That said, there are a number of parallels, both in U.S. history and in the contemporary experience of emerging markets, for the use of credit as a populist palliative. A previous episode of high income inequality in the United States came toward the end of the nineteenth century and the beginning of the twentieth century. As small and medium-sized farmers perceived that they were falling behind, their grievances about the lack of access to credit and the need for banking reforms were articulated by the Populist Party. Pressure from such quarters helped accelerate the deregulation of banking and the explosion of banks in the early part of the twentieth century. Indeed, in North Dakota, after a Populist candidate won the 1916 gubernatorial race with the support of small farmers, the Populist Party created the United States’ first state-owned bank, the Bank of North Dakota.50 The explosion in rural bank credit was followed in the 1920s by a steady decline in the prices of agricultural produce, widespread farmer distress, and the failure of a large number of small rural banks. As in the recent crisis, populist credit expansion went too far.
The tradition of using government-linked financial institutions to expand credit to politically important constituencies of moderate creditworthiness is also well established in emerging markets. For example, Shawn Cole, a professor at Harvard Business School, finds that Indian state-owned banks increase their lending to the politically important but relatively poor constituency of farmers by about 5 to 10 percentage points in election years.51 The effect is most pronounced in districts with close elections. The consequences of the lending are greater loan defaults and no measurable increase in agricultural output, which suggest that it really serves as a costly form of income redistribution. Most recently, the coalition United Progressive Alliance (UPA) government waived the repayment of loans made to small and medium-sized farmers just before the 2009 elections, an act that some commentators believed helped the coalition get reelected. Populism and credit are familiar bedfellows around the world.
Summary and Conclusion
Growing income inequality in the United States stemming from unequal access to quality education led to political pressure for more housing credit. This pressure created a serious fault line that distorted lending in the financial sector. Broadening access to housing loans and home ownership was an easy, popular, and quick way to address perceptions of inequality. Politicians set about achieving it through the agencies and departments they had set up to deal with the housing-debt disasters during the Great Depression. Ironically, the same organizations may have helped precipitate the ongoing housing catastrophe.
This is not to fault their intent. Both the Clinton administration’s attempt to make housing affordable to the less well-off and the Bush administration’s attempt to expand home ownership were laudable. They were also politically astute in that they focused on alleviating the concerns of those being left behind while buying time for more direct policies to work. But the gap between government intent and outcomes can be very wide indeed, especially when action is mediated through the private sector. More always seems better to the impatient politician. But any instrument of government policy has its limitations, and what works in small doses can become a nightmare when scaled up, especially when scaled up quickly. Some support to low-income housing might have had benefits and prompted little private-sector reaction. But support at a scale that distorted housing prices and private-sector incentives was too much. Furthermore, the private sector’s objectives are not the government’s objectives, and all too often policies are set without taking this disparity into account. Serious unintended consequences can result.
Successive governments pushed Fannie and Freddie to support low-income lending. Given their historical focus on prime mortgages, these agencies had no direct way of originating or buying subprime loans in the quantities that were being prescribed. So in the years of the greatest excess, they bought subprime mortgage-backed securities, but without adjusting for the significantly higher risks that were involved. And the early rewards from taking these risks were higher profits. That there also were very few defaults initially emboldened the agencies to plunge further, and their weak and politically influenced regulator did little to restrain them. At the same time, as brokers came to know that someone out there was willing to buy subprime mortgage-backed securities without asking too many questions, they rushed to originate loans without checking the borrowers’ creditworthiness, and credit quality deteriorated. But for a while, the problems were hidden by growing house prices and low defaults—easy credit masked the problems caused by easy credit—until house prices stopped rising and the flood of defaults burst forth.
On net, easy credit, as is typically the case, proved an extremely costly way to redistribute. Too many poor families who should never have been lured into buying a house have been evicted after losing their meager savings and are now homeless; too many houses have been built that will not be lived in; and too many financial institutions have incurred enormous losses that the taxpayer will have to absorb for years to come. Although home ownership rates did go up—from 64.2 percent of households in 1994 to 69.2 percent in 2004—too many households that could not afford to borrow were induced to do so, and since 2004, even home ownership has declined steadily (to 67.2 percent as of the fourth quarter of 2009), with the rate likely to fall further as many households face foreclosure.52
This is a lesson that needs to be more widely absorbed. Few “solutions” hold more support and promise up front, and lead to more recrimination after the fact, than opening the spigot of lending. For poor countries there is a strong parallel with the past enthusiasm for foreign aid. Now we know that aid leads to dependency, indebtedness, and poor governance and rarely leads to growth.53 The new miracle solution is microcredit—lending to the poor through group loans, a system in which peer pressure from the group makes individuals more likely to repay. Although it has promise on a small scale, history suggests that when scaled up, and especially when used as an instrument of government policy, it will likely create significant problems.
