It all comes down to this: We have to match growth to debt. If we can't create miracles from growth, we have to consider inflation to reduce the value of our debt
We have only two ways out of our current global economic mess: innovation and inflation. And as the saying goes, we should hope for the best (more innovation) and prepare for the worst (higher inflation).
Looking across the world, the underlying problem is that borrowers--households and governments--have taken on debt that they can't afford to pay back, given the current rate of income and economic growth. In the U.S, too many homeowners are struggling with mortgages that far exceed the value of their homes and cannot be repaid from their current incomes. In Europe, Greece and perhaps other countries have issued bonds that they cannot pay back unless growth unexpectedly skyrockets.
Down the road the same principle of matching growth to debt allows us to perceive potential financial crises to come. Young male college graduates, for example, have seen their real earnings plunge by 19% since 2000, with young female college grads experiencing a similar decline. Meanwhile education borrowing has soared, suggesting that we are on the verge of a student loan crisis, where young grads simply cannot pay back their mountain of debt.
It's not easy to explain why lenders overestimated the ability of debtors to pay. Or, rather, there are too many explanations. Some believe that complicated financial instruments obscured the true amount of debt, as in the case of the U.S. financial crisis. Others think that greedy financiers expected to be bailed out, or worse, simply didn't care. In Greece, the official numbers understated the budget deficits for many years.
An alternative class of explanations points to excess optimism about future growth as the main culprit. In the case of student loans, the conventional wisdom is that education is always a good investment, suggesting to both students and lenders that borrowing for college is always a good idea. In the case of housing, many economists subscribed to the belief that national home prices never go down.
To be truly effective, reinflation would have to be followed by all of the world's major central banks
Another piece of the puzzle is the unexpected innovation shortfall of recent years, which I, Tyler Cowen, and others have documented. This shortfall, particularly in biosciences, has led to a slowing of growth in the developed countries. What's more, the true extent of the growth slowdown has been masked by flaws in the economic statistics.
But no matter which explanation you favor, the essential mismatch between growth and debt has only two possible solutions: Increase the growth rate or reduce the debt. For a country like the U.S., increasing the growth rate requires innovation, and innovation requires a devotion to investment: Investment in physical capital, investment in human capital, investment in knowledge capital. That increased investment, in turn, should result in higher rates of productivity growth and increased innovation.
In other words, we have to shift from a consumer economy to a production economy. This is partly about a change in spending patterns, but also about a change in attitude. For example, we need to boost R&D and other investment in knowledge capital, but we also need federal regulatory agencies to encourage rather than discourage innovation. We need more infrastructure spending and other investment in physical capital, but it should be directed towards supporting exports and production in the U.S., rather than clearing up bottlenecks of imported consumer goods. This profound shift in policy and behavior is essential over the long run, but it won't be easy or quick.