Raghuram Rajan: Going bust for growth
Remarks by Dr Raghuram Rajan, Governor of the Reserve Bank of India, to the Economic
Club of New York, New York City, 19 May 2015.
* * *
Raghuram Rajan thanks Dr. Prachi Mishra of the Reserve Bank for very useful comments and research support.
There are few areas of robust growth around the world, with the IMF repeatedly reducing its
growth forecasts in recent quarters. This period of slow growth is particularly dangerous
because both industrial countries and emerging markets need high growth to quell rising
domestic political tensions. Policies that attempt to divert growth from others rather than
create new growth are more likely under these circumstances. Even as we create conditions
for sustainable growth, we need new rules of the game, enforced impartially by multilateral
organizations, to ensure countries adhere to international responsibilities.
The conventional diagnosis and remedy
Why is the world finding it so hard to restore pre-Great Recession growth rates? The obvious
answer is that the financial boom preceding the Great Recession left industrial countries with
an overhang of debt, and debt, whether on governments, households, or banks, is holding
back growth.1 While the remedy may be to write down debt so as to revive demand from the
indebted, it is debatable whether additional debt fuelled demand is sustainable in the long
run. At any rate, large-scale debt write-offs (or fiscal transfers to the heavily indebted) seem
politically difficult even if they are economically warranted.
How does one offset weak household and government demand if debt write-downs are off
the table? Ideally, the response would be to incentivize investment and job creation through
low interest rates and tax incentives. But if final demand from consumers is likely to be very
weak for a considerable period of time because of debt overhang, the real return on new
investment may collapse. The Wicksellian neutral real rate - loosely speaking the interest
rate required to bring the economy back to full employment with stable inflation - may even
be strongly negative.2 This typically has been taken as grounds for aggressive monetary
policy. Because policy rates cannot be reduced significantly below zero (though a number of
European countries are testing these limits), equilibrium long term interest rates may stay
higher than levels necessary to incentivize investment. Hence, central banks have embarked
on unconventional monetary policy (UMP), which would directly lower long rates.
Another way to stimulate demand is for governments that still have the ability to borrow to
increase spending. Since this will increase already-high levels of government debt,
proponents suggest investing in infrastructure, which may have high returns today when
construction costs and interest rates are low. However, high-return infrastructure investment
is harder to identify and implement in developed countries where most obvious investments
have already been made - political influence is as likely to create bridges to nowhere or
unviable high speed train networks as needed infrastructure. Also, while everyone can see
the need for repair and renovation of existing infrastructure, this requires far more
decentralized spending than mega projects, and may be harder to initiate and finance from
the centre.
Put differently, high-return infrastructure investment is a good idea but may be hard to
implement on a large scale for most advanced country governments. To the extent that such
debt fuelled spending creates a self-fulfilling virtuous cycle of confidence and activity, it can
be a bridge to sustainable growth. But to the extent that it misallocates capital (because there
are insufficient "shovel-ready" projects, so much of the emergency spending is diverted to
rent-seeking pork), it can worsen public anxieties about the future, reducing corporate
investment and increasing household savings.
All this highlights another concern. Even if stimulus works in raising growth temporarily - and
the above discussion suggests it may not - this growth has to be a bridge to sustained
aggregate demand. But what if it isn't?
The productivity puzzle, secular stagnation, and other concerns.
The arguments I have just enunciated for action apply to an economy where nothing
fundamentally is wrong except perhaps excessive debt - what is needed is a cyclical return
of growth to potential growth. Yet a number of economists such as Tyler Cowen, Robert
Gordon, and Larry Summers have raised the possibility that potential growth in industrial
countries had fallen even before the Great Recession. Perhaps then the growth that we are
trying to return to is unachievable without serious distortions.
The term "secular stagnation" used by Larry Summers to describe the current persistent
economic malaise, echoing Alvin Hansen's speech in 1938 in the midst of the Great
Depression, has caught on.3 But different economists focus on different aspects and causes
of the stagnation.4 Summers emphasizes the inadequacy of aggregate demand, and the fact
that the zero lower bound as well as the potential for financial instability prevents monetary
policy from being more active. Among the reasons for weak aggregate demand include
ageing populations that want to consume less and the increasing income share of the very
rich, whose marginal propensity to consume is small.
