Fault Lines by Raghuram Rajan

Why India slowed.

Wed, 01 May 2013 04:25:00 GMT

NEW DELHI – For a country as poor as India, growth should be what Americans call a “no-brainer.” It is largely a matter of providing public goods: decent governance, security of life and property, and basic infrastructure like roads, bridges, ports, and power, as well as access to education and basic health care. Unlike many equally poor countries, India already has a strong entrepreneurial class, a reasonably large and well-educated middle class, and a number of world-class corporations that can be enlisted in the effort to provide these public goods.

Why, then, has India’s GDP growth slowed so much, from nearly 10% year on year in 2010-11 to 5% today? Was annual growth of almost 8% in the decade from 2002 to 2012 an aberration? I believe that it was not, and that two important factors have have come into play in the last two years.

First, India probably was not fully prepared for its rapid growth in the years before the global financial crisis. For example, new factories and mines require land. But land is often held by small farmers or inhabited by tribal groups, who have neither clear and clean title nor the information and capability to deal on equal terms with a developer or corporate acquirer. Not surprisingly, farmers and tribal groups often felt exploited as savvy buyers purchased their land for a pittance and resold it for a fortune. And the compensation that poor farmers did receive did not go very far; having sold their primary means of earning income, they then faced a steep rise in the local cost of living, owing to development.

In short, strong growth tests economic institutions’ capacity to cope, and India’s were found lacking. Its land titling was fragmented, the laws governing land acquisition were archaic, and the process of rezoning land for industrial use was non-transparent.

India is a vibrant democracy, and as the economic system failed the poor and the weak, the political system tried to compensate. Unlike in some other developing economies, where the rights of farmers or tribals have never stood in the way of development, in India politicians and NGOs took up their cause. Land acquisition became progressively more difficult.

A similar story played out elsewhere. For example, the government’s inability to allocate resources such as mining rights or wireless spectrum in a transparent way led the courts to intervene and demand change. And, as the bureaucracy got hauled before the courts, it saw limited upside from taking decisions, despite the significant downside from not acting. As the bureaucracy retreated from helping businesses navigate India’s plethora of rules, the required permissions and clearances no longer came through. In sum, because India’s existing economic institutions could not cope with strong growth, its political checks and balances started kicking in to prevent further damage, and growth slowed.

The second reason for India’s slowdown stems from the global financial crisis, which caused an abrupt fall in growth. Many emerging markets, which were growing strongly before the crisis, responded by injecting substantial amounts of monetary and fiscal stimulus. For a while, as industrial countries recovered in 2010, this seemed like the right medicine. Emerging markets around the world enjoyed a spectacular recovery.

But, as industrial countries, beset by fiscal, sovereign-debt, and banking problems, slowed once again, the fix for emerging markets turned out to be only temporary. To offset the collapse in demand from industrial countries, they had stimulated domestic demand. But domestic demand did not call for the same goods, and the goods that were locally demanded were already in short supply before the crisis. The net result was overheating – asset-price booms and inflation across the emerging world.

In India, matters were aggravated by the investment slowdown that began as political opposition to unbridled development emerged. The resulting supply constraints exacerbated inflation. So, even as growth slowed, the central bank raised interest rates in order to rebalance demand and the available supply, causing the economy to slow further.

To revive growth in the short run, India must improve supply, which means shifting from consumption to investment. And it must do so by creating new, transparent institutions and processes, which would limit adverse political reaction. Over the medium term, it must take an axe to the thicket of unwieldy regulations that make businesses so dependent on an agile and co-operative bureaucracy.

One example of a new institution is the Cabinet Committee on Investment, which has been created to facilitate the completion of large projects. By bringing together the key ministers, the committee has coordinated and accelerated decision-making, and has already approved tens of billions of dollars in spending in its first few meetings.

