view themselves as losers from “free trade,” with some help from other groups, had grown large enough in 2016 to put the openly protectionist Trump into the White House. That means the 70-year postwar era, in which the United States led the global free-trade system, and the 40-year post-1980 era, during which it continued to take in so many imports despite running large trade deficits, are becoming unsustainable. Since it was this U.S.-led free trade regime that rendered wars obsolete and made global prosperity possible, everyone—and especially the countries that benefited from the U.S.-led framework—must now think about what must be done to maintain a system that has brought so much peace and prosperity to humanity.

A careful observer will note that free trade is under threat not because of internal contradictions within the regime, but rather because of the free flows of capital that have distorted both exchange rates and trade flows. And free flows of capital have done this because market forces adjust exchange rates and interest rates in individual countries so as to equalize the return on capital across countries, as though they were coming together to form a single nation. The problem is that none of the countries involved has any intention of joining with others to form a single political entity.

In other words, there is a fundamental conflict between free capital flows, which try to equalize the return on capital across countries, and the efforts of individual countries to equalize, or balance, their trade and current accounts under a free-trade framework. And it was free trade that brought about the greatest peace and prosperity in human history. This means it must be defended against unfettered capital flows, which are exacerbating trade imbalances, spawning protectionist pressures, and undermining the effectiveness of monetary policy.

This means policy makers cannot be indifferent to trade imbalances and exchange rates. They should not let market-determined exchange rates, which are often determined by capital flows, diverge too far from trade-equilibrating exchange rates. And Trump has proven that this can be achieved if the authorities constantly harp on about the need to reduce trade imbalances, thereby dissuading portfolio investors from betting on a movement of exchange rates that would exacerbate trade imbalances. Occasional threats of official intervention in the foreign exchange market may also be helpful in this regard.

Balancing every bilateral trade account is neither possible nor desirable in a world of more than 200 countries. But allowing trade imbalances to grow without limit is also an unsustainable policy when those who consider themselves losers from free trade will soon outnumber the winners. Governments must therefore keep trade imbalances within manageable limits.

For emerging countries seeking export-led growth with Strategy B, the already substantial social backlash against free trade in the pursued countries also means the easy days are over. Emerging countries that have relied on the export-led growth model must open their own markets to imports from pursued countries faster or accept higher exchange rates if they want to maintain access to the markets of the latter.

If there is a choice between accepting a higher exchange rate or opening up the domestic market, they should opt for the latter because it is always better for themselves and the world to reduce trade imbalances by having surplus countries increase their imports instead of reducing their exports. They should not make the mistake that Japan made in the early 1990s, when it resisted market-opening pressures from abroad and ended up with a strong yen that forced many of its best manufacturers to leave the country.

Russia's invasion of Ukraine has reminded the world that the threat to world peace from autocrats is still present. When the United States confronted a similar threat during World War II and the Cold War, the country was in its golden era and Americans were confident that they were in possession of a superior system offering a brighter future. In the Soviet Union, which had outlawed the market mechanism and profit motive, no one except the government's central planners could decide on over-stretching to maintain economic growth, and the resultant accumulation of inefficiencies and unviable enterprises led to its eventual demise.

Today, it is China that is in the golden era. The United States is in the pursued era and is facing a wide range of challenges. With a polarized polity, the Americans are also far less confident of themselves, especially in relation to rapidly growing China. Some Wall Street types are even increasing investments in China as a “protest vote” to the hopelessly divided and dysfunctional Washington, D.C.

But the pursued era need not entail national decline once the source of the problem is identified and correct policies are implemented. And the United States, having enacted at least two of the three key structural policies that are required for this era, is enjoying faster economic growth than other pursued countries such as Japan and Europe. Perhaps U.S. President Joe Biden's “Build Back Better” program should be specifically directed at the unaddressed issue of education and social welfare to rectify the remaining problems. If these structural policies are combined with reoriented fiscal, monetary, and trade policies that are appropriate for the pursued era, the United States and other pursued economies should be doing much better than they are doing now. And that should give self-confidence to the peoples of these countries that is essential in their efforts to compete with China.

At the most fundamental level, everyone must realize that, apart from the post-LTP golden era of industrialization, which is characterized by a surfeit of low-hanging investment opportunities, shortages of borrowers have always been a bigger problem for growth than shortages of lenders. The poor economic performance of the advanced countries today stems from the fact that households continue to save for an uncertain future, but businesses are unable to find enough attractive domestic investment opportunities to absorb those savings.

Instead of making facile assumptions about trend growth rates and assuming that there are always willing borrowers, policy makers and economists need to forcefully confront this problem of inferior domestic returns on capital. The availability of investment opportunities and willing borrowers should never be taken for granted. This is particularly true in countries that are in balance sheet recessions or are being pursued, a group that includes nearly every advanced economy in the world today.