Raghuram Rajan – Economy Watch

Why Merely Addressing Inequality Will Not Restore Growth: Raghuram Rajan

Raghuram Rajan — Mon, 16 Jul 2012 09:02:07 +0000

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As a reformed Europe starts growing, parts of it might experience US-style inequality. But Europe would be far worse off if it were to avoid serious reform and lapse, Japan-like, into egalitarian and genteel decline.

CHICAGO – To understand how to achieve a sustained recovery from the Great Recession, we need to understand its causes. And identifying causes means starting with the evidence.

Two facts stand out. First, overall demand for goods and services is much weaker, both in Europe and the United States, than it was in the go-go years before the recession. Second, most of the economic gains in the US in recent years have gone to the rich, while the middle class has fallen behind in relative terms. In Europe, concerns about domestic income inequality, though more muted, are compounded by angst about inequality between countries, as Germany roars ahead while the southern periphery stalls.

Persuasive explanations of the crisis point to linkages between today’s tepid demand and rising income inequality. Progressive economists argue that the weakening of unions in the US, together with tax policies favouring the rich, slowed middle-class income growth, while traditional transfer programs were cut back. With incomes stagnant, households were encouraged to borrow, especially against home equity, to maintain consumption.

Rising house prices gave people the illusion that increasing wealth backed their borrowing. But, now that house prices have collapsed and credit is unavailable to underwater households, demand has plummeted. The key to recovery, then, is to tax the rich, increase transfers, and restore worker incomes by enhancing union bargaining power and raising minimum wages.

This emphasis on anti-worker, pro-rich policies as the recession’s primary cause fits less well with events in Europe. Countries like Germany that reformed labour laws to create more flexibility for employers, and did not raise wages rapidly, seem to be in better economic shape than countries like France and Spain, where labour was better protected.

So consider an alternative explanation: Starting in the early 1970’s, advanced economies found it increasingly difficult to grow. Countries like the US and the United Kingdom eventually responded by deregulating their economies.

Greater competition and the adoption of new technologies increased the demand for, and incomes of, highly skilled, talented, and educated workers doing non-routine jobs like consulting. More routine, once well-paying, jobs done by the unskilled or the moderately educated were automated or outsourced. So income inequality emerged, not primarily because of policies favouring the rich, but because the liberalized economy favoured those equipped to take advantage of it.

The short-sighted political response to the anxieties of those falling behind was to ease their access to credit. Faced with little regulatory restraint, banks overdosed on risky loans. Thus, while differing on the root causes of inequality (at least in the US), the progressive and alternative narratives agree about its consequences.

[quote]The alternative narrative has more to say. Continental Europe did not deregulate as much, and preferred to seek growth in greater economic integration. But the price for protecting workers and firms was slower growth and higher unemployment. And, while inequality did not increase as much as in the US, job prospects were terrible for the young and unemployed, who were left out of the protected system.[/quote]

The advent of the euro was a seeming boon, because it reduced borrowing costs and allowed countries to create jobs through debt-financed spending. The crisis ended that spending, whether by national governments (Greece), local governments (Spain), the construction sector (Ireland and Spain), or the financial sector (Ireland). Unfortunately, past spending pushed up wages, without a commensurate increase in productivity, leaving the heavy spenders indebted and uncompetitive.

The important exception to this pattern is Germany, which was accustomed to low borrowing costs even before it entered the eurozone. Germany had to contend with historically high unemployment, stemming from reunification with a sick East Germany. In the euro’s initial years, Germany had no option but to reduce worker protections, limit wage increases, and reduce pensions as it tried to increase employment. Germany’s labour costs fell relative to the rest of the eurozone, and its exports and GDP growth exploded.

The alternative view suggests different remedies. The US should focus on helping to tailor the education and skills of the people being left behind to the available jobs. This will not be easy or quick, but it beats having corrosively high levels of inequality of opportunity, as well as a large segment of the population dependent on transfers. Rather than paying for any necessary spending by raising tax rates on the rich sky high, which would hurt entrepreneurship, more thoughtful across-the-board tax reform is needed.

For the uncompetitive parts of the eurozone, structural reforms can no longer be postponed. But, given the large adjustment needs, it is not politically feasible to do everything, including painful fiscal tightening, immediately. Less austerity, while not a sustainable growth strategy, may ease the pain of adjustment. That, in a nutshell, is the fundamental eurozone dilemma: the periphery needs financing as it adjusts, while Germany, pointing to the post-euro experience, says that it cannot trust countries to reform once they get the money.

The Germans have been insisting on institutional change – more centralized eurozone control over periphery banks and government budgets in exchange for expanded access to financing for the periphery. Yet institutional change, despite the euphoria that greeted the latest EU summit, will take time, for it requires careful structuring and broader public support.

Europe may be better off with stop-gap measures. If confidence in Italy or Spain deteriorates again, the eurozone may have to resort to the traditional bridge between weak credibility and low-cost financing: a temporary International Monetary Fund-style monitored reform program.

Such programs cannot dispense with the need for government resolve, as Greece’s travails demonstrate. And governments hate the implied loss of sovereignty and face. But determined governments, like those of Brazil and India, have negotiated programs in the past that set them on the path to sustained growth.

As a reformed Europe starts growing, parts of it may experience US-style inequality. But growth can provide the resources to address that. Far worse for Europe would be to avoid serious reform and lapse into egalitarian and genteel decline. Japan, not the US, is the example to avoid.

By Raghuram Rajan

Copyright: Project-Syndicate, 2012

Raghuram Rajan served as IMF’s Chief Economist from September 2003 to January 2007. In 2003, Rajan was the inaugural recipient of the Fischer Black Prize awarded by the American Finance Association for contributions to the theory and practice of finance by an economist under the age of 40. Rajan is currently the Eric J. Gleacher Distinguished Service Professor of Finance at the Booth School of Business at the University of Chicago, and was voted by Economist readers as the economist with the most important ideas in the post-financial crisis world.

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The Broken BRIC – Why India’s Economy Is Underperforming: Raghuram Rajan

Raghuram Rajan — Wed, 13 Jun 2012 07:32:38 +0000

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Major emerging-market economies around the world are slowing, for reasons both shared and unique. Hardest to understand, though, is why India, where annual GDP growth has fallen by five percentage points since 2010, is underperforming so much relative to its potential.