In addition to more investment, India needs less consumption and higher savings. The government has taken a first step by tightening its own budget and spending less, especially on distortionary subsidies. Households also need stronger incentives to increase financial savings. New fixed-income instruments such as inflation indexed bonds will help. So will lower inflation, which raises real returns on bank deposits. Lower government spending, together with tight monetary policy, are contributing to greater price stability.

If all goes well, India’s economy should recover and return to its recent 8% average in the next couple of years. Enormous new projects are in the works to sustain this growth. For example, the planned Delhi Mumbai Industrial Corridor, a project with Japanese collaboration entailing more than $90 billion in investment, will link Delhi to Mumbai’s ports, covering an overall length of 1,483 kilometers (921 miles) and passing through six states. The project includes nine large industrial zones, high-speed freight lines, three ports, six airports, a six-lane expressway , and a 4,000-megawatt power plant.

We have already seen a significant boost to economic activity as India built its highway system, and the boost to jobs and growth from the Delhi Mumbai Industrial Corridor, linking the country’s political and financial capitals, could be significantly greater.

To the extent that democratic responses to institutional incapacity will lead to stronger and more sustainable growth, India’s current slowdown has a silver lining. But if its politicians engage in fractious point-scoring rather than in institution building, the slowdown may be a cloud that portends a storm.

India Re-Emergent: Speech to IIM Alumni

Thu, 11 Apr 2013 04:10:27 GMT

Dear Chairperson, fellow IIM alumni, and dear friends:

Thanks very much to the organizers and Mr. Tharman Shanmugharatnam for inviting me to this global meet, the first of its kind. I hope there will be many more to come.

In my talk this morning, I want to focus on why India slowed and how we can revive growth. But I also want to talk about a larger theme: how India’s story, which is being written even as we speak, is unique – of a large country growing out of poverty through free enterprise even while being fully democratic. If this story concludes happily, and I have every confidence it will, it offers an example for many poor countries around the world of how growth and democracy can be mutually supportive rather than antagonistic. But let me start first with why we have slowed.

Why India Slowed

For a country as poor as India, and we are still a poor country, growth should be what Americans call a “no-brainer.” It is largely a matter of providing public goods: decent governance, security of life and property, and basic infrastructure like roads, bridges, ports, and power, as well as access to education and basic health care. We then let the entrepreneurial ones amongst us drive growth.

And, unlike many equally poor countries, India already has a very strong entrepreneurial class, a reasonably large and well-educated middle class, and a number of world-class corporations that can be enlisted in the effort to provide these public goods.

Why then has India slowed so much, from nearly 10% growth in 2010-11 to the 5% today? Was the near 8% growth in the decade from 2002 to 2012 an aberration? I will argue the answer is no.

There are two important reasons that have come together in the last two years for why India slowed.

India grew fast in the years before the global financial crisis. We were probably not fully prepared for that growth. For example, new factories and mines need land. But land is often held by small farmers or inhabited by tribals, who neither have clear and clean title to the land, nor the information or capabilities to deal on equal terms with a developer or corporate acquirer.

Not surprisingly, farmers and tribals often felt unfairly treated as savvy buyers purchased their land for a pittance, later reselling it for a fortune. And having lost their primary means of livelihood, the compensation the poor farmer got did not last long as development pushed up the local cost of living.

The point is strong growth tests the capacity of institutions to cope. And India’s economic institutions were found lacking. Our land titling was fragmented, the laws governing land acquisition archaic, and the process of rezoning land for industrial use non-transparent.

India is a vibrant democracy, and as the economic system failed the economically weak, the political system tried to compensate. Unlike in some other developing economies where the rights of the farmer or the tribal have never stood in the way of development, in India politicians and NGOs took up their cause. Land acquisition became progressively more difficult.

A similar story repeated elsewhere. For example, the government’s inability to allocate resources such as mining rights or spectrum in a transparent way led the courts to intervene and demand change. And as the bureaucracy got hauled up by the courts, it saw very limited upside from taking decisions and many downsides. Given India has a plethora of rules, the absence of a helping hand from the bureaucracy to navigate them, to grant the required permissions and clearances, was problematic.

