How to Grow the World Economy After Recession

How to grow
A special report on the world economy
October 9th 2010

The Economist October 9th 2010 A special report on the world economy 1

How to grow
Also in this section
Withdrawal symptoms
After the stimulus, the hangover. Page 3

The cost of repair
A battered nance sector means slower
growth. Page 6

From hoarding to hiring
Some countries have successfully preserved
jobs. Now they must create new ones.
Page 9

Pass and move
Spain o ers a test case for labour-market
reform in Europe. Page 12

Smart work
Faster productivity growth will be an
important part of rich economies’ revival. Without faster growth the rich world’s economies will be stuck. But what
Page 13 can be done to achieve it? Our economics team sets out the options
A better way
The rich world should worry about growth-
W HAT will tomorrow’s historians see
as the de ning economic trend of the
early 21st century? There are plenty of po-
The next few years could be de ned as
much by the stagnation of the West as by
the emergence of the rest, for three main
promoting reforms more than short-term
tential candidates, from the remaking of - reasons. The rst is the sheer scale of the re-
scal austerity. Page 16
nance in the wake of the crash of 2008 to cession of 2008-09 and the weakness of
the explosion of sovereign debt. But the list the subsequent recovery. For the advanced
will almost certainly be topped by the dra- economies as a whole, the slump that fol-
matic shift in global economic heft. lowed the global nancial crisis was by far
Ten years ago rich countries dominated the deepest since the 1930s. It has left an un-
the world economy, contributing around precedented degree of unemployed work-
two-thirds of global GDP after allowing for ers and underused factories in its wake. Al-
di erences in purchasing power. Since though output stopped shrinking in most
then that share has fallen to just over half. countries a year ago, the recovery is prov-
In another decade it could be down to 40%. ing too weak to put that idle capacity back
The bulk of global output will be produced to work quickly (see chart 1, next page). The
in the emerging world. OECD, the Paris-based organisation that
The pace of the shift testi es to these tracks advanced economies, does not ex-
countries’ success. Thanks to globalisation pect this output gap to close until 2015.
and good policies, virtually all developing The second reason to worry about stag-
countries are catching up with their richer nation has to do with slowing supply. The
peers. In 2002-08 more than 85% of devel- level of demand determines whether
oping economies grew faster than Ameri- economies run above or below their
ca’s, compared with less than a third be- trend rate of growth, but that trend rate
tween 1960 and 2000, and virtually none itself depends on the supply of workers
in the century before that. and their productivity. That productivity in
This rise of the rest is a remarkable turn depends on the rate of capital invest-
achievement, bringing with it unprece- ment and the pace of innovation. Across
dented improvements in living standards the rich world the supply of workers is
for the majority of people on the planet. about to slow as the number of pensioners
But there is another, less happy, explana- rises. In western Europe the change will be
A list of acknowledgments and sources is at
tion for the rapid shift in the global centre especially marked. Over the coming de-
Economist.com/specialreports of economic gravity: the lack of growth in cade the region’s working-age population,
the big rich economies of America, west- which until now has been rising slowly,
An audio interview with the authors is at
ern Europe and Japan. That will be the fo- will shrink by some 0.3% a year. In Japan,
Economist.com/audiovideo/specialreports cus of this special report. where the pool of potential workers is al- 1

