Fault Lines: How Hidden Fractures Still Threaten the World Economy

by Raghuram G. Rajan

  This mutually beneficial but ultimately unsustainable equilibrium has been disrupted by the financial crisis and the subsequent downturn. Like many a developing country before it, the United States has come to recognize that the spending financed by a populist credit expansion is typically unproductive. Indebted U.S. households, weighed down by houses that are worth less than the mortgages they owe, have started saving more. To ensure that spending does not collapse, the U.S. government has stepped in to spend, but there are limits to how much it can do effectively. Consensus forecasts today suggest the United States will have to settle for a period of relatively slow growth. Forecasting is always difficult (especially about the future!), but if these forecasts are correct, sustained high unemployment will compound uncertainty for a middle class already hit by stagnant wages. They will have to face all this without the opiate of rising house prices and illusory wealth. Households in Spain and in the United Kingdom are in a similar situation, while smaller countries like Greece are on the verge of crisis.

  Prudent macroeconomic management suggests that large-deficit countries should be more careful about spending and save more. If the world economy is not to slow considerably, the countries with trade surpluses will have to offset this shift by spending more. Ideally, the richer among them—Germany and Japan—should improve productivity in domestically oriented sectors like banking and retailing so that the added growth leads to greater incomes and more spending, while poorer but fast-growing developing countries like China and Vietnam should gradually reduce their emphasis on exports and promote domestic consumption.

  There is even some hope that developing countries will start running large trade deficits once again and pull the industrial countries out of their growth slump, especially if multilateral lending institutions are reformed to be more supportive of borrowing. Such a hope is unrealistic and even dangerous, because developing countries have historically found it difficult to safely expand domestic demand financed with foreign borrowing. The problem is that domestic demand typically expands rapidly at times when the government has political aims or the financial sector has skewed incentives. In such situations, the fundamental allocation of resources is distorted. Anticipated financial support from multilateral organizations only increases wasteful spending before the inevitable crisis. Irresponsible foreign lenders get a larger subsidy, and the size of the hole that taxpayers eventually have to fill increases. There is, of course, some room for multilateral organizations to improve the availability of loans to countries with responsible policies, if nothing else so that countries do not run trade surpluses only to build up foreign exchange reserves. But in the foreseeable future, the response to the sustained reduction in industrial-country trade deficits should not be a commensurate sustained expansion of developing-country deficits and debts. Instead, it should require a narrowing of trade surpluses around the world, among both industrial and developing countries.

  In practice, any such shift will be politically painful in the short term both for deficit and for surplus countries. Even as I write, the Federal Reserve is holding interest rates artificially low (especially in the housing market) in the hopes that households will start consuming more again—after all, household consumption has been the primary source of growth in recent years. China is actively intervening to stabilize the value of the renminbi against the dollar so that its exports do not suffer. These myopic actions will help entrench a longer-term pattern of behavior that will make it harder to move away from the current unsustainable equilibrium.

  Of course, as Herbert Stein, the chairman of Richard Nixon’s Council of Economic Advisors, once said, “If something is unsustainable, it will stop.” Foreign investors have become increasingly wary about the amount of debt the U.S. government has had to issue to finance its deficits. With the majority of U.S. taxpayers believing they have benefited little from the boom years, the battle over who will bear the burden of additional taxes could turn ugly. Unlike the typical emerging-market country, the United States has not suffered a “sudden stop” of capital inflows during this crisis, because it has still been able to attract capital on easy terms from the rest of the world. However, if foreign investors fear that the United States will be unlikely to achieve the political consensus needed to set its government finances in order, they could start worrying that the government will follow the time-honored path of reducing the real value of its public debt through a bout of high inflation. If they take fright, they will sell their holdings of U.S. government bonds, causing the value of the dollar to slide more quickly. U.S. interest rates might have to go up substantially to retain foreign investor interest, thereby reducing U.S. growth even further than anticipated. That shift will bring down the U.S. trade deficit and spending, but in a way that maximizes pain all around.

  Even if the status quo does persist for longer than we expect, there are longer-run consequences of maintaining the current pattern of imbalances. One is the issue of environmental sustainability around the world. Undoubtedly, as developing countries grown richer, their households will look to consume more. At current levels of technology, it is simply infeasible for the world to aspire to consume as much, and waste as much, as the average suburban American household does: as the former Indian finance minister Yashwant Sinha put it, we would then have no world to live in.3 No doubt technology will improve over time, making a unit of consumption progressively less destructive to the environment. Nevertheless, if sacrifices are to be evenly spread across the world, it makes sense for consumption growth to shift from rich deficit countries to developing ones.