So the first reason for slowing growth is that India’s economic institutions could not cope with strong growth, and its political checks and balances started kicking in to prevent further damage.

The second reason has to do with the global financial crisis. As it hit, India, as did other emerging markets, experienced an abrupt fall in growth. And encouraged by the IMF and the G-20, many emerging markets, which were growing strongly before the crisis, injected substantial amounts of monetary and fiscal stimulus. For a while, as industrial countries recovered in 2010, it looked like this was the right medicine. Emerging markets around the world enjoyed a spectacular recovery.

But as industrial countries, beset by fiscal, sovereign debt, and banking problems, slowed once again after the first flush of recovery, emerging markets found they had tackled the wrong problem. To replace the collapsed demand from industrial countries they had stimulated domestic demand. But domestic demand did not fall on the same goods that the industrial world had demanded. And the goods that were locally demanded were already in short supply before the crisis. The net result was overheating – asset price booms and inflation across the emerging world.

In India, matters were exacerbated by the fact that investments slowed as the political reaction I described earlier emerged to oppose unbridled investment and development. The resulting supply constraints further exacerbated inflation. So even as growth slowed, the central bank raised interest rates so as to rebalance demand and the available supply, and the economy slowed further.

The picture thus far seems gloomy. But in a vibrant democracy like ours, adversity creates the search for responses, and eventually solutions.

Restarting Growth

So how do we re-energize growth? In the short run, we have to improve supply, which means moving away from consumption to investment. And we have to do it by creating new transparent institutions and processes that will limit adverse political reaction.

Using these institutions, we have to fix the problems in the coal and gas sectors, for without energy, we do not have power, and without power, we do not have growth. The issues here are not insurmountable but they need steady and determined effort. Importantly, if we can provide coal and gas supplies to the power projects on the verge of completion, India could have plentiful power and much stronger growth in the coming years.

We need better coordination and implementation within government to ensure that projects, once started, will be finished on time. That will also give more impetus for new projects to start. The Cabinet Committee on Investment has been set up to remove the governmental impediments to large projects. It has already cleared $ 14 billion worth of projects in its first 3 meetings, and the hope is that the pace of clearance will accelerate.

In addition to more investment, we need less consumption and more saving. The government has taken a first step by tightening its own budget, and spending less, especially on distortionary subsidies. Households also need to be incentivized to increase financial savings. Lower inflation, which raises real returns on bank deposits and other fixed income instruments, will help here.

If all goes well, India should recover from its growth slowdown and go back to its recent 8 percent average in the next couple of years. Enormous new projects are on the anvil to sustain this growth.

As just one example of what is likely, the Delhi Mumbai Industrial Corridor, a project with Japanese collaboration entailing over $ 90 billion in investment, will link Delhi to Mumbai’s ports, covering an overall length of 1483 km and passing through six States.

This project will have nine mega industrial zones, high speed freight lines, three ports, six airports, a six-lane intersection-free expressway connecting the country’s political and financial capitals, and a 4000 MW power plant. We have already seen a significant boost to economic activity as India built out the Golden Quadrilateral highway system, the boost to jobs and growth from the Delhi Mumbai Industrial Corridor can only be imagined.

Moreover, the institutional change we are undertaking – greater transparency in the allocation of contracts, for example – will create a level playing field for Indians and foreigners alike. That will spur growth.

So as the Prime Minister said in a speech on Wednesday, we should not be overly gloomy on the Indian economy. Fluctuating waves of sentiment have historically washed against the economy even while it chugs along at a steady pace. We should pay heed to sentiment but not be overwhelmed by it.

Free Enterprise and Democracy

But a growth recovery still leaves an important question. How do we achieve a stable balance between economics and politics, between free enterprise and democracy? After all, central to India’s unique growth story is that it is trying to rely on the private sector to lift India out of poverty even while giving its citizens full democratic rights.