Tyler Cowen and Robert Gordon on the other hand, emphasize a weak supply potential.5
They argue that the post-World War II years were an aberration because growth was helped
in industrial countries by reconstruction, the spread of technologies such as electricity,
telephones, and automobiles, rising educational attainment, higher labour participation rates
as women entered the work force, a restoration of global trade, and increasing investments
of capital. However, post-war total factor productivity growth - the part of growth stemming
from new ideas and methods of production - was lower than its 1920-50 high. More recently,
not only has productivity growth fallen further (with a temporary positive uptick towards the
end of the 1990s because of the IT revolution), but growth has been held back by the
headwinds of plateauing education levels and labour participation rates, as well as a
shrinking labour force in some countries because of population ageing.
It is obvious from these lists of factors that it is hard to disentangle the effects of weak
aggregate demand from slow growth in potential supply. Population ageing contributes to
both. Indeed, one may cause the other. For example, anticipating a slowdown in growth
potential, households, worried about impending retirement in the face of undeliverable
pension and healthcare entitlements, may try and build savings. This will depress demand
further. Conversely, anticipated weak demand may reduce incentives for corporations to
invest in physical and human capital, causing supply potential to grow more slowly.
Structural reforms, typically ones that increase competition, foster innovation, and drive
institutional change, are the way to raise potential growth. But these immediately hurt
protected constituencies that have become accustomed to the rents they get from the status
quo. Moreover, the gains to constituencies that are benefited are typically later and uncertain
while the pain is immediate and its incidence clear. No wonder Jean-Claude Juncker, then
Luxembourg's prime minister, said at the height of the Euro crisis, "We all know what to do,
we just don't know how to get re-elected after we've done it!"
The growth imperative
If indeed fundamentals are such that that the industrial world has, and will, grow slowly for a
while before new technologies and new markets come to the rescue, would it be politically
easy to settle for slower growth? After all, per capita income is high in industrial countries,
and a few years of slow growth would not be devastating at the aggregate level. Why is there
so much of a political need for growth?
One reason is the need to fulfil government commitments. As sociologist Wolfgang Streeck
writes, in the strong growth years of the 1960s when visions of a "Great Society" seemed
attainable, industrial economies made enormous promises of social security to the wider
public.6 Promises have been augmented since then in some countries by politically
convenient (because hidden from budgets) but fiscally unsound increases in pension and old
age healthcare commitments to public sector workers. And most recently, the government
debt taken on before and after the Great Recession has added to government commitments,
even while the Baby Boomer generation has started retiring in large numbers. Without the
immediate promise of growth, all these commitments could soon be seen as unsustainable.
Another reason to desire growth is that economies tend to favour insiders - those who have
jobs for example. The brunt of the joblessness caused by slow growth is born by new
entrants to the labour market. Not only are they unemployed in larger numbers, but the
lifetime earnings of cohorts that enter the labour force in difficult times is lower. Growth is
necessary for inter-generational equity, especially because these are the generations that
will be working to pay off commitments to older generations. Given these are also the cohorts
that can take to the streets, growth is essential for social harmony.
Not only are the benefits of growth unequally distributed across generations, they are also
very unequally distributed within generation. Because of changes in technology and the
expansion of global competition, routine repetitive jobs, whether done by the skilled or the
unskilled, have diminished greatly in industrial countries. Many of these jobs, ranging from
assembly line worker to legal aides or insurance clerks, have either been automated or
outsourced. The desirable high-paying jobs are non-routine skilled ones such as that of a
consultant or an app designer, but they require skills. The middle class recognizes that they
need quality higher education and training to not slip into competing with the poor for
lowskilled non-routine jobs such as security guard or gardener. But the poor quality early
education they have received, as well as the prohibitive cost of quality higher education, puts
many better livelihoods out of reach. With every percentage point of growth creating fewer
"good" jobs for the unskilled or moderately skilled, more growth is needed to keep them
happily employed. Equally, the rapid deterioration in skills for the unemployed is an additional
reason to push for growth.
The deflation fear
Finally, a big factor persuading authorities in industrial countries to push for higher growth is
the fear of deflation. The canonical example here is Japan, where many are persuaded that
the key mistake it made was to slip into deflation, which has persisted and held back growth.
