Capitalism and Society

Volume 4, Issue 3

2009

Article 3

THE FUTURE OF CAPITALISM

Rethinking Macroeconomics
Jeffrey D. Sachs, Columbia University

Recommended Citation:
Sachs, Jeffrey D. (2009) "Rethinking Macroeconomics," Capitalism and Society: Vol. 4: Iss. 3,
Article 3.
DOI: 10.2202/1932-0213.1065

Sachs: Rethinking Macroeconomics

The crash of 2008 exposed deep failures at the core of macroeconomic

policymaking and macroeconomic thinking in the United States. The crisiss
rapid spread from its epicenter on Wall Street to nearly the entire world
underscored the interconnectedness of the global economy. The American
purveyors of the ancien rgime hope that a few superficial fixes will get us back
on our way. This is not to be. Sustained and widespread future prosperity will
require basic reforms in global macroeconomic governance and in
macroeconomic science. Such reforms are never easy, as they require new ways
of thinking. Yet business as usual could prove calamitous. This essay describes
the reform path.
To set our new direction, we must understand how we arrived at the
current impasse. The financial crisis of 2008 was not an accident. It was the
result of a long period of political decadence in the United States aided and
abetted by a growing hole in economic science. Decadence is a tough word, but
the truth is that the US walked headlong into the fury. Because of the central
roles of both the dollar and Wall Street in the global financial system, and because
of the centrality of US economic thinking in shaping global economic policies and
institutions, the rest of the world has been carried with it into the fury. This
dominance will come to an end with this crisis, however.
From the Presidency of Ronald Reagan, beginning in 1981, until today,
US economic policy has operated with a flawed set of assumptions, perpetuated
by both Republican and Democratic Administrations and by the Federal Reserve
Board. There have been heated debates, to be sure, between neo-Keynesians and
free-market economists (variously grouped under the rubrics of supply-side,
rational expectations, and efficient-market theories). These debates have,
however, obscured a large and ultimately damaging consensus on economic
thinking.
The differences between the two schools of thought are well known. NeoKeynesian economists emphasize active aggregate demand management, with
little attention to the uses of that spending. Free-market economists of various
stripes (such as the rational expectations, efficient markets, supply-side, and realbusiness-cycle schools, all close cousins) generally call for tax cuts and
deregulation, and believe in the stabilizing role of efficient financial markets and
financial market expectations.
Yet these two broad schools of thought share five assumptions (often
implicit) that are even more consequential than their differences. First, both the
Neo-Keynesians and free-market schools believe that economic policy making
should largely remain the purview of individual countries (or in the case of
Europe, the purview of the Euro-zone). Global cooperation is not much needed,
except perhaps to set a few regulatory standards. Second, both schools focus on
price stability, low unemployment, and high economic growth as the main