There is indeed a fundamental commonality between democracy and free enterprise. Both guarantee participation to all, but neither guarantees power or success. Instead, political and economic entrepreneurs try to persuade the public that their product is the best one, and it is collective choice, whether by the electorate or the marketplace, which determines success. And when they outlive their welcome, democracies and markets are ruthless in ejecting incumbents.

These similarities are, of course, accompanied by considerable differences. After all, in aggregating choices, democracy treats individuals as equal, with every adult getting an equal vote, whereas the free enterprise system empowers individuals based on how much income they generate and how much property they own.

There is therefore an inherent tension between systems: the less-well-off majority could vote to dispossess the rich and successful. And the rich, through their money power, could try to erode the political rights of the voter. Indeed, there is a delicate balance between democracy and free enterprise, which if upset, could destroy both.

What preserves that balance across the world? One reason that the median voter rationally agrees to protect the property of the rich may be that she sees the rich as more efficient managers of that property. So, to the extent that the rich are self-made, and have come out winners in a competitive, fair, and transparent market, society may be better off allowing them to own and manage wealth, while taking a reasonable share as taxes.

The more, however, that the rich are seen as idle, incompetent, or crooked, the more the median voter should be willing to vote for tough regulations and punitive taxes on them.

In today’s Russia, for example, property rights do not enjoy widespread popular support, because so many of the country’s fabulously wealthy oligarchs are seen as having acquired their wealth through dubious means. They grew rich because they managed the system, not because they managed their businesses well. When the government goes after a rich oil tycoon like Mikhail Khodorkovsky, few voices are raised in protest.

And, as the rich kowtow to the authorities to protect their wealth, a strong check on official arbitrariness disappears. Government is free to become more autocratic.

In contrast, under conditions of fair transparent competition, the process of creative destruction tends to pull down badly managed wealth, replacing it with new and dynamic wealth. Great inequality, built up over generations, does not become a source of great popular resentment. On the contrary, everyone can dream that they, too, will become rich, and they support the system that allows them the opportunity.

So one condition for the free enterprise system to have democratic support is that it be seen as competitive and efficient, allocating rewards to the bright and capable, rather than just the well-connected.

A second condition is that most people should believe they have a reasonable shot at success in the free market. This is not a given, especially in a poor country like India.

A poor child growing up in an Indian village with bad nutrition, indifferent teachers, and limited access to the kind of learning opportunities available in modern cities, starts adult life with very little chance of being successful in the vibrant economy India has.

A certain amount of inequality in circumstances is inevitable, and even useful, but too much and it breeds resentment of the free enterprise system. Why would the poor vote for expanding free enterprise, for more good jobs in finance and other services, when they know they simply are not good enough to get one themselves? Why not instead vote for the traditional politician who promises patronage, and sometimes even delivers on it.

In sum, to obtain democratic support, the free enterprise system has to be seen as following fair rules of the game – competition is essential. Also, most players should also believe they have the basic capabilities to have a reasonable chance of bettering themselves – meaning growth should be inclusive. If rewards are excessively skewed, and few feel they have a chance of getting them, the system loses democratic legitimacy.

The government has to play a delicate role here. It has to make the system fair, both in appearance and actuality. And it also has to ensure that the broad mass of people have the wherewithal to participate initially on equal terms.

It should not, however, go further and determine winners and losers in the economic system, for that would make the political vote dominant over the economic vote. Equally, it cannot let money power buy votes for that would make democracy a sham.

A number of outcomes are possible if the government fails this task. One is corporatist capture, where entrenched incumbents such as industrialists or trade unions skew the system further in favor of themselves. This has been Mexico’s plight, though the government of President Pena has decided to take on the corporatist interests by cutting the telecom barons down to size and arresting the head of the teachers’ union.

A second is soak the rich or socialist policies where entrepreneurs are labeled parasitic exploiters, and the public votes to tax them heavily. France is currently in the midst of implementing these policies and discovering how costly they are as the industrialists leave.

