Wednesday, 14 November 2012



Some time ago, in May to be precise, one of my favourite blogger, Tyler Cowen (from Marginal Revolution, link on the side) posted the following: 

Raghu Rajan nails it

by  on May 3, 2012 at 4:13 am in Economics | Permalink
The industrial countries have a choice. They can act as if all is well except that their consumers are in a funk and so what John Maynard Keynes called “animal spirits” must be revived through stimulus measures. Or they can treat the crisis as a wake-up call and move to fix all that has been papered over in the last few decades and thus put themselves in a better position to take advantage of coming opportunities. For better or worse, the narrative that persuades these countries’ governments and publics will determine their futures—and that of the global economy.
Every paragraph of his piece is excellent, and as I like to say “We are all stagnationists now.”  Hat tip goes to The Browser
I don't know if the hyper-links follow through a C&P so here is the link to the original:

Now this was high praise indeed and so I followed the hyper-link and read Mr. Rajan's piece. And I walked away a lot less impressed than Tyler Cowen... 

Now, I am not the only one who wasn't over-awed. Mr. Cowen had a subsequent post detailing some of the reception the article got and his own reaction to the reactions:

Hopefully, I'll get to those too.

Although May was some time ago, the issues debated are still important and the discourse hasn't changed so, hopefully, this belated reply will not feel irrelevant to the readers'.

I will adopt the slightly unusual technique (for this blog, at least) to go through the piece more or less paragraph by paragraph and add my comments. To facilitate comprehension, the original text will be in "Georgia font" and my comments will be italicised. Ideally, this is a technique I might re-use on other articles since a lot of my own economic thinking tends to be in reaction to other people's articles/theories. 

BTW, I am not entirely sure about the legality or the netiquette of quoting someone as lengthily as I am going to as I go through Raghu Rajan's piece in extensive detail. Let me just state for the record that I obviously respect his authorship, his legal rights re. reproduction and I hope that me linking to the original piece will make it clear I am not trying to steal anything from him or indeed from Tyler Cowen

I'll start with a quick summary of Raghu Rajan's thesis so that the reader can link the pieces more easily.

Basically, he is of the 'structural unemployment' school of thinking and insists that the Great Recession we're experiencing is so bad mostly because it is the long-delayed result - long-delayed mostly by misguided governments' actions, of course - of a growing disconnect between people's skills/education and what is required by the economy.

Let us beginning the quoting and commenting. As I said above, the comments are in italic, everything else is Raghu Rajan's:

According to the conventional interpretation of the global economic recession, growth has ground to a halt in the West because demand has collapsed a casualty of the massive amount of debt accumulated before the crisis. Households and countries are not spending because they can’t borrow the funds to do so, and the best way to revive growth, the argument goes, is to find ways to get the money flowing again. Governments that still can should run up even larger deficits, and central banks should push interest rates even lower to encourage thrifty households to buy rather than save. Leaders should worry about the accumulated debt later, once their economies have picked up again. This narrative—the standard Keynesian line, modified for a debt crisis—is the one to which most Western officials, central bankers, and Wall Street economists subscribe today. As the United States has shown signs of recovery, Keynesian pundits have been quick to claim success for their policies, pointing to Europe’s emerging recession as proof of the folly of government austerity. But it is hard to tie recovery (or the lack of it) to specific policy interventions. Until recently, these same pundits were complaining that the stimulus packages in the United States were too small. So they could have claimed credit for Keynesian stimulus even if the recovery had not materialized, saying, “We told you to do more.” And the massive fiscal deficits in Europe, as well as the European Central Bank’s tremendous increase in lending to banks, suggest that it is not for want of government stimulus that growth is still fragile there.

Me: So far, okay. I could debate the narrative by pointing out that growing European fiscal deficits aren't really caused by 'stimulus' but by the automatic stabilizers kicking into higher gear and the concomitant drop in fiscal revenues as the economy slows down. I could also point out that the ECB lending is meant to save banks and has had no stimulating effect on the real economy - It is simply but importantly protecting it from an outright banking collapse. But let's play nice and let it slide...

In fact, today’s economic troubles are not simply the result of inadequate demand but the result, equally, of a distorted supply side. For decades before the financial crisis in 2008, advanced economies were losing their ability to grow by making useful things. But they needed to somehow replace the jobs that had been lost to technology and foreign competition and to pay for the pensions and health care of their ageing populations. So in an effort to pump up growth, governments spent more than they could afford and promoted easy credit to get households to do the same. The growth that these countries engineered, with its dependence on borrowing, proved unsustainable. Rather than attempting to return to their artificially inflated GDP numbers from before the crisis, governments need to address the underlying flaws in their economies.

Me: Now, there is certainly a lot of truth in that. Anyone can see that the trade deficit between the USA and China is a sign of things badly out of whack. Similarly, the trade deficit between Germany and the rest of the EU is Not.A.Good.Thing (TM), even for Germany.

