ONE QUESTION THAT HAS COME UP numerous times since the publication of the hardcover edition of this book is, exactly whose side are you on? After all, I am a Chicago economist; and yet here I am, arguing that some governments need to strengthen their social safety nets if they want to move away from excessive policy activism and serial crises. Isn't this at odds with those who say we can have economic growth or greater social welfare, but certainly not both?
At the risk of dodging the question, that's not the way I look at it. I like to think of myself as a pragmatist, focusing on what works. I also believe in an equal opportunity society, where we do not forcibly equate outcomes but nothing holds back an individual's ability to achieve his or her potential. So perhaps the better question is, what kind of society do we want, and what is the best and fairest way for us to get there?
Societies need to create an environment where the creativity of individuals can flourish, where people have both the incentive and the ability to realize their potential. This typically means creating vibrant, competitive markets, and easing everyone's access to them. Generally, governments have a role in creating the infrastructure for these markets and providing the regulatory support for them, but not much beyond that. Indeed, one of my major concerns in the book has been the distortions that emerge when governments want to push markets and market prices in particular directions.
In a perfect world, a vibrant market is the result of more or less evenly matched individuals competing on a level playing field. Of course, ours is far from a perfect world; we enter it unequally, and our ability to advance is strongly influenced by factors beyond our control—not only the genes we inherit, but the circumstances into which we are born. Different levels of health (from differences in early nutrition) as well as different capacities to deal with educational and social challenges (as a result of differences in family and community norms) profoundly shape our ability to acquire the capabilities necessary to thrive in a competitive marketplace. The ability of individuals to make choices, or take advantage of opportunities, is therefore limited by the capabilities they inherit or acquire early on. We are born unequal, and our early years, over which we have no control, make us even more so. This is not right or efficient, and societies should play a role in improving everyone's capabilities, especially the capabilities of those who are most deprived.
At some point, though, helping some can keep others from realizing their full potential. How to balance an egalitarian vision with the freedom to compete? I see two ways of reconciling these seeming contradictions. First, societies should focus on improving access for all—to quality education, health care, finance, and markets—rather than determining outcomes. Second, the egalitarian urge should dominate when we consider policies targeted at early childhood—when capabilities are acquired—and a more market-oriented approach should be considered when we choose policies targeted at adults, who are more equipped to make choices.
Finally, I do think societies need to create a minimum economic safety net for individuals and families, not just because it is inhumane to let even the proverbial grasshopper starve in winter, but also because it is necessary for social and policy stability as well as the early childhood egalitarianism I referred to above. Clearly, the size of the safety net needs to be tailored to the nature of the economy, and equally clearly, safety nets distort economic incentives. But trading off costs and benefits, and adding a dollop of humanity, some safety net wins out. The safety net in the United States at the time of this writing is probably a little too thin if the long-duration shocks the economy has experienced are likely to repeat, while the safety net in some parts of Europe should perhaps be reined in. Poorer countries like India are commendably trying to create safety nets, but they have to be careful that they do not succumb to populist pressures to expand them to unaffordable levels.
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It has been over a year since the book was written, and I now have the luxury of looking back and asking what I would change. By and large, the answer is very little—if anything, the fault lines I was worried about have become more pronounced, even though the world seems to be in the midst of a steady but not spectacular recovery. At the same time, amid the obvious concerns, I still see reasons for hope.
In the book, I emphasize inequality stemming from a mismatch between the kinds of job opportunities the U.S. economy creates and the skill levels of significant parts of the population as a primary source of the growing inequality and rising political tension in the United States. The ongoing job recession bears this out. The U.S. unemployment rate for those with undergraduate degrees is a third of that for high school dropouts. Of course, not every college degree is a passport to a job. Sometimes the lack of appropriate vocational training or jobrelated skills is the key impediment. The larger point, however, is that far too many commentators ignore the possibility that the United States has a deep structural problem that has been papered over by fiscal and monetary stimulus. Once again the government and the Fed have seen aggressive stimulus as the way to get the economy growing, without worrying about the long-term sustainability of that growth.
