The main argument in favor of the extended period of extraordinary monetary accommodation has been that it would provide the space for balance sheets to heal and the economy to get back to pre-crisis growth trajectory. Now, what if a return to the pre-crisis growth path may no longer be possible, for whatever reasons?
Economists like Robert Gordon have for some time now been cautioning about a productivity growth slow-down. Tyler Cowen had popularized this trend in his book "Average is Over", claiming that all the low-hanging fruits of recent technology revolutions have been plucked and actual productivity enhancing innovation has reached a plateau. Larry Summers has sought to provide a theoretical framework to the underlying trends by resuscitating Hyman Minsky's 'secular stagnation' hypothesis. Essentially, declining investment demand, induced by a variety of long-term structural factors, have forced down the Wicksellian natural interest rate to historic low levels, with limited prospects of a recovery for the foreseeable future.
The supporters of unconventional monetary policy responses, led by Paul Krugman, have argued that such policies will not only help repair distressed household and corporate balance sheets, but also stoke the inflationary expectations required to restore consumption and an exit from the liquidity trap. They have claimed that central bankers could "credibly promise to be irresponsible" and unhinge inflationary expectations. While they also support fiscal policy measures, all those are made conditional on the persistence of monetary accommodation.
In this context, a recent dialogue between Larry Summers and Paul Krugman is instructive. Krugman, one of cheer-leaders of ever more monetary accommodation, assumes a return to pre-crisis growth path. But Summers describes the belief in pre-crisis recovery taking hold as a 'deus ex machina' event, and writes,
The essence of the secular stagnation and hysteresis ideas that I have been pushing is that there is no assurance that capitalist economies, when plunged into downturn, will, over any interval, revert to what had been normal. Understanding this phenomenon and responding to it seems the central challenge for macroeconomics in this era... I suspect it will lead to more emphasis on fiscal rather than monetary actions in depressed economies.
Krugman has grudgingly accepted the possibility that a return to pre-crisis normalcy may not be possible, thereby making policy response that much harder. If we agree to Summers' point that pre-crisis growth may not be a possibility, then low interest rates are here to stay, thereby making government borrowings, especially to finance much-needed investments in infrastructure in the US less of a problem. But the flip side of this argument is that this too may have limited traction as a growth driver and may end up down a slippery slope, as Japan is today. While the US does not face as bad a demographic headwind, Japan's struggles with the use of fiscal expansion in triggering growth draws attention to the limitations of fiscal policy itself in such circumstances.
In any case, all this would also mean that the US has followed Japan and, possibly, Europe, into a long period of low growth rates, with attendant drag on the emerging markets and the world economy itself.