CHICAGO – Emerging markets around the world – Brazil, China, India, and Russia, to name the largest – are slowing. One reason is that they continue to be dependent, directly or indirectly, on exports to advanced industrial countries. Slow growth there, especially in Europe, is economically depressing.

But a second reason is that they each have important weaknesses, which they have not overcome in good times. For China, it is excessive reliance on fixed-asset investment for growth. In Brazil, low savings and various institutional impediments keep interest rates high and investment low, while the educational system does not serve significant parts of the population well. And Russia, despite a very well educated population, continues to be reliant on commodity industries for economic growth.

[quote]Hardest to understand, though, is why India is underperforming so much relative to its potential. Indeed, annual GDP growth has fallen by five percentage points since 2010.[/quote]

For a country as poor as India, growth should be what Americans call a “no-brainer.” It is largely a matter of providing public goods: basic infrastructure like roads, bridges, ports, and power, as well as access to education and basic health care. And, unlike many equally poor countries, India already has a very strong entrepreneurial class, a reasonably large and well-educated middle class, and a number of world-class corporations that can be enlisted in the effort to provide these public goods.

Related: Comparing India to The World

Satisfying the demand for such goods is itself a source of growth. But, also, a reliable road creates tremendous additional activity, as trade increases between connected areas, and myriad businesses, restaurants, and hotels spring up along the way.

As India did away with the stultifying License Raj in the 1990’s, successive governments understood the imperative of economic growth, so much so that the Bharatiya Janata Party (BJP) contested the 2004 election on a pro-development platform, encapsulated in the slogan, “India Shining.” But the BJP-led coalition lost that election. Whether the debacle reflected the BJP’s unfortunate choice of coalition partners or its emphasis on growth when too many Indians had not benefited from it, the lesson for politicians was that growth did not provide electoral rewards.

In any event, that election suggested a need to spread the benefits of growth to rural areas and the poor. There are two ways of going about that. The first, which is harder and takes time, is to increase income-generating capabilities in rural areas, and among the poor, by improving access to education, health care, finance, water, and power. The second is to increase voters’ spending power through populist subsidies and transfers, which typically tend to be directed toward the politically influential rather than the truly needy.

In the years after the BJP’s loss, with a few notable exceptions, India’s political class decided that traditional populism was a surer route to re-election. This perception also accorded well with the median (typically poor) voter’s low expectation of government in India – seeing it as a source of sporadic handouts rather than of reliable public services.

For a few years, the momentum created by previous reforms, together with strong global growth, carried India forward. Politicians saw little need to vote for further reforms, especially those that would upset powerful vested interests. The lurch toward populism was strengthened when the Congress-led United Progressive Alliance concluded that a rural employment-guarantee scheme and a populist farm-loan waiver aided its victory in the 2009 election.

[quote]But, while politicians spent the growth dividend on poorly targeted giveaways such as subsidized petrol and cooking gas, the need for further reform only increased. For example, industrialization requires a transparent system for acquiring land from farmers and tribal people, which in turn presupposes much better land-ownership records than India has.[/quote]

As demand for land and land prices increased, corruption became rampant, with some politicians, industrialists, and bureaucrats using the lack of transparency in land ownership and zoning to misappropriate assets. India’s corrupt elites had moved from controlling licenses to cornering newly valuable resources like land. The Resource Raj rose from the ashes of the License Raj.

India’s citizenry eventually reacted. An eclectic mix of idealistic and opportunistic politicians and NGOs mobilized people against land acquisitions. With investigative journalists getting into the act, land acquisition became a political land mine.

Moreover, key institutions, such as the Comptroller and Auditor General and the judiciary, staffed by an increasingly angry middle class, also launched investigations. As evidence emerged of widespread corruption in contracts and resource allocation, ministers, bureaucrats, and high-level corporate officers were arrested, and some have spent long periods in jail.

[quote]The collateral effect, however, is that even honest officials are now too frightened to help corporations to navigate India’s maze of bureaucracy. As a result, industrial, mining, and infrastructure projects have ground to a halt.[/quote]

Populist government spending and the inability of the supply side of the economy to keep pace has, in turn, led to elevated inflation, while Indian households, worried that no asset looks safe, have taken to investing in gold. Because India does not produce much gold itself, these purchases have contributed to an abnormally wide current-account deficit. Not much more was required to dampen foreign investors’ enthusiasm for the India story, with the rupee falling significantly in recent weeks.

As with the other major emerging markets, India’s fate is in its own hands. Hard times tend to concentrate minds. If its politicians can take a few steps to show that they can overcome narrow partisan interests to establish the more transparent and efficient government that a middle-income country needs, they could quickly re-energize India’s enormous engines of potential growth. Otherwise, India’s youth, their hopes and ambitions frustrated, could decide to take matters into their own hands.

By Raghuram Rajan

Copyright: Project-Syndicate, 2012

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Sympathy For The “Devil” – Why The Bernanke Bashing Is Uncalled For: Raghuram Rajan

Raghuram Rajan — Thu, 10 May 2012 07:47:21 +0000

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Ben Bernanke is a marked man. Ever since he was appointed as the Chairman of the U.S. Federal Reserve in 2006, Bernanke has been a constant target for criticism – with some progressive economists now blaming him for not doing enough for the economy. But while the man is not without flaw, Bernanke has actually gone further than any other central banker in recent times in attempting to stimulate the economy through monetary policy.

CHICAGO – Poor Ben Bernanke! As Chairman of the United States Federal Reserve Board, he has gone further than any other central banker in recent times in attempting to stimulate the economy through monetary policy. He has cut short-term interest rates to the bone. He has adopted innovative new methods of monetary easing. Again and again, he has repeated that, so long as inflationary pressure remains contained, his main concern is the high level of US unemployment. Yet progressive economists chastise him for not doing enough.

What more could they possibly want? Raise the inflation target, they say, and all will be well. Of course, this would be a radical departure for the Fed, which has worked hard to convince the public that it will keep inflation around 2 percent. That credibility has allowed the Fed to be aggressive: it is difficult to imagine that it could have expanded its balance sheet to the extent that it has if the public thought that it could not be trusted on inflation. So why do these economists want the Fed to sacrifice its hard-won gains?