As fiscal problems limit the government's capacity to stimulate the economy (if nothing else because conservatives of all hues start worrying about the rivers of budgetary red ink that flow as far as the eye can see), the problems of a middle class who find their jobs replaced by technological change and foreign competition will become very real. Some (increasingly men) will drop out of the formal labor force and rely on a better-educated spouse's income—in part because their lower wages do not compensate for the additional costs incurred by working, such as child care. Unemployment rolls will fall, giving an illusory impression that things are getting better. But families will suffer, both from the fall in overall incomes, and from the tensions that arise when the traditional earner does not fulfill his role. The unemployable middle-aged, who cannot fall back on the support of a family, will try to access social security early by filing for disability—the number of people on disability is growing rapidly, imposing an additional burden on an already-stretched government budget. And those that cannot rely on either family or government will slip into the ranks of the very poor, with all the pain that that entails.
What can be done? Unfortunately, we do not have good answers. Upgrading skills and education is not easy. Retraining programs have a checkered history. But realizing that there are no quick fixes, we should focus less on short-term stimulus as a response to the unemployment crisis and more on innovative approaches to help out-of-work Americans build better futures for themselves. Active labor market policies—econ-speak for the kind of policies operative in Scandinavian countries that help the unemployed train for new jobs and then support them while they search actively—are well worth examining. So too are new scalable technologies, such as online learning programs, that reduce the cost of university education or skill acquisition—though we should recognize that technology alone, without human support, rarely fixes problems. We also need to encourage stronger alliances between schools, local authorities, and businesses to create comprehensive learning programs whose end product is employable youth. Fortunately, many experiments and pilot projects are already under way across the country. We need to learn quickly from them and scale up those that are most promising.
It is encouraging that the Obama administration is starting to put more emphasis on education and infrastructure as a way of improving the capabilities of the U.S. economy, making the workforce more productive and, in the process, reducing income inequality and the number of wasted lives. Documentaries like Waiting for Superman—which highlights the weaknesses of U.S. public school education as it follows young children hoping to exit the public system by winning a lottery to get into a charter school—are taking the debate over education reforms to the larger public. Tight state government budgets are forcing states to explore how they can get more for less, and this is pushing teacher unions to reexamine issues like teacher quality and teacher tenure that they have long tried to ignore.
At times like these, there is a need for political give-and-take, as the United States needs to make important policy changes. But the recent crisis seems to have discredited the government as much as it has discredited the financial sector, for reasons I will explain shortly. Not only is there little trust that public initiatives will work, but the crisis also seems to have empowered those on the political extremes. The 2012 election could be critical in determining which way the United States goes.
I highlighted the problems created by growing inequality in the United States, but I do not want to suggest that they are the problems of the United States alone. Technological change is occurring across the world, while growing trade exposes many sheltered sectors to competition. Every country is seeing some segments of the population benefiting from these new opportunities, while others lose out because they do not have the capabilities to compete. So there is pressure on governments across the world to help improve the capabilities of their workforces. If they do succeed, this will make us all better off.
In the short run, though, the slower growth of industrial countries—hobbled by public and household debt—and the necessary shift in global demand to the more populous emerging world will create new tensions that need to be managed. For instance, industrial-country corporations have historically benefited from having the bulk of their demand nearby. Top management can anticipate market trends and act speedily on them because these trends emerge where they live. But as markets move to distant lands, a variety of services will have to be located closer to those markets, and management control will have to accompany that movement. This can create significant dislocations.
To understand the importance of these changes, consider the Apple iPod. Of the $149 market price for an iPod nano, the Chinese manufacturer—who sourced all the components and put the device together—only receives a quarter of that amount. The rest goes to Apple for designing the iPod, for licensing its brand name, for its marketing efforts, for its distribution channels, and for the software and content packaged with the product. As new markets are increasingly found in distant lands, many of these functions will move nearer those markets, and so will value added and jobs. Tomorrow's iSing (a hypothetical handheld karaoke machine) may not only be designed in China with the Chinese consumer in mind, but the advertising campaign to sell it in the West could be put together in Mumbai. Large corporations will increasingly set up research, design, and marketing centers in the emerging markets, not because they are trying to benefit from cheap skilled manpower there, but because employees there are more familiar with the needs of the local markets.
In industrial countries it will seem as if prime jobs are being shipped overseas. There will be calls to stop “Benedict Arnold” corporations from selling their own citizens short. Politicians could try to coerce their multinational corporations into protecting high-quality local jobs, in the process hamstringing them relative to global competition. In reality, though, the new demand from the emerging markets will also create jobs in industrial countries, and everyone could be better off if this process is not impeded. Political compulsions may, however, result in much worse outcomes.