Capitalism and Society, Vol. 4 [2009], Iss. 3, Art. 3

objectives of macroeconomic policy. Third, both schools regard the management

of key macroeconomic aggregates as the way to achieve price stability and high
growth. For Keynesians, the main aggregates are the budget deficit and monetary
policy, managed so as to stabilize aggregate demand. The free-market school
prefers low marginal tax rates and a predictable money supply. Fourth, both
schools of thought view issues of income distribution as peripheral to
macroeconomic management, perhaps interesting morally or politically but not
especially relevant to growth and inflation. Fifth, both the neo-Keynesians and the
free-market school regard structural issues such as energy, climate, and
infrastructure to be of little macroeconomic significance. Perhaps these factors
require a modicum of policy attention, but they are certainly not regarded as
critical to restoring jobs, growth, and prosperity, and could even be a hindrance in
the short term; for example, if climate-change policies hike up the price of energy.
These five assumptions played out in the US in a consistent and
increasingly deficient set of macroeconomic policies from the early 1980s until
today. Three main policies prevailed. First, the top marginal tax rates were cut in
the early and mid-1980s and kept low thereafter. The wealthy prevailed in
keeping the lid on top tax rates through Republican and Democratic politicians
alike, in part through their ever-increasingly bi-partisan generosity in funding
political campaigns. Second, the Fed encouraged the maximum growth of credit
consistent with price stability, as measured by the consumer price index, or CPI.
The Fed pushed interest rates down as far as possible whenever the economy
weakened, as long as CPI inflation remained low. A second strategy of the Fed
has been to champion all manner of financial deregulation, opening the door for
securitization, sub-prime mortgages, and the blending of commercial and
investment banking, as long as the resulting credit boom did not create inflation.
Third, federal budget spending, other than for the military and entitlements
spending (Medicare, Medicaid, Veterans benefits, and Social Security), was
chronically starved for cash. Structural challenges like energy, climate change,
higher education, public health and infrastructure were not treated as economic
priorities.
For the twenty years of Alan Greenspans tenure as Chairman of the
Federal Reserve, from 1987 to 2006, these policies seemed to work. Of course
there were shocks and challenges, including the disconcerting frequency of
financial scares such as Black Monday (1987), Mexico (1994), East Asia (1997),
Long-term Capital Management (1998), and the Dot.Coms (1998-2000). These
were taken as one-off accidents, not as harbingers of more fundamental
instability. There was little challenge to the basic policy framework or the
stringent limits of the macroeconomic debate. The late 1990s are often regarded
as the halcyon days of the policy regime, with their rapid growth, low inflation,
and high employment. In retrospect, however, we also see in these years the

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Sachs: Rethinking Macroeconomics

collapse of private saving, the explosion of foreign borrowing, the Dot.com

bubble, the start of the housing bubble, and the failure to address underlying
structural problems.
The collapse of the subprime bubble has given some pause, but the old
policy machine is still trying to rise from the rubble, something like a Terminator
robot reassembling its parts after a seemingly shattering blow. In late 2008,
America briefly recognized that its profligacy had led to the mega-collapse of
2008, but during 2009 the Obama White House, Congress, and Fed have
attempted to re-create the preceding bubble. The Fed has once again put its foot
on the accelerator, driving interest rates to nearly zero, even lower than the rates
of 2002-2005.
Credit policies and derivatives markets remain largely
unregulated. The White House and Congress are attempting in every way they
can through tax cuts, rebates on home buying, and cash for clunkers to boost
total spending. The cash-for-clunkers epitomizes the shortsightedness of it all.
We paid billions of dollars for individuals to trash their existing cars and buy new
ones. In general, the neo-Keynesians think about stimulus that is, aggregate
demand without thinking much about the various needs and uses of public and
private spending, or about the longer-term consequences of budget policies.
Yet none of this will work. The US economy, and the world economy,
cannot recover sustainably by propping up consumers for yet another binge.
Zero-interest rate policies will create a new carry-trade bubble of some sort, as
Wall Street funds another Dubai-style real estate spending spree or some as yet
unrecognized and destabilizing commodity play. Meanwhile, the crises of
unemployment among the unskilled, uninsured, and poor eat away at American
society, where one in three children now subsist on food stamps.
Every one of the five assumptions guiding economic policy since 1981
needs a basic rethink. Each of the consensus pillars of macroeconomic policy has
become untenable. A new strategy of economic governance one that is
structural and global is now needed, and a new science of macroeconomics must
supersede the stale debates of Keynesian and rational expectations theories.
First, economic policy can no longer be taken one country at a time.
Global cooperation now matters. Greenspan was in fact tricked by globalization.
He thought that as long as inflation remained low, he could and indeed should
spur credit expansion to the hilt, the better to maximize economic growth (and
his repeated appointment as Fed Chairman). Yet in a globalized economy, the US
overheating didnt show up in the CPI, but instead mainly as a massive trade
deficit with Europe and Asia. (The credit boom also showed up in soaring
housing prices, which are not properly treated in the US CPI). China, notably,
was happy to provide on credit all of the goods that the US demanded and that the
Fed policy encouraged. The CPI simply doesnt register the imbalance of an open
economy importing heavily from the rest of the world. Now, to rebalance the

