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May 05 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%. 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?
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.
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 may encourage spending if credit were easy, it is not at all clear that traditional savers today will 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, we 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 because households there have too much debt stemming from the housing boom. 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% 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.
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).
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% 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.
April 30 This appeared in Foreign Affairs, May-June 2012
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.
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 aging 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. 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.
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: 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 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 economists’ 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 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 percent, Greece’s was 12 percent, and Spain’s was 16 percent. 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 aging populations.
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.
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.
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 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.
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 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 faraway 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 households 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 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. 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 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. Think of it this way: when factories used mechanical lathes, university-educated Joe and high-school-educated Moe were no different 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 offer good benefits have disappeared, and the laid-off 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. Others have spent too much time in shrinking industries, such as auto manufacturing, instead of acquiring skills in growing sectors, such as medical technology. 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 ten percent 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 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 less likely to have a degree than those between 45 and 54, even though degrees have become more valuable in the labor 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.
THE POLITICIANS RESPOND
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 understandable; 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 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 homeownership 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. 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 shortsighted 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.
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. 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-fueled growth was unsustainable.
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. 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 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 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.
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 anytime 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 counseling about educational and training programs, can help people make better decisions before they enroll 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 labor 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.
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 “one percent” label does -- could denigrate the wealth creation that has served the country so well. The debate on inequality should focus on how the United States can level up rather than on how it should level down.
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 channeling 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.
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.
April 14 Speech at a function to re-release a book of essays in honor of Dr. Manmohan Singh.
Honourable Prime Minister, my fellow panelists, and distinguished guests:
It is an honor to be here to celebrate the reforms that India undertook in the 1990s, especially the role of the central figure in those reforms, then finance minister and now prime minister, Dr. Manmohan Singh. By reducing controls and increasing competition and entry, those reforms unleashed the latent and suppressed energy of our people.
India has achieved much in the two and a quarter decades since then. There is so much to celebrate, whether it is that we have moved away from the Hindu rate of growth of 3.5 percent or whether it is that so many millions of Indians have moved out of debilitating poverty into a life of some comfort – and yes, despite all the furor over the Planning Commission’s poverty line, we have brought down poverty enormously.
Shops are full of goods that we could only dream of buying in 1990, many of them made in India. I can withdraw money from my U.S. bank account today from any ATM nearby (by the way, not incurring the fees I would incur in the US), while a migrant worker can send money using his cell phone to his family’s bank account in his village. We can buy air and train tickets on-line, which has eliminated long waits and some corruption in those areas. Organizations like Shankar Netralaya are showing the world how to offer medical care cheaply but effectively. The consumer has never had more choice in India than today.
And even though we lament the deterioration in our old institutions, superb new ones have come up such as the National Stock Exchange or the twenty-four seven TV networks. The latter’s competition for news does keep our administrators on their toes even though some in the audience may feel the networks often produce more sound than light.
As Mr Chidambaram and Mr Yashwant Sinha built on Dr. Manmohan Singh’s reforms in the years after this book’s first edition was published, we enjoyed the strongest period of growth India has ever had. Even our gloom today over the fall in growth to between 6 and 7 percent reflects how far we have come – twenty years ago we would have been elated with such performance.
However, even as the world becomes more competitive, India’s star has dimmed in the last few months, as our governance is besmirched by corruption scandals and our macroeconomic health has deteriorated. Alarm bells should sound when domestic industry no longer wants to invest in India, even while eagerly investing abroad.
Why the gloom? The problem, that I am sure is obvious to this audience, is that despite the tremendous success of the first generation of reforms, some of the key next-generation reforms have been stymied. Typically, these are the reforms that reduce rents and patronage, while increasing competition – for example, the bill on foreign entry into higher education, attempts to auction resources transparently, or attempts to transform public sector enterprises into more autonomous corporations. On the other hand, rent, patronage, or entitlement enhancing measures have sailed through. Clearly, there are many exceptions to this asymmetric reform process – the Right to Information Act and the setting up of the Unique ID Authority being important game changers of the right sort -- but I am talking about a central tendency.
For a while, growth papered over the paralysis in growth enhancing reforms, while it made the expansion in subsidies and entitlements seem affordable. With growth slowing, government tax revenues stagnant as a fraction of GDP, and spending high, fiscal deficits remain high. At the same time, private consumption, especially in rural areas, is growing strongly on the back of rising incomes, strong credit growth, and continuing government transfers and subsidies.
