Monday, May 7, 2012

Rajan on the world's troubles

My colleague Raghu Rajan wrote a very thoughtful essay in Foreign Affairs. Though titled "The True Lessons of the Recession" it's really more a grand view of the last 50 years and prospects for growth ahead. The subtitle "The West Can’t Borrow and Spend Its Way to Recovery" is worth repeating.

Raghu reminds us that growth, in the end, comes from productivity. Keynesians have stolen the term to mean a few years of caffeinated stimulus, but to everyone else, growth means better living standards for decades. And the lesson of modern growth theory is that such growth comes only from greater from productivity -- people able to produce more valuable goods and services per hour that they work.

Raghu reminds us that growth is not a given. There is no stone tablet saying GDP per capita will rise 2% per year forever. Every drop of growth is hard-won. It comes from people investing in ideas, in the human capital that produces ideas, in better skills, and able to start businesses, displace ossified incumbents, make new and better products and services.

He offers a thoughtful capsule view of the last 50 years; the strong postwar growth, how it petered out, and how the US responded with deregulation. Now it's petering out again, and the question for us is whether we will be able to remove the sand in the gears. 

Raghu reminds us what economists know but seems forgotten in policy circles: The global rise in inequality over the last 30 years comes from the rising returns to skill, not from lower taxes, "greed" or malfaisance. The rich didn't get richer; new people came in and got rich. As he put it, starting in the 1980s, 
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.
Raghu goes on to a long list of disastrous policies our government has followed which are greatly to blame for the current mess.  

While I agree these policies are disastrous, I'm less convinced of Raghu's political narrative: that our government subsidized houses and credit as a benevolent but ham-handed attempt to address rising inequality.  There is more to an overarching theory of the political determinants of US economic policy than this. 

In part, I think Raghu's own analysis proves the point,
Outside the United States, other governments responded differently to slowing growth in the 1990s. Some countries focused on making themselves more competitive.
OK, so if other governments such as Germany chose different policies, then our particularly damaging policies were not simply an inevitable reaction to the skill premium.

I part company even more as Raghu describes what to do about it. Raghu's analysis emphasizes  America's disastrous inability to provide its middle-class citizens with decent education. You would think a stunning denunciation of teacher's unions and associated public-school bureaucracy would follow, but it doesn't.

Raghu offers instead:     
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.
This kind of sentence drives me a bit batty. Who is the subject of this sentence, really? You smell a new set of programs, but to be put in place by the same government that Raghu so skewers for the last 20 years?

Admittedly, Raghu adds, 
None of this will be easy,... 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. 
OK, but he's still apologizing for not layering new programs on top of the old failed programs. And with this little caveat the start-new-programs instinct takes over full-force,
That is not to say that Washington should be passive. Although educational reform and universal health care are long overdue, ...
Wait a minute, Raghu! You just diagnosed the disasters of America's public education system, and how desire to subsidize the middle class led to policy disasters. You want the same genius system to run health care too?
[Washington] 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. 
Again, that indefinite tense. Who is going to provide this "more information?" and "counseling?" What about that "checkered history" of such efforts in the past?   
...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. 
Rajan offers brillant analysis of the global skill premium, and we're back to tinkering with the tax code to overcome the disincentives offered by the minimum wage?

As finance professors, both Raghu and I pay extra attention to financial regulation.
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. 
Amen, brother Rajan. But continuing,
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.
What? The Dodd-Frank act is a monster compared to Fannie and Freddie, which Raghu just skwered. He surely would not write
At the same time, agencies such as Fannie and Freddie, although much derided for the subsidies and distortions they impose, need to be given the chance to do their job of channeling funds to housing, small business and student loans. As the experience with these agencies builds, they can be altered if their side-effects are too onerous.
 He does write
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.
Yes. Exactly why hoping that a complex monster like Dodd-Frank can work is sure to lead to more trouble.  Dodd Frank is designed and destined to lobotomize, monopolize and politicize the financial system. 

In sum, I think Raghu's soft tinker-at-the-edges solutions just don't match the eloquence of his diagnosis. We have a disastrous public education system that is leaving the middle class and poor behind, and a shattered middle-class family structure that renders education even more difficult. Accept his diagnosis that our political system drove us to financial disaster by patching up the resulting inequality.  Is not the answer much more far reaching, and much more of the stop-banging-our-head-against the wall variety?