Ditto, I have also said before that the Anglo-Saxons responded to the 70-80s slump by sustaining/boosting consumption through consumer credit while Continental Europe, by and large, used fiscal deficits to get the same Aggregated Demand increase.

In the United States, that means educating or retraining the workers who are falling behind, encouraging entrepreneurship and innovation, and harnessing the power of the financial sector to do good while preventing it from going off track. In southern Europe, by contrast, it means removing the regulations that protect firms and workers from competition and shrinking the government’s presence in a number of areas, in the process eliminating unnecessary, unproductive jobs.

Me: Here is where I really disagree. All these propositions are worth-while and, with some caveats, do need to be implemented. However, they represent a very very partial response to the never-ending crisis we're going through because, ultimately, in my opinion, the supply side misalignment Raghu Rajan describes is but a minor element in the macro picture.

The End of Easy Growth

To understand what will, and won’t, work to restore sustainable growth, it helps to consider a thumbnail sketch of the economic history of the past 60 years. The 1950s and 1960s were a time of rapid economic expansion in the West and Japan. Several factors underpinned this long boom: post war reconstruction, the resurgence of trade after the protectionist 1930s, more educated work forces, and the broader use of technologies such as electricity and the internal consumption engine. But as the economist Tyler Cowen has argued, once these low-hanging fruit had been plucked, it became much harder to keep economies humming. The era of fast growth came to a sudden end in the early 1970s, when the OPEC countries, realizing the value of their collective bargaining power, jacked up the price of oil.

Me: I've done my own thumbnail sketch of economic history since 1930s/WWII in a previous post but I'll repeat some of that here, to highlight the differences between my view of how things went and Prof. Rajan's. So, obviously, I got no beef with his description of the post-war boom. However, I disagree with the way he describes the early 70s crisis. The OPEC countries did not jack up the price of oil out of the blue, just because they suddenly realise their power.

While the Yom Kippur War is the proximate political cause, the end of Bretton Woods, which led to the US$ depreciation, is the deeper economic cause: Oil traded in $ so the  OPEC countries had seen their real income reduced for several years as the price of the barrel did not move. The increase of the oil price was "just" catch-up.

By the way, Bretton Woods ended because the US government could not maintain the gold coverage it was supposed to. Why couldn't they maintain it? Mainly because they were having a rather pointless far-away war and were refusing to pay for it through taxation or reduced spending... Any parallel with the 2000s situation is purely coincidental... "Plus ├ža change..."

As growth faltered, government spending ballooned. During the good years of the 1960s, democratic governments had been quick to expand the welfare state. But this meant that when unemployment later rose, so did government spending on benefits for the jobless, even as tax revenues shrank. For a while, central banks accommodated that spending with expansionary monetary policy. That, however, led to high inflation in the 1970s, which was exacerbated by the rise in oil prices. Such inflation, although it lowered the real value of governments’ debt, did not induce growth. Instead, stagflation eroded most economists’ and policymakers’ faith in Keynesian stimulus policies.

Me: No argument there. We could expand a bit on the wage-price spiral aspect of the early 70s inflation and thus introduce the role of collective bargaining/unions in the economy but that can be done later. I certainly think that the loss of faith in Keynesianism is a rather key consequence of the stagflation of the 70s-80s.

Central banks then changed course, making low and stable inflation their primary objective. But governments continued their deficit spending, and public debt as a share of GDP in industrial countries climbed steadily beginning in the late 1970s—this time without inflation to reduce its real value. Recognizing the need to find new sources of growth, Washington, toward the end of President Jimmy Carter’s term and then under President Ronald Reagan, deregulated many industries, such as aviation, electric power, trucking, and finance. So did Prime Minister Margaret Thatcher in the United Kingdom. Eventually, productivity began to pick up.

Whereas the United States and the United Kingdom responded to the slump of the 1970s with frenetic deregulation, continental Europe made more cosmetic reforms. The European Commission pushed deregulation in various industries, including the financial sector, but these measures were limited, especially when it came to introducing competition and dismantling generous worker protections. Perhaps as a result, while productivity growth took off once again in the United States starting in the mid-1990s, it fell to a crawl in continental Europe, especially in its poorer and less reform-minded southern periphery. In 1999, when the euro was introduced, Italy’s unemployment rate was 11%, Greece’s was 12 %, and Spain’s was 16%. The resulting drain on government coffers made it difficult to save for future spending on health care and pensions, promises made even more onerous by rapidly ageing populations.

Me: While I don't doubt that deregulation can be beneficial to productivity growth, I think Prof. Rajan is a bit audacious in attributing it solely to that cause. The springs of technological innovation and  how it spreads throughout society aren't that well understood so it might have been somewhat of a coincidence that productivity did pick up, eventually - though, the pick up isn't exactly impressive until the late 90s internet boom and so one might question a 15 years lag effect...