Capitalism and Society, Vol. 4 [2009], Iss. 3, Art. 3

world economy, its clear that the US must cut back on foreign borrowing while
China and others must spur their own domestic demand. Global macroeconomic
cooperation is needed to smooth this short-run transition and to avoid future
mega-imbalances.
Second, the narrow policy focus on three short-term goals price stability,
low unemployment, and high economic growth is woefully insufficient. By
focusing relentlessly on three headline numbers the CPI, the unemployment
rate, and the GNP policymakers and politicians allowed the US economy to
become profoundly imbalanced in several ways. Poverty is now deeply
entrenched. Much of the young workforce lacks the skills needed for good jobs.
The infrastructure has been allowed to crumble during thirty years of neglect, and
will need new public-private partnerships to revive and upgrade. Energy and
climate insecurity similarly cloud the future. The next generation of large-scale
investments in renewable and nuclear energy, electric vehicles, sustainable
buildings and urban design are held hostage to the lack of clear public policies
in these areas.
Third, the stimulus tools of standard macroeconomics are spent. Interest
rates are near zero but debt-ridden, unemployed, and frightened households can
no longer pick up the pace. Keynesians urge even greater budget deficits, though
the $1.4 trillion hole in fiscal year 2009 must give pause. The federal budget gap
is now so large that the deficit has itself become a major source of anxiety and
uncertainty. Another tax cut would be more likely to frighten than stimulate the
economy. Anybody who adds across budget columns will realize that the federal
budget is at the breaking point, and needs higher rather than lower tax revenues.
The Federal Government collects a mere 18 percent of GNP in revenues, which
are fully swallowed up by spending on health and retirement, the military, and
interest payments on the debt. The rest of government, including infrastructure,
science, education, climate, energy, poverty reduction, and public administration,
is financed by borrowing, with China the largest creditor.
Fourth, the sustained thirty-year neglect of income distribution is no
longer tolerable either practically or morally. In the central cities, half the kids
are dropping out of high school. There is an epidemic of dropouts from four-year
colleges as well, as families can no longer meet tuitions. One in five US children
are now growing up in poverty, and the rate is as high as one in three in the case
of African-American and Hispanic households. The welfare reform of the Clinton
era ending welfare as we know it sent poor single mothers out to work
without providing childcare or early schooling for the young kids left behind each
day. Yet even with this tsunami of social distress, Wall Street is readying to
launch the biggest stink bomb of all, by pocketing the bailout support (including
zero-interest credits from the Fed as well as overpayments for toxic assets) in a
new round of mega-bonuses for the miscreants who caused the crisis in the first

DOI: 10.2202/1932-0213.1065

Sachs: Rethinking Macroeconomics

place. Yet Congress and the White House are set to let this happen, so as not to
cross their campaign financiers in the lead-up to the 2010 elections. Decadence is
the watchword.
Fifth, the fallacy of the long-maintained assumption that the economy can
grow and provide high employment while neglecting structural challenges such as
energy and infrastructure is exposed by the US economys continuing
weaknesses. Even with interest rates at near zero, the economy limps along, on
the edge of a double dip. Unemployment remains perilously high and will stay so
for low-skilled workers. Trillions of dollars of real demand, not makeshift jobs or
last-gasp consumerism, are bottled up in infrastructure and low-carbon energy
projects that cant get off the ground until the government creates a sound policy
and financial environment.
Since the operating assumptions of macroeconomics from the 1980s
onward are pass, so too is the policy framework that has dominated the US and
the world economy for the past thirty years. Rather than championing low taxes
as the key to growth, we need to champion an efficient and fair public sector that
is large enough to meet the needs of infrastructure, science and technology,
climate, higher education, and poverty alleviation. Taxes need to be seen not as
dial to be tuned for stimulus, or only as impediment to private initiative, but as the
means to pay for critical public goods that are complementary to the private-led
economy. The US federal tax take of 18 percent of GNP is manifestly too low for
this purpose.
Credit policy also needs a similar overhaul. The Greenspan and Bernanke
rule to maximize the growth of consumer credit subject to the inflation target
has put the US into unprecedented indebtedness. We should be pleased that
households have cut back on consumption. Rather than trying to recreate the last
bubble, we should be mobilizing the renewed propensity to save in order to invest
in sustainable energy, food production, environmental conservation, skill
formation, research and development, and other priority needs.
Third, we should aim for an investment-led rather than consumption-led
recovery, by focusing on the complex complementarities of public and private
investments. Macroeconomists trained in the past thirty years believe that
demand increases depend mainly on interest rates and deficit or tax levels. Yet
increased spending on renewable or nuclear power plants, a robust power grid,
carbon-capture and sequestration, wastewater treatment facilities, fast inter-city
rail, higher education, urban co-generation of electricity and heat, green buildings,
and countless other new sustainable technologies, will depend on establishing a
policy framework that harmonizes regulations, land use, public financing, and
private investment. Large-scale stimulus, in other words, requires the nitty-gritty
of public-private planning, technology assessments, demonstration projects, and
complex project financing.

