Fault Lines: How Hidden Fractures Still Threaten the World Economy

by Raghuram G. Rajan

  A parallel set of arguments ascribes the American difference to the absence of strong workers’ organizations in the United States. White American males did not have to fight domestic elites for the right to vote. As a result, a national workers’ movement never really took hold in the United States—in contrast to the United Kingdom, for example, where workers’ organizations developed during the fight for the vote in the nineteenth century.18 The right to vote might have been an all-encompassing issue that united workers who were otherwise divided by local differences in work conditions and objectives. That it did not occur left labor unions fragmented.

  Indeed, in the second half of the nineteenth century when strong labor unions were developing elsewhere, the fact that the United States was a large country with an uncultivated “frontier” meant that workers could simply pull up stakes and move if they found local conditions oppressive, and this flexibility in turn also limited the extent to which conditions could become oppressive for the mobile worker. The difficulty of organizing a nationwide workers’ movement in a country where differences in circumstances were sizeable, and workers had individual options to exit tough conditions by moving on, should not be underestimated.

  A related argument for why strong nationwide worker organizations did not develop is that (except in the South) the United States lacked a large oppressed peasantry who could make common cause with workers, and it did not experience the desperate deprivation and breakdown of authority that occurred in many countries in Europe after each of the world wars. Indeed, only 20 percent of the labor force in Western Europe had some form of pension insurance before World War I, only 22 percent had health insurance, and unemployment insurance was almost unheard of. Workers, many of whom had become politically aware while fighting in the trenches of World War I, organized after the war to demand some form of protection against economic adversity.19 Their demands were voiced by socialist parties that gained strength in the postwar chaos, and many European countries did enact pro-worker legislation. By contrast, socialist parties have never commanded much voting power in the United States.

  We should also not minimize the importance of population heterogeneity. “There but for the grace of God go I” offers a powerful rationale for social insurance. People are more willing to be taxed to benefit others if they believe that the benefits go largely to people like themselves, and not disproportionately to groups they do not identify with. This may also explain why Americans give generously to charities: they have more control over who the beneficiaries are.20 Politicians who want to derail benefits legislation have often been quick to raise the specter of hard-earned taxpayer money going to the undeserving, irresponsible, and lazy, and such demagoguery is especially potent when the bogeymen look and behave differently from their constituents.

  In much of the twentieth century, the targets for demagogues were African Americans, but over time Americans have learned to recognize the deeper purpose behind such language. More recently, illegal immigrants have emerged as the new target, and much angst is expended over the possibility that benefits may leak to them. Indeed, a battle has erupted in the most recent round of health care legislation over the access of illegal immigrants to any form of taxpayer-funded programs. In this debate, few legislators have asked how U.S. society can remain healthy and humane with a sick and unprotected immigrant population in its midst.

  Finally, business interests and money power have always been an important force in the United States. Although these interests had the same difficulty in organizing as workers did in a large, diverse country—except when a specific piece of legislation collectively affected them and united them in opposition—they had two strengths workers lacked. First, firm owners aggregated the economic power of their firms and thus were individually much more powerful than any of their workers, even if owners as a group were not well organized. Second, if business conditions became oppressive in one state, owners could move investment to another state. The threat of the loss of business investment and the associated taxes gave states, especially industrial ones, strong incentives not to reduce business profitability.

  Of course, not all benefits reduce long-term profitability. Firm owners are typically not hard-hearted Dickensian figures, squeezing every drop of blood out of their workers—indeed, such behavior rarely maximizes profits. Workers who feel safer (because of unemployment insurance and pension benefits) and are healthier (because of health insurance) might indeed be happier and work more enthusiastically for their employers, especially in skilled jobs where worker effort is essential but hard to monitor. It is likely, though, that in the early twentieth century, a significant proportion of U.S. employers were small and could not afford to pay benefits, and the nature of the work they offered did not require workers to be happy or enthusiastic. Fear of making these firms uncompetitive, and losing these kinds of businesses to other states, may well have prevented states from legislating benefits.21

  Nevertheless, the safety net in the United States, albeit weak, does exist. Despite all the above-mentioned difficulties, legislation protecting workers was indeed passed during the Great Depression. The centerpiece of the legislation was the Social Security Act of 1935, which instituted not only old-age social security benefits but also unemployment insurance. Why did it happen when it did? The answers are interesting, for they suggest ways in which change may occur again in the United States.

  First, the pain workers felt from Depression-era unemployment was immense and persistent. Unemployment quickly rose into double digits by mid-1930, peaking at 24.9 percent in 1933 but never coming down into single digits throughout the 1930s, despite a supposed recovery (and another subsequent plunge) during the Depression.22 In 1939, at the onset of World War II, unemployment was around 18 percent. Moreover, it was nationwide. In John Steinbeck’s haunting novel The Grapes of Wrath, the Joads, Oklahoma tenant farmers whose farm is no longer profitable, go looking for jobs in the promised land of California, only to find that there are none there either. This time, moving on was not the answer, and the effect was to unify worker demands across the country.