[quote]The answer lies in their view of the root cause of continued high unemployment: excessively high real interest rates. Their logic is simple. Before the financial crisis erupted in 2008, consumers buoyed US demand by borrowing heavily against their rising house prices. Now these heavily indebted households cannot borrow and spend any more.[/quote]

An important source of aggregate demand has evaporated. As consumers stopped buying, real (inflation-adjusted) interest rates should have fallen to encourage thrifty households to spend. But real interest rates did not fall enough, because nominal interest rates cannot go below zero. By increasing inflation, the Fed would turn real interest rates seriously negative, thereby coercing thrifty households into spending instead of saving. With rising demand, firms would hire, and all would be well.

This is a different logic from the one that calls for inflation as a way of reducing long-term debt (at the expense of investors), but it has equally serious weaknesses. First, while low rates might encourage spending if credit were easy, it is not at all clear that traditional savers today would go out and spend. Think of the soon-to-retire office worker. She saved because she wanted enough money to retire. Given the terrible returns on savings since 2007, the prospect of continuing low interest rates might make her put even more money aside.

Alternatively, low interest rates could push her (or her pension fund) to buy risky long-maturity bonds. Given that these bonds are already aggressively priced, such a move might thus set her up for a fall when interest rates eventually rise. Indeed, America may well be in the process of adding a pension crisis to the unemployment problem.

Second, household over-indebtedness in the US, as well as the fall in demand, is localized, as my colleague Amir Sufi and his co-author, Atif Mian, have shown. Hairdressers in Las Vegas lost their jobs partly because households there have too much debt stemming from the housing boom, and partly because many local construction workers and real-estate brokers were laid off. Even if we can coerce traditional debt-free savers to spend, it is unlikely that there are enough of them in Las Vegas.

If these debt-free savers are in New York City, which did not experience as much of a boom and a bust, cutting real interest rates will encourage spending on haircuts in New York City, which already has plenty of demand, but not in Las Vegas, which has too little. Put differently, real interest rates are too blunt a stimulus tool, even if they work.

Third, we have little idea about how the public forms expectations about the central bank’s future actions. If the Fed announces that it will tolerate 4 percent inflation, could the public think that the Fed is bluffing, or that, if an implicit inflation target can be broken once, it can be broken again? Would expectations shift to a much higher inflation rate? How would the added risk premium affect long-term interest rates? What kind of recession would the US have to endure to bring inflation back to comfortable levels?

The answer to all of these questions is: We really don’t know. Given the dubious benefits of still lower real interest rates, placing central-bank credibility at risk would be irresponsible.

Finally, it is not even clear that the zero lower bound is primarily responsible for high US unemployment. Traditional Keynesian frictions like the difficulty of reducing wages and benefits in some industries, as well as non-traditional frictions like the difficulty of moving when one cannot sell (or buy) a house, may share blame.

[quote]We cannot ignore high unemployment. Clearly, improving indebted households’ ability to refinance at low current interest rates could help to reduce their debt burden, as would writing off some mortgage debt in cases where falling house prices have left borrowers deep underwater (that is, the outstanding mortgage exceeds the house’s value).[/quote]

More could be done here. The good news is that household debt is coming down through a combination of repayments and write-offs. But it is also important to recognize that the path to a sustainable recovery does not lie in restoring irresponsible and unaffordable pre-crisis spending, which had the collateral effect of creating unsustainable jobs in construction and finance.

With a savings rate of barely 4 percent of GDP, the average US household is unlikely to be over-saving. Sensible policy lies in improving the capabilities of the workforce across the country, so that they can get sustainable jobs with steady incomes. That takes time, but it might be the best option left.

By Raghuram Rajan

Copyright: Project-Syndicate, 2012

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The Illusion Of Choice In Libertarian Paternalism: Raghuram Rajan

Raghuram Rajan — Tue, 17 Apr 2012 08:31:28 +0000

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Libertarian paternalism, or “soft paternalism”, is a political philosophy which states that government can nudge citizens into making decisions that are good for themselves, while offering complete freedom to individuals to make up their own minds. The problem is that the semblance of choice is an illusion, because individuals do not consciously think through their decision.

CHICAGO – There are many arguments against government paternalism: apart from limiting individual choice (for example, the choice to remain uninsured in the current health-care debate in the United States) and preventing individuals from learning, history suggests time and again that the conventional wisdom prevalent in society is wrong. And, since governments typically try to enforce the conventional wisdom, the consequences could be disastrous, because they are magnified by the state’s coordinating – and coercive – power.

A clear example is financial regulation, which in many ways is a form of paternalism. In the US, the low risk assigned to senior tranches of mortgage-backed securities made them attractive instruments for banks to hold, given the relatively high return they offered. But they proved far from safe, despite the prior conventional wisdom. And, because the regulator had pronounced them safe, far too many banks overloaded on them, rendering them even more risky when the banks tried to sell them at the same time.

Other examples of the danger of the coordinating power of government paternalism abound. As I drive to downtown Chicago, I pass a series of high-rise housing projects, meant in their time to be the miracle cure for homelessness, poverty, unemployment, and crime. Today, they are seen as the best way to concentrate and perpetuate many of those ills.

Not only were the housing projects kept a safe distance from areas that had good jobs, but, with few residents experiencing stable families and livelihoods, there were not enough local examples of success to guide young people. As a result, many went astray.

The fashion today is to integrate poor households into flourishing communities. No doubt we will discover some unintended consequences in the future, and the power of government coordination will ensure that those consequences are widespread.

But some amount of paternalism is necessary in civilized societies. Social security is a paternalistic form of forced savings for old age, preventing individuals from consuming and saving as they please. It exists, in part, because individuals know that civilized societies will never stand by and watch the elderly starve. So individuals are forced to save in order to prevent them from gaming the system – not saving when young, knowing that they will be assured a minimum level of support by a humane society when old. Similarly, the mandated purchase of insurance in the Obama administration’s health-care bill is an attempt to prevent the young and the healthy from remaining uninsured and turning to the government for support only when they discover that they need it.

So, if paternalism has benefits as well as costs, how do we get the former without the latter? My colleague, Richard Thaler, along with Cass Sunstein, who currently serves in the Obama administration, wrote a best-selling book, Nudge, in which they suggest a way to reduce our uneasiness with paternalism. Essentially, by exploiting behavioral quirks, they would nudge people into making decisions that are good for them, even while individuals have complete freedom to change their mind. So libertarian paternalism, in their view, eliminates one of the main objections to paternalism – that it constrains individual choice.