A third is competitive populism, where the dominant elite tries to buy off those falling behind with sops such as cheap credit or free consumer goods. The United States before the recent crisis could well have been accused of encouraging cheap housing finance so as to assuage the anger of the middle class, which was experiencing stagnant incomes.

When carried to an extreme, corporatist policies lead to fascism, socialist policies to communism, and competitive populism to economic crisis and chaos.

How it will play out in India

All three outcomes are possible in India today. However, I feel confident we will do much better, finding a mutually reinforcing equilibrium between democracy and free enterprise.

We are improving competition through greater transparency, by opening up the economy further to foreign investment, to trade – I should mention that the sum of Indian exports and imports to GDP is now nearly 50% -- and by empowering a Competition Commission, which is starting to ask the right questions even off the government.

We are also working to make growth more inclusive. In doing so, we ought to agree that:

A good job is the best form of inclusion. Rather than assuming the poor need an increasing array of handouts, they should be empowered to equip themselves and their children to become effective contributors to the economy.

Where the poor need help, they should get targeted cash transfers, which they can spend on the education, food, or healthcare they want, whether from a private provider or a government provider. Better they make choices than have the choices of some remote government or civil society thrust on them.

We must also remember that the line between equipping the poor to get decent jobs and populist vote-buying is a thin one, and governments must be careful not to cross it.

To raise resources for such spending, the rich must play their part. The government must broaden the tax base, both by finding and penalizing tax evaders and also giving them incentives to declare their income by increasing the status associated with legitimacy.

The government has to also become more transparent and responsive to the people. Fortunately, information technology can help tremendously, by giving people more of a sense of what their due is, and making clear which part of the government is proving wasteful, corrupt, or a bottle neck.

Opportunities.

If we take such reasonable and feasible steps, therefore, I am confident Indian free enterprise and democracy will reinforce each other. A self-assured India, brimming with ideas and energy, can play an enormously beneficial role in the world. We will offer an alternative view of development, one combining free enterprise with democracy, bringing together cutting edge innovative companies with bottom-of-the pyramid services. We could teach both the West and the rest, even while learning from them, as we did in the historic past when we were a global broker of ideas. We could be a voice for good in the international arena.

I think people like you have an enormous role to play, not just in business and finance, but in shaping India’s engagement with ideas and with the world. It is important that you step up your contribution quickly.

India will become a superpower due to the size of its population, long before its citizens grow rich. Without a world view, a view formed through informed and reasoned debate amongst those who think deeply about these issues, India’s interaction with the world may be purely reactive, guided by the politics of the moment and the unthinking traditions of the past.

That will be dangerous, especially because the powers India will deal with will have far more sophisticated reasoning guiding their actions. India must draw on its best minds across the world, and I hope you will be willing to give back if asked.

Let me conclude. I have not spoken about entrepreneurship or Jugaad or frugal engineering or all those important innovations emerging in Indian business today. I wanted to focus on a broader theme, one that still raises more questions in my mind than answers – the links between our growth and our democracy. I would, of course, be happy to answer any questions of yours that I have an answer to.

Love the Bank, Hate the Banker

Sun, 31 Mar 2013 14:05:08 GMT

NEW DELHI – Public discourse is rarely nuanced. The public’s attention span is short, and subtleties tend to confuse. Better to take a clear, albeit incorrect, position, for at least the message gets through. The sharper and shriller it is, the more likely it is to capture the public’s attention, be repeated, and frame the terms of debate.

Consider, for example, the debate about bank regulation. Bankers are widely reviled today. But banking is also mystifying. So any critic who has the intellectual heft to clear away the smokescreen that bankers have laid around their business, and can portray bankers as both incompetent and malevolent, finds a ready audience. The critic’s message – that banks need to be cut down to size – resonates widely.

Bankers can, of course, ignore their critics and the public, and use their money to lobby in the right quarters to maintain their privileges. But, every once in a while, a banker, tired of being portrayed as a rogue, lashes out. He (it is usually a man) warns the public that even the most moderate regulations placed on banks will bring about the end of civilization as we know it. And so the shrillness continues, with the public no wiser for it.