A closer look at the Japanese experience suggests that it is by no means clear that its
growth has been slower than warranted let alone that deflation caused slow growth. It is true
that after its devastating crisis in the early 1990s, Japan may have prolonged the slowdown
by not taking early action to clean up its banking system or restructure over-indebted
corporations. But once it took decisive action in the late 1990s and early 2000s, Japanese
growth per capita or per worker looks comparable with other industrial countries (Table 1).7
Slow aggregate Japanese economic growth may simply be because its population is
shrinking, and fewer people are entering the labour force rather than because it is
underperforming other developed economies.
What about the deleterious effects of deflation? One worrisome effect of deflation is that if
wages are downwardly-sticky, real wages rise and cause unemployment. Yet Japanese
unemployment has averaged 4.5% between 2000-2014, compared to 6.4% in the US and
9.4% in the Euro area during the same period.8 In part, the Japanese have obtained wage
flexibility by moving away from the old lifetime unemployment contracts for new hires to short
term contracts. Indeed, with the decline in union power across industrial countries and the
increase in temporary or even "zero hour" workers, downward wage flexibility may be
significantly higher than previously estimated. While not without social costs, such flexibility
allows an economy to cope with sustained deflation.
Another concern has been that moderately low inflation spirals down into seriously large
deflation, where the zero lower bound on nominal interest rates keeps real interest rates
unconscionably high. Once again, it is not clear this happened in Japan. In the years 1999 to
2012, average CPI deflation ranged between -0.01% in 2004 to -1.3% in 2009, but without
any clear spiralling pattern (Figure 1).
Even if deflation is moderate, it may cause customers to postpone purchases and increase
savings in anticipation of a lower price in the future, especially if the zero lower bound raises
real interest rates above their desired value. In Fig 2, we plot household savings as a share
of GDP in Japan against the deflation rate. Again, it is hard to see a sustained pattern of
higher savings with higher deflation.
Finally, it is true that deflation increases the real burden of existing debt, thus exacerbating
debt overhang. But this is true of any unanticipated disinflation, and is not specific to
deflation. If debt is excessive, a targeted restructuring is better than inflating it away across
the board.
Regardless of all these arguments, the spectre of deflation haunts central bankers. When
coupled with the other political concerns raised by slow and unequal growth listed above, it is
no wonder that the authorities in developed countries do not want to settle for low growth,
even if that is indeed their economy's potential.
So the central dilemma in industrial economies has been how to reconcile the political
imperative for strong growth with the reality that cyclical stimulus measures have proved
ineffective in restoring high growth, debt write-offs are politically unacceptable, and structural
reforms have the wrong timing, politically speaking, of pain versus gain. There is, however,
one other channel for growth - exports.
Emerging market response
If industrial countries are stuck in low growth, can emerging markets (I use the term broadly
to also stand for developing or frontier markets) take up the global slack in demand? After all,
emerging markets have a clear need for infrastructure investment, as well as growing
populations that can be a source of final demand. Why cannot industrial countries export to
emerging markets as a way to bolster growth? After all, they have done so in the past.
Emerging markets have no less of an imperative for growth than industrial countries. While
many do not have past entitlement promises to deliver on, some have ageing populations
that have to be provided for, and many have young, poor, populations with sky-high
expectations of growth. Ideally, emerging markets would invest for the future, funded by the
rich world, thus bolstering aggregate world demand.
The 1990s were indeed a period when emerging markets borrowed from the rest of the world
in attempting to finance infrastructure and development. It did not end well, with credit
booms, large unviable prestige projects, and eventual busts. The Mexican Crisis of 1994, the
Asian Crisis of 1997-98, and the Argentinian Crisis of 2001 highlighted the inability of
emerging markets to manage large increases in domestic investment funded by foreign
capital inflows. The lesson from the 1990s crises was that emerging market reliance on
foreign capital for growth was dangerous. With investment prudently limited to domestic
savings, this naturally curtailed their ability to serve as growth engines for the world.
Following the 1990s crises, as the dotted line in Figure 3 indicates, a number of emerging
markets went further to run current account surpluses after cutting investment sharply, and
started accumulating foreign exchange reserves to preserve exchange competitiveness.
