Foreign Affairs - 05/2012 - The True Lessons of the Recession

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The True Lessons of the Recession
The West Can't Borrow and Spend Its Way to Recovery
Raghuram Rajan
Volume 91 * Number 3
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The True Lessons
of the Recession
The West Can't Borrow and
Spend Its Way to Recovery
Raghuram Rajan
Accordingtothe 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 argu-
ment goes, is to find ways to get the money flowing again. Govern-
ments 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 ocials, 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,
Raghuram Rajan is Professor of Finance at the University of Chicago
Booth School of Business and the author of Fault Lines: How Hidden
Fractures Still Threaten the World Economy


Raghuram Rajan
"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.
In fact, today's economic troubles are not simply the result of inad-
equate 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 aging
populations. So in an eort to pump up growth, governments spent
more than they could aord and promoted easy credit to get house-
holds 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. 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 o 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.
Tounderstandwhat 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 eco-
nomic expansion in the West and Japan. Several factors underpinned
this long boom: postwar 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

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The True Lessons of the Recession
the early 1970s, when the opec countries, realizing the value of their
collective bargaining power, jacked up the price of oil.
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 econo-
mists' and policymakers' faith in Keynesian stimulus policies.
Central banks then changed course, making low and stable inflation
their primary objective. But governments continued their deficit spend-
ing, 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 pro-
tections. Perhaps as a result, while productivity growth took o
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 percent, Greece's
was 12 percent, and Spain's was 16 percent. The resulting drain on
government coers made it dicult to save for future spending
on health care and pensions, promises made even more onerous by
rapidly aging populations.

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Raghuram Rajan
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 eciency, 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.
disrup tingthestatusquo
FortheUnited 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.
During the postwar era of heavy regulation and limited competition,
established firms in the United States had grown fat and happy,
enjoying massive quasi-monopolistic profits. They shared these returns
with their shareholders and their workers. For banks, this was the age
of the "3-6-3" formula: borrow at three percent, lend at six percent,
and head o 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.
In the 1980s and 1990s, the dismantling of regulations and trade
barriers put an end to this cozy 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 them-
selves, 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 faraway

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The True Lessons of the Recession
consumers. Relative to incomes, cotton shirts and canned peaches
have never been cheaper.
At the same time as regular consumers' purchasing power grew,
so did Wall Street payouts. 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 one percent of house-
holds had obtained only 8.9 percent of the total income generated in
the United States in 1976, but by 2007 this had increased to nearly
25 percent. 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.
It is tempting to blame the ever-widening income gap on skewed
corporate incentives and misguided tax policies, but neither explana-
tion is sucient. 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. 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 over-
paying the underperforming ceo--but most are simply reflections
of the value of skills in a competitive world.
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.

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Raghuram Rajan
Think of it this way: when factories used mechanical lathes, university-
educated Joe and high-school-educated Moe were no dierent and
earned similar paychecks. 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. Nonroutine, 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 oer good benefits have
disappeared, and the laid-o workers have had to either upgrade their
skills or take lower-paying service jobs.
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.
The way out of the
Others have spent too much time in shrink-
crisis cannot be still
ing industries, such as auto manufacturing,
more borrowing
instead of acquiring skills in growing sec-
tors, such as medical technology. As the
and spending.
economists Claudia Goldin and Lawrence
Katz have put it, in "the race between tech-
nology 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 dierence between the incomes
of the top ten percent of earners (who typically hold university degrees)
and those of the middle (most of whom have only a high school di-
ploma) has grown steadily. By contrast, the dierence between median
incomes and incomes of the bottom ten percent 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 percent of
those aged 25 to 54 with no high school diploma have no job, and high
school dropouts are three times as likely to be unemployed as university
graduates. What is more, Americans between the ages of 25 and 34 are

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The True Lessons of the Recession
less likely to have a degree than those between 45 and 54, even though
degrees have become more valuable in the labor market. Most trou-
bling, 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.
In the years before the crisis, the everyday reality for middle-class
Americans was a paycheck 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 understand-
able; after all, it is not easy to upgrade workers' skills quickly. 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 neighbors--if they could aord 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 aordable homeownership for low-income groups.
Such policies helped money flow to lower-middle-class house-
holds and raised their spending--so much so that consumption
inequality rose much less than income inequality in the years before
the crisis. 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

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Raghuram Rajan
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 shortsighted policies. In 2001,
in response to the dot-com bust, the Fed cut short-term interest
rates to the bone. Even though the over-
stretched corporations that were meant to be
The industrial countries stimulated were not interested in investing,
should treat the crisis
artificially low interest rates acted as a
as a wake-up call and
tremendous subsidy to the parts of the
economy that relied on debt, such as housing
move to fix all that has
and finance. This led to an expansion in
been papered over in
housing construction (and related services,
such as real estate brokerage and mortgage
the last few decades.
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 unaordable 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.
Outside the United States, other governments responded dierently
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. But some other European countries, such as Greece and Italy,

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The True Lessons of the Recession
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 combi-
nation 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-fueled
growth was unsustainable.
Sincethegrowth 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. 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 o 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-o 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 over
time, 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 spread-

foreignaffairs. May/June2012