So what should the United States do to deal with the waning of the American dream, with the shrinking of opportunities for the large mass of the American people? Ignoring the problem will only make matters worse. Inequality feeds on itself. Moreover, it will precipitate a backlash. When people see a dim economic future in a democracy, they work through political channels to obtain redress, and if the political channel does not respond, they resort to other means. The first victims of a political search for scapegoats are those who are visible and easily demonized, but powerless to defend themselves. Illegal immigrants and foreign workers do not vote, but they are essential to the economy—the former because they often do jobs no one else will touch in normal times, and the latter because they are the source of the cheap imports that have raised the standard of living for all, but especially those with low incomes. There has to be a better way than simply finding scapegoats, and I examine possible solutions in subsequent chapters.
At this point, though, I want to turn to a problem that was growing in magnitude elsewhere in the world. Even as political compulsions in the United States were pushing it to become more favorable to boosting consumption, countries like Germany and Japan, which were extremely dependent on exports for growth, were accounting for a larger share of the world economy. Why they, and a growing number of emerging markets, have become dependent in this way, and the consequences of such dependence for countries like the United States, are the issues I turn to now.
CHAPTER TWO
Exporting to Grow
I GREW UP IN DIFFERENT PARTS of the world because my father was an Indian diplomat. My first real memories of India are from my early teens, in the mid-1970s, when he returned to work in Delhi. It was not an easy time. We were not poor, but my parents had to bring up four children on my father’s government salary. More problematic, there was very little to buy, especially for children who had grown used to the plentiful choices in European supermarkets. Every evening,
one of us children trudged around the local markets looking for bread. The government was trying to limit the production of “unnecessary” consumer goods, of which bread was deemed one. Moreover, because the government also regulated the official sale price for bread, the little that was produced was diverted to favored clients and sold at black-market prices. So we went around the empty stores, trying to ingratiate ourselves with the shopkeepers in the hope that one would sell us half a loaf of bread from his hidden stock—at twice the fixed price. I remember the joy we felt when a friend’s brother bought a shop in the market. My new connections ensured our bread supply, allowing us to stop haunting the market.
We were not so lucky in our quest for a car. High import duties made foreign cars unaffordable. The government allowed only three domestic firms to produce cars, and only in limited quantities, for cars were deemed unnecessary as well. The only Indian-made car that could accommodate our large family was the Ambassador—a local version of the 1954 Oxford Morris, virtually unchanged from the original. But the waiting list for an Ambassador, which in most other countries would be deemed an antique, was years. So my father settled for a scooter that he rode to work. Because public transport was unreliable, family outings were rare.
The government wanted to limit consumption and encourage savings, and households did save a lot. But there were also unintended consequences. Because goods were in short supply and prices were fixed at ludicrously low levels, little was available in the open market. Black markets flourished: everything could be obtained if you had cash or connections. Few jobs were created: the production of more cars would have meant more demand for restaurants and cinemas and thus more jobs not only for auto workers but also for waiters and ticket clerks. I thought there might be some grand design I did not understand, but the government’s policy clearly was not working, because India was still poor. I was determined to learn more, so I became interested in economics. This book is another unintended consequence of the government’s policies.
Thirty-five years later, it is relatively easy to describe the typical path that successful countries have followed in the search for growth. It has emphasized both substantial government intervention in the early stages—which is why I broadly refer to it as relationship or managed capitalism—and a focus on exports. Although easy to describe, it is much harder to implement. At key junctures, the government has to take steps that go against its natural inclinations; the India of my youth muffed the game plan. Perhaps this is one reason why only a handful of countries have grown rapidly out of poverty in recent years.
The export-led managed-growth strategy, when implemented well, has been the primary path out of poverty in the postwar era. In the early days of this strategy, the exporters were small enough to allow the rest of the world to boost its spending and absorb the exports easily. Unfortunately, even as exporters like Germany and Japan have become large and rich, the habits and institutions they acquired while growing have left them unable to generate strong, sustainable domestic demand and become more balanced in their growth.
The surpluses they put out into the global goods markets have circled the world, looking for those who have the creditworthiness to buy the goods, and tempting countries, companies, and households around the world into spending. In the 1990s, developing countries ran the trade deficits necessary to absorb these goods: the next chapter shows how many of them suffered deep financial crises and forswore further deficits and borrowing. Even as developing countries dropped the hot potato of foreign-debt-financed spending in the late 1990s, the United States, as well as European countries such as Greece, Spain, and the United Kingdom, picked it up. First, though, I want to describe the export-led managed growth strategy and why it worked.