You might be unconvinced and still think deregulation was the key. If so, how would you explain that most countries experiencing even a low-key bush war see their productivity collapse and yet the Renaissance started in war-torn 15th century Italy? It's not that I have a good answer to that question, it's just that it makes the point about our lack of understanding about the drivers of innovation and technological changes.

In countries that did reform, deregulation was not an unmitigated blessing. It did boost entrepreneurship and innovation, increase competition, and force existing firms to focus on efficiency, all of which gave consumers cheaper and better products. But it also had the unintended consequence of increasing income inequality—creating a gap that, by and large, governments dealt with not by preparing their work forces for a knowledge economy but by giving them access to cheap credit.

Me: I am glad to see that, at least, Prof. Rajan does not insist that deregulation was pure bliss and does note some of its drawbacks. Frankly, it's not that I am against deregulation. In general, I do believe competition is the motor to deliver all the good thing Capitalism is supposed to deliver. But I am very suspicious of the kind of partial deregulation we got where Labour is the one having to weather the whole of the volatility generated by a less stable system while Capital does very well out of it, thank you for asking.

Disrupting The Status Quo

For the United States, the world’s largest economy, deregulation has been a mixed bag. Over the past few decades, the competition it has induced has widened the income gap between the rich and the poor and made it harder for the average American to find a stable well-paying job with good benefits. But that competition has also led to a flood of cheap consumer goods, which has meant that any income he or she gets now goes further than ever before.

Me: Let's start with the fact that people got cheaper consumer goods. That's great but having a bigger and cheaper TV screen doesn't compensate for jobs becoming less secure and, furthermore, while TV screens and cars might have reduced in price, things like health care and education or retirement got meaningfully more expensive. Basically, technological progress asides - and, again, who knows if most of it would not have occurred without all this "liberalisation" - I am not sure all that deregulation has done nearly as much good as Prof. Rajan suggests.

During the post-war era of heavy regulation and limited competition, established firms in the United States had grown fat and happy, enjoying massive quasi-monopolistic profits.

Me: Dude?!  Look at a chart on the share of corporate profit as a percentage of GDP. The 60s and 70s were above the 80s (the conservative recession) but, starting in the 90s and never truly looking back, they've climbed higher and higher...

Basically, I really doubt that the modern era and the deregulation Prof. Rajan raves about have done much to eradicate the 'massive quasi-monopolistic profits' he mentions. Indeed, I am not the only one to point out that we live in a crony capitalist system where big firms (if not the small ones) do very well, indeed, at the expense of everyone else...

They shared these returns with their shareholders and their workers.

Me: Why? I hope Prof. Rajan isn't going to argue that those CEOs back then were full of love and kindness for their fellow man. They shared whatever returns they had because they were forced to do so by the unions. And governments. Now, I am not a huge fan of unions. They can easily be corrupt and they tend to fight for the status quo, regardless of its merits. Still, one thing they do have going for them, as far as I am concerned, is that they were effective in getting workers their share of the pie...

For banks, this was the age of the “3-6-3” formula: borrow at 3%, lend at 6% and head off to the golf course at 3 pm. Banks were profitable, safe, and boring, and the price was paid by depositors, who got the occasional toaster instead of market interest rates. Unions fought for well-paying jobs with good benefits, and firms were happy to accommodate them to secure industrial peace—after all, there were plenty of profits to be shared.

Me: See above. I don't think there was any happiness in the fact that managers and CEOs had to share the loot with anyone. It's just that they didn't have a choice. Enough with the happy claptrap: Yesterday just as today, everybody wanted money, more of it and was willing and eager to screw the other parties to get it... The main difference was that, back then, Management had to contend with the unions while, now, it doesn't.

 In the 1980s and 1990s, the dismantling of regulations and trade barriers put an end to this cosy life. New entrepreneurs with better products challenged their slower-moving competitors, and the variety and quality of consumer products improved radically, altering peoples’ lives largely for the better. Personal computers, connected through the Internet, have allowed users to entertain, inform, and shop for themselves and cell phones have let people stay in constant contact with friends (and bosses). The shipping container, meanwhile, has enabled small foreign manufacturers to ship products speedily to far away consumers. Relative to incomes, cotton shirts and canned peaches have never been cheaper.

Me: A bit rosy, that description. For some perspective:

Basically, despite the cheap imported goods, our standards of living kept on dropping and two of the most important things for families - besides a home - kept on increasing a lot faster than income... And, speaking of homes, there too, prices kept on rising above inflation for a good long while, although the present crisis may lead to some correction...

At the same time as regular consumers’ purchasing power grew, so did Wall Street pay-outs. Because companies’ profits were under pressure, they began to innovate more and take greater risks, and doing so required financiers who could understand those risks, price them accurately, and distribute them judiciously. Banking was no longer boring; indeed, it became the command center of the economy, financing one company’s expansion here while putting another into bankruptcy there.

