Photo: AFP

Photo: AFP

The global crisis in two narratives

The global 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.

Photo: AFP

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-fuelled 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 1950s and 1960s, an era of rapid growth in the West and Japan. Several factors, including post-war reconstruction, the resurgence of trade after the protectionist 1930s, 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 fruits" were plucked, it became much harder to propel growth from the 1970s onward.

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 its resources shrank. For a while, central banks accommodated that spending. The resulting high inflation created widespread discontent, especially because little growth resulted.

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 gross domestic product (GDP) in industrial countries climbed steadily from the late 1970s, 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 US deregulated industry and the financial sector, as did Margaret Thatcher in the UK. Productivity growth increased substantially in these countries, which persuaded 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 healthcare and pensions. Public debt continued to grow. And incomes of the moderately educated middle class failed to benefit from deregulation-led growth. 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 such as construction, and precipitated a consumption boom as people borrowed against overvalued houses. In other countries, such as 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 aftermath of a deep crisis to calm a panic, but it is no solution to a fundamental problem.

If this diagnosis is correct, advanced countries need to focus on reviving innovation and productivity growth and on realigning welfare promises with revenue capacity, while alleviating the pain of the truly destitute in the short run.

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. Too little government attention has been focused on such issues, partly because payoffs occur beyond electoral horizons, and partly because the effectiveness of government programmes has been mixed. Tax reform, however, can 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.

Raghuram Rajan is professor of finance at the Booth School of Business, University of Chicago, and the author of Fault Lines: How Hidden Fractures Still Threaten the World Economy.

©2012/Project Syndicate

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