The Third Pillar

by Raghuram Rajan

  What still held the United States back was its minorities. When World War II ended, it was hard for American society to sustain claims of white superiority when the nation had just sacrificed hundreds of thousands of lives combating Nazi and Japanese totalitarianism and their claims of racial superiority. The bells celebrating the victory of the forces of democracy and freedom rang hollow when set against the reality of the black experience—where African American military policemen posted in the southern United States could not enter restaurants in which their German prisoners were being served meals.15

  Even though poverty rates among African Americans were higher than the average population, they certainly did not constitute the majority of the poor. Nevertheless, any measure to help the poor had to pass muster with Southern politicians, some of whom would have preferred the measures to bypass blacks. Indeed, even though African American servicemen were not excluded from getting benefits under the GI Bill, their actual access to its benefits, especially in the South, was much more limited.

  In 1963, from the steps of the Lincoln Memorial, Dr. Martin Luther King Jr. urged Americans to honor the promissory note the founding fathers had given that “all men—yes, black men as well as white men—would be guaranteed the unalienable rights of life, liberty, and the pursuit of happiness.” When he declared, “We refuse to believe that the bank of justice is bankrupt. We refuse to believe that there are insufficient funds in the great vaults of opportunity of this nation. So we’ve come to cash this check, a check that will give us upon demand the riches of freedom and the security of justice,” he was speaking both figuratively and literally.16 The Civil Rights movement undoubtedly pricked the nation’s conscience, and, when coupled with the public’s generosity buoyed by rising incomes, helped overcome America’s traditional reluctance to expand the safety net.

  President Lyndon Johnson, who had lived among, and worked with, the poor during his youth and through the Depression years, provided persuasive leadership. The political attractiveness of targeting the votes of blacks who had migrated from southern agricultural jobs for the industrial jobs in northern cities gave politicians the incentive to follow.17 Congress enacted a radical set of government- and community-based programs intended to wage war on poverty and make the United States into Johnson’s Great Society. Funding was increased significantly for welfare, especially for the indigent elderly, for health care (including Medicare for the elderly and Medicaid for the poor), and for education—the Elementary and Secondary Education Act of 1965 was reauthorized by President Bush as the No Child Left Behind Act of 2001, and by President Obama as the Every Student Succeeds Act in 2015.

  Importantly, poor communities got direct support from the federal government with a stipulation that it entail “maximum feasible participation” of the local community in decision making, in part so that southern state governments, unsympathetic to African American communities, would not divert support. Poverty levels did come down in the 1960s. As related in a searing critique by Daniel Moynihan in his book Maximum Feasible Misunderstanding, though, many of the programs were poorly coordinated and poorly structured. Perhaps there was a fundamental inconsistency in the state taking up the role of strengthening community. Moreover, it was not clear whether the objective of community engagement was to organize a new power structure for the community, confront the existing power structure, or extend or assist the existing power structure.18 At any rate, the programs did not sit well with existing structures and interests, and did not draw in those in the community with sensible ideas of how to raise economic opportunity.

  Traditional political leadership, intent on protecting its turf, pushed back on community involvement, while neighborhood activists fought any structure that was not their own. Almost inevitably, the War on Poverty became more top-down than bottom-up, and failed to sustain enthusiasm even among initial supporters like Dr. King, who wanted more comprehensive, coordinated action. As the Vietnam War consumed President Johnson’s political energies, some of the innovative spending was repurposed to support the war effort. As northern blacks became confirmed Democratic voters and not voters in play, political support disintegrated, and the innovative decentralized aspects of the program atrophied.19 What remained was the increased federal and state spending on social security, health care, and education. US social spending never approached European levels, but the thirty glorious postwar years had seen the spigots opened in the United States as well.

  IMMIGRATION

  The postwar baby boom would eventually create a larger labor force, but in the meantime, strong growth created many new jobs. As citizens moved up into better-paying jobs, countries needed workers for the jobs they vacated. West Germany, even after absorbing the migrants fleeing East Germany, had yet more jobs to fill, and in the 1960s signed agreements with Greece, Morocco, Portugal, Spain, Tunisia, Turkey, and Yugoslavia whereby they would send “guest” workers to West Germany, on condition they would eventually return. In 1973, foreign workers were one-eighth of the labor force in Germany. France was not far behind, with 2.3 million foreign workers, or 11 percent of the labor force. Many of these were employed for childcare, as cooks, and as custodians.20 England drew immigrants from the Caribbean and South Asia, including those expelled by Idi Amin from East Africa.