  Second, Franklin Roosevelt obtained a strong political mandate, and broad nationwide legislation overcame the collective-action problem each state faced: the fear of frightening away business if it legislated worker protection alone.23 Third, there were exceptions carved out in the legislation: for instance, in a nod to the powerful Southern Democrats who did not want to raise the cost of their black workers (or have the legislation derailed by politicians raising fears that benefits would go to blacks), agricultural workers were not covered. Finally, surprising as it may seem, strong business interests also supported the legislation.24

  This last reason is interesting. Why would businesses want to increase their own costs? Having the state provide worker benefits had two tremendous advantages for some firms, especially large ones. First, firms that already paid their workers benefits like old-age pensions (because these made broader economic sense, as discussed earlier), could offload some of the costs on to the state. Moreover, all firms, especially pesky small competitors to big business, would be subject to the additional costs, whether or not they were able to increase profits by providing worker benefits. And for small firms employing unskilled workers, the imposition of worker benefits typically increased costs without any redeeming increase in profits. Thus the legislation reduced competition for powerful incumbents by eliminating one of the important advantages of entrants: their ability to pay low wages and benefits. Like much of the legislation during the New Deal era, the good parts came with bad, anticompetitive elements.

  What are the lessons from all of this? Huge adverse economic shocks have powerful effects on concentrating the national mind because everyone is similarly affected. They thus offer opportunity for change. Even so, and despite large legislative majorities, compromise is inevitable because people also look beyond the calamity to their interests in the recovery. Finally, there is typically a trade-off between co
mpetition, innovation, flexibility, access, and efficiency on the one hand, and security on the other. Security implies a protection of privilege, a protection that has to be indiscriminate if it is to calm anxiety. But this invariably means that resources will be transferred to beneficiaries regardless of the efficiency with which they can use them. One person’s safety comes at the expense of another’s opportunity or efficiency, and good legislation has to tread carefully to achieve the right balance.

  The Problem with Discretionary Stimulus

  I have argued that there are a number of reasons why the United States has a weak safety net. But why is that a problem? After all, the United States has a flourishing democracy that responds to the concerns of the people and can enact policies in a downturn to help those who are in difficulty. Unfortunately, policy made in the midst of a downturn is often hurried, opportunistic, and poorly thought out. Although deep crises offer an opportunity for serious rethinking and transformation, if new policies have to be devised in response to every downturn, the result is inappropriate, unpredictable, and excessive policy making.

  John Maynard Keynes, perhaps the most influential economist after Karl Marx, argued that recessions were caused by a deficit of demand, and that governments could play a role in a recovery by increasing spending, financed by running budget deficits. His views enjoyed immense influence in the decades after World War II, but his policy recommendations were effectively institutionalized earlier, during the Depression, through structures such as unemployment insurance. If demand faltered, the government would automatically transfer purchasing power to people, for example through unemployment benefits. Also, because firms would pay lower taxes as a result of lower profits, taxes were effectively reduced. Most mainstream economists believed the case for increasing government spending beyond these “automatic stabilizers,” except in truly severe recessions, was weak. Instead, much of the task of putting the economy back on the road to recovery was left to monetary policy.

  In the United States, though, the absence of a strong safety net, coupled with slow job growth in recoveries, has made every one of the recent recessions “truly severe” from a political perspective. This has created tremendous pressure on governments to stimulate, both through fiscal means—tax cuts and spending increases—and through easy monetary policy. Some parts of the stimulus do go toward extending the safety net—for example, unemployment insurance benefits and subsidies for health insurance have been extended in the current recession for some laid-off workers. But stimulus packages invariably do a lot more. The key question therefore is this: If job recoveries continue to be slow, is there a problem with allowing stimulus to be discretionary instead of strengthening the safety net?

  There is! First, workers themselves face tremendous anxiety when benefits are discretionary because they do not know if the recession will be deep and prolonged enough to provoke stimulus spending, and, even if it does, whether they will benefit. Second, both fiscal and monetary policies work with lags. The expenditure for roads that is voted on today will probably not be spent until many months from now. But voters want politicians to respond to their current needs. A politician’s counsel of patience is taken as a reflection of impotence and is therefore not conducive to her reelection. If the current unemployment rate as well as current job growth drive policy actions, then it is possible that policy will remain far too stimulative for far too long. The roads that are budgeted for today will be built a year from now, when recovery is already well under way, potentially causing the economy to overheat and forcing costly policy reversals then.

  Third, and perhaps most important, discretion leads to abuse. More problematic, when politicians exercise discretion at a time of great necessity, it leads to inventive abuse. Specifically, politicians bring out all their pet projects during a downturn, and then some more, all under the guise of stimulus to support recovery. Significant elements of spending are simply payback to powerful interest groups, or a fulfillment of election promises with little need to justify their short-term benefit. Over one-third of the stimulus package passed by the Obama administration in its early months consisted of one-time tax rebates, which are known to, and did, have little effect on spending: they were more a form of redistribution to fulfill election promises.25

  As an example of more egregiously directed spending, $6.5 billion was approved for cancer research to appease a particular senator.26 Cancer research is unlikely to create many jobs in the short term: indeed, it would be more appropriate if the money were spent slowly rather than wasted on harebrained proposals fished out from the bottom of researchers’ drawers in response to an announcement of new grant funding. Yet it features as part of the stimulus simply because the need to pass a stimulus package gives every politician the right to a share of the pork.