A more specific example drives home the point. A significant number of banks operated at very high levels of leverage prior to the recent crisis, with debt/equity ratios of 30-1 (or more) in some cases, and much of the debt very short term. One might reasonably conclude that banks operated with too little equity capital, and too little margin of safety, and that a reasonable regulatory response would be to require that banks be better capitalized.

But this is where the consensus breaks down. The critics want banks to operate with far less leverage, especially short-term borrowing; indeed, some want all-equity banks, so that the system becomes safe. The bankers retort that they must pay a higher return on any additional equity that they issue, so that more equity would increase their cost of capital, forcing them to raise interest rates on the loans they make, which would reduce economic activity.

Neither side is quite right in their public arguments. The bankers do not seem to have internalized a fundamental axiom of modern finance: risk emanates from the assets that a bank holds. According to the Modigliani Miller theorem, the mix of debt and equity that it uses to finance its assets does not alter its average cost of financing. Use more “cheap” debt, and equity becomes riskier and costlier, keeping overall financing costs the same. Use more equity, and equity becomes less leveraged and less risky, which causes investors to demand lower returns to hold it, and again the overall financing cost remains the same. Put differently, given a set of cash flows from a bank’s assets, the bank’s value is not affected by how those cash flows are distributed among investors, so more leverage does not reduce the bank’s cost of funding.

If their public argument is incorrect (and they must know it), why then do bankers prefer short-term borrowing to long-term equity finance? The critics would say that it is because of the tax preference accorded to debt, or because banks are too big to fail.

But these arguments do not withstand scrutiny. If the tax deductibility of interest made debt attractive, then bankers should be indifferent between long-term debt and short-term debt. Yet they seem to prefer the latter.

Similarly, too-big-to-fail banks would not care about the failure risk associated with debt financing. But, again, it is unclear why they should prefer short-term debt. After all, if bankers were trying to benefit, would they not issue long-term debt, for which the default risk, and the gain from the implicit government guarantee, is high? Furthermore, why do small banks, which have no implicit backing from the government, also have so much leverage?

The critics’ arguments about the benefits of equity are equally unsatisfying. Of course, given a set of bank assets, more equity would reduce the risk of failure. But failure is not always a bad thing; a banker operating an all-equity bank, with no need ever to repay investors, would be likelier to take unwarranted risk. The need to repay or roll over debt imposes discipline, giving the banker a stronger incentive to manage risk carefully.

For example, when Washington Mutual collapsed in 2008, following an uncontrolled lending spree (it was the largest bank failure in American history), it was not because equity holders decided to close it down, but because depositors did not trust it anymore. How much more value would Washington Mutual’s management have destroyed if the bank had been all-equity financed?

In sum, there are tradeoffs. Too much short-term debt makes banks more prone to failure, while too much equity places little restraint on bankers’ capacity to destroy value. The truth lies somewhere between the positions of today’s strident critics and indignant bankers, which may be why the moderately leveraged bank has been a feature of Western economies for a thousand years. Our distaste for the banker must not be allowed to destroy the bank.

Will Programmers Rule?

Sun, 31 Mar 2013 14:02:10 GMT

NEW DELHI – Marc Andreessen made his first fortune writing the code that became Netscape, the Internet browser. He is now a venture capitalist who evangelizes about the growing importance of software in business today. Indeed, he proclaims that software is eating the world – that it will be the primary source of added value – and offers the following prediction: the world will one day be divided between people who tell computers what to do and people who are told by computers what to do.

Andreessen’s aim is to shock his listeners – not just for effect, but to get them to do something about it. To stop the world from being divided between a few alpha programmers and many drones, he wants the potential drones to stop taking easy liberal arts courses in college. Instead, he wants them to focus on courses in science, technology, engineering, and math (STEM), where the good jobs will be. But will this solve the problem that he poses?