Meanwhile, the best companies became more meritocratic, and they paid more to attract top talent. The top 1% of households had obtained only 8.9 % of the total income generated in the United States in 1976, but by 2007 this had increased to nearly 25%. Even as the salaries of upper management grew, however, its ranks diversified. Compared with executives in 1980, corporate leaders in the United States in 2001 were younger, more likely to be women, and less likely to have Ivy League degrees (although they had more advanced degrees). It was no longer as important to belong to the right country club to reach the top; what mattered was having a good education and the right skills.

Me: I dare say, having the right education is pretty much the same thing as belonging to the right country club. And, to repeat, consumers' purchasing power did NOT grow. The fact that you can now buy a computer for a few hundred bucks while it would set you back a few thousands 20 years ago has nothing to do with anything. Louis XIVth would have been unable to get a 12 bit machine, even if he would have been willing to trade the whole of Versailles for one. That's technological progress, not purchasing power increase.

Also I don't know whether to laugh or cry at the description of companies as 'more meritocratic'. I call bullshit. See below.

It is tempting to blame the ever-widening income gap on skewed corporate incentives and misguided tax policies, but neither explanation is sufficient. If the rise in executive salaries were just the result of bad corporate governance, as some have claimed, then doctors, lawyers, and academics would not have also seen their salaries grow as much as they have in recent years.

Me: What about the salaries of engineers and architects? If the premium on education has indeed increase, all highly educated people should have seen their salary rise if not in equal measure at least relatively in line. It hasn't.

Executive salaries rose because executives manage to rob both Capital (low dividend pay-outs) and Labour (no or pitiful salary increase for the general workforce) out of the wealth generated.

What about the professions mentioned by Prof. Rajan? They did see their compensation rise. But why? Not because of some increasing premium on education but because market and institutional forces ended up giving these specific professions more power to extract surplus. Lawyers' fees have risen with the increase of legal hassle everyone has to contend with and with the potential pay-outs that can be won in court (or penalties you might incur if you happen to lose). Doctors have slowly but surely realise the power they hold (asymmetry of information, with the patient/customer both unable to interpret the information he is given and generally unable and unwilling to compare health care providers. And, generally, if forced to choose between "your money or your life", most people give up their money. This fact gives tremendous power to doctors willing to play hard ball and unconstrained by... well, regulations... and/or social standards). Similarly, as we've seen, education costs have risen faster than inflation for a good few decades. Education is seen, rightly for the most part, as a protection against unemployment and the main path to better paying jobs. Even with the fees' increase we've experienced, we have not yet reached the end of the students/customers willingness to pay. Of course, as universities are raking it in, professors have insisted and have managed to get their cut of the extra profits.

And although the top tax rates were indeed lowered during the presidency of George W. Bush, these cuts weren’t the primary source of the inequality, either, since inequality in before-tax incomes also rose. This is not to say that all top salaries are deserved—it is not hard to find the pliant board overpaying the under-performing CEO — but most are simply reflections of the value of skills in a competitive world.

Me: I disagree. If those astronomical pay-checks were deserved, where is the performance justifying them? Dividend payouts have been slashed in the last decade. And the stock prices haven't really increased either. So, if being a shareholder has been a pretty disappointing endeavour for the last 10 years, where exactly is all that skill and competence going? What are we getting exactly for all that CEO brilliance? No, I find it a lot easier to believe that CEOs are sitting on each others' boards and handing each others big fat undeserved wads of cash, using capitalist rhetoric to justify it but avoiding actual capitalism like the plague. To be honest, that's what I and, in truth, any rational being would do in their shoes and that's why I find it a better explanation that belief in unquantified, invisible competence and skill...

 In fact, since the 1980s, the income gap has widened not just between CEOs and the rest of society but across the economy, too, as routine tasks have been automated or outsourced. With the aid of technology and capital, one skilled worker can displace many unskilled workers. Think of it this way: when factories used mechanical lathes, university educated Joe and high-school-educated Moe were no different and earned similar pay checks. But when factories upgraded to computerized lathes, not only was Joe more useful; Moe was no longer needed. Not all low-skilled jobs have disappeared. Non-routine, low-paying service jobs that are hard to automate or outsource, such as taxi driving, hairdressing, or gardening, remain plentiful. So the U.S. work force has bifurcated into low-paying professions that require few skills and high-paying ones that call for creativity and credentials. Comfortable, routine jobs that require moderate skills and offer good benefits have disappeared, and the laid-off workers have had to either upgrade their skills or take lower-paying service jobs. 

Me: Now, that's actually true and crucially important for our modern societies. I am not sure exactly how Nir Jaimovich and Henri Sui constructed their 'routine occupations' but they too describe the same reality as Prof. Rajan and anyone alive in the last 30 years is likely to intuitively agree with this finding. To quote: "The disappearance of routine occupations in the past 30 years represents a ‘polarisation’ of employment because the middle of the wage distribution has been hollowed out".

