January 30, 2013
Not all demand is created equal
by Raghuram Rajan @www.nst.com.my
Raghuram Rajan, Professor of Finance at the University of Chicago Booth School of Business and the chief economic adviser in India’s finance ministry, served as the International Monetary Fund’s youngest-ever chief economist and was Chairman of India’s Committee on Financial Sector Reforms. He is the author of Fault Lines: How Hidden Fractures Still Threaten the World Economy.
TWO fundamental beliefs have driven economic policy around the world in recent years. The first is that the world suffers from a shortage of aggregate demand relative to supply; the second is that monetary and fiscal stimulus will close the gap.
Is it possible that the diagnosis is right, but that the remedy is wrong? That would explain why we have made little headway so far in restoring growth to pre-crisis levels. And it would also indicate that we must rethink our remedies.
High levels of involuntary unemployment throughout the advanced economies suggest that demand lags behind potential supply. While unemployment is significantly higher in sectors that were booming before the crisis, such as construction in the United States, it is more widespread, underpinning the view that greater demand is necessary to restore full employment.
Policymakers initially resorted to government spending and low interest rates to boost demand. As government debt has ballooned and policy interest rates have hit rock bottom, central banks have focused on increasingly innovative policy to boost demand. Yet growth continues to be painfully slow.
What if the problem is the assumption that all demand is created equal? Pre-crisis demand was boosted by massive amounts of borrowing.
When borrowing becomes easier, it is not the well-to-do, whose spending is not constrained by their incomes, who increase their consumption; rather, the increase comes from poorer and younger families whose needs and dreams far outpace their incomes.
Moreover, the goods that are easiest to buy are those that are easy to post as collateral — houses and cars, rather than perishables. And rising house prices in some regions make it easier to borrow even more to spend on other daily needs such as diapers and baby food.
While it catalyses a more generalised demand, it is not unreasonable to believe that much of debt-fuelled demand is more focused.
So, as lending dries up, borrowing households can no longer spend, and demand for certain goods changes disproportionately, especially in areas that boomed earlier.
Of course, the effects spread through the economy. But unemployment is most pronounced in the construction and automobile sectors, or in regions where house prices rose particularly rapidly.
A general stimulus to demand, such as a cut in payroll taxes, may be ineffective in restoring the economy to full employment. The general stimulus goes to everyone, not just the former borrowers.
Indeed, because the pattern of demand that is expressible has shifted with the change in access to borrowing, the pace at which the economy can grow without inflation may also fall.
Unlike a normal cyclical recession, in which demand falls across the board and recovery requires merely rehiring laid-off workers to resume their old jobs, economic recovery following a lending bust typically requires workers to move across industries and to new locations.
There is thus a subtle but important difference between my debt-driven demand view and the neo-Keynesian explanation that deleveraging (saving by chastened borrowers) or debt overhang (the inability of debt-laden borrowers to spend) is responsible for slow post-crisis growth.
The neo-Keynesian economist wants to boost demand generally. But if we believe that debt-driven demand is different, demand stimulus will at best be a palliative.
Writing down former borrowers’ debt may be slightly more effective in producing the old pattern of demand, but it will probably not restore it to the pre-crisis level.
The only sustainable solution is to allow the supply side to adjust to more normal and sustainable sources of demand — to ease the way for construction workers and autoworkers to retrain for faster-growing industries.
The worst thing that governments can do is to stand in the way by propping up unviable firms or by sustaining demand in unviable industries through easy credit.
Supply-side adjustments take time, and, after five years of recession, economies have made some headway. But continued misdiagnosis will have lasting effects.
The advanced countries will spend decades working off high public-debt loads, while their central banks will have to unwind bloated balance sheets and back off from promises of support that markets have come to rely on.
Frighteningly, the new Japanese government is still trying to deal with the aftermath of the country’s two-decade-old property bust.
One can only hope that it will not indulge in more of the kind of spending that already has proven so ineffective — and that has left Japan with the highest debt burden in the Organisation for Economic Cooperation and Development.
Unfortunately, history provides little cause for optimism.– Project Syndicate