Perhaps not. Two attributes of software creation allow a few talented programmers to corner the market and take all the associated profits. First, software with a slight edge tends to get a significantly greater share of the available market; and, second, the available market is global, because it costs so little to make an extra copy and send it anywhere in the world. As a result, those who are creative and competent enough to write that slightly better search engine will capture the global market.

In this winner-take-all environment, only a small number of those who have taken programming courses will reap a majority of the rents. Completing the right preparatory courses is no guarantee of receiving a share of the software jackpot. Differences in luck and talent among those equally prepared will ensure that the quality of products of software firms lies on a bell curve, with only a few Googles and Facebooks and many more bored, moderately paid computer technicians helping the average confused person deal with malware.

Put differently, in a winner-take-all world, bringing up the average level of skills or education does nothing to alter the skewed distribution of income. So, will anything prevent inequality from widening?

The obvious answer is yes. But how society responds will mean the difference between a prosperous world and a world torn apart by slow growth and resentment.

Property rights are ultimately sanctioned by society, and, to the extent that they seem to be unfair, society has an incentive to change them. But will society see the software billionaire as having come by her wealth unfairly, or will it see her wealth as a fair reward for cleverness?

The more that everyone has access to the same educational opportunities, the more society will tend to accept some receiving disproportionate rewards. After all, they themselves have a chance to be winners. Interestingly, software may itself reduce the cost of expanding educational access – witness the Massive Open Online Courses (MOOCs) offered by companies like Coursera.

But equal access is probably an unlikely ideal. The other extreme is very unequal access, made more unequal because the wealthy have the time to help their kids with homework and the money to arrange for tuitions, while the poor leave their children to watch TV while they work a second job. Will the resentful workers who must follow a computer’s instructions – say, in assembling an order in Amazon’s fulfillment centers – vote to tax the programmers who put them there until the software creators lose the incentive to innovate, leaving society poorer? Or will the rich programmers all migrate to Monaco or Switzerland, taking the brains and rents with them, as society falls apart into barricaded and mutually resentful enclaves and ghettoes?

In reality, many intermediate possibilities exist. One is that cultural norms may develop that encourage billionaires to share their wealth, even if they are spared taxation. For example, the Giving Pledge is a commitment by some of the world’s richest people, Warren Buffett and Bill Gates amongst them, to devote the majority of their wealth to philanthropy.

Economic competition may also play a role – if billions are to be made by innovators, more of the most talented get into innovation, so that, even in a winner-take-all world, the winner captures the market for a fleeting moment before someone else takes it away from him. The billions to be made today may only be millions tomorrow.

And values also adjust. While a quartz watch keeps time more accurately than the most finely crafted handmade mechanical Swiss watch, the value of a quartz watch has plummeted, while Swiss watches’ value has climbed into the stratosphere. Even though they are virtually indistinguishable in appearance, people seem to cherish the knowledge that someone has lovingly crafted their watch.

So it may well be that the demand for discussing medieval French church music in small classes at a university will grow even as the demand for MOOCs grows. Not everyone should heed Andreessen’s exhortation to quit liberal arts programs!

That is not to say that his basic concerns are unwarranted. Better access for all to fundamental needs like quality education is necessary to make the winner-take-all character of markets more tolerable. But societies may also have to change. If we are lucky, the changes will take place spontaneously.

Debt Driven Demand

Sat, 26 Jan 2013 05:14:03 GMT

NEW DELHI – Two fundamental beliefs have driven economic policy around the world in recent years. The first is that the world suffers from a shortage of aggregate demand relative to supply; the second is that monetary and fiscal stimulus will close the gap.

Is it possible that the diagnosis is right, but that the remedy is wrong? That would explain why we have made little headway so far in restoring growth to pre-crisis levels. And it would also indicate that we must rethink our remedies.

High levels of involuntary unemployment throughout the advanced economies suggest that demand lags behind potential supply. While unemployment is significantly higher in sectors that boomed before the crisis, such as construction in the United States, it is more widespread, underpinning the view that greater demand is necessary to restore full employment.

