The fear of “L”

By Kaushik Basu
January 7, 2014

(This piece comes from¬†Project Syndicate. The opinions expressed are the author’s own)

For the last few years, economists have been running through the alphabet to describe the shape of the long-awaited recovery — starting with an optimistic V, proceeding to a more downbeat U, and ending up at a despairing W. But now a deeper anxiety is beginning to stalk the profession: the fear of what I call an “L-shaped” recovery.

Viewed in the light of the past five dismal years, 2013 was not bad for the advanced economies. The eurozone technically emerged from recession, the unemployment rate in the United States was lower than in previous years, and Japan began to stir after a long slumber and the negative shock of the earthquake and tsunami in 2011.

But if we look beneath the surface, it becomes evident that we are still hovering on the edge of a precipice. In the third quarter of this year, GDP contracted, on a year-on-year basis, not just in well-known cases like Greece and Portugal, but also in Italy, Spain, the Netherlands, and the Czech Republic. And GDP in some countries, like France and Sweden, grew at rates lower than population growth, implying that per capita income declined.

Moreover, labor-market conditions deteriorated toward the end of the year. The number of unemployed in Germany grew for four consecutive months up to November. Among the industrialized countries, the US is the bright spot. But, even there, while the unemployment rate has dropped during the year, and now stands at 7%, long-term joblessness is at an unusually high 36% of total unemployment, threatening to erode the skills base and make recovery that much more difficult.

Japan’s revival, meanwhile, was caused by a much-needed liquidity injection. But Japan’s upturn will be short-lived unless Prime Minister Shinzo Abe’s government follows through on its promise of deeper structural reforms.

Given these developments, a few commentators have written recently about the possibility of a prolonged slowdown in industrialized countries. This is not a popular view, with others criticizing its advocates for stoking pessimism. But the pessimists cannot be dismissed out of hand.

The fear of an L-shaped recovery is legitimate. Modern technology has enabled workers in emerging economies to join a global labor market; in the absence of major policy innovation, this is likely to cause a prolonged drag on rich countries. And there are few signs of innovation.

There is, instead, a crisis of the economics profession, one that mirrors the crisis of the advanced economies. Thanks to technological change and relentless globalization, the character of entire economies has changed dramatically over the last 50 years. This has not been matched by changes in policymakers’ thinking.

Why this stasis? One possibility is that the same factors that are making entrepreneurs over-cautious about new ventures are making policymakers prone to conservatism. An engaging paper by the World Bank economists Leora Klapper and Inessa Love shows that one major consequence of the financial crisis has been entrepreneurs’ reluctance to start new firms. They show that after a steady increase from 2004 to 2007, firm creation dropped sharply. In the United Kingdom, for example, the number of newly registered limited-liability companies fell from 450,000 in 2007 to 372,000 in 2008 and 330,000 in 2009.

What is interesting is that while this decline is most marked in advanced economies, which are especially dependent on financial markets, it is visible in virtually all of the 95 countries that the authors studied. The reason is not hard to fathom: A recession is a time when we tend to become cautious and stick to familiar territory, steering clear of new projects.

The same mindset has become apparent among economists and policymakers. In times of profound uncertainty, the tendency is to cling to the domain of the familiar and avoid innovative thinking. This is especially unfortunate nowadays, when the structure of the global economy is changing rapidly.

A telltale sign of over-caution among economists and policymakers has been their propensity to convert the need for evidence to an aversion to analytical creativity. We should, of course, use the best available evidence in crafting policy. But there are areas in which there is no evidence. In these uncharted territories, one must rely on a combination of intuition and theory. To resist new policy on the grounds that it is not founded in hard evidence is to trap us in the status quo.

To see the mistake in this criticism, imagine that, on the basis of theory and some assumptions, one recommends new policy X, even though there is no hard evidence regarding whether or not X works. Now use Y to refer to ‚Äúnot doing X.‚ÄĚ If there is no evidence regarding whether X works, there clearly is no evidence concerning whether Y works. So, if the lack of evidence is considered a good reason not to do X, it is also a good reason not to do Y. But this is a contradiction, because it is impossible not to do either X or Y.

The propensity to use this inconsistent argument reflects a proclivity for the¬†status quo¬†and a bias against policy innovation. But what we need now is precisely the type of new analytical thinking that spurred the great advances of economics as a discipline over the last two and a half centuries ‚Äď and that led to major policy breakthroughs during the Great Depression.

It is the absence of such creative thinking that has led the economics profession into an impasse, forcing economists and policymakers to contend with the fear of “L.”

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