For example, in deciding how their pension savings will be allocated, most people simply choose the default option in their employer-offered plan. Often, the default option is unsuitable for most individuals – for instance, it typically allocates all savings to low-return money-market funds. Sunstein and Thaler would have the employer choose a default option that works for most people, such as 60 percent in equities, 30 percent in bonds, and 10 percent in money-market funds.

That is the paternalistic part. The libertarian part is that the employee has the right to opt out of the default option. Because people rarely move away from the default option, the employer’s paternalistic choice prevails, and we get libertarian paternalism. What is not to like?

[quote]The problem is that the semblance of choice in libertarian paternalism is an illusion. Choice remains unexercised, because individuals do not consciously think through their decision. If their choices can be directed, is this not paternalism plain and simple, rendered more sinister because individuals are unaware that they are being nudged, and cannot raise their guard?[/quote]

One response is to point out that most plans already have a default option that determines savings allocations. Sunstein and Thaler merely say that the default option should be set in a way that is good for people, and clearly they have an idea of what is good.

This, then, is the nub of the problem. In choosing the default option, the government or the employer nudges all employees into prevailing fads such as “buy equity for the long run.” This, they believe, is better than the current typical default option of putting individuals’ money into money-market funds. But it may be worse: coordinating everyone into risky asset investments may be more dangerous than coordinating them into boring investments like money-market funds.

Could there be a better alternative? What if there were no default option, and individuals were sent repeated, and increasingly urgent, reminders to choose an allocation if they did not choose one already. The conventional wisdom could be offered as a recommendation, along with explanations of why it makes sense, but it would not be the default. This would force people to exercise choice. Some people would differ from the conventional wisdom, benefiting the system by introducing some variety and resilience.

More generally, the flaw in some forms of libertarian paternalism is that the free choice that it appears to offer leaves the paternalism largely unconstrained. Would it not be far better to force conscious choice in order to limit the consequences of paternalistic mistakes?

Related: What Is Political Economy ???

Related: Political Economy Theory

By Raghuram Rajan

Copyright: Project-Syndicate, 2012

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Inequality In Retrospective – The Hidden Effects Of The Income Gap: Raghuram Rajan

Raghuram Rajan — Thu, 15 Mar 2012 08:29:22 +0000

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The everyday inequality that most Americans face has deep pernicious effects, which go beyond the typical arguments discussed during the “1% versus 99%” debate. But while these effects are fairly unknown, they still play a role in our daily lives and can even affect policy decision-making.

CHICAGO – Why did the household savings rate in the United States plummet before the Great Recession? Two of my colleagues at the University of Chicago, Marianne Bertrand and Adair Morse, offer an intriguing answer: growing income inequality.

Bertrand and Morse find that in the years before the crisis, in areas (usually states) where consumption was high among households in the top fifth of the income distribution, household consumption was high at lower income levels as well. After ruling out a number of possible explanations, they concluded that poorer households imitated the consumption patterns of richer households in their area.

Consistent with the idea that households at lower income levels were “keeping up with the Vanderbilts,” the non-rich (but not the really poor) living near high-spending wealthy consumers tended to spend much more on items that richer households usually consumed, such as jewelry, beauty and fitness, and domestic services. Indeed, many borrowed to finance their spending, with the result that the proportion of poorer households in financial distress or filing for bankruptcy was significantly higher in areas where the rich earned (and spent) more. Were it not for such imitative consumption, non-rich households would have saved, on average, more than $800 annually in recent years.

[quote]This is one of the first detailed studies of the adverse effects of income inequality that I have seen. It goes beyond the headline-grabbing “1%” debate to show that even the everyday inequality that most Americans face – between the incomes of, say, typical readers of this commentary and the rest – has deep pernicious effects.[/quote]

Related: Effects of Economic Inequality

Equally interesting is the link that the study finds between income inequality and pre-crisis economic policy. Republican Congressmen from districts with higher levels of income inequality were more likely to vote for legislation to expand housing credit to the poor in the years before the crisis (almost all Democrats voted for such legislation, making it hard to distinguish their motives). And the effect of spending by the rich on non-rich households’ spending was higher in areas where house prices could move more, suggesting that housing credit and the ability to borrow against rising home equity may have supported over-consumption by the non-rich.

I was most fascinated, though, by the difference in legislators’ response to inequality now and in the past. In a study of the congressional vote on the McFadden Act of 1927, which sought to boost competition in lending, Rodney Ramcharan of the US Federal Reserve and I found that legislators from districts with a highly unequal distribution of land holdings – farming was the primary source of income in many districts then – tended to vote against the act. More inequality led legislators, at least in that case, to prefer less competition and less expansion in lending. And we found that counties with less bank competition experienced a milder farmland boom, and therefore a smaller bust in the years before the Great Depression.

The obvious lesson to be drawn from these episodes is the importance of unintended consequences. In the early twentieth century, a congressional district’s rich landowners were likely to own the local banks as well, or to be related to, or friends with, bank owners. They benefited from limiting competition and controlling access to finance.

Representatives voted on behalf of their districts’ powerful interests. They preferred less competition in credit markets not out of concern for the unwitting farmers, but in order to defend powerful lenders’ profits. It worked, but an unintended collateral effect was to protect these districts from getting carried away by the financial frenzy.

Why did twenty-first-century legislators behave differently? The cynical, and increasingly popular, view is that they were again voting their pocketbooks – all financial legislation in the run-up to the 2008 crisis was supposedly driven by the financial sector’s appetite for more customers to devour with teaser loans and dubious mortgages.

[quote]But, if voting was influenced by the financial sector, the supposed party of the plutocrats, the Republicans, should have voted in unison for the bill. Instead, they split on the basis of whose non-rich constituents were more desirous of obtaining finance. Twenty-first-century legislators seemed to be more democratic, responding to their voters’ possibly misguided wishes, rather than primarily to powerful financial interests.[/quote]

Indeed, once the unintended consequences of their actions – more financial duress for the non-rich after the crisis – became clear, Bertrand and Morse show that the legislators in unequal districts moved against the financial sector to protect their constituents, voting to set limits on interest rates charged by “payday” lenders (who lend to over-indebted lower-income borrowers at very high interest rates). Of course, such legislation will have unanticipated consequences, which future studies will unearth, but the intent behind it cannot be doubted.