Unfortunately, for various reasons—inadequate early schooling, dysfunctional families and communities, the high cost of university education—far too many Americans have not gotten the education or skills they need.

Me: Here is another key difference between Prof. Rajan and I. All the factors he mentions are real enough but he fails to consider experiences outside of the USA.

His solution to the polarisation described is that the US workforce should be better qualified so that they can "bifurcate up", as it were. Well, Europe, Northern Europe and France especially, have maintained a high quality public education system, from early schooling to university-level education. The educational attainment is a lot higher in France than in the US. In the USA, a bit less than 30% of the 25-29 years old have a bachelor degree or more. In France, according to the Ministry of the Education statistics, it's above 40%. This better educated workforce has done nothing to help France's unemployment issue. All we got is a better class of unemployed and under-employed people. As the saying went in the 90s crisis in France, "wanna hire a PhD? Check out the pizza delivery boy"...

Yes, yes, if only France "liberalised", all would be well. Personally, I frankly doubt it. I am not against a serious dose of liberalisation in France, although not quite what most right wing politicians and economists tend to think about when they use that buzzword but I am not kidding myself and thinking that this would be enough or indeed strongly correlated with the aim of reducing unemployment. Liberalisation may well achieve some other goals that I care about (such as making the French system more meritocratic) but, in and of itself, this will do little for reducing unemployment.

Others have spent too much time in shrinking industries, such as auto manufacturing, instead of acquiring skills in growing sectors, such as medical technology.

Me: Huh? I thought education was commending a higher premium now. Look at lawyers, doctors and university professors. But somehow auto engineers' education premium did NOT increase? Huh. Could it be that other factors, such as indeed the sector you're in and your ability to direct created wealth your way is more important/has more explanatory power than education, skill and competence?

As the economists Claudia Goldin and Lawrence Katz have put it, in “the race between technology and education” in the United States in the last few decades, education has fallen behind. As Americans’ skills have lagged, the gap between the wages of the well-educated and the wages of the moderately educated has grown even further. Since the early 1980s, the difference between the incomes of the top 10% of earners (who typically hold university degrees) and those of the middle (most of whom have only a high school diploma) has grown steadily. By contrast, the difference between median incomes and incomes of the bottom 10% has barely budged. The top is running away from the middle, and the middle is merging with the bottom. The statistics are alarming. In the United States, 35 % of those aged 25 to 54 with no high school diploma have no job, and high school drop-outs are three times as likely to be unemployed as university graduates. What is more, Americans between the ages of 25 and 34 are less likely to have a degree than those between 45 and 54, even though degrees have become more valuable in the labour market. Most troubling, however, is that in recent years, the children of rich parents have been far more likely to get college degrees than were similar children in the past, whereas college completion rates for children in poor households have stayed consistently low. The income divide created by the educational divide is becoming entrenched.

Me: The educational divide did not create the income divide. It is far more correct to say that the income divide is now creating an educational divide as the right education becomes the new 'right country club' label you need to have to take your place amongst the self-perpetuating elite and the elite is now making as sure as possible that such 'right education' is indeed out of reach of the plebs, just as they used to make sure that their country clubs did not let in unsuitable characters.

The Politicians Respond

In the years before the crisis, the everyday reality for middle-class Americans was a pay check that refused to grow and a job that became less secure every year, even while the upper-middle class and the very rich got richer. Well-paying, low-skilled jobs with good benefits were becoming harder and harder to find, except perhaps in the government. Rather than address the underlying reasons for this trend, American politicians opted for easy answers. Their response may be understandable; after all, it is not easy to upgrade workers’ skills quickly.

Me: ... and, to repeat, European countries' experience show that, in any case, a qualified workforce does little to insure against the phenomenon  of mass unemployment... 

But the resulting fixes did more damage than good. Politicians sought to boost consumption, hoping that if middle-class voters felt like they were keeping up with their richer neighbours—if they could afford a new car every few years and the occasional exotic holiday—they might pay less attention to the fact that their salaries weren't growing. One easy way to do that was to enhance the public’s access to credit. Accordingly, starting in the early 1990s, U.S. leaders encouraged the financial sector to lend more to households, especially lower-middle-class ones. In 1992, Congress passed the Federal Housing Enterprises Financial Safety and Soundness Act, partly to gain more control over Fannie Mae and Freddie Mac, the giant private mortgage agencies, and partly to promote affordable home-ownership for low-income groups. Such policies helped money flow to lower-middle-class households and raised their spending—so much so that consumption inequality rose much less than income inequality in the years before the crisis.

