January 30th, 2012
12:00 PM ET

Rajan: A crisis in two narratives

Editor's Note: Raghuram Rajan, a former chief economist of the IMF, is Professor of Finance at the University of Chicago's Booth School of Business and the author of Fault Lines: How Hidden Fractures Still Threaten the World Economy.

By Raghuram Rajan, Project Syndicate

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.

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.

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.

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.

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.

The views expressed in this article are solely those of Raghuram Rajan.

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Topics: Economy

soundoff (6 Responses)
  1. Prudence

    Good reflection on history. Unfortunately the pop-psychology/warmed over Kenesian "animal spirits" silliness detracted from the rationale.

    January 30, 2012 at 12:42 pm | Reply
  2. j. von hettlingen

    This economic crisis shows once more that the Keynesian formula is good for instant solutions and that it had worked well mostly in Western democracies, which for a long time had good ratings and creditworthiness. The emerging economies couldn't borrow and they had to work and save hard. As these countries don't provide a welfare system like the one we have in the West, there will be less public spendings and more private savings.

    January 30, 2012 at 5:40 pm | Reply
  3. Benedict

    In effect,reduce the size of the cake or you‘ll have a long case of stomach indigestion!

    January 31, 2012 at 11:53 pm | Reply
  4. daniel kim

    Immigrants like "professor" rajan, from filthy greedy rich versus the majority poor in India are the same overpaid tenured people in overpriced colleges like Univ of Chicago taking the jobs away from Americans and conspired with Wall Street, military weapons and oil barrons and yet has the audacity to complain too much focus is spent on funding and hiring teachers!!!

    It is the Iraq-Afghanistan wars, Defence and Veteran Affairs departments that cost $10 trillions that ballooned our national debt to $15 trillion and NOT paternalism or spending on educating and helping the disabled, poor and working class!!!! Even computer majors are discouraged not only in America but Asia because the finance industry is overpaying their greedy fraudsters manipulating the currency, interest rates and off course, CDOs bundling subprimed mortgages that made them trillions and yet no criminal charges have been brought to jail banks and hedgefunds like Chase Jaime Dimond, ex-Countrywide and BoA CEOs, etc!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!

    July 7, 2012 at 2:01 pm | Reply
  5. Stephan

    Fred Harrison predicted the bust in August 2005 using the model based on the incteartion between the land market and the banking system. The conventionally accepted economics theories ignore land so of course their predictions are defective. Harrison put his prediction into a book, The Great Recession of 2010. He explains the theory in brief Things are going to get a lot worse before they start to get better, as the government's policies have just held back the tide and cannot resist much longer.Inequality is easily explained. There are those who have land and collect rent. There are those who do not and must work for wages and pay rent. Most people have a little bit of an interest in land so enjoy a little bit of land rental income but few, even business people, actually own the land on which they work and it is inordinately difficult to get to do so. Thus the great political division between left and right does not reflect the fundamental economic divide.As for free markets – there can be no such thing so long as land is monopolised. So governments can tinker or they can deal with the problem. Nearly all choose to tinker, including the radical left who ought to know better. So the power remains in the land.

    July 5, 2014 at 10:57 am | Reply
  6. Yassin

    As an EVangelist I was unsure of what the agdena might be having read the book and reflected on the contention I am a conVErt. This isn't anything new' comments are correct but the assembly and context of it all is. Vested interest is of course The Dark Side' but I feel compelled to push back on it as I want to hand over to my children and others a baton that is not toxic coated Good for you Ozzie!

    July 21, 2014 at 10:50 am | Reply

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