2 A special report on the world economy The Economist October 9th 2010

2 ready shrinking, the pace of decline will now reckons that the fallout from the -
2
more than double, to around 0.7% a year. Onwards, ever upwards nancial crisis will, on average, knock some
America’s demography is far more favour- US real GDP per person, 2009 $’000 Log 3% o rich countries’ potential output.
able, but the growth in its working-age scale Most of that decline has already occurred.
population, at some 0.3% a year over the 60 The longer that demand remains weak,
coming two decades, will be less than a 40 the greater the damage is likely to be. Ja-
third of the post-war average. pan’s experience over the past two de-
20
With millions of workers unemployed, cades is a cautionary example, especially
an impending slowdown in the labour 10
to fast-ageing European economies. The
supply might not seem much of a problem. 8 country’s nancial crash in the early 1990s
But these demographic shifts set the 6 contributed to a slump in productivity
boundaries for rich countries’ medium- 4 growth. Soon afterwards the working-age
term future, including their ability to ser- population began to shrink. A series of
2
vice their public debt. Unless more immi- policy mistakes caused the hangover from
grants are allowed in, or a larger propor- 1
the nancial crisis to linger. The economy
tion of the working-age population joins 1869 90 1910 3040 5060 7080 90 2009
1900 20
failed to recover and de ation set in. The
the labour force, or people retire later, or result was a persistent combination of
Sources: US Department of Commerce; BLS; The Economist
their productivity accelerates, the ageing weak demand and slowing supply.
population will translate into perma- To avoid Japan’s fate, rich countries
nently slower potential growth. world. Growth in output per worker in need to foster growth in two ways, by sup-
Calculations by Dale Jorgenson of Har- America, which had risen sharply in the porting short-term demand and by boost-
vard University and Khuong Vu of the Na- late 1990s thanks to increased output of in- ing long-term supply. Unfortunately, to-
tional University of Singapore make the formation technology, and again in the ear- day’s policymakers often see these two
point starkly. They show that the average ly part of this decade as the gains from IT strategies as alternatives rather than com-
underlying annual growth rate of the G7 spread throughout the economy, began to plements. Many of the Keynesian econo-
group of big rich economies between 1998 ag after 2004. It revived during the reces- mists who fret about the lack of private de-
and 2008 was 2.1%. On current demo- sion as rms slashed their labour force, but mand think that concerns about econo-
graphic trends, and assuming that produc- that boost may not last. Japan’s productivi- mies’ medium-term potential are beside
tivity improves at the same rate as in the ty slumped after its bubble burst in the ear- the point at the moment. They include Paul
past ten years, that potential rate of growth ly 1990s. Western Europe’s, overall, has Krugman, a Nobel laureate and commen-
will come down to 1.45% a year over the also weakened since the mid-1990s. tator in the New York Times, and many of
next ten years, its slowest pace since the The third reason to fret about the rich President Barack Obama’s economic team.
second world war. world’s stagnation is that the hangover
Faster productivity growth could help from the nancial crisis and the feebleness Stimulus v austerity
to mitigate the slowdown, but it does not of the recovery could themselves dent European economists put more emphasis
seem to be forthcoming. Before the nan- economies’ potential. Long periods of high on boosting medium-term growth, favour-
cial crisis hit, the trend in productivity unemployment tend to reduce rather than ing reforms such as making labour markets
growth was at or slowing in many rich augment the pool of potential workers. more exible. They tend to reject further
countries even as it soared in the emerging The unemployed lose their skills, and disil- scal stimulus to prop up demand. Jean-
lusioned workers drop out of the work- Claude Trichet, the president of the Euro-
force. The shrinking of banks’ balance- pean Central Bank, is a strong advocate of
1
Yawning sheets that follows a nancial bust makes structural reforms in Europe. But he is also
Output gap* as % of potential GDP, forecast credit more costly and harder to come by. one of the most ardent champions of the
2010 2011 Optimists point to America’s experi- idea that cutting budget de cits will itself
7 6 5 4 3 2 1 – 0 ence over the past century as evidence that boost growth. All this has led to a passion- 1
Japan recessions, even severe ones, need not do
lasting damage. After every downturn the
3
Germany economy eventually bounced back so that All right for some
for the period as a whole America’s under- GDP per person employed*
France
lying growth rate per person remained re- % increase on previous year