Emerging markets, too, will have to adapt to the challenges of expanding their own demand to compensate for the slow growth of industrial-country demand. Some change is already happening. The lesson China seems to have learned in the Great Recession is the need to reduce its dependence on foreign demand: the Chinese know that they cannot continue growing at double-digit rates without encountering protectionist barriers. As I've argued in the book, while much of the world has fixated on China's manipulation of the renminbi exchange rate as its primary means of expanding domestic demand, Beijing knows that it is just as important to reduce the pro-producer bias in its domestic policy so as to boost household incomes and consumption. In practice, this means increased wages, higher interest rates for household bank deposits, and improved delivery of health and education services; at the same time, the government is increasing corporate taxes as well as the subsidized prices that corporations pay for inputs such as energy and land. The Chinese government is also encouraging infrastructure investment to link the interior, poorer Western provinces to the richer, coastal ones.
Of course, various interests in China, including the cash-rich state-owned corporations and banks, as well as foreign firms that set up production facilities in China to benefit from the low exchange rate, are opposed to change. They will fight any loss of their relative privilege. China will not reform overnight and begin demanding huge amounts of consumption goods. But this could very well happen over time—indeed, China's twelfth five-year plan, to be implemented in early 2011, emphasizes the expansion of domestic demand.
Other emerging markets, such as Brazil and India, which have historically not repressed consumption as severely as China, are already on a tear, buoyed by growing inflows of foreign capital. Emerging-emerging trade is increasing rapidly. To facilitate the growth in their own demand vis-à-vis industrial countries, emerging markets have to allow their real exchange rates to appreciate, and this is happening as they either allow their nominal exchange rates to appreciate or experience higher inflation. But all of this raises an important question: can emerging markets manage to increase domestic spending in a more stable way than in the past, or will they experience yet another credit boom followed by a bust?
One could hope that emerging-market governments have learned their lessons and will avoid past excesses; however, history does not offer much basis for such optimism. To keep the past from repeating, regulators in both emerging markets and developed economies will have to take on a more assertive role. To ensure that foreign capital inflows do not once again support unviable investment and irresponsible lending, foreign investors need to be exposed to the full risk of losses. At the same time, domestic financial firms should not have the incentive to expand their balance sheets rapidly when money is cheap. This requires better domestic and cross-border regulation than we have had in the past. Next time has to be different.
Democratic governments are not programmed to think about actions that have short-term costs but produce long-term gain, the typical pattern of returns of any investment. That they ever make such investments is a consequence of either an unusually brave leadership or an electorate that understands the costs of postponing hard choices. Brave leadership is rare. But so too is an informed and committed electorate, because the experts themselves are so confusing. Economists of different persuasions find it difficult to reach a consensus about the necessity of any policy—take, for example, the cacophony of voices over whether government spending is the only thing keeping us from an economic depression or is moving us steadily down the road to perdition. Each side swears that Economics 101 is on its side and the other side either skipped those classes or is simply being ideological. The debate does not lead to consensus, the moderates in the electorate do not know what to believe, and the result is that policy choices follow the path of least discomfort—until they can no more.
One explanation, then, of the huge liabilities of governments in industrial countries, which had built up even before the Great Recession pushed them to near-unsustainable levels, is that they have grown as democracy and markets have flourished. Markets, especially really competitive ones, create economic volatility. The public rewards democratic governments for dealing with volatility—whether spending to create jobs, or rescuing banks that have dodgy securities on their balance sheets. Even if inaction, or action oriented toward the longer term, is the best policy, it is not an option—after all, politicians were elected to govern, and governing inevitably means action, not masterly inactivity. A sympathetic press amplifies heart-rending stories of lost jobs and homes, making those counseling against intervention appear callous. Democracies are necessarily soft-hearted, whereas markets and nature are not; government action has inevitably expanded to fill the gap.
With governments in many developed countries reaching the limits of their capacities, three undesirable possibilities loom large, aside from the desirable one that these governments will undertake long-postponed reforms because they now have no choice. One possibility is that governments intervene directly in markets, both domestic and cross-border, to reduce competition and volatility while they rebuild their buffering capacity. A second is that they muzzle democracy so that people's anger is not allowed to be expressed. A third is that they find unprotected scapegoats. All three approaches were experimented with during the Great Depression, and the world's experience with them was not happy.
