[Viewpoint] A crisis in two narratives

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[Viewpoint] A crisis in two narratives

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 more crises.

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 policy makers 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 pays off quickly.

Attention is therefore shifting to the second narrative, which suggests the advanced economies’ fundamental capacity to grow by making useful things has been sinking for decades, a trend that was masked by debt-fueled spending. More such spending will not restore growth. Instead, they must improve the growth environment.

The second narrative starts with the 1950s and 1960s, an era of rapid growth in the West and Japan. Several factors underpinned the long boom, including postwar reconstruction, the resurgence of trade after the protectionist 1930s, the introduction of new technologies and expansion of educational attainment. But, as Tyler Cowen has argued in his book “The Great Stagnation,” once these “low-hanging fruit” were plucked, it became harder to propel growth after the 1970s.

Meanwhile, as Wolfgang Streeck writes persuasively in New Left Review, democratic governments, facing what seemed, in the 1960s, 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 resources shrank. For a while, central banks accommodated. The resulting 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 focused on low and stable inflation as their main 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 1970s, this time without inflation to reduce 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, persuading 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 less tenable by rising life expectancy and falling birthrates. Public debt continued to grow. Incomes of the moderately educated middle class failed to benefit from deregulation-led growth (though it improved their lot as consumers).

Recently the advanced economies’ frenzied search for growth has taken different forms. In some countries, most notably the U.S., a private-sector credit boom created jobs in low-skilled industries like construction, precipitating a consumption boom as people borrowed against overvalued houses. In other countries, like Greece, and 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’ precrisis GDP was unsustainable, bolstered by borrowing and unproductive make-work jobs. More borrowed growth - the Keynesian way - 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 U.S., 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. 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, lower-cost alternative energies and sharply rising demand in emerging markets for higher-value 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.

Copyright: Project Syndicate, 2012.

* The author is a professor of finance at the Booth School of Business, University of Chicago.

by Raghuram Rajan
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