  It is also in the exporters’ long-run self-interest to alter their strategies. Although the reliance on exports has been very successful at both promoting rapid growth and ensuring stability, the Japanese experience raises questions about whether countries should follow it until they become rich—and risk subsequent stagnation—or turn to a more balanced path long before then. For a number of exporters, like China and Malaysia, the initial phase of building capabilities is long over. The challenge now is to broaden their sources of growth, withdrawing implicit and explicit subsidies to exporters gradually while extending the discipline of competition to the sectors focused on domestic production. Large countries like China may have no alternative but to wean themselves off dependence on global demand, because the world’s ability to absorb Chinese exports will be limited if China does not import more goods from them. Of course, the world’s political tolerance for buying Chinese goods may wear out long before its economic capacity to buy them does.

  Change will therefore help global stability and sustainability and will be beneficial for each country in the long run. But change does upset the cozy status quo and the interests that benefit from it. For instance, the real estate lobby in the United States has no desire to see government support for housing diminish, even though the United States probably has far more housing stock than it can afford. Similarly, the export lobby in China has no interest in seeing the renminbi strengthen significantly. So we are caught between the rock of a financially and environmentally unsustainable pattern of global demand and a hard place of a politically difficult change in domestic policies.

  These issues are not new. The political scientist Jeffry Frieden of Harvard University writes of the 1920s, when there was a macroeconomic imbalance between a great power running a sustained current-account deficit and a rising power that financed the deficits.4 The rising power was the United States, and the great power was Germany, which had borrowed heavily from abroad

  to fuel a consumption boom that, among other things, dampened some of the underlying social tensions that beset the Weimar Republic. This was no small matter: without American financing to sustain the dynamism of the German economy, Weimar social and political instability might have caused serious problems for the rest of Europe….

  The German-American financial relationship rested on weak political foundations, as neither country was really prepared for the implications of the
capital flows. The United States was not willing to provide an open market for German goods that would facilitate debt service, or any government measures to deal with eventual financial distress, and the Germans were unwilling or unable to make the sacrifices necessary to provide prompt debt service.5

  As the Depression hit, each country looked inward, ignoring the consequences for other countries. The Smoot-Hawley Act passed by the U.S. Congress in June 1930 raised trade tariffs on imports in an attempt to protect U.S. jobs, making it still more difficult for debtor countries around the world to service debts. These countries either defaulted on their debt or overthrew governments that tried to adopt the austerity measures required to service it. Hitler was carried to power on the coattails of economic distress, and one of his first acts after taking power in January 1933 was to declare that Germany would not pay its foreign creditors. His message of hate and revenge fell on receptive ears in a Germany that felt ill-treated by the global economy.

  The United States does not have the political weaknesses of the Weimar Republic, but the broader point is that without global economic cooperation when change is needed, countries could descend into opportunistic nationalism to the detriment of the global economy and the global political environment. Nationalism, coupled with great faith in the power of the government to enact domestic bargains between labor and capital, has been seen before: it was called fascism then. It is a development to be avoided at all costs.

  Our existing global institutions, like the IMF and the World Bank, will likely prove ineffective in fostering global cooperation if they continue to operate as they have in the past. They will have to make radical changes in how they function, appealing more directly to the people than to their leaders, to soft power rather than to hard power. I discuss how such an approach dovetails well with the reforms that are needed in China. Clearly, the soft power of multilateral organizations can also be used to promote the reforms, discussed in the previous chapter, that are necessary in the United States.

  The G-20 and the IMF

  In September 2009, the leaders of the world’s largest economies met in Pittsburgh and designated their group, the G-20, as the primary forum for global economic cooperation. Much like its predecessor organization, the G-7, the new self-proclaimed guardian of the world economy excludes many countries—almost a necessity in order to get dialogue rather than a cacophony, but undemocratic nevertheless. Who is in and who is out is also somewhat arbitrarily decided: Argentina is a member, while Spain, with a GDP that is nearly five times the size of Argentina’s, is a member only indirectly, through the European Union. Be that as it may, the leaders of the G-20 patted themselves on the back for a “coordinated” fiscal and monetary stimulus in response to the crisis and had an unusually brief (for an official communiqué) description of the result: “It worked.” They went on to say: “Today we are launching a Framework for Strong, Sustainable, and Balanced Growth. To put in place this framework, we commit to develop a process whereby we set out our objectives, put forward policies to achieve these objectives, and together assess our progress. We will ask the IMF to help us with its analysis of how our respective national or regional policy frameworks fit together…. We will work together to ensure that our fiscal, monetary, trade, and structural policies are collectively consistent with more sustainable and balanced trajectories of growth.”6

  So the G-20, having successfully coordinated responses to the crisis, is now taking on the bigger challenge of making sure national growth strategies fit together to rebalance global growth. This is precisely what I have argued must be done. Given its recent achievements during the crisis, however, can we have any confidence that the G-20, working through the IMF, will be effective?