Me: Blaming Fannie Mae, Freddie Mac and the Federal Housing Act for the housing bubble is getting really old. But I guess we must allow anti-government devotees their little fantasies. For a more correct take:

These policies were also politically popular. Unlike when it came to an expansion in government welfare transfers, few groups opposed expanding credit to the lower-middle class—not the politicians who wanted more growth and happy constituents, not the bankers and brokers who profited from the mortgage fees, not the borrowers who could now buy their dream houses with virtually no money down and not the laissez-faire bank regulators who thought they could pick up the pieces if the housing market collapsed. Cynical as it may seem, easy credit was used as a palliative by successive administrations unable or unwilling to directly address the deeper problems with the economy or the anxieties of the middle class. 

The Federal Reserve abetted these short-sighted policies. In 2001, in response to the dot-com bust, the Fed cut short-term interest rates to the bone. Even though the overstretched corporations that were meant to be stimulated were not interested in investing, artificially low interest rates acted as a tremendous subsidy to the parts of the economy that relied on debt, such as housing and finance. This led to an expansion in housing construction (and related services, such as real estate brokerage and mortgage lending), which created jobs, especially for the unskilled. Progressive economists applauded this process, arguing that the housing boom would lift the economy out of the doldrums.

But the Fed-supported bubble proved unsustainable. Many construction workers have lost their jobs and are now in deeper trouble than before, having also borrowed to buy unaffordable houses. Bankers obviously deserve a large share of the blame for the crisis. Some of the financial sector’s activities were clearly predatory, if not outright criminal. But the role that the politically induced expansion of credit played cannot be ignored; it is the main reason the usual checks and balances on financial risk taking broke down.

Me: As I said, we can pick over the details and I don't think officials, be they the Fed or the US government, really had a clear idea of what they were doing - using cheap credit as a palliative to income stagnation - but it's true that it eventually worked out that way.

Outside the United States, other governments responded differently to slowing growth in the 1990s. Some countries focused on making themselves more competitive. Fiscally conservative Germany, for example, reduced unemployment benefits even while reducing worker protections. Wages grew slowly even as productivity increased and Germany became one of the most competitive manufacturers in the world.

Me: ... helped in no small way by getting into the Euro with an under-appreciated Deutsche Mark and never correcting that initial imbalance. But I wouldn't want to spoil the familiar narrative of the hard working German and his genetic pre-disposition for manufacturing.

But some other European countries, such as Greece and Italy, had little incentive to reform, as the inflow of easy credit after their accession to the Eurozone kept growth going and helped bring down unemployment. The Greek government borrowed to create high-paying but unproductive government jobs, and unemployment came down sharply. But eventually, Greece could borrow no more, and its GDP is now shrinking fast. Not all European countries in trouble relied on federal borrowing and spending. In Spain, a combination of a construction boom and spending by local governments created jobs. In Ireland, it was primarily a housing bubble that did the trick. Regardless, the common thread was that debt-fuelled growth was unsustainable.

Me: Well, the details matter but, yes, debt is a fine thing until it isn't.

What Can Be Done?

Since the growth before the crisis was distorted in fundamental ways, it is hard to imagine that governments could restore demand quickly—or that doing so would be enough to get the global economy back on track. The status-quo ante is not a good place to return to because bloated finance, residential construction, and government sectors need to shrink and workers need to move to more productive work.

Me: We could also try paying workers for the work they do, like we used to. I bet that this would restore demand pretty quickly. I mean, after all, it's not like people didn't want extra houses and expensive cars and large TV screens. It's just that they finance such consumption with borrowed money. Replace 'borrowed' with 'earned' and there is nothing unsustainable about the growth before the crisis - well, the ecologists may disagree about that but ecological limits are a different kind of unsustainability

The way out of the crisis cannot be still more borrowing and spending, especially if the spending does not build lasting assets that will help future generations pay off the debts that they will be saddled with. Instead, the best short-term policy response is to focus on long-term sustainable growth. Countries that don’t have the option of running higher deficits, such as Greece, Italy, and Spain, should shrink the size of their governments and improve their tax collection. They must allow freer entry into such professions as accounting, law, and pharmaceuticals, while exposing sectors such as transportation to more competition, and they should reduce employment protections—moves that would create more private-sector jobs for laid-off government workers and unemployed youth. Fiscal austerity is not painless and will probably subtract from growth in the short run. It would be far better to phase reforms in overtime, yet it is precisely because governments did not act in good times that they are forced to do so, and quickly, in bad times. Indeed, there is a case to be made for doing what is necessary quickly and across the board so that everyone feels that the pain is shared, rather than spreading it over time and risking dissipating the political will. Governments should not, however, underestimate the pain that these measures will cause to the elderly, the youth, and the poor, and where possible, they should enact targeted legislation to alleviate the measures’ impact.

Me: Yes, because the IMF programs of 'liberalisation' and fiscal austerity have had such success in the past... Nonetheless, I agree on at least two points. One, following such policies will certainly hurt. Indeed, I am even less positive than Prof. Rajan and would argue that implementing such policies have a good chance to lead to the election of either neo-fascist governments or extreme-left ones. Two, countries such as Greece should definitely, no matter what, improve their tax collecting capabilities. I am unaware of any country developing without an effective central government.