One factor diminishing the likelihood of the first possibility, that governments intervene more directly in markets, is that the recent crisis seems to have discredited the government as much as it has discredited the financial sector. During the Great Depression, matters were very different. As the economic collapse caused the public to suspect the private sector and markets, faith in government grew.
For instance, in the United States, public support for President Franklin Roosevelt's New Deal initiatives was broad-based throughout the 1930s. One possible reason for the difference in attitudes today is that bankers were visibly punished in the 1930s. Legislation such as the Glass-Steagall Act in the 1930s clipped their wings. Many bankers also suffered direct losses then as their banks collapsed, or as inquiries exposed them to public ridicule or even jail.
Today, in contrast, broad segments of the public see the big banks and big government as being run by the same elite who took the country into the crisis through their misguided policies, and then spent public money under one guise or another bailing banks out. While bankers are back to earning enormous bonuses, the taxpayer has been left to foot the bill for the economic collapse. Many citizens are unemployed and in danger of being evicted from their homes. That no important banker has been put in jail, despite causing such widespread pain; that the large banks now account for an even bigger share of the financial sector after benefiting from a government rescue; and that efforts, like the Dodd-Frank bill, to legislate more constraints on banks have been lobbied into shadows of their original selves, suggests a crony-capitalistic system where the elite, whether in government or in the big firms in the private sector, looks after itself.
In the United States, this has strengthened the Tea Party movement, which seems to coalesce around opposition to the expansion of the government (and elites more generally), even if that expansion is intended to regulate big banks (presumably with the libertarian view that government regulations typically tend to be shaped by the powerful among the regulated). Movements like the Tea Party have thus tended to check Progressives, who, after a crisis of the sort we have had, typically want more government action, including curbing markets and unbridled competition.
The United States is not alone in having discredited governments. In the Euro area, in addition to the perceived nexus between banks and governments, the greater willingness of the European governing elite to embrace European integration, without bringing the broader public along, has added to public suspicions of government intent. In Japan, two decades of relentless economic crisis have decimated public faith in politicians and even in the renowned Japanese government bureaucracy.
The second undesirable possibility, which is that governments that have little spending capacity to meet the needs of the distressed muzzle democracy so that people's anger is not allowed to be expressed, is also remote for now. Democratic institutions in industrial countries are stronger and have deeper roots than they had in the 1930s.
That leaves the third undesirable possibility, the search for unprotected scapegoats. Unfortunately, this is the path a number of countries are taking, with undocumented immigrants and Muslims being the first targets, and legal immigrants following next. Foreign investment has also been subject to unusual criticism and increasing strictures. While foreign goods trade is now better protected through international agreements and institutions than in the 1930s, services trade is not, and it has been the target of protectionist measures. To the extent that politicians find scapegoats in order to release social pressures, without any intent of doing harm, scapegoating may seem beneficial in helping societies avoid worse possibilities. But as the 1930s indicate, scapegoating typically leads to something much worse.
Equally worrisome is the fact that as politicians hesitate to undertake the painful actions that are needed to restore their economies to the right course, the problems get worse and harder to solve. More years of drift will build up bigger public debt burdens, more unaffordable entitlements, and a larger underclass.
Emerging markets also need to understand the sources of the problems of industrial countries and figure out for themselves the appropriate realms of the government and markets. Far too many are unthinkingly importing the institutions of the developed world, and, together with them, the potential for unsustainable growth in government liabilities. To date, those that have prospered have had growth on their side, and have also been helped by skeptical markets, which are still unwilling to tolerate huge, unfunded emerging-market government promises. They cannot, however, be complacent.
My book offers no silver bullets, no obvious solutions that will fix everything in one go. I have pointed to small steps that I think can make a difference, and taken together, these could effect big, needed changes. But any reform, even if we can overcome the many obstacles to change, will have unintended consequences, and we will have to adjust the reforms as we see their effects play out in practice.
Why am I hopeful, then, that we will be able to fix the fault lines? I think the recent crisis gives us little choice. That it was extremely painful but not terminally so makes it a useful stress test. We have uncovered deficiencies, and we know that the system has little capacity to sustain a repeat. We will bicker, no doubt, and we will try easy options. But eventually, as we realize that there is no alternative to addressing our real problems, democratic debate, coupled with human ingenuity, will come up with widely acceptable solutions to our problems. We may not see those solutions now, but so long as we are aware of the problems we have to solve, and work on them, I have no doubt that solutions will emerge.
April 2011