Capitalism and Society, Vol. 4 [2009], Iss. 3, Art. 3

The new tools of macroeconomics, therefore, are quite different from the
existing tools. The new tools begin with a medium-term (say, ten-year) budget
framework, so that tax policies are not pulled out of thin air or campaign rhetoric,
but reflect the calculated needs for public outlays; a medium-term set of income
distributional goals and strategies, especially to break the back of child-poverty,
rising school drop-out rates, and training for low-skilled workers; structural
objectives regarding the rebuilding of infrastructure and the transition to a lowcarbon economy; and a new set of institutions to carry out these policies. The
new institutions might include a National Infrastructure Bank, as Obama
mentioned during the campaign, to help finance public-private partnerships in
energy, water, and transport. The Energy Department might be reconstituted as
the Department of Energy and Climate Change, to bring the requisite expertise
and financing for the low-carbon economy under one roof.
These challenges might seem particular to the US but they are truly a
global drama, replayed in virtually every country. What ails the US ails much of
the world. The structural challenges of energy, climate, infrastructure, poverty,
and education are common challenges. Some of them require a truly global
policy framework, such as climate-change mitigation and a worldwide transition
to sustainable energy systems. Moreover, given Americas fragile finances and
diminished global stature, the US cannot lead the world on these issues; it can
only partner with others in efforts to find the solutions. We therefore find
ourselves in an inevitably risky transition from a world with one dominant
economic power to a multi-polar world where the institutions of economic
cooperation are still very weak. In short, macroeconomics needs an overhaul not
only in concepts and tools, but in global cooperation as well.
We must bolster international economic cooperation on the fly and in the
heat of crisis. As a first step, the G20 should be bolstered as the new forum for
macroeconomic decision-making. We have moved from a G7 that was largely a
G1 (the US) to a larger grouping that rightly includes Brazil, China, India,
Indonesia, and other emerging markets. Representation, broadly speaking, has
expanded from one billion people in the G7 high-income world to 4.2 billion
people represented at the G20 table. Still, the G20 must add the voices of the
poor, especially of Africa, which would bring another one billion to the table. A
permanent seat for the African Union would be a vital start.
Global representation must be bolstered in other ways. As a practical
matter, strong regional cooperation would greatly facilitate stronger global
cooperation as well. The European Union is the model here. While the EU has its
countless critics, it has effectively balanced significant internal diversity and
national sovereignty with deep and beneficent regional cooperation. If the
African Union, East Asia, South Asia, NAFTA, and South America would
emulate the efficacy of the European Union through similar regional institutions,

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Sachs: Rethinking Macroeconomics