  Finally, even as I write, the real estate industry has ensured the renewal of a “temporary” tax break to first-time home buyers on the grounds that withdrawing it will seriously damage home prices. Such tax breaks amount to a subsidy to a few—first-time buyers, brokers, and construction firms—and typically have limited effects on growth because they simply substitute current sales for future sales. Their merit, if any, is that they are temporary, and thus bring forward purchases at a time when activity is lean. Renewal defeats their very purpose. But subsidies are an addictive drug. It is precisely because the benefits are enjoyed by the few (who lobby strongly for them) and the costs paid by the many (who don’t care enough to lobby) that they endure.

  Opportunism is bipartisan. When the 2001 recession hit, the U.S. Treasury did not stand idly by. In order to stimulate growth as well as fulfill campaign promises, the Bush administration cut taxes on earned income and on capital gains and dividends. This response, which differed from standard Keynesian prescriptions espoused by the Obama administration to boost government spending, reflected the more conservative, supply-side roots of the Bush administration: it was an attempt to improve the incentives for businesses to raise investment and production. But when coupled with rising expenditures on national security after the September 11 terrorist attacks on the World Trade Center, its effect on government finances was decidedly not conservative. More important, given that industry had been on an investment binge, the stimulus was unlikely to be effective in supporting investment and job growth in the short term, no matter what its long-term benefits.

  The broader point is that discretionary fiscal stimulus tends to be based on ideology and on past obligations or interests rather than attuned to the needs of the moment. Clearly, if there is a strong case to be made that it will “work” in creating long-term jobs or averting a self-destructive downward spiral in the economy, few would dispute the need to spend. Typically, such action entails limited, targeted spending or tax measures. In practice, though, administrations use the shadow of the recession to do what they have always wanted to do. Rahm Emmanuel, President Obama’s chief of staff, captured this mindset perfectly when he said, just before the Obama administration took office, “You never want a serious crisis to go to waste.”27

  The policies that tend to be legislated at such times are unlikely to be centrist. When the government of the day seizes the opportunity to ram through its longer-term policies, it naturally focuses on making down payments on policies that could likely be pruned by more prolonged, reasoned debate. The window afforded by the emergency therefore has led to more partisan legislation in the past and will likely do so in the future, especially because the increased polarization of Congress ensures that any legislative agenda that is not firmly centrist will have difficulty passing once the window of opportunity closes. Because partisan legislation tends to be reversed by future administrations from the other side, the lack of an effective safety net can lead not just to waste but also to more policy fluctuations and uncertainty.

  There are three additional downsides to the absence of a strong U.S. safety net when recoveries are turning out to be jobless. First, even with the possibility of discretionary
stimulus, workers themselves do not know if they will be supported and when: this uncertainty creates exactly the personal anxiety and political pressure that the safety net is meant to avert. Second, the United States’ lack of a firm safety net and its willingness to stimulate until the jobs come home is well understood by the rest of the world. When a global downturn adds to the effects of the persistent structural demand shortfall created by export-led strategies, as it did in 2001, not only do many countries find it hard to stimulate their economies effectively, but they also know that in a global game of policy chicken, the United States will flinch first. Many countries hitch themselves to the U.S. engine and do commensurately less on their own. The weight the United States has to pull increases, and the likelihood that it will do it itself serious injury multiplies. Finally, and most important, the persistent and politically motivated monetary stimulus that accompanies discretionary fiscal stimulus is, if anything, even more dangerous for the long-term health of the U.S. economy, and indeed the world, for it affects the behavior of the financial sector. I turn to that fault line now.

  CHAPTER FIVE

  From Bubble to Bubble

  NO CENTRAL BANKER HAS HAD to adapt his views more under the public eye than Ben Bernanke, the chairman of the Federal Reserve Board. In February 2004, in a speech to the Eastern Economic Association, Bernanke, then a governor of the Federal Reserve Board, spoke of the “Great Moderation,” the observation that the fluctuations of output and inflation in industrial countries had come down steadily since the mid-1980s. Because the Holy Grail of economic management is strong, steady growth, without booms, busts, or high inflation, this trend suggested that something was working.

  Bernanke considered three possible explanations: first, that we might have just been lucky, with the world economy experiencing fewer accidents such as war and oil-price increases over this period. Second, that economies had changed, for example as corporations developed systems to acquire sales information more quickly and to translate it more continuously into production and inventory decisions. Such improvements could explain how economies had been able to avoid the more dramatic inventory buildups and production cutbacks that had characterized previous recessions. Third, as a result of advances in our economic understanding, central bankers, many of them former academic economists, understood better how monetary policy affected economic output.