  Unfortunately not. It is very easy to get politicians to spend in the face of a crisis and to get central banks to ease monetary policy. No coordination is required, as every country wants to pump up its economy to the extent possible: the G-20 leaders were pushing on an open door when they called for coordinated stimulus. The real difficulties emerge when countries need to undertake politically painful reforms, reforms that might even seem to be more oriented toward helping other countries in the short run rather than the reformer itself. Politics is always local: there is no constituency for the global economy.

  I know, because we have been through an attempt at global policy coordination before, precisely to deal with the problem of large global trade imbalances. That effort failed, and it is instructive to understand why.

  In 2006, as the U.S. current-account deficit broke record after record and as China’s current-account surplus soared, the IMF became deeply concerned. The managing director, Rodrigo de Rato, decided a new approach was warranted. We at the Fund (I was still the chief economist then) called on the five entities most responsible for the imbalances—the United States, the Euro zone, China, Japan, and Saudi Arabia—to come together to discuss how they would jointly bring the imbalances down. To prepare for the meetings, I jointly headed an IMF team, which traveled around the world in the summer of 2006, trying to secure some agreement among the countries that had been called together for the consultation. We were following the adage that nothing of substance is settled at most international meetings; all important issues are usually settled beforehand.

  The weather ranged from 122 degrees in the shade in Riyadh, Saudi Arabia, to unseasonably cool in Tokyo. The response from our interlocutors was, however, pretty uniform. Countries agreed that the trade imbalances were a potential source of instability, and economic reforms were needed to bring them down before markets took fright or politicians decided to enter the fray with protectionist measures. But each country was then quick to point out why it was not responsible for the imbalances and why it would be so much easier for some other country to push a magic button to make them disappear.

  For instance, the United States authorities argued that it was not their fault that the rest of the world was so eager to put their money in the United States: imbalances were the fault of the Chinese, who were buying dollars to restrain the appreciation of the renminbi. It was the pressure of these enormous inflows that led the United States to consume. The Chinese argued that if they allowed the renminbi to appreciate faster, exports from China to the United States would fall, while exports from Cambodia or Vietnam would pick up, and the U.S. trade deficit would remain unchanged. In their view, the real problem was that the U.S. consumer had no self-restraint. Moreover, their trade surplus was so large only because the United States limited Chinese purchases of high-tech equipment. And so it went. Everyone pointed the finger at someone else. The truth was that everyone contributed in some way to the problem, but no one wanted to be part of the solution.

  At the end of 2006, I returned from the Fund to the University of Chicago, dejected that we had accomplished so little. When the consultations eventually concluded in 2007, the Fund declared that they had been a success: there had been a free and frank exchange of views, which is bureaucratese for total disagreement. Every country agreed to do what it had always intended to do, which was very little. The consultations had failed to produce concrete action. A few months later, born partly from the actions that created the imbalances, the crisis began.

  The IMF did not fail because our arguments were not convincing. The reason everyone pointed a finger at everyone else was not that they did not understand their own responsibility but because no one we spoke to could really commit to the actions that were needed. Indeed, these were decisions that even the head of government could not take. For instance, no U.S. president can commit to reining in the budget deficit: that is a decision that only Congress can take. Similarly, no Chinese president can unilaterally agree to allow the renminbi to appreciate: that is a decision deliberated for months by various echelons of the State Council and the Communist Party. Moreover, the needed changes went beyond reining in the budget deficit or letting the currency appreciate. They required deeper fundamental changes to the economy. And the global good c
ounts for little among the politicians in the U.S. Congress or the Chinese Communist Party when it comes to contemplating fundamental change.

  This is why, despite hoping for the best, I have deep skepticism that anything will come of the ambitious G-20 declaration. Nor is it likely that the IMF will achieve anything more than it did in the multilateral consultations that ended in 2007, crisis notwithstanding. Change will come only when countries are forced to change, or decide it is in their best interest to do so, but that process may be too costly, or too slow, for the global economy.

  If doing nothing is not a viable option, how can we get global cooperation? I think any answer lies in a fundamental remake of multilateral institutions like the IMF and the ways they interact with sovereign countries.

  Multilateral Institutions and Their Influence

  Multilateral institutions have hitherto worked in two ways. One approach is the quasi-legal one followed by the World Trade Organization (WTO), which regulates trade between participating countries. The WTO bases its actions on a set of agreements that limit barriers to trade. These agreements have been signed and ratified by member governments after long and arduous negotiations. The WTO has a dispute-resolution process aimed at enforcing participants’ adherence to the agreements, and because the rules are relatively clear, adherence can be judged in a quasi-legal setting. Penalties against violators, usually in the form of sanctions on their trade, are easily imposed. Countries do give up some sovereignty, such as the freedom to set import tariffs or subsidize favored industries, in exchange for others doing the same, and these concessions promote mutually beneficial trade. When industry presses national politicians to protect them, the politicians can simply throw up their hands and blame the WTO.