the myriad tasks of global economic governance whether at the United Nations
or at the G20 would be greatly simplified. The recent summits between the
European Union and its African and East Asian counterparts signal the way
forward.
Regional cooperation will hasten reform of the international monetary
system. The dollar can no longer serve as a stable linchpin of the global
economy. The success of the Euro in weathering this crisis should give
inspiration to East Asia to follow on with much greater regional monetary
cooperation, including the gradual movement towards a common currency basket
among the major economies. A harmonized policy in East Asia would have the
virtue of easing Chinas transition from a dollar peg to a flexible rate. Flexibility
of the Yuan within a system of East Asian exchange rate cooperation will be
much more successful than a continued focus on the bilateral dollar-Yuan rate.
The structural challenges facing the world economy, notably around
climate, water, energy, food supplies, and extreme poverty, require the spotlight.
They are not the poor cousins of global macroeconomic management, but the key
to it. Global macroeconomics should be reconstituted around these global
challenges, since solutions to these problems will do more to promote and sustain
global growth than further fiddling with macroeconomic dials. Yet as important
as these areas are to our current and future economic wellbeing, we have a surfeit
of words and a dangerous deficit of real actions.
The politicians posture without understanding the technical underpinnings
of the structural challenges: their magnitude, timing, spatial extent, future
dynamics, or costs of mitigation and adaptation. The real experts are very far from
the podiums and negotiating tables. The macroeconomists, as Ive stressed, dont
even recognize that medium-term (decadal or even generation-long) programs to
address energy, climate, and extreme poverty are vital for sustained economic
growth. We will need, urgently, to strengthen global institutions so that they can
provide reliable expert guidance, quantification, monitoring, and oversight of
global cooperative actions. The data matter, and we are flying blind.
We would do well to start the new macroeconomics with three crucial and
interconnected challenges: climate and energy security, food and nutrition
security (including land use, water use and biodiversity), and poverty reduction.
In each area, we need new institutions that can help the world to take the long
view, making assessments of needs, investment priorities, and means of financing.
These institutions would help to connect business, policy, and science, a threeway relationship vital for every major area of concern, but largely non-existent in
an institutionalized manner. Many will shudder at the prospect of such planning,
but the purpose is not rigid calculation but rather to design practical frameworks
for action in which private and public actors will play complementary roles.

Capitalism and Society, Vol. 4 [2009], Iss. 3, Art. 3

Climate change and energy security issues, for example, should be housed
in a new Global Energy and Environment Organization (GEEO) to supplant the
small-scale secretariat of the UN Framework Convention on Climate Change.
The new GEEO would pull together the existing pieces of various international
bodies and treaty secretariats into an effective unified structure, overseeing
technical analyses, compliance with international agreements, and financial flows
for climate-change mitigation and adaptation. The growing global food and
nutrition crisis also needs a similarly powerful home that would combine the work
of several existing agencies and treaty organizations involving agriculture and
nutrition, perhaps in a new World Food and Nutrition Agency. The challenge of
poverty reduction, vital not only for economic development but also for restoring
peace in war-torn impoverished regions like Afghanistan, Sudan, and Somalia,
requires a Global Sustainable Development Agency, built upon the leadership of
the United Nations Development Programme. A stronger agency would have the
mandate and wherewithal to coordinate the worlds efforts to achieve the
Millennium Development Goals.
One of the catchphrases of recent years in the international system has
been that we should use existing mechanisms rather than create new
institutions. This is a recklessly reactionary point of view. The existing
institutions were born after World War II, in a different time facing a different set
of challenges. The G20 is new because the world economy has been recast by the
rise of the emerging economies. The worlds macroeconomic challenges are new
because we have hit generational roadblocks due to persistent poverty, escalating
environmental threats, and deepening energy insecurity. While we have powerful
new technologies to address our challenges, they will require public-private
partnerships for testing and large-scale deployment. Macroeconomic aggregates
will not produce the next generation of automobiles, the safe worldwide use of
nuclear power, the protection of rainforests, or the global capture and disposal of
carbon dioxide at coal-fired plants.
This essay began with interest rates and budget deficits and ended with
international organizations, a category as far removed from mainstream
macroeconomics as one can imagine. Yet bridging the divide of macroeconomics
and global governance is exactly the challenge we face, both in policy and
scientific terms. The issues which have burned so brightly in our recent
macroeconomic debates interest rates, monetary growth, fiscal stimulus
packages, top marginal tax rates, financial deregulation are not the variables that
will truly determine our economic future. The new macroeconomics must be
structural concerning itself with poverty, education, food, energy, and climate
over the CPI if we are to find our way to sustainable recovery and development.

DOI: 10.2202/1932-0213.1065