  Europe wanted to treat these immigrants as temporary, and many did not enjoy the same workforce protections as citizens. In downturns, these were the workers who were first to be laid off. Employers had little incentive to invest in them or promote them, while countries did not believe they had to work on integrating them. The immigrants themselves, thankful for jobs that payed significantly more than at home, were docile and submitted to a separate and unequal existence, on the outskirts of the cities whose essential services they helped run. Many stayed on, though, and their children were no longer willing to accept a second-class existence. Population homogeneity, which contributed so much to the ease with which European countries had adopted generous social policies, diminished—in many cases, immigrants looked and spoke very differently from the native population. Even at this early stage, politicians, such as Enoch Powell in the United Kingdom, started speaking up (in 1968) about the “sense of being a persecuted minority which is growing among ordinary English people,” and warned about “the River Tiber foaming with much blood” as immigrants organized.21 He was alarmist no doubt, but his speech was of a tradition that resurges periodically.

  The United States too amended its immigration laws, which had been reformed in 1924 to both restrict immigration and give preference to Western Europeans. In keeping with the prevailing sentiment against racism, the Hart-Celler Act of 1965 eliminated national origin, race, or ancestry as a basis for immigration, and stopped privileging immigration from Western Europe over other countries. It gave priority to relatives of citizens, as also those with especially needed skills. After its steady decline from about 15 percent of the population in 1910, the immigrant share of the population in the United States hit a trough in 1970 of around 5 percent, after which the numbers started climbing steadily once again with the new, more tolerant, environment.

  In tracing problems back to that era, one should not overlook the benefits of the spectacular postwar growth, and the resumption of trade: The incipient authoritarian tendencies of developed countries, manifest in the interwar period, were quelled. Democracy was placed on firmer foundations with strong economic growth, and as pre- and post-market supports built trust in the policies of moderate centrist parties. More developing countries were drawn into the path of liberalism. The treatment of minorities and immigrants improved. The world was, by and large, at peace.

  AND THEN GROWTH STOPPED . . .

  Unfortunately, as the 1960s ended, and just as governments had promised their citizens a substantial share of the high anticipated future growth, growth suddenly proved much harder to generate. There were plenty of proximate causes: rising inflation in the United States as spending on
the Vietnam quagmire added to the new social spending promised in the War on Poverty; the subsequent breakdown of the Bretton Woods system of fixed exchange rates as the United States abandoned the international convertibility of the dollar into gold; the tripling of oil prices as OPEC tested its powers after the Yom Kippur war broke out . . . But perhaps the most obvious reason was that the gains from the Second Industrial Revolution had largely played out.

  This would not have mattered earlier in Europe and Japan when they were in catch-up mode. As Europe and Japan got closer to the known frontier of innovation and productive efficiency in the early 1970s, though, they had to shift from imitating ideas and best practices elsewhere to innovating on their own. With the frontier expanding more slowly, their growth also slowed.

  Most economists envisage growth for economies at the frontier as periods of path-breaking innovation (when the key innovations of the technological revolution emerge) followed by steady development and implementation until most of the gains from that innovation have been reaped. Tyler Cowen of George Mason University and Robert Gordon of Northwestern University argue that most of the possibilities of the Second Industrial Revolution had been exhausted by the end of the 1960s.22 For instance, the big innovation that made commercial air travel more attractive than travel by ocean liner was reasonably safe and fast jet planes with pressurized air cabins. During my lifetime, commercial planes have gotten a lot safer and the rides relatively cheaper. Flights are easier to book, less noisy and much more comfortable (the older reader might remember bumpier rides and air sickness), despite the more cramped seating. However, the technology of travel has not fundamentally changed.

  Emphasizing this point, Gordon points out that growth in output per hour worked in the United States was at its highest at 2.8 percent in the period 1920 to 1970. This is when the main innovations of the Second Industrial Revolution were being developed and used across the country.23 After that, though, growth dropped to only 1.6 percent between 1970 and 2014.

  An aside may be useful here. We are in the midst of the ICT revolution, when the media breathlessly reports the latest advances in artificial intelligence or in immunotherapy, and yet growth in output per hour over the last few decades has been “only” 1.6 percent per year. How can we call this a revolution, and yet also claim growth is low? To set this in context, note that between 1870 and 1920, a period that included life-changing innovations like the internal combustion engine, the airplane, and electric lighting, growth in output per hour was similar at 1.8 percent. The reality is that growth at the frontier is hard—for much of history, countries grew at a fraction of a percentage point a year, if at all. So 1.6 percent annually is not trivial. Moreover, innovation translates into actual growth after long and unpredictable lags, for it takes time for society to envisage and build systems that can use the innovations productively. For instance, as historian Paul David pointed out, electric power displaced steam power in factories only when factories were rebuilt to use multiple small motors rather than one single large engine.24 Finally, technological change may have substantial impact in some areas and not in others at any point in time, keeping the overall growth rate moderate even while changing our lives—for instance, I rarely visit a bank or a department store any more as I transact online, while students still go to school every day and sit in classrooms listening to teachers, as they have for centuries.