The result: The gap between our spending and our saving is making us dependent on short term foreign inflows to a dangerously high extent, at a time that the international investor is increasingly skeptical about the India story.
The depreciating rupee is the first warning sign of an unstable macroeconomy, rising long term interest rates could be the second. Dangerously volatile oil prices could lead to a blowout in our fiscal and current account deficits, while at the same time depressing exchange rates and elevating interest rates. Given geo-political uncertainties, we cannot be complacent.
For a large vibrant economy like India’s, there is always hope. We still have tools to tackle our problems. But we must exercise those tools with vigor and a sense of urgency. I know that sense of urgency is shared within the government, but urgency has to translate to persuasion and action. We need a common minimum program across all sensible political parties to ensure that we stabilize the economy and foreign investor perceptions quickly.
If politics and narrow personal advantage trumps economics and national interest, as it has done for the last few years, we will jeopardize the legacy of Dr. Manmohan Singh’s reforms that are so well documented in the book.
How have we come to this pass? As an academic, I will offer a possible causal narrative, without any claim that this is tested by evidence. It is, at best, a working hypothesis, but as I will argue, offers a plausible course of action. My hypothesis is as follows: While Dr. Singh’s reforms opened up the economy and brought in competition in a number of areas, they were incomplete in four important respects:
First, they left untouched a number of areas such as higher education, where the License Permit Raj continued and significant rent-seeking persisted. Second, they left the public sector occupying the commanding heights, even possessing a virtual monopoly in some areas such as in coal. Third, they did not recognize the importance of national resources such as land, spectrum, and commodities, and left their allocation ill-defined. And fourth, despite undoubted successes, they did not change the public mindset as much as they might have.
All this was to a large extent understandable. One could not do everything at one go, so reforms had to be prioritized. Moreover, the need to undertake some reforms became apparent only after the success of the first set of reforms. For instance, the public hunger for education, and the rents from running capitation fee colleges became obvious only after the dramatic increases in growth and the demand for skilled workers post reform.
Similarly, the patronage from controlling the public sector, as well as the attractiveness of its use for public policy increased rapidly after reforms. Commodities became valuable only after rapid Chinese growth in the last ten years.
And finally, because many reforms were gradual in order to not awake the opposition of vested interests, they were not publicized. But reform by stealth, by its very nature, does not win hearts and minds. Moreover, the significant fruits of that first stage of reforms, and their trickling down to the broader public, occurred with a long lag – often more than a decade after they were enacted. The public could not see the link, nor was it trumpeted. Public mindsets therefore moved only a little, especially in attitudes towards competition and the private sector. I doubt very much that our carpenter attributes his cheap cell phone and his speedy state-of-the-art two-wheeler to the competition brought about by the reforms.
By the early 2000s, India was therefore ripe for a second generation of reforms to cement Dr. Manmohan Singh’s legacy. But powerful elements of the political class, which had never been fully convinced about giving up rents from the License Raj in the first place, had by then formed an unholy coalition with aggressive business people, whom I will refer to simply as the connected. What has ensued is coalition adharma, a coalition of the bad. The new post-License Raj equilibrium became the Resource Raj.
The Resource Raj resulted in massive fortunes generated by the connected and by politicians. Again, this is not to take away from genuinely innovative and strong businesses there are myriad examples of. Many industries became really competitive and innovative, including ones like telecom that are the focus of investigations today. Dr. Manmohan Singh’s reforms documented in this book have made India enormously better off.
But if we want to understand why there is a sense of pessimism today, we have to acknowledge that the full intent of those reforms, to liberalize so as to enhance entry, competition, and efficiency, to move from a producer bias to a consumer bias, and to price and allocate national resources and opportunities fairly, have not been realized in a number of areas of the economy.
The second generation of reforms are ready and packaged in the form of bills waiting to be passed. But these bills, some of them conceived in Mr. Atal Behari Vajpayee’s government, are stuck, not just because the government does not have the votes to pass them, but because there is not enough political will, even in the ruling coalition, to move on them.
Finally, what has made the unreformed areas bottlenecks today is that the middle class has grown larger, and it has become more aware, partly because of legislation like the Right to Information Act brought in by the UPA government. Newly assertive institutions such as the press, the CAG, and the judiciary have started uncovering the massive nexus between the oligarchy and the politicians and bureaucrats that built up during the go-go years. Unlike in the past, middle class anger now has tools with which to assert itself even if the middle class is still numerically an electoral minority.