We should not come away from these episodes thinking that expanding access to finance is bad. In general, expanding access is beneficial (just not before a crisis!), but finance is a powerful tool that has to be used sensibly. Access is good; excess is bad.

But there is a more important point: while there are many gaps between the intent and consequences of legislation, legislators do seem ultimately to care more about their less-moneyed constituents than they did in the past. Democracy is stronger. In these cynical times, that is encouraging.

By Raghuram Rajan

Copyright: Project-Syndicate, 2012

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The Price of Inaction – Why We Are Paying For Our Own Mistakes: Raghuram Rajan

Raghuram Rajan — Fri, 24 Feb 2012 08:03:46 +0000

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It is easy to blame politicians for our current economic woes, but do the public have to bear some of the blame as well? As Axel Weber would say, policymakers simply do not have the public mandate to get ahead of problems, especially novel ones that seem small initially, but, if unresolved, imply potentially large costs. What then should the public do to overcome this?

CHICAGO – On a recent visit to Europe, I found economists, journalists, and business people thoroughly frustrated with their politicians. Why, they ask, can’t politicians see the abyss that yawns before them, and come together to resolve the euro crisis once and for all?

Even if there is no consensus on what a solution might be, can’t they meet and thrash out a plan that goes beyond their repeated half-measures? It is only because of the European Central Bank’s bold decision to lend long term to banks that we have seen some respite recently, or so their argument goes. Politicians, in contrast, are failing Europe by being forever behind the curve. Why do they find it so hard to lead?

One answer that can be easily dismissed is that politicians simply don’t understand the gravity of the situation. Political leaders need not be economic geniuses to understand the advice that they hear, and many are both intelligent and well-read.

A second answer – that politicians have short time horizons, owing to electoral cycles – may contain a kernel of truth, but it is inadequate, because the adverse consequences of timid action often become apparent well before they are up for re-election.

The best answer that I have heard comes from Axel Weber, the former president of Germany’s Bundesbank and an astute political observer. In Weber’s view, policymakers simply do not have the public mandate to get ahead of problems, especially novel ones that seem small initially, but, if unresolved, imply potentially large costs.

[quote]If the problem has not been experienced before, the public is not convinced of the potential costs of inaction. And, if action prevents the problem, the public never experiences the averted calamity, and voters therefore penalize political leaders for the immediate costs that the action entails. Even if politicians have perfect foresight of the disaster that awaits if nothing is done, they may have little ability to persuade voters, or less insightful party members, that the short-term costs must be paid.[/quote]

Talk is cheap, and, in the absence of evidence to the contrary, the status quo usually appears comfortable enough. So leaders’ ability to take corrective action increases only with time, as some of the costs of inaction are experienced.

Calamity can still be averted if the costs of inaction escalate steadily. The worst problems, however, are those with “inaction costs” that remain invisible for a long time, but increase suddenly and explosively. By the time the leader has the mandate to act, it may be too late.

A classic example was Winston Churchill’s warnings against Adolf Hitler’s ambitions. Hitler’s plans were outlined in Mein Kampf for all to read – and he did not disguise them in his speeches. Yet few in Britain wanted to give them credence, and many thought that communism was the greater threat, especially in the bleak years of the Great Depression.

The Nazis’ dismembering of Czechoslovakia in 1938 made the sincerity of Hitler’s ambitions all too clear. But it was only after the invasion of Poland the following year that Churchill was appointed First Lord of the Admiralty, and he became Prime Minister only after the invasion of France in 1940, when Britain stood alone.

Britain might well have been better off had Churchill held power earlier, but that would have meant costly rearmament, which was unacceptable so long as there was a chance that Hitler proved to be a paper tiger. And, of course, it would also have meant entrusting Britain’s fate to a politician who, though now regarded as an indomitable leader, was widely distrusted at the time.

Non-linear costs of inaction are most obvious in the financial sector. At the same time, financial-sector problems may be particularly difficult to address: if politicians emphasize the need for action too strongly in order to get a mandate, they might precipitate the very turmoil that they seek to contain.

Between the Bear Stearns crisis and the failure of Lehman Brothers, the United States government could do little to get ahead of the growing problem (though, of course, the government-backed mortgage underwriters Fannie Mae and Freddie Mac were placed under conservatorship in the interim). It took the post-Lehman panic for Congress to authorize the Troubled Asset Relief Program, which threw a financial lifeline to banks and the auto industry, among others. And only frenetic action by the Federal Reserve and Treasury (with authorities around the world joining) prevented a systemic meltdown. A subprime-mortgage problem that was initially estimated to imply losses of a few hundred billion dollars imposed far higher costs on the entire world.

Similarly, eurozone politicians have obtained a mandate to take bolder action only as the markets have made the costs of inaction more salient. Even setting aside Germany’s understandable attempt to limit how much it would have to pay, it is difficult to see how politicians could have gotten ahead of the problem.

While the ECB has bought the eurozone some time, the calming effect on markets may be a mixed blessing. Have Europeans seen enough of the abyss to tolerate stronger action by their leaders? If not, markets might have to deteriorate further to make possible a comprehensive resolution to the eurozone crisis.

Similarly, with government bond yields as low as they are in the US, the public has little sense of urgency about its fiscal problems, though some doomsayers, like Peter Peterson of the Blackstone Group, have been trying their best to awaken it. One hopes that the coming US presidential election will lead to a more enlightened public debate about tax and entitlement reform. Otherwise, a rapid escalation of yields in the bond market might be necessary for the public to accept that there is a problem, and for politicians to have the room to resolve it.

[quote]Don’t blame the leaders for appearing short-sighted and indecisive; the fault may lie with us, the public, for not listening to the worrywarts.[/quote]

By Raghuram Rajan

Copyright: Project-Syndicate, 2012

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The Keynesian Formula Will Not Solve Our Fundamental Growth Problem: Raghuram Rajan

Raghuram Rajan — Wed, 01 Feb 2012 09:39:25 +0000

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The current economic crisis demands solutions. But while most government officials, central bankers, and Wall Street economists have subscribed to the standard Keynesian formula for recovery, the potential results from this step simply paper over much of the real problems to the economy and create an illusion of normalcy. (Attached Video: Raghuram Rajan on Risks to the Global Economy)

CHICAGO – With the world’s industrial democracies in crisis, two competing narratives of its sources – and appropriate remedies – are emerging. The first, better-known diagnosis is that demand has collapsed because of high debt accumulated prior to the crisis. Households (and countries) that were most prone to spend cannot borrow any more. To revive growth, others must be encouraged to spend – governments that can still borrow should run larger deficits, and rock-bottom interest rates should discourage thrifty households from saving.