The United States, for its part, can take some comfort in the powerful forces that should help create more productive jobs in the future: better information and communications technology, lower-cost clean energy, and sharply rising demand in emerging markets for higher value-added goods. But it also needs to take decisive action now so that it can be ready to take advantage of these forces. The United States must improve the capabilities of its work force, preserve an environment for innovation, and regulate finance better so as to prevent excess.

None of this will be easy, of course. Consider how hard it is to improve the match between skills and jobs. Since the housing and financial sectors will not employ the numbers they did during the pre-crisis credit boom any time soon, people who worked in, or depended on, those sectors will have to change careers. That takes time and is not always possible; the housing industry, in particular, employed many low-skilled workers, who are hard to place. Government programs aimed at skill building have a checkered history. Even government attempts to help students finance their educations have not always worked; some predatory private colleges have lured students with access to government financing into expensive degrees that have little value in the job market. Instead, much of the initiative has to come from people themselves.

That is not to say that Washington should be passive. Although educational reform and universal health care are long overdue, it can do more on other fronts. More information on job prospects in various career tracks, along with better counselling about educational and training programs, can help people make better decisions before they enrol in expensive but useless programs. In areas with high youth unemployment, subsidies for firms to hire first-time young workers may get youth into the labour force and help them understand what it takes to hold a job. The government could support older unemployed workers more—paying for child care and training—so that they can retrain even while looking for work. Some portion of employed workers’ unemployment insurance fees could accumulate in training and job-search accounts that could help them acquire skills or look for work if they get laid off.

At the same time, since new business ventures are what will create the innovation that is necessary for growth, the United States has to preserve its entrepreneurial environment. Although the political right is probably alarmist about the downsides of somewhat higher income taxes, significantly higher taxes can reduce the returns for entrepreneurship and skill acquisition considerably—for the rich and the poor alike. Far better to reform the tax system, eliminating the loopholes and tax subsidies that accountants are so fond of finding in order to keep marginal income tax rates from rising too much.

Me: See my previous posts on taxes and tax rates. Depending on what is considered 'high income', we can see some work-leisure substitution effects for some professions but I note that Bill Gates wasn't all that deterred by the high tax rates he was facing when he created Microsoft in 1975 and I don't think that low tax rates are really what motivated Mark Zuckerberg to create Facebook in 2004.

Culture also matters. Although it is important to shine the spotlight on egregious unearned salaries, clubbing all high earners into an undifferentiated mass—as the “1%” label does—could denigrate the wealth creation that has served the country so well.

Me: Has it? If the bottom 50% has seen little of the wealth created and even the further 49% are mostly treading water, what is all that wealth created for?

The debate on inequality should focus on how the United States can level up rather than on how it should level down.

Me: But levelling up the way Prof. Rajan suggests might be impossible. Sure, by all means, let's try and fine-tune our wealth creation engine. Maybe we'll coax significant improvements, although history tend to show that productivity gains don't really climb faster than 2-3% per year. However, in parallel, I definitely think we should make sure the top 0.1% stop vacuum-ing all the money. Labour got cheap because it got plentiful and because it lost the capacity to fight for its share of the pie. Neither of these two factors is a law of nature.

Finally, even though the country should never forget that financial excess tipped the world over into crisis, politicians must not lobotomize banking through regulation to make it boring again. Finance needs to be vibrant to make possible the entrepreneurship and innovation that the world sorely needs. At the same time, legislation such as the Dodd-Frank act, which overhauled financial regulation, although much derided for the burdens it imposes, needs to be given the chance to do its job of channelling the private sector’s energies away from excess risk taking. As the experience with these new regulations builds, they can be altered if they are too onerous. Americans should remain alert to the reality that regulations are shaped by incumbents to benefit themselves. They should also remember the role political mandates and Federal Reserve policies played in the crisis and watch out for a repeat.

Me: Mouais. I don't like the rah-rah tone at the beginning of the paragraph but the message is correct. We need regulation to do its job in the least damaging way possible and it's always going to be a balance with adjustments along the way.

I could add things are not looking good in that regard and that we could also proceed with great rules of thumb rather than endlessly complex regulations like Dodd-Frank and co but that, actually, big corporations, despite their constant bitching about it, love complex and detailed regulations as it more or less guarantee they'll find some loopholes. Big, simple, rule of thumbs (say, "the leverage of any retail bank is limited to 10x") are a lot less malleable.

The industrial countries have a choice. They can act as if all is well except that their consumers are in a funk and so what John Maynard Keynes called “animal spirits” must be revived through stimulus measures. Or they can treat the crisis as a wake-up call and move to fix all that has been papered over in the last few decades and thus put themselves in a better position to take advantage of coming opportunities. For better or worse, the narrative that persuades these countries’ governments and publics will determine their futures—and that of the global economy.