Policymakers initially resorted to government spending and low interest rates to boost demand. As government debt has ballooned and policy interest rates have hit rock bottom, central banks have focused on increasingly innovative policy to boost demand. Yet growth continues to be painfully slow. Why?

What if the problem is the assumption that all demand is created equal? We know that pre-crisis demand was boosted by massive amounts of borrowing. When borrowing becomes easier, it is not the well-to-do, whose spending is not constrained by their incomes, who increase their consumption; rather, the increase comes from poorer and younger families whose needs and dreams far outpace their incomes. Their needs can be different from those of the rich.

Moreover, the goods that are easiest to buy are those that are easy to post as collateral – houses and cars, rather than perishables. And rising house prices in some regions make it easier to borrow yet more to spend on other daily needs such as diapers and baby food.

The point is that debt-fueled demand emanates from particular households in particular regions for particular goods. While it catalyzes a more generalized demand – the elderly plumber who works longer hours in the boom spends more on his stamp collection – it is not unreasonable to believe that much of debt-fueled demand is more focused. So, as lending dries up, borrowing households can no longer spend, and demand for certain goods changes disproportionately, especially in areas that boomed earlier.

Of course, the effects spread through the economy – as demand for cars falls, the demand for steel also falls, and steel workers are laid off. But unemployment is most pronounced in the construction and automobile sectors, or in a region where house prices rose particularly rapidly.

It is easy to see why a general stimulus to demand, such as a cut in payroll taxes, may be ineffective in restoring the economy to full employment. The general stimulus goes to everyone, not the former borrowers. Their spending patterns differ – the older, wealthier household buys jewelry from Tiffany, rather than a car from General Motors. And even the former borrowers are unlikely to use their stimulus money to pay for more housing – they have soured on the dreams that housing held out.

Indeed, because the pattern of demand that is expressible has shifted with the change in access to borrowing, the pace at which the economy can grow without inflation may also fall. With too many construction workers and too few jewelers, greater demand may result in higher jewelry prices rather than more output.

Put differently, the bust that follows years of a debt-fueled boom leaves behind an economy that supplies too much of the wrong kind of good relative to the changed demand. Unlike a normal cyclical recession, in which demand falls across the board and recovery requires merely rehiring laid-off workers to resume their old jobs, economic recovery following a lending bust typically requires workers to move across industries and to new locations.

There is thus a subtle but important difference between my debt-driven demand view and the neo-Keynesian explanation that deleveraging (saving by chastened borrowers) or debt overhang (the inability of debt-laden borrowers to spend) is responsible for slow post-crisis growth. Both views accept that the central source of weak aggregate demand is the disappearance of demand from former borrowers. But they differ on solutions.

The neo-Keynesian economist wants to boost demand generally. But if we believe that debt-driven demand is different, demand stimulus will at best be a palliative. Writing down former borrowers’ debt may be a little more effective in producing the old pattern of demand, but it will probably not restore it to the pre-crisis level. In any case, do we really want the former borrowers to borrow themselves into trouble again?

The only sustainable solution is to allow the supply side to adjust to more normal and sustainable sources of demand – to ease the way for construction workers and autoworkers to retrain for faster-growing industries. The worst thing that governments can do is to stand in the way by propping up unviable firms or by sustaining demand in unviable industries through easy credit.

Supply-side adjustments take time, and, after five years of recession, economies have made some headway. But continued misdiagnosis will have lasting effects. The advanced countries will spend decades working off high public-debt loads, while their central banks will have to unwind bloated balance sheets and back off from promises of support that markets have come to rely on.

Frighteningly, the new Japanese government is still trying to deal with the aftermath of the country’s two-decade-old property bust. One can only hope that it will not indulge in more of the kind of spending that already has proven so ineffective – and that has left Japan with the highest debt burden (230% of GDP) in the OECD. Unfortunately, history provides little cause for optimism.