Rather than generating excess demand for the world's goods, they became suppliers (or
equivalently, savers), searching for demand elsewhere. And the debt-fuelled demand from
the industrial countries before the Global Financial Crisis, as indicated by their current
account deficits, spilled over into a demand for emerging market goods. The years before the
crisis were years of plenty for countries like China that catered directly to industrial country
demand, and countries in Africa, Asia, and Latin America that sold commodities and
intermediate goods to the direct suppliers.
In 2005, Ben Bernanke, then a governor at the Federal Reserve, coined the term "Global
Savings Glut" to describe the current account surpluses, especially of emerging markets, that
were finding their way into the United States.9 He argued that these depressed U.S. interest
rates, enhancing consumption, and the U.S. current account deficit. Bernanke pointed to a
number of adverse consequences to the United States from these flows including the
misallocation of resources to non-traded goods like housing away from tradable
manufacturing. He suggested that it would be good if United States' current account deficit
shrank, but that primarily required emerging markets to reduce their exchange rate
intervention rather than actions on the part of the United States.
So pre-global financial crisis, emerging markets and industrial countries were locked in a
dangerous relationship of capital flows and demand that reversed the equally dangerous
pattern before the emerging market crises in the late 1990s. Sustained exchange rate
intervention by emerging market central banks, as well as an excessive tolerance for
leverage in industrial countries contributed to the eventual global disaster. But post-financial
crisis, the pattern is reversing once again.
Post global financial crisis, much like the emerging markets in the early 2000s, industrial
countries have curtailed their investment without increasing their consumption (as a fraction
of GDP), thus reducing their demand for foreign goods and their reliance on foreign finance.
Indeed, as the solid line in Figure 3 indicates, advanced economies ran current account
surpluses in 2013 and were also projected to do so in 2014, a shift in current account
balances of about 1.5 percentage points of GDP since 2008.
The counterpart of this shift of advanced economies from current account deficit (demand
creating) to surplus (supply creating) has been a substantial fall in current account surpluses
in emerging markets over the same period. This relative increase in demand for foreign
goods from emerging markets has come about through a ramp up in investment from 2008,
rather than a fall in savings - a shift of 2.7 percentage points of GDP in current account
balances between 2008 and 2014. Facilitating or causing this shift has been a broad
appreciation of real effective exchange rates in emerging markets and a depreciation in
industrial country rates between 2006-2014.
Have industrial country central banks policies, similar to the sustained exchange rate
intervention by emerging market central banks in the early 2000s, accelerated this current
account adjustment? Possibly, and likely candidates would be what are broadly called
unconventional monetary policies (UMP).
Unconventional monetary policy
Unconventional monetary policies include both policies where the central bank attempts to
commit to hold interest rates at near zero for long, as well as policies that affect central bank
balance sheets such as buying assets in certain markets, including exchange markets, in
order to affect market prices.10
There clearly is a role for unconventional policies - when markets are broken or grossly
dysfunctional, central bankers may step in with their balance sheets to mend markets. The
key question is what happens when these policies are prolonged long beyond repairing
markets to actually distorting them. The benefit to cost ratio there is less clear.
Take, for instance, the zero-lower-bound problem. Because short term policy rates cannot be
pushed much below zero, and because long rates tack on a risk premium to short rates,
central banks may use UMP to directly affect long rates. Direct action by a risk tolerant
central bank, such as purchasing long bonds, effectively shrinks the risk premium available
on remaining long assets.11
This has two effects. First, those who can rebalance between short and long assets now
prefer holding short term assets because, risk adjusted, these are a better deal. Thus as the
central bank increases bond purchases under quantitative easing, the willingness of
commercial banks to hold unremunerated reserves rather than long term assets increases.
Second, those institutions that cannot shift to short term assets, such as pension funds, bond
mutual funds, and insurance companies, will either continue holding their assets and suffer a
relative under-compensation for risk, or turn to riskier assets. This behaviour, also termed the
search for yield, will occur if the relative under-compensation for risk in more exotic assets is
lower, or simply because institutions have to meet a fixed nominal rate of return constraint on
their portfolios. Of course, such portfolio rebalancing will also take place because the central
bank buys long duration bonds out of institutional portfolios, leaving them cash to redeploy.