Under these circumstances, budgetary recklessness is a virtue, at least in the short term. In the medium term, once growth revives, debt can be paid down and the financial sector curbed so that it does not inflict another crisis on the world.

This narrative – the standard Keynesian line, modified for a debt crisis – is the one to which most government officials, central bankers, and Wall Street economists have subscribed, and needs little elaboration. Its virtue is that it gives policymakers something clear to do, with promised returns that match the political cycle. Unfortunately, despite past stimulus, growth is still tepid, and it is increasingly difficult to find sensible new spending that can pay off in the short run.

Attention is therefore shifting to the second narrative, which suggests that the advanced economies’ fundamental capacity to grow by making useful things has been declining for decades, a trend that was masked by debt-fueled spending. More such spending will not return these countries to a sustainable growth path. Instead, they must improve the environment for growth.

The second narrative starts with the 1950’s and 1960’s, an era of rapid growth in the West and Japan. Several factors, including post-war reconstruction, the resurgence of trade after the protectionist 1930’s, the introduction of new technologies in power, transport, and communications across countries, and expansion of educational attainment, underpinned the long boom. But, as Tyler Cowen has argued in his book The Great Stagnation, once these “low-hanging fruit” were plucked, it became much harder to propel growth from the 1970’s onward.

Meanwhile, as Wolfgang Streeck writes persuasively in New Left Review, democratic governments, facing what seemed, in the 1960’s, like an endless vista of innovation and growth, were quick to expand the welfare state. But, when growth faltered, this meant that government spending expanded, even as its resources shrank. For a while, central banks accommodated that spending. The resulting high inflation created widespread discontent, especially because little growth resulted. Faith in Keynesian stimulus diminished, though high inflation did reduce public-debt levels.

Central banks then began to focus on low and stable inflation as their primary objective, and became more independent from their political masters. But deficit spending by governments continued apace, and public debt as a share of GDP in industrial countries climbed steadily from the late 1970’s, this time without inflation to reduce its real value.

Recognizing the need to find new sources of growth, towards the end of Jimmy Carter’s presidency, and then under Ronald Reagan, the United States deregulated industry and the financial sector, as did Margaret Thatcher in the United Kingdom. Productivity growth increased substantially in these countries over time, which persuaded Continental Europe to adopt reforms of its own, often pushed by the European Commission.

Yet even this growth was not enough, given previous governments’ generous promises of health care and pensions – promises made even less tenable by rising life expectancy and falling birth rates. Public debt continued to grow. And the incomes of the moderately educated middle class failed to benefit from deregulation-led growth (though it improved their lot as consumers).

The most recent phase of the advanced economies’ frenzied search for growth took different forms. In some countries, most notably the US, a private-sector credit boom created jobs in low-skilled industries like construction, and precipitated a consumption boom as people borrowed against overvalued houses. In other countries, like Greece, as well as under regional administrations in Italy and Spain, a government-led hiring spree created secure jobs for the moderately educated.

[quote]In this “fundamental” narrative, the advanced countries’ pre-crisis GDP was unsustainable, bolstered by borrowing and unproductive make-work jobs. More borrowed growth – the Keynesian formula – may create the illusion of normalcy, and may be useful in the immediate aftermath of a deep crisis to calm a panic, but it is no solution to a fundamental growth problem. [/quote]

If this diagnosis is correct, advanced countries need to focus on reviving innovation and productivity growth over the medium term, and on realigning welfare promises with revenue capacity, while alleviating the pain of the truly destitute in the short run. For example, Southern Europe’s growth potential may consist in deregulating service sectors and reducing employment protection to spur creation of more private-sector jobs for retrenched government workers and unemployed youth.

In the US, the imperative is to improve the match between potential jobs and worker skills. People understand better than the government what they need and are acting accordingly. Many women, for example, are leaving low-paying jobs to acquire skills that will open doors to higher-paying positions. Too little government attention has been focused on such issues, partly because payoffs occur beyond electoral horizons, and partly because the effectiveness of government programs has been mixed. Tax reform, however, can provide spur retraining and maintain incentives to work, even while fixing gaping fiscal holes.

[quote]Three powerful forces, one hopes, will help to create more productive jobs in the future: better use of information and communications technology (and new ways to make it pay), lower-cost energy as alternative sources are harnessed, and sharply rising demand in emerging markets for higher-value-added goods.[/quote]

The advanced countries have a choice. They can act as if all is well, except that their consumers are in a funk, and that “animal spirits” must be revived through stimulus. Or they can treat the crisis as a wake-up call to fix what debt has papered over in the last few decades. For better or worse, the narrative that persuades these countries’ governments and publics will determine their future – and that of the global economy.

(Video) Raghuram Rajan Discusses The Risks To The Global Economy:

By Raghuram Rajan

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Citizens of Europe to Bear the Cost for Damages They Didn’t Cause: Raghuram Rajan

Raghuram Rajan — Thu, 08 Dec 2011 10:10:06 +0000

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As the indebted eurozone countries scramble to find ways to raise liquidity or risk default, contagion threatens to spread across the continent and the globe – an unfortunate reality of globalization and the interdependency of economic and financial markets. However, the pain is for citizens across Europe to bear, for they will inherit a national debt.

CHICAGO – If any solution to the European crisis proposed over the next few days is to restore confidence to the sovereign-bond markets, it will have to be both economically viable and politically palatable to rescuers and rescued alike. This means paying attention not just to the plan’s technical details, but also to appearances.

There is growing consensus about any solution’s key elements. First, Italy and Spain will have to come up with credible medium-term plans that will not just restore their fiscal health, but also improve their ability to grow their way out of trouble. While any plan will involve pain for citizens, the markets must deem the pain politically tolerable, at least relative to the alternatives.