  Growth also slowed because the growth in working population fell. Overall economic growth is, approximately, the sum of the growth in output per person working and the growth in number of people working. While the postwar growth in developed country populations was strong initially because of the baby boom, female fertility rates fell dramatically. The birth rate in West Germany fell from 17.3 per thousand population in 1960 to about 10 in the mid-1970s, and stayed at that level. The falls in Italy and Spain were, if anything, more dramatic.25 While female participation in the labor force increased for a while and compensated for the overall fall in population growth, it too plateaued by the early years of this century.

  As a result of slowing growth in output per hour and the slowing growth of the labor force, US economic growth has been slowing steadily since the 1960s, from an average annual growth rate of 4.5 percent in the 1960s, to about 3 percent in the next three decades, to about 2 percent in this century. While there has been a lot of debate about whether we are underplaying innovation and productivity by under-measuring growth—we don’t fully capture the quality of new cars or the safety of air travel, and we don’t put a monetary value on many of the services the internet provides us for free—the emerging consensus is that these effects are too small to account for the drop in productivity growth, and that the decline is real.26 Of course, nothing indicates it could not pick up again, and techno-optimists believe we will eventually see the fruits of the ICT revolution reflected in greater productivity growth, though probably not at postwar rates.

  BALLOONING GOVERNMENT DEFICITS

  The promises made to the public on health care and pensions in the sixties, which were premised on continuing strong productivity growth and strong population growth, had to confront the reality in the 1970s that growth in both was likely to be much slower. Fewer babies also meant more rapid population aging, and an increasing share of the population of the elderly, whose pensions and health care would have to be paid by a shrinking number of younger people in the workforce—unless the country chose to allow more immigration. Moreover, as the underlying growth potential of economies slowed, recessions were no longer shallow, so outlays on unemployment insurance and poor relief also increased. It was now clear that governments had overpromised in the years of strong growth.

  Government spending as a share of GDP ballooned. For a while, central banks accommodated that spending with expansionary monetary policy because they worried about slowing growth. In contrast to the Keynesian prediction, easy monetary policy no longer induced growth. Instead, economies suffered both stagnant growth and high inflation—quickly termed stagflation. The reason was simple. Keynesian stimulus worked well when the problem was insufficient demand—cutting interest rates would make people spend more thus restoring growth. In the early 1970s, though, the problem was supply—the lack of competition was beginning to tell. In the immediate postwar decades, the reallocation of labor to more productive sectors, coupled with greater capital investment and more effective production techniques, had allowed supply to keep pace with strong demand. Now, inefficient management practices and overstaffing began to limit what could be supplied at a price people would pay. More demand stimulus under such conditions would just result in more inflation, not more growth.

  The misery index, the sum of the annual inflation rate and the unemployment rate, climbed across the developed world. It reached its highest level in the postwar United States under President Jimmy Carter. Taming inflation was now a political imperative. Carter appointed Paul Volcker as chairman of the Federal Reserve, and Volcker embarked on a no-holds-barred fight against inflation, raising the federal funds interest rate to 19.1 percent in 1981, a level that had not been seen postwar (or since). That did the job, though the United States suffered a double-dip recession. As the United States brought inflation under control, central banks across the world made low and stable inflation their primary objective.

  Inflation fell but states, beset by low tax revenues and high spending on unemployment and attendant benefits, found it hard to bring down their deficit spending. In the United States, initiatives to “starve the [government] beast” and bring down taxes contributed to yet higher deficits. Public debt as a share of GDP in developed countries climbed steadily beginning in the late 1970s—primarily because jolts of higher inflation were no longer available to reduce its real value. In the United States, for example, postwar government debt as a fraction of GDP hit a trough in 1981 and has climbed since (the only exception being the late 1990s when high economic growth and fiscal surpluses brought debt down tem
porarily). Across the developed world, states realized they had to find new ways of reenergizing growth because productivity growth from technological change was no longer readily available. They turned for help to the markets.

  THE SEARCH FOR GREATER EFFICIENCY

  The postwar consensus was that the state had an important role to play in the market, if not in actually producing goods and services, certainly in regulating them and restraining excessive competition. Too little competition was not deemed a problem. The only deviation from this consensus was that impediments to trade were collectively self-defeating, so customs and tariff barriers were reduced steadily after the war. Now, states reexamined the anticompetitive consensus, as the public grew impatient with rising inflation and unemployment. The votaries for the market, such as the University of Chicago’s Friedrich Hayek and Milton Friedman, who had been ignored during the period of state ascendancy, now found a wider audience, including among influential politicians. The growing realization that all manner of cozy oligopolies had taken hold of the productive sector, and that greater competition could be a source of productive efficiency as well as growth, spurred reforms.

  These included deregulating industries, privatizing public-sector firms, reducing the extent to which workers were protected from layoffs by law, eliminating restrictions on securities issuance and pricing in financial markets, as well as on competition between banks, brokers, and other financial institutions, and further reducing barriers to trade and capital flows. Interestingly, as industries in one country got more competitive, the effects flowed through trade, and increasingly capital flows, to spur reform and competition in other countries.