None of this need be a problem if everyone knows when to stop. Unfortunately, there are few
constraints on central banks undertaking these policies since they are self-financing
(commercial banks become more willing to hold central bank reserves as the risk premium
on long bonds shrinks). If the policy does not seem to be increasing growth, one can simply
do more. All the while, the distortion in asset prices and the mis-allocation of funds can
increase, which can be very costly when the central bank decides to exit.
Equally important though, is that domestic fund managers can search for yield abroad,
depreciating the sending country's currency and causing the receiving country's currency to
appreciate, perhaps significantly more so than ordinary monetary policy. This may indeed
cause the increase in domestic competitiveness that could energize the sending country's
exports. But such increases in competitiveness and "demand shifting" can be very
detrimental for global stability, especially if unaccompanied by domestic demand creation.
Spill overs to emerging markets and musical crises
If UMP enhances financial risk taking in the originating country without enhancing domestic
investment or consumption, the exchange rate impact of UMP may simply shift demand
away from countries not engaging in UMP, without creating much compensating domestic
demand for their goods. If so, UMP would resemble very much the exchange rate
intervention policies of the emerging markets pre-global financial crisis.
Indeed, the post-global crisis capital flows into emerging markets have been huge, despite
the best efforts of emerging markets to push them back by accumulating reserves (net
capital flows to emerging economies reached US$ 550 bn in 2013 compared to US$120 bn
in 2006).12, These flows have increased local leverage, not just due to the direct effect of
cross-border banking flows but also the indirect effect, as the appreciating exchange rate and
rising asset prices, especially of real estate, make it seem that emerging market borrowers
have more equity than they really have. Bernanke's concerns in 2005 about mal-investment
in the United States resulting from capital inflows from emerging markets have surfaced in
emerging markets post-crisis as a result of capital inflows from industrial countries.
Have crises in emerging markets in the 1990s been transformed into crises in industrial
countries in the 2000s and once again into vulnerabilities in emerging markets in the 2010s,
as countries react to the problem of inadequate global demand by exporting their problems to
other countries? The "taper tantrum" in July 2013 certainly seemed to suggest that emerging
markets that ran large current account deficits were vulnerable once again.14 Is the world
engaged in a macabre game of musical crises as each country attempts to boost growth? If
possibly yes, as suggested by the previous discussion, how do we break this cycle?
Good policies...and good behaviour
In an ideal world, the political imperative for growth would not outstrip the economy's
potential. Given that we do not live in such a world, and given that social security
commitments, over-indebtedness, and poverty are not going to disappear, it is probably wiser
to look for ways to enhance sustainable growth.
Clearly, the long run response to weak global growth should be policies that promote
innovation as well as structural reforms that enhance efficiency. Given that growth within
countries is poorly distributed, policies that improve the domestic distribution of capabilities
and opportunities without significantly dampening incentives for innovation and efficiency are
also needed.
In the short run though, the need for sensible investment is paramount. In industrial
countries, green energy initiatives such as carbon taxes or emission limits, while giving
industry clear signals on where to invest, also have the ability to move the needle on
aggregate investment and help long run goals on environment protection.
Most emerging markets have large infrastructure investment needs. We still need to
understand how to improve project selection and finance - too much public sector
involvement results in sloth and rent seeking, too much private sector involvement leads to
risk intolerance and profiteering. Going forward, well-designed public private partnerships,
drawing on successful experiences elsewhere, should complement private initiative.
The Australian Presidency of the G 20 created a welcome mechanism to share best
investment practices across countries. At the same time, we must recognize that large scale
investment projects need patient risk capital, which is in short supply in emerging markets.
Private investors rarely have the risk tolerance that governments or multilateral institutions
12
Based on the World Economic Outlook database. Emerging economies include "emerging and developing"
countries. Net capital flows include net direct investment, net portfolio investment, and "other" net investment.
13
Indeed, similar to the behavior of commercial banks, the willingness of emerging market central banks to hold
short term paper in response to capital inflows enhances the ability of the industrial country central bank to
engage in further UMP. In a sense, emerging market central banks provide liquidity for foreign investors by
holding precautionary reserves.
