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AUTHOR
Picture of Raghu Rajan

Raghu Rajan

Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago Booth School of Business.

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Raghuram Rajan is the Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago Booth School of Business.

Dr. Rajan is also currently an economic advisor to the Prime Minister of India. Prior to resuming teaching in 2007, Dr. Rajan was the Economic Counselor and Director of Research (in plain English, the Chief Economist) at the International Monetary Fund (from 2003). Since then, he has chaired the Indian government’s Committee on Financial Sector Reforms, which submitted its report in September 2008.

Dr. Rajan’s research interests are in banking, corporate finance, and economic development, especially the role finance plays in it. His papers have been published in all the top economics and finance journals, and he has served on the editorial board of the American Economic Review and the Journal of Finance.  He has written Fault Lines: How Hidden Fractures Still Threaten the World Economy (Princeton University Press) which won the Financial Times/Goldman Sachs Business Book of the Year 2010 award. He has also co-authored Saving Capitalism from the Capitalists with Luigi Zingales .

Dr. Rajan is a senior advisor to Booz and Co, on the academic advisory board of Moodys, and on the international advisory board of Bank Itau-Unibanco. He is a director of the Chicago Council on Global Affairs and on the Comptroller General of the United State’s Advisory Council. Dr. Rajan is the President (elect) of the American Finance Association and a member of the American Academy of Arts and Sciences. In January 2003, the American Finance Association awarded Dr. Rajan the inaugural Fischer Black Prize, given every two years to the financial economist under age 40 who has made the most significant contribution to the theory and practice of finance.

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November 07

The Big Blink

CHICAGO – World growth is likely to remain subdued over the next few years, with industrial countries struggling to repair household and government balance sheets, and emerging markets weaning themselves off of industrial-country demand. As this clean-up from the Great Recession continues, one thing is clear: the source of global demand in the future will be the billions of consumers in Africa, China, and India.  But it will take time to activate that demand, for what is now being produced around the world for industrial-country consumers cannot simply be shipped to emerging-market consumers, especially the poorer ones among them.

 

If we want to talk about billions of new consumers, rather than the tens of millions who have incomes similar to the middle classes in industrial countries, we must recognize that many emerging-market consumers have much lower incomes than industrial-country consumers, and live in vastly different conditions. Their needs are different, and producers around the world have, until recently, largely ignored them.

 

But times are changing. Increasingly, producers are focusing on people who, if not at the bottom of the income pyramid, comprise the vast numbers nearer the base. For example, an Indian company, Godrej, is making an innovative refrigerator targeted at poor villagers. Village women typically are forced to cook multiple times during the day because the food that they prepare in the morning spoils in the heat. They would like to be able to refrigerate uneaten food, which would limit waste as well as time spent cooking. Unfortunately, with electricity supply intermittent even when available, compressor-based electric refrigerators, which consume a lot of power, have not been an option.

 

Godrej’s engineers observed that if the objective was only to keep food from spoiling, and not necessarily to make ice, it would be sufficient if the refrigerator cooled to a few degrees above zero centigrade. This would allow the use of a less power-hungry fan instead of a compressor, and the fan could run on batteries rather than relying on the power grid.

 

This is the kind of frugally engineered product that can create enormous new consumer demand in emerging markets. Companies in the industrial world are taking note. General Electric, for example, is cutting down the functions provided by its medical equipment to only what is strictly useful in order to supply remote rural clinics across the developing world. “Just-enough” functionality makes the equipment affordable without compromising quality.

 

Over the next decade, growth in this kind of developing-country demand will help offset the slow growth of demand in industrial countries. But the process cannot be rushed. Unfortunately, with high levels of unemployment in industrial countries, policymakers want to do something – anything – to increase growth fast. The aggressive policies that they are following, however, could jeopardize the process of adjustment.

 

Consider the United States Federal Reserve’s foray into quantitative easing. Clearly, the Fed’s objective is to increase bond prices, in the hope that lower long-term interest rates will propel corporate investment. In addition, the Fed hopes that lower long-term interest rates will push up asset prices, giving households more wealth and greater incentive to spend. Finally, by demonstrating a willingness to print money, the Fed hopes to increase inflationary expectations from their current low levels.

 

Even though the markets seem to be anticipating substantial levels of quantitative easing, US corporate investment remains subdued. And US households seem wary of splurging again as they did in the past, no matter how wealthy they feel.

 

The Fed has, however, succeeded in enhancing expectations of inflation in the US. With its anticipated bond purchases keeping a lid on interest rates, the net effect is that investors do not see an adequate real return from holding dollar assets, which is perhaps one reason the dollar has been depreciating.

 

Emerging markets are worried because they believe that the Fed’s ultra-aggressive monetary policy will have little effect in expanding US domestic demand. Instead, it will shift demand towards US producers, much as direct foreign-exchange intervention would. In other words, quantitative easing seems to be as effective a method of depreciating the dollar as selling it in currency markets would be.

 

Because they know that it will take time for domestic demand to pick up, emerging markets are unwilling to risk a collapse in exports to the US by allowing their currencies to strengthen against the dollar too quickly. They are resisting appreciation through foreign-exchange intervention and capital controls. As a result, we might not see steady growth of demand in emerging markets. Instead, excess liquidity and fresh asset bubbles could emerge in the world’s financial and housing markets, impeding, if not torpedoing, growth.

 

In the ongoing showdown over currencies, who will blink first? The US (and other industrial countries) could argue that it has high levels of unemployment and should be free to adopt policies that boost growth, even at the expense of growth in emerging markets. These countries, in turn, could argue that even very poor US households are much better off than the average emerging-market household.

 

Rather than bickering about who has the stronger case, it would be better if all sides compromised – if everyone blinked simultaneously. The US should dial back its aggressive monetary policy, focusing on repairing its own economy’s structural problems, while emerging markets should respond by allowing their exchange rates to appreciate steadily, thereby facilitating the growth of domestic demand. Is it too much to hope that the G-20 can achieve such a commonsensical compromise?

 

Comments (5)

  • 12/21/10 - japincherI think you are correct about the best option being if all sides compromised. That's usually the...  Show Full Comment
  • 11/28/10 - Bills1And, to turn your comment around, what is also interesting is that the products of the Chinese...  Show Full Comment
  • 11/16/10 - AndySHello. Can you explain more in detail (maybe in a small article) what the Fed is trying to do ?