It is important that these plans be seen as domestically devised (though voters will have no illusions about the external and market pressures that have forced their governments to act). At the same time, an external agency such as the International Monetary Fund could render the plan more credible by evaluating it for consistency with the country’s goals and monitoring its implementation.

Second, some vehicle – the IMF or the European Financial Stability Facility, with either entity funded directly by countries or the European Central Bank – has to stand ready to fund borrowing by Italy, Spain, and any other potentially distressed countries over the next year or two. But there is an important caveat, which has largely been ignored in public discussions: if this funding is senior to private debt (as IMF funding typically is), it will be harder for these countries to regain access to markets. After all, the more a country borrows in the short term from official sources, the further back in line it pushes private creditors. That makes private lenders susceptible to larger haircuts if the country eventually defaults – and thus more hesitant to lend in the first place.

In other words, private markets need to be convinced both that there is a low probability of default (hence the importance of credible plans), and that there is some additional loss-bearing capacity in the new funding, so that, if there is a default, outstanding or rolled-over private debt does not have to bear the full brunt.

This may seem unfair. Why should the taxpayer accept a loss when they are bailing out the private sector by providing new funding? In an ideal world, distressed countries would default as soon as private markets stopped funding them, and they would impose the losses on private bondholders. In the real world, however, if Italy and Spain are viewed as being solvent, or too big to fail, official funding should be structured so that it gives these countries their best chance to regain market confidence.

This does not mean that official funding should be junior to private debt in any restructuring, for that would require substantially more loss-bearing capacity from the official sector – capacity that is probably not available. Indeed, if official funding were junior, it would be providing a larger cushion to private creditors – and thus bailing them out to an even greater extent.

The simplest solution is to treat official funding no differently from private debt – best achieved if official lenders buy sovereign bonds as they are issued (possibly at a predetermined yield) and agree to be treated on par with private creditors in a restructuring. As the country regains market confidence, the official funding can be reduced, and eventually the bonds can be sold back to the markets.

The bottom line is that official funding must be accompanied by loss-bearing capacity. If the funding is channeled through the IMF, and is to be treated on par with private debt, the Fund will need a guarantee from the EFSF or strong eurozone countries that it will be indemnified in any restructuring. Of course, the IMF’s member states might be willing to accept some burden sharing if a sufficient buffer provided by the eurozone were eroded, but that cannot be taken for granted.

Once the first two elements of the plan are in place, there should be little need for the third – bond purchases by the ECB in the secondary market in order to narrow interest-rate spreads and provide further confidence. Indeed, if the ECB intends to claim preferred-creditor status for any bonds that it buys, it is probably best that it buy very few. Of course, the ECB will have to continue to provide support to banks until confidence about their holdings returns.

But there is one more element that is needed to assure markets that the solution is politically viable. Citizens across Europe, whether in rescued countries or rescuing countries, will be paying for years to clean up a mess for which they were not responsible. Not all banks voluntarily loaded up on distressed government bonds – some were pressured by supervisors, others by governments – but many have made unwise bets. If they are seen as profiting unduly from the rescue, even as they return to their bad old ways of paying for non-performance, they will undermine political support for the rescue – and perhaps even for capitalism.

So a final element of the package ought to be a monitored pledge by eurozone banks that they will not unload bonds as the official sector steps in; that they will raise capital over time instead of continuing to deleverage (if this hurts bank equity holders, they should think of this as burden sharing); and that they will be circumspect about banker bonuses until economies start growing strongly again. Cries that this is not capitalism should be met with a firm retort: “Nor are bailouts!”

By Raghuram Rajan

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Sorry “99%”, There Are No Quick Fixes For Inequality: Raghuram Rajan

Raghuram Rajan — Tue, 15 Nov 2011 09:07:51 +0000

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Reading some economists, it might seem that the answer to all current problems is to tax the richest 1 percent and redistribute to everyone else. But if governments tax their rich more, they should do it with the aim of improving access and opportunity for all, rather than as a punitive measure to rectify some imagined wrong.

CHICAGO – It is amazing how the “one percent” epithet, a reference to the top 1 percent of earners, has caught on in the United States and elsewhere in the developed world. In the United States, this 1 percent includes all those with a 2006 household income of at least $386,000. In the popular narrative, the 1 percent is thickly populated with unscrupulous corporate titans, greedy bankers, and insider-trading hedge-fund managers. Reading some progressive economists, it might seem that the answer to all of America’s current problems is to tax the 1 percent and redistribute to everyone else.

Of course, underlying this narrative is the view that this income is ill-gotten, made possible by Bush-era tax cuts, the broken corporate governance system, and the conflict-of-interest-ridden financial system. The 1 percent are not people who have earned money the hard way by making real things, so there is no harm in taking it away from them.

Clearly, this caricature is based on some truth. For instance, corporations, especially in the financial sector, reward too many executives richly despite mediocre performance. But apart from tarring too many with the same brush, there is something deeply troubling about this narrative’s reductionism.

[quote]It ignores, for example, the fact that many of the truly rich are entrepreneurs. It likewise ignores the fact that many of the wealthy are sports stars and entertainers, and that their ranks include professionals such as doctors, lawyers, consultants, and even some of our favorite progressive economists. In other words, the rich today are more likely to be working than idle.[/quote]

But what might be the most important overlooked fact is that the rise in income inequality is not just at the very top, though it is most pronounced there. Academic studies suggest that the top tenth percentile of income distribution in the US, and elsewhere, is also moving farther away from the median earner. This is an inconvenient fact for the progressive economist. “We are the 90 percent,” sounds less dramatic than “we are the 99 percent.” And, for some of the protesters, it may not even be true.

Perhaps most problematic, though, is that something other than plutocrat-friendly policies is largely responsible for the growing inequality. That something is education and skills. True, not every degree is a passport to a job. Freshly-minted degree holders, especially from lower-quality programs, are finding it particularly hard to get a job nowadays, because they are competing with experienced workers who are also jobless. Nevertheless, the unemployment rate for those with degrees is one-third the unemployment rate for those without a high school diploma.

Close examination suggests that the single biggest difference between those at or above the top tenth percentile of the income distribution and those below the 50th percentile is that the former have a degree or two while the latter, typically, do not. Technological change and global competition have made it impossible for American workers to get good jobs without strong skills. As Harvard professors Claudia Golden and Larry Katz put it, in the race between technology and education, education is falling behind.