One sentence on "educational reform" isn't enough, let's talk about the deep reforms that need to be taken, now. How can he  hope that the same political system will act more wisely, though it has much greater arbitrary power with the health law and Dodd-Frank?  Take his reading of the 1980s deregulation and how it solved the stagnation of the 1970s and gave us a new round of growth. Is the answer not the same sort, get out of the way rather than a spate of new Federal "competitiveness" programs?

Raghu regains his eloquence on the idea that a touch more stimulus is all we need, that growth is just a short-run "demand" problems not deep "supply" problems. 
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...
Yes, but why does the same advice not hold for the US as well? Certainly not because we have the option (for a while) of running higher deficits.

But he really comes in to focus with this gorgeous paragraph: 
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


Anyway, go read the original -- provocative, thoughtful, and refreshingly well-written.


  1. So I want to know, if deregulation gave us growth in the 80s and 90s, what happened during the Bush years (2001-2008)? Deregulation in the late 90s and early 00s was not followed by growth. Isn't this an indication that the returns to further deregulation are low at this point?

    1. Noah, regulation began to increase again in the 90's. There was some re-regulation billed as "de-regulation", but on the whole, regulation grew. I used to have a chart of the number of regulations, but I can't find it. This chart shows the growth of regulatory bureaucracies.

      But, regulation is never the only variable. I don't understand why you think removing regulatory drag is ever a bad idea.

    2. The answer is simple, there was no meaningful deregulation of industry during the Bush administration.

    3. Deregulation in the early 00's? Are these people teenagers? Did they LIVE through the 00's?

      *I* seem to remember SarPox, "know thy customer" and the other Patriot Act "enhancements" to banking regulations. Hell, I make a living helping companies comply with this stuff so I think I would have remembered a SINGLE PIECE of DE-regulation between 2001 and 2008. I don't.


  2. What about Krugman's claim that the construction and financial industry employment narrative being off the mark?

    I remember this also being a point of contention when he criticized I think it was your comment for saying something like "construction workers in Nevada need something better to do besides swing hammers"...

  3. Actually, one of the basic premises of Rajan's article is 180 degrees wrong.

    Industrial production in the USA from 1985 to 2012 more than doubled!!!!


    This was accomplished in a era of inflation ranging between 2 percent and 6 percent, generally speaking. It is in tight-money Japan that industrial production sank by 20 percent in roughly the same period.

    Though the number of people employed in USA manufacturing has decreased, wonderful increases in worker productivity have allowed actual production to rise nicely.

    I don't know how Rajan could get such a fundamental aspect of the USA economy so wrong, unless he was relying on talk radio and partisan blabbermeisters.

    If the Fed would get bullish, real estate would recover, and we would see the "structural changes" in our economy disappear. People still want to live in houses and start businesses in warehouses and office buildings. As we see from the McCains the McCourts and others, as incomes rise, people actually will pay for more than one or two houses.

    Besides that, one of the best aspects of free enterprise systems is that they are flexible. If one contends that structural changes mean employees are semi-permanently unemployed, then one is suggesting the system is not flexible. But it is flexible.

    The USA problem is so simple: There is a shortage of aggregate demand. Duh.

    Rajan made a fundamental error in this latter regard as well.

    1. Value added. This does coincide with the increased use of derivitaves in the casino. But in real life you still can't turn lead into gold. Production in the united states has almost halted in that time period. Value added needs to be looked as Bruno said. Any person preaching value added is to be seen as a parot jumping up and down in its cage. We have had enough alchemy. It has to go.

  4. I agree with the final paragraph you quote but the rest of the piece is just right wing platitudes and outright nonsense. I expect that Rajan and I would disagree about most of the necessary "fixes"

    Most of the increases from productivity gains over the last thirty years have gone to the top 10%. Rajan's policy prescription comes down to: the standard of living of the bottom 90% has to fall so the standard of living of the top 10% can rise even more. Rajan avoids entirely disclosing just how big the sacrifices he is asking the middle class to make will be.

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  6. Most of the discussion here is nonsense and no matter how its being criticized, Rajan points are only dubbed.