14
For those who advocate allowing exchange rate adjustment as central to macro-management, it should be
sobering that countries that allowed the real exchange rate to appreciate the most during the prior period of
quantitative easing suffered the greatest adverse impact to financial conditions (see Eichengreen, Barry and
Poonam Gupta (2013), "Tapering Talk: The Impact of Expectations of Reduced Federal Reserve Security
Purchases on Emerging Markets", Working Paper, University of California, Berkeley and Mishra, Prachi, Kenji
Moriyama, Papa N'Diaye and Lam Nguyen (2014), "The Impact of Fed Tapering Announcements on Emerging
Markets", IMF working paper).
have. So, in addition to knowledge sharing, global growth would benefit from an
augmentation of the capital base of multilateral institutions like the World Bank, the African
Development Bank, and the Asian Development Bank, so that they can provide part of the
patient risk tolerant capital the emerging world needs. Despite competing domestic demands,
industrial countries should recognize the important catalytic role that the development banks
can play and help bolster their capital. At the very least, they should not stand in the way of
others augmenting capital and taking more ownership.
Clearly, sensible investment has a much better chance of paying dividends when
macroeconomic policies are sound. And such policies are easier when the adverse spill
overs from cross-border capital flows are limited. This may require new rules of the game for
policy making.
New rules of the game?
How do we focus on domestic demand creation and avoid this game of musical crises with
countries trying to depreciate their exchange rate through sustained direct exchange rate
intervention or through unconventional monetary policies (where demand creating
transmission channels are blocked)?15 It might be useful to examine and challenge the
rationales used to justify such actions.
Rationale 1: Would the world not be better off if we grew strongly?
Undoubtedly, if there were no negative spill overs from a country's actions, the world would
indeed be better off if the country grew. But the whole point about policies that primarily
affect domestic growth by depreciating the domestic exchange rate is that they work by
pulling growth from others, not creating growth for others.
Rationale 2: We are in a deep recession. We need to use any means available to jump start
growth. Once we get out of recession, the payoff for other countries from our growth will be
considerable.
This may be a legitimate rationale if the policy is a "one-off" and once the country gets out of
its growth funk, it is willing to let its currency appreciate so that it absorbs imports, thus
pulling other countries with it. But if the strengthening currency leads to a continuation of the
unconventional policies as the country's authorities become unwilling to give back the growth
they obtained by undervaluing their currency, or if the strengthening currency leads to
greater domestic political clamour about foreign countries undervaluing their currencies, this
rationale is suspect. Moreover, policies that encourage sustained unidirectional capital
outflows to other countries can be very debilitating for the recipient's financial stability, over
and above any effects on their competitiveness. Thus any "one-off" has to be limited in
duration.
Rationale 3: Our domestic mandate requires us to do what it takes to fulfil our inflation
objective, and unconventional monetary policy is indeed necessary when we hit against the
zero lower bound.
This rationale has two weaknesses. First, it places a domestic mandate above an
international responsibility. If this were seen to be legitimate, then no country would ever
respect international responsibilities when inconvenient. Second, it implicitly assumes that
the only way to achieve the inflation mandate is through unconventional monetary policy
(even assuming UMPs are successful in elevating inflation on a sustained basis, for which
there is little evidence).
Rationale 4: We take into account the feedback effects to our economy from the rest of the
world while setting policy. Therefore, we are not oblivious to the consequences of
unconventional monetary policies on other countries.
Ideally, responsible global citizenship would require a country to act as it would act in a world
without boundaries. In such a world, a policy maker should judge whether the overall positive
domestic and international benefits of a policy, discounted over time, outweigh its costs.
Some policies may have largely domestic benefits and foreign costs, but they may be
reasonable in a world without boundaries because more people are benefited than are hurt.
By this definition, Rationale 4 does not necessarily amount to responsible global citizenship
because a country only takes into account the global "spillbacks" to itself from any policies it
undertakes, instead of the spill overs also. So, for example, Country A may destroy industry I
in country B through its policies, but will only take into account the spillback from industry I
purchasing less of country A's exports.
Rationale 5: Monetary policy with a domestic focus is already very complicated and hard to
communicate. It would be impossibly complex if we were additionally burdened with having
to think about the effects of (unconventional) monetary policies on other countries.
This widely-heard rationale is really an abandonment of responsibility. It amounts to
asserting that the monetary authority only has a domestic mandate, which is Rationale 3
above. In an interconnected globalized world, "complexity" cannot be a defense.
Rationale 6: We will do what we must, you can adjust.
Adjustments are never