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Our reduced size economy

Here’s something I wrote in January, 2009, about fiscal stimulus:

Before the housing bubble burst, the economy was a size XL shirt. Now it’s size L shirt. The economy is rapidly losing weight so that it can fit into the size L shirt. What this means is closed down factories, canceled construction projects, and massive job loss.

The purpose of fiscal stimulus is to stretch the shirt back out to size XL. This works by replacing consumer borrowing (by way of home equity loans, cash-out refinances, and credit cards) with government borrowing. The idea is that the government will stretch the shirt until the economy grows enough for the shirt to remain size XL without fiscal stimulus.

And my bigger question is this: what if the size L economy is the new normal, and the only thing that will save us in the end is population growth? What then is the proper course of action for the government? If the current crisis is a product of structural change, what’s the best recourse? Replacing consumer borrowing with government borrowing isn’t going to save us if there’s no path back to the size XL economy anytime soon.

Looking at today’s job report, it strikes me that we’re going to be stuck at size L for quite some time.

4 Comments

  1. Actually, I’d prefer population contraction and a nation that has learned about the limits to growth. The misery we’re going to endure is the result of living beyond our means since the end of World War 2.

  2. I don’t always agree with your point of view, but I do in this case. The economy, left to its own, will size itself to fit. The stimulus to the extent that it increased the national debt has the potential to deepen (reduce) the size of the “new normal.” I think this will happen as the inevitable federal VAT will further erode consumer spending.

  3. The other side of the coin that I see is that we have millions of people who are willing to work but are unable to do so because there are no jobs. The opportunity cost of the amount of idle capacity we have in the economy right now is pretty high, I think. It’s frustrating that we could be using that capacity to build or improve things and we’re instead just squandering it. I don’t know what the policy prescription is, but the status quo seems very wasteful to me.

  4. Doesn’t anyone think our trade policies have anything to do with the “size L” economy? Why do we have millions of people willing to work but no jobs?

    It seems to me that we let jobs leave. Now we are looking for any other reason for the high unemployment because a more restricted trade policy could anger the countries that buy our bonds.

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