The Elusive Search for Growth
Few people realize that many of today’s wealthy nations are rich today because they grew steadily for a long time, not because they grew particularly fast. Between 1820 and 1870, the per capita incomes of Australia and the United States, the fast-growing emerging markets of their time (I refer to them as early developers), grew annually at 1.8 percent and 1.3 percent, respectively.1 By contrast, late developers like Chile, South Korea, and Taiwan, which joined the ranks of wealthier nations only in recent decades, grew at multiples of these rates over a shorter period. Japan was not quite a poor country in 1950 (though in 1950 its per capita income was lower than Mexico’s). However, between 1950 and 1973, Japanese per capita income grew at a rate of around 8 percent a year. These late developers have set the aspirational level for today’s developing countries, but theirs is a very different path from that of the early developers especially with respect to the speed of their growth.
How did the late developers grow so fast? In the entire history of humankind, no country had grown as fast as Japan did between 1950 and 1973. But since then, South Korea, Malaysia, Taiwan, and China have approached and even exceeded this rate of growth. To understand these developments, we have to understand why countries are poor in the first place and how they attempt to climb out of poverty.
Is More Capital the Key to Growth?
A difference obvious to anyone who travels from a rich country to a poor country is the varying levels of physical capital. In rich countries, vast airports accommodating big planes, enormous factories packed with high-tech machinery, huge combines in well-irrigated fields, and households with appliances and gadgets for every imaginable use suggest to us that far more physical capital is in use than in poor countries. Physical capital increases income because it makes everyone more productive. A single construction worker with a backhoe can shift far more mud than several workers with shovels and wheelbarrows.
If, however, the only difference between the rich and the poor countries is physical capital, the obvious question, posed by the University of Chicago Nobel laureate Robert Lucas in a seminal paper in 1990, is, Why does more money not flow from rich countries to poor countries so as to enable the poor countries to buy the physical capital they need?2 After all, poor countries would gain enormously from a little more capital investment: in some parts of Africa, it is easier to get to a city a few hundred miles away by taking a flight to London or Paris and taking another flight back to the African destination than to try to go there directly. Commerce would be vastly increased in Africa if good roads were built between cities, whereas an additional road would not make an iota of difference in already overconnected Japan. Indeed, Lucas calculated that a dollar’s worth of physical capital in India would produce 58 times the returns available in the United States. Global financial markets, he argued, could not be so blind as to ignore these enormous differences in returns, even taking into account the greater risk of investing in India.
Perhaps, Lucas concluded, the explanation is that the returns in poor countries are lower than suggested by these simple calculations because these countries lack other factors necessary to produce returns: perhaps education or, more broadly, human capital. It may seem that an Egyptian farmer, using the ox and plow that his ancestors used five thousand years ago, could increase his efficiency enormously by using a tractor. By comparison, it would seem likely that a farmer in Iowa who already owns an array of agricultural machinery would improve his yield only marginally by buying an additional tractor. But the Egyptian farmer is likely to be far less educated than the farmer in Iowa and to know less about the kinds of fertilizers and pesticides that are needed or when they should be applied to maximize crop yields. As a result, the additional income the Egyptian farmer could generate with a single tractor might be far less than what the Iowa farmer could generate by buying one more machine to add to the many he already has.
However, even accounting for differences in human capital between rich and poor countries, Lucas surmised that capital should still be far more productive in the latter. Moreover, evidence suggests that the enormous investments in education around the world in recent years have not made a great difference to growth.3 Something else seems to be missing in poor countri
es that keeps machines and educated people from maximizing productivity and the countries from growing rich—something that dollops of foreign aid cannot readily supply.
Organizational Capital
The real problem, in my view, is that developing countries, certainly in the early stages of growth, do not have the organizational structure to deploy large quantities of physical capital effectively.4 You cannot simply buy a complicated, high-speed machine tool and hire a smart operator to run it: you need a whole organization surrounding that operator if the machine is to be put to productive use. You need reliable suppliers to provide the raw materials, buyers to take the output from the tool and use it in their production lines, managers to decide the mix of products that will be made, a maintenance team to take care of repairs, a purchasing team to deal with suppliers, a marketing team to deal with buyers, a security outfit to guard the facility at night, and so on. The organizational differences between a small car repair shop and Toyota, or between a medical dispensary housed in a shed and the Mayo Clinic, are enormous, and determine their ability to use large modern sophisticated machines effectively.
Of course, these complex organizations do not operate in a vacuum either. They need other complex organizations to provide inputs and sometimes to buy their output. Equally important, they need finance, infrastructure—for example, electric power, and transport and communication networks—and governance institutions to provide security to property and life as well as to facilitate business transactions.
Fault Lines: How Hidden Fractures Still Threaten the World Economy Page 7