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  7. I am deeply confused by the fake dichotomy presented by Raju and others. Yes, if there are deep structural flaws they should be fixed. Yes, if there is a short run demand shortfall, that should be fixed, too. Where is the contradiction? Where is the false choice ? What on earth makes this an either/or question ?

    1. I agree. It is an open question what structural reforms Rajan is calling for (beyond saying the middle class should work harder for less) but if any of the reforms make sense and involve the immediate spending of money I expect the Keynesians would cheer the reforms on.

  8. Prof. Cochrane,

    I am just an interest dummy in Economics but I have read this paper, loved it, but did not get a thing of what is the guy saying. I mean, he is saying that it is fooly to attempt to treat a huge crisis like a temporary shock that you can finance due cash flow problems. Ok, agreed!

    But in the conclusion, he says that the way out of this mess is PERMANENT expenses increase be in social programs, education, infra-structure, investment in inovation, investment in clean energy or correction of externalities. I mean, you cannot incur in temporary deficit but must increase expenses permanently?

    I agree it is an obvious question, but still, I don't understand its answer ....

  9. I certainly concur with your scepticism. And maybe I can add some explanation for it (in summary).

    (Democratic) politics is the ultimate prisoners' dilemma (of the free-rider game to obtain through political power what cannot be obtained through negotiation), which even repetition cannot cure (at least as far as we can see):

    (1) everybody has a reason to complain about inequality;
    (2) every political attempt at correcting inequality creates new inequalities (leading back to 1).

    Commutative justice and distributive justice (Thomas d'Aquino) are two non-intersecting domains, but through politics distributive justice 'expands' into the domain of commutative justice and 'supersedes' its order (Mancur Olson). As there are an infinite number of rules or forms of distributive justice (Isaiah Berlin), political questions of distributive justice can never be settled (Kenneth Arrow). Democratic politics as the continuation of war (of all against all) with democratic means is the only outcome (Frédéric Bastiat).

    A bit in the line of Gregory Clark's findings on the Industrial Revolution ("A Farewell to Alms") one could speculate that the prisoners' dilemma will one day be overcome (Democratic Revolution) if only a critical mass of people will have become immune to the temptation of politics. But it is mere speculation without logical foundation.

    [Boiling it down to the smallest element, one could say that it all hinges on the little word 'we'. "Nobody has the privilege to govern us, except ourselves" is not a bad formula to describe the idea of democratic self-government. But there are two radically opposed meanings that can be given to the word 'ourselves': either 'we' as a collective of people (which leads to Hobbesian or collectivist democracy), or 'each of us himself' (which leads to lawful democracy).]

    My main references:

    Anthony de Jasay, "The State", 1985.
    Frank Van Dun, "The Fundamental Principle of Law", 1982 (only in Dutch, but all his follow-up writing is in English, with "Hobbesian Democracy" being not a bad starting point).
    Eric Voegelin, "The New Science of Politics", 1951 (or, as an introduction, "Hitler and the Germans", 1959).

    PS: It just so happens that Anthony de Jasay's last column "Class War by Judo" (Reflections from Europe - May 7, 2012) is on the same topic. Just one quote:

    "Standard economic history teaches that labour during the Industrial Revolution rose from abject misery and subjection by organising and resisting exploitation. It is more plausible to conclude that labour rose from misery thanks to being too weak to be able to depress high profitability and hence the rapid accumulation of capital. The judo fighter yields to his stronger opponent by calculating design. Labour in 19th century Europe and 21st century Asia yielded to capital, not by design, but by its intrinsic weakness. Yet the result is much the same. One wonders whether the clamour for social justice can be powerful enough to undo such a slow but benign outcome of the class war."

  10. Structural narratives are very compelling given the recent data. For instance, much of the labor market malaise can be summarized with the shift in the Beveridge Curve (see chart), long-term unemployed, the skilled/unskilled unemployment ratio and the labor force participation rate.

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  11. Yes, I would say that Rajan treats the theory of government failure as if it didn't exist.

  12. Rohan wrote an excellent paper. Thank you for directing us to it.

  13. Anthony de Jasay, "The State", 1985.
    Frank Van Dun, "The Fundamental Principle of Law", 1982 (only in Dutch, but all his follow-up writing is in English, with "Hobbesian Democracy" being not a bad starting point).
    Eric Voegelin, "The New Science of Politics", 1951 (or, as an introduction, "Hitler and the Germans", 1959).


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