Under this scrutiny, the non-transparent systems to acquire and allocate land, iron ore, and other commodities have ground to a halt, so business and investment in these areas is threatened. I pointed out that we have not established public support for the basic principles of competition and free enterprise. Indeed, distrust of even the legitimate activities of the private sector has grown. Not surprisingly, the utopia promised by the extreme left is once again enjoying a resurgence of popularity. Unfortunately, even necessary new reforms such as the proposed Land Acquisition Bill do not draw fully on the intent of Dr. Manmohan Singh’s reforms, underemphasizing the need to provide good incentives, and making success overly dependent on government capacity.
This then is the dangerous place we are at. Growth is slowing, in part because of bottlenecks. At the same time, given public dissatisfaction, politicians are even more focused on subsidies and transfers to keep people happy, especially as general elections near. No one wants to be blamed for taking away the goodies, even as our ability to pay for them has plummeted. Politicians are loathe to act quickly to give up their rents, so reforms that might improve sentiment are stuck. And opposition to liberalization is gathering strength amongst the angry middle class – they have become more willing to listen to old discredited remedies once again because their trust in the private sector has been shattered.
But we should not succumb to pessimism. There is no reason that India’s growth cannot regain double digits. Simply moving our millions from low productivity agriculture to rural industry or services will give us growth for years to come, provided we are willing to do the minimum necessary to collect the low hanging fruit. That requires completing the second generation of reforms. We need to liberalize sectors like education, retail, and the press, freeing entry and improving customer choice. We need to transform more government owned firms into well-managed publicly owned firms which are free from political influence or government support. And we need to evolve transparent means of pricing and allocating the bountiful natural resources in our country. Clearly, we need to ensure that growth reaches more people. But there is no better way of inclusion than a decent job, no doubt augmented by better public services as well as targeted conditional cash transfers to the poor.
I am hopeful that our increasingly difficult situation will focus political minds.
Given that the public is no longer willing to tolerate the adharmik coalition and the lack of transparency, perhaps politicians will see they have no alternative but to change. Moreover, and perhaps as important, the connected businesspeople are themselves now frustrated with the free-for-all resource grab, and government paralysis. I sense they too want change. When everyone wants change, it just might occur.
In addition to the medium term changes I have just outlined, here are at least three steps that we must take in the short term. They are nothing that the government does not know, but are worth emphasizing.
1) Raise fuel prices to international levels in a set of quick steps, then completely deregulate them. Announce this as soon as politically possible, and do not roll back.
2) Resolve the commodity bottleneck in a way that does not give a windfall or bailout to any party, least of all the private promoters, but that ensures these projects/plants can resume production. If necessary, write down the equity of these promoters before restructuring bank liabilities.
3) Be kinder to foreign investors – they are not the enemy but a necessity -- we need their money to fund our spending to the tune of 4% of GDP. No doubt, however badly we treat them today, they may eventually want to be in India, but crisis are always about timing. We need them now, when India looks increasingly tattered compared to alternative investment opportunities, not five years from now when growth recovers.
We should open up more to FDI where feasible, because FDI is a safer form of financing. We should bring certainty about taxation to foreign investors, and resist the temptation to levy new retrospective claims. If we think Mauritius and Singapore offer undue arbitrage opportunities, and I think they do, we should renegotiate those treaties with prospective effect. Yes, there will be one time adverse effects, but so be it. And finally, we should avoid the tremendous uncertainty created by catch-all measures like GAR, which give tax authorities unbridled power. We should focus instead on clearly delineating specific actions we want to prevent.
I have been very frank – as an academic, that is the only value I bring. The history of development is replete with countries that grew strongly for a while, only to stutter and stop as their leaders and their people started taking growth as their birth-right. Somewhat paradoxically, it is only when we are paranoid about sustaining growth that we will continue achieving it. We need to become paranoid again, as we were in the early 1990s, and perhaps then we will achieve the full promise of Dr. Manmohan Singh’s reforms. Thank you. April 13 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.
Read the rest at
http://www.project-syndicate.org/commentary/the-trouble-with-libertarian-paternalism March 23 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.
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.
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.
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.
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. |