There is nothing more deceptive than an obvious fact.
–Arthur Conan Doyle, “The Boscombe Valley Mystery”
It’s around 1.30 pm on Thursday afternoon and I have just finished reading a wonderful speech titled ‘Going bust for growth‘, made by the Reserve Bank of India governor Raghuram Rajan, to the Economic Club of New York on May 19, 2015. The speech which runs into 14 pages like all Rajan speeches is a very good read and gets to the heart of the issue and explains things very well.
No wonder the prime minister Narendra Modi is so impressed with Rajan. As Modi said about Rajan in April earlier this year: “I happen to meet Raghuram (Rajan) once every two months and he comes prepared with three or four slides. He makes me understand them so perfectly that I don’t need to question anything, I understand what he says.”
In his latest speech Rajan talks about the steps taken by developed countries in the aftermath of the financial crisis that broke out in September 2008, why they are not working and how they are creating problems for what the developed world likes to call emerging markets.
Consumer demand collapsed in the aftermath of the financial crisis. One of the things that governments of the developed world did was to borrow and increase spending. This money was supposed to be spent towards creating physical infrastructure.
Returns on investing in infrastructure are supposed to be high given that currently both interest rates as well as constructions costs are low. Nevertheless, it is not easy to spend on building infrastructure in a developed country. As Rajan points out: “However, high-return infrastructure investment is harder to identify and implement in developed countries where most obvious investments have already been made – political influence is as likely to create bridges to nowhere or unviable high speed train networks as needed infrastructure.”
Nevertheless, money can be spent on improving existing infrastructure. The trouble here is that decision making in this case needs to be a lot more decentralized in comparison to spending on mega projects. Given this, it “may be harder to initiate and finance from the centre”. Hence, spending money on infrastructure may not always be the best way going around in order to create economic growth in developed countries.
Also, money being spent always does not go to projects which are likely to generate the most returns. It may go to projects backed by politicians who have the most influence. It’s worth remembering here that even in well-functioning democracies some groups wield more influence than others. As Raghuram Rajan and Luigi Zingales write in Saving Capitalism from the Capitalists: “Policy making is often captured by powerful special interests that thrive because of the peculiarities of democratic governance… Governments may work in the interest of a privileged few rather than the larger public and dig the wrong channels.”
Other than increased spending, central banks of developed countries also printed and pumped money into the financial system. They did this by printing money to buy government and private bonds. By buying these bonds, the idea was to pump a lot of money into the financial system, keep interest rates low, with the hope of people borrowing and spending more at low interest rates.
But low interest rates make things difficult for investors. They need to invest in riskier assets and go searching for yield (return). Since the start of the financial crisis, there has been a huge flow of money from the developed markets into emerging markets, in search of a higher return.
As Rajan put it in his speech: “Indeed, the post-global crisis capital flows into emerging markets have been huge, despite the best efforts of emerging markets to push them back by accumulating reserves (net capital flows to emerging economies reached US$ 550 bn in 2013 compared to US$120 bn in 2006).”
So the money flowing into the emerging markets has increased many times over since the start of the financial crisis. And these flows create problems in emerging markets. When the money is coming in it leads to the appreciation of the local currency against the dollar (unless the central bank intervenes), creating problems for exporters. And when this money leaves in a hurry it leaves financial markets in a mess (Stock markets fall, yields on government bonds go up as foreign investors leave in a hurry) and the value of the local currency depreciates against the dollar., creating problems for importers. This makes things much more difficult for central banks in emerging markets.
Further, despite many years of increased government spending, money printing and low interest rates, economic growth is yet to recover in developed countries. What this tells us is that policies followed in the aftermath of the financial crisis haven’t really worked. And the reason for this the slow growth of consumer demand.
A major reason for the same is that Western economies have lost the ability to make things. As Rajan and Zingales point out: “For decades before the financial crisis in 2008, advanced economies were losing their ability to grow by making useful things. But they needed to somehow replace the jobs that had been lost to technology and foreign competition… So in an effort to pump up growth, governments spent more than they could afford and promoted easy credit to get households to do the same. The growth that these countries engineered, with its dependence on borrowing, proved unsustainable.”
With a manufacturing in developed countries being outsourced to emerging markets, a section of the population isn’t exactly employable any more. As Rajan said in his speech: “Because of changes in technology and the expansion of global competition, routine repetitive jobs, whether done by the skilled or the unskilled, have diminished greatly in industrial countries. Many of these jobs, ranging from assembly line worker to legal aides or insurance clerks, have either been automated or outsourced.”
And this is where the problem is. Good jobs now require skills. “The middle class recognizes that they need quality higher education and training to not slip into competing with the poor for low-skilled non-routine jobs such as security guard or gardener. But the poor quality early education they have received, as well as the prohibitive cost of quality higher education, puts many better livelihoods out of reach,” said Rajan.
This is a problem that cannot go away either by spending more money on physical infrastructure or by maintaining low interest rates by printing money. It needs to be tackled over the long-term. But how politicians understand that term?
The column originally appeared on The Daily Reckoning on May 22, 2015