To acknowledge the fact that the broken educational and skills-building system is responsible for much of the growing inequality that ordinary people experience would, however, detract from the larger populist agenda of rallying the masses against the very rich. It has the inconvenient implication that the poor have a role in pulling themselves out of the morass. There are no easy and quick fixes to education – every US president since Gerald Ford in the mid-1970’s has called for educational reforms, with little effect. In contrast, blaming the undeserving 1 percent offers a redistributive policy agenda with immediate effects.

[quote]The US has tried quick fixes before. Income inequality grew rapidly in the last decade, but consumption inequality did not. The reason: easy credit, especially subprime mortgages, which helped those without means to keep up with the Joneses. The ending, as everyone knows, was not a happy one. The less-well-off ultimately became even worse off as they lost their jobs and homes. [/quote]

The US needs to improve the quality of its workforce by developing the skills that are relevant to the jobs that its firms are creating. Several steps can be taken towards these goals, including improving community attitudes towards education, reforming schools, tying the curriculum in community colleges and vocational institutions more closely to the needs of local firms, making higher education more affordable, and finding effective ways to retrain unemployed workers.

None of this is easy or likely to produce results quickly, and some of it may require more resources. While eliminating inefficient spending, especially inefficient tax subsidies, can generate some of these funds, more tax revenues may be needed. The rich can certainly afford to pay more, but if governments increase taxes on the wealthy, they should do it with the aim of improving opportunities for all, rather than as a punitive measure to rectify an imagined wrong.

By Raghuram Rajan

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SOS – The Eurozone Can No Longer Save Themselves: Raghuram Rajan

Raghuram Rajan — Mon, 17 Oct 2011 07:44:53 +0000

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17 October 2011.

The eurozone crisis is now a global crisis. If the crisis cannot be resolved quickly, the entire world will suffer. Despite the global implications, the eurozone continues to try and rely on itself to solve its woes. This is a recipe for trouble. The eurozone should suppress any wounded pride, acknowledge that it needs help, and provide quickly what it has already promised.

17 October 2011.

CHICAGO – How will the eurozone crisis play out in the next few weeks? With luck, Italy may soon get a credible government of national unity, Spain will obtain a new government in November with a mandate for change, and Greece will do enough to avoid roiling the markets. But none of this can be relied upon.

So, what needs to be done? First, eurozone banks have to be recapitalized. Second, enough funding must be available to meet Italy’s and Spain’s needs over the next year or so if their market access dries up. And, third, Greece, now the sickest man of Europe, must be treated in a way that does not spread the infection to the other countries on the eurozone’s periphery.

All of this requires financing – bank recapitalization alone could require hundreds of billions of euros (though these needs would be mitigated somewhat if the sovereign debt of large eurozone countries looked healthier).

[quote]In the short run, it is unlikely that Germany (and Northern Europe more generally) will put up more money for the others. Germans are upset at being asked to support countries that do not seem to want to adjust – unlike Germany, which is competitive because it endured years of pain: low wage increases to absorb the former East Germany’s workers and deep labor-market and pension reforms. The unwillingness of the Greek rich to pay taxes, or of Italian parliamentarians to cut their own perks, confirms Germans’ fears. At the same time, German politicians have done a poor job explaining to their people how much they have gained from the euro.[/quote]

But we are where we are. A glimmer of hope is Europe’s willingness to use the European Financial Stability Facility (EFSF) imaginatively – as equity or first-loss cover. Clearly, some of the EFSF funds will have to go to recapitalize banks that cannot raise money from the markets. As for the rest, the amounts that are not already committed to the peripheral countries could be used to support borrowing that can be lent onward to Italy and Spain.

There is, however, no consensus about how to do this. Some propose bringing in the European Central Bank to leverage the EFSF’s funds. This is a recipe for trouble. Giving the ECB a quasi-fiscal role, even if it is somewhat insulated from losses, risks undermining its credibility. And if Italy were helped, the incoming ECB President, Mario Draghi, an Italian, would be criticized, no matter how dire Italy’s need. Moreover, financing would have to be accompanied by conditionality, and these institutions have neither the requisite expertise nor the necessary distance from the countries at risk to apply and enforce appropriate conditions.

Finally, both the EFSF and the ECB ultimately rely on the same eurozone resources for their financial strength. If markets start panicking about large eurozone defaults, they could question whether even a willing Germany has the necessary capacity to support the EFSF-ECB combine. Put differently, these institutions do not offer a credible, non-inflationary, external source of strength.

[break]

A Standby Program For The Eurozone

Indeed, the eurozone’s problems might soon become too big for its members to address. The world has a stake in their resolution. And it has an institution that can channel help: the International Monetary Fund. The IMF could set up a special vehicle along the lines of its New Arrangements to Borrow (NAB), which would be capitalized by a first-loss layer from the EFSF with the IMF’s own capital comprising a second layer.

This NAB-like vehicle could borrow as needed from countries, including the United States and China, as well as tap financial markets. It would offer large lines of credit to illiquid countries like Italy, with conditionality intended to help such countries resume borrowing from markets at reasonable cost.

A special vehicle is required because the amounts that must be made available far exceed what IMF members can usually access, and it is only right that if the eurozone seeks such amounts for its members, it should bear a significant portion of any potential losses. At the same time, the Fund’s capital resources would back the vehicle if the first-loss buffer provided by the eurozone were eroded; that way, the market would understand that strength from outside the eurozone can be brought to bear.

[quote]The IMF is not an institution that inspires warm and cuddly feelings. But it is also not the mindless preacher of fiscal austerity that it is accused of being – and it should start taking the lead in managing the crisis, rather than holding up the rear. The eurozone needs an independent outside assessment of what needs to be done, and rapid implementation, before it is too late and the incipient bank runs become uncontrollable.[/quote]

Of course, the IMF cannot act without the permission of its masters, the large countries. The eurozone should suppress any wounded pride, acknowledge that it needs help, and provide quickly what it has already promised. The US should continue pushing hard for a solution. And the emerging-market countries should pitch in too, once some safeguards for their money are in place. Unresolved, the crisis will spare no one.

As for the birthplace of the euro crisis, Greece’s debt will almost surely have to be restructured. But adequate funding structures for Italy and Spain must be in place before any resolution. So, while others have to step forward to do their part, it is best if Greece steps back from the brink.

By Raghuram Rajan

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