Me: Except that the consumers ARE in a funk. They're in a funk because their incomes haven't grown in the past 30 years and they've substituted credit growth to income growth. As brilliantly explained by Richard Koo and others, this crisis is a balance sheet recession, first and foremost. So the most urgent solutions should be centred around debt forgiveness/restructuring and, longer term, around recreating income growth for the bottom 99%.

The main difference between Prof. Rajan and I (apart from our likely respective position on the political spectrum) is that I do not believe that closing the educational gap will actually lead to this restoring of income growth for the greater mass of people. If it did,  Continental/Northern Europe would be doing well at present. It isn't ergo the problem - and the solutions - are elsewhere.


  1. Great post! There are a load of things I want to quibble over in this, but I can't do it in blog comments.

    I guess mostly it's to do with definitions though, which is possibly just my anal-retentive legal training kicking in... Stuff like the distinction between stimulus/automatic stabilisers seems arbitrary to me, for instance. I mean, sure, differenciating the two is useful in certain discussions, but it's not like they're necessarily and universally separate things...

  2. Hi, Zichao

    Thanks for taking the time and thanks for your constant support, it means a lot to me.

    To your specific point, I thought the difference between 'stimulus' and 'automatic stabiliser' did matter here because, while the stabilisers may help maintain/stave off a collapse in Aggregated Demand, they are not suffisent to really boost AD, which I would consider the point of 'stimulus' i.e. stabiliser help smooth AD bumps and drops while stimulus (try to) increase AD outright.

  3. There are five major changes in the world economy over the past generation that have significant, undigested consequences for economic policy and thought:

    • Over this period the effective world labor force has doubled, with consequences on the distribution of wealth around the world and within individual economies. [the most effective foreign aid non-policy has been the American balance of payments deficit that has helped fund this process]
    • As standards of living have improved as a result, birth rates have declined and are approaching a projected stable population level. This removes one of the supports for rapid (if any) economic growth. Economic thought needs to adapt to deal with stability, rather than growth
    • As economies have grown, the mix of job categories shift towards services. Economics, as a discipline, developed during the rise of the industrial revolution and is based on the imagery of the factory floor, where investment is clearly visible and measurable as is its impact on productivity. “Services” are much more complex. Some (utilities, hospitals) are very capital intensive and may match the old economic model; others do not and look more like swapping my hours for yours. In the latter case these hours are valued by measures that are not well defined. [think of it as taking in each other’s laundry – I’ll wash and you iron and we are both happier?]
    • A lot of the GDP growth in the past generation or two has come as women moved from household labor (which was not counted) into paid labor (which is). This may have increased GDP, but may have also, in part, led to the deterioration of education of the very young. Coupled with a potential role in increasing single earner families the impact on education may be even stronger.
    • Finally, the rise of computers and the internet have probably increased individual “productivity” substantially, but in ways that may not yet be included in economic thought. The paradigm of the internet is “free”; the cost structure is largely buried in the overheads of various institutions, probably largely educational ones. (e.g. there are supposed to be over 500,000 people who trade on eBay, but who are not counted as being employed, and their operating costs are buried somewhere else.) Furthermore, much of what goes on in the internet is “stateless” and not easily quantifiable. It may represent more actual commerce that the usual “underground (and illegal?) economy” does.

    So how does this relate to our current problems, and to the arguments around Rahjan’s work?
    The US economy (as measured by GDP) was growing relatively slowly up to 2007, took a hit, and then started to grow again at about the same rate, but from a lower start. We are not seeing the typical growth spurt (but then the real message of Reinhart and Rogoff was not to expect one). I think that, as usual, the US has been more flexible in the face of all these changes and is moving to restructure to work better in the future. Something like 2 million of those who are no longer working have arranged to go on some kind of disability system and may never return.

    Construction has not recovered well, and probably will not until the financial losses that triggered the recession are allocated and dealt with (this process is impeded by huge regulatory forces that penalize the lenders if the admit the losses directly, unless we do what we did with the S&L crisis and set up a “bad bank” or some similar system to clean up the lenders’ balance sheets.)

    The states (some of them) are taking steps to rationalize the promises that were made to various groups in the past that clearly cannot be kept. With luck most of them will avoid a complete financial meltdown, but some will probably have to face the equivalent of bankruptcy to reset those promises. And as usual, inflation will play a large part in the process, by effectively reducing the promised payments.

    1. So I agree with a lot of what you say about the limitations of GDP but it's still the best measure we got.

      NB: While I am in favour of anyone, including women, becoming financially independent, the massive influx of women in the workforce has had the same effect than globalisation: Labour got ever more plentiful.

      As to 'stability', it's an interesting point but we will have to see. Assuming people finally get to see some income growth, they would spend it and acquire more 'stuff', even if there is less/no population growth.

      I've meant to write about pensions in the cadre of an article on France and the French system. Thanks for reminding me to get on with it.