The disappointing economic data on US activity in recent months has brought a key policy debate back into focus. Is there a chronic shortage of growth in the developed world, and if so what should be done about it? The Keynesian side of this debate has been well served, with frequent outstanding contributions from Paul Krugman, Brad DeLong and others. But I have had more trouble finding serious economic contributions from the classical school, even though they seem to be gaining ground in political and policy circles on both sides of the Atlantic. For that reason, I was particularly interested in the recent lecture on the US recession given by the University of Chicago’s Robert Lucas. Lucas is universally recognised as an intellectual giant, and his lecture gives a neat synopsis of what the classical school currently thinks, straight from the horse’s mouth.
Lucas starts by establishing that real US GDP has grown at a remarkably consistent rate of about 3 per cent annum (or 2 per cent per capita) ever since 1870. In fact, there has only been one big dip below this trendline over the whole of that period, which occurred during the Depression of the 1930s. But the recent recession has also seen something of a dip, albeit only about one third as large. Lucas asks why this has happened, and what will happen next.
His description of how the US fell into recession in 2008 is fairly standard, though with some new twists. In his view, the recession was caused by a rush to liquidity after the failure of Lehman, with those who had funded the surge in investment bank and shadow bank activity in the 2000s suddenly suffering losses and stampeding into government debt for safety. Lucas says that this event was the modern day equivalent of the failure of commercial banks in the early 1930s, when there were severe losses of bank deposits as the Fed failed to provide the banking sector with enough liquidity to prevent a cascade of banking failures. This time, says Lucas, the Fed correctly injected very large amounts of liquidity into the financial system, so the blow to the economy was much smaller than it had been in the 1930s.
So far, so consensus. However, Lucas then goes on to discuss the prospect of further recovery from here. 
He says that the past experience of the US would suggest that there should be an “automatic” recovery in output back to its long term 3 per cent trendline, which would imply (and this is my interpretation) that real GDP growth might be expected to run consistently at about 4 per cent per annum for roughly the next decade or so. That is what would normally be expected as the free market system repaired itself and private sector balance sheets returned to equilibrium. Yet, Lucas speculates that this time the outcome may be very different.
This is not because he agrees with the Keynesians that a shortage of aggregate demand will prevent the economy from returning to full capacity. Instead, he argues that government policies which are unfriendly to the supply side of the US economy may be preventing the animal spirits of the private sector from recovering.
The specific policies he has in mind are higher taxes focused on the rich, an increase in government involvement in the medical sector and new regulation on the financial sector. Lucas asks whether the US is shifting towards a European-style welfare state, which he says has restricted European levels of GDP per head by about 20 to 30 per cent for several decades. And his evidence for this conclusion is contained in the second graph, which shows that European levels of GDP per head have stopped converging on the US level since the 1970s. This would not be expected since, in free market systems, there is a tendency for countries with relatively low productivity levels to converge continuously on the leader, as best practice technologies are diffused over time. According to Lucas, the European welfare state has prevented that.
Whatever one thinks of this argument as it applies to Europe (and I must admit that I now find it more persuasive than I did a couple of decades ago), it is hard to believe that American economic policy has suddenly changed so much in the last couple of years that the trend rate of growth of the economy has already dropped by as much as 1 to 2 per cent per annum. Structural changes of this type normally work into the economy extremely slowly and, while they can have large cumulative effects over long periods, their initial effects are not large.
As yet, there has been no increase in taxation, on the rich or anyone else. Nor have the Obama administration’s medical and financial sector reforms really taken effect. It would take a remarkably far sighted private sector to have already reacted adversely to this set of long term reforms, even if they might do so eventually.
There is of course another possible reason why the US (and UK) economies might not be converging on their long term GDP growth trends at present, and that is that there is insufficient growth in aggregate demand to fuel a “normal” recovery in output. The sluggish growth in US and UK GDP in the past couple of quarters has raised the likelihood that this is re-emerging as a core problem for the global economy. If so, it would raise further difficult questions about whether fiscal and central bank balance sheets are in any fit state to address this problem by easing policy further.
Yet a shortage of demand is not mentioned, even as a remote possibility, by Prof Lucas. As a convinced classicist, he seems to have ruled this out by a priori conviction, rather than any detailed empirical work. That still remains to be done.