United markably stable (see chart 2). Despite a lack 5
States
of demand, America’s underlying produc-
OECD tivity grew faster in the 1930s than in any 4
other decade of the 20th century. Today’s Emerging economies
Canada 3
high unemployment may also be prepar-
Italy ing the ground for more e cient processes. 2
Most economists, however, reckon that
Spain rich economies’ capacity has already sus- 1
Advanced
tained some damage, especially in coun- economies
Britain 0
tries where much of the growth came from
1970 75 80 85 90 95 2000 05 10†
*Difference between actual bubble industries like construction, as in †Forecast
Source: OECD and potential GDP Source: The Conference Board *Structural trend
Spain, and nance, as in Britain. The OECD


2 ate but narrow debate about scal stimu- noring threats to economies’ potential gest that labour markets may not be as ex-
lus versus austerity. growth and of missing the opportunity for ible as many people believe.
This special report will argue that both growth-enhancing microeconomic re- Faster growth is not a silver bullet. It
sides are blinkered. Governments should forms. Most rich-country governments will not eliminate the need to trim back
think more coherently about how to sup- have learned one important lesson from unrealistic promises to pensioners; no rich
port demand and boost supply at the same previous nancial crises: they have country can simply grow its way out of
time. The exact priorities will di er from cleaned up their banking sectors reason- looming pension and health-care commit-
country to country, but there are several ably quickly. But more competition and de- ments. Nor will it stop the relentless shift
common themes. First, the Keynesians are regulation deserve higher billing, especial- of economic gravity to the emerging
right to observe that, for the rich world as a ly in services, which in all rich countries world. Since developing economies are
whole, there is a danger of overdoing the are likely to be the source of most future more populous than rich ones, they will
short-term budget austerity. Excessive employment and productivity growth. inevitably come to dominate the world
budget-cutting poses a risk to the recovery, Instead, too many governments are de- economy. But whether that shift takes
not least because it cannot easily be o set termined to boost innovation by reinvent- place against a background of prosperity
by looser monetary policy. Improvements ing industrial policy. Making the jobless or stagnation depends on the pace of
to the structure of taxation and spending more employable should be higher on the growth in the rich countries. For the mo-
matter as much as the short-term de cits. list, especially in America, where record ment, worryingly, too many of them seem
Second, there is an equally big risk of ig- levels of long-term unemployment sug- to be headed for stagnation. 7

Withdrawal symptoms
After the stimulus, the hangover

S OME Americans have always taken the
national debt personally. During the
1940 census (according to the late David
McCord Wright, an American economist) a
housewife was asked if she had a mort-
gage on her home. Yes, she replied. For
$40 billion.
That gure (about 40% of 1940 GDP)
now seems quaint. The federal debt held
by the public was $8.9 trillion in August
2010, or about 60% of GDP. Add to that the
Treasury debt held by America’s public-
pension scheme, and the national debt
reached $10 trillion back in September
2008. The extra digit obliged the national
debt clock near New York’s Times Square
to move its dollar sign to make room.
Many of today’s Americans feel as in-
dignant about the debt as that 1940s house-
wife did. But they are just as pro igate as
their government (see chart 4, next page).
Their mortgages and other debts also $473 billion. Businesses and banks joined this frugality has helped American house-
amount to around $13 trillion, almost 120% in later. Although the federal debt dis- holds rebuild some of the wealth washed
of their annual disposable income. played on the Times Square clock is ticking away by the recession. Their net worth is
The most remarkable thing about that remorselessly upwards, the true national now about 490% of their disposable in-
gure, though, is not how big it is, but that it debt, including households, banks and come, compared with just 440% in the
is smaller than it was two years ago. For rms, is now lower than it was in the rst worst months of the crisis. As a cushion
over 60 years after the second world war, quarter of 2009. against a riskier world, American house-
household debt moved in only one direc- In 2008-09, for the rst time since the holds will probably try to set aside a stash
tion: upwards. Then, in the second quarter 1930s Depression, consumer spending in of assets worth some 540-550% of their in-
of 2008, it started to fall not just as a pro- real terms fell for two years in a row. come, according to Martin Sommer of the
portion of income, or after allowing for in- Households are now saving 6% of their IMF and Jirka Slacalek of the European
ation, but in everyday dollars and cents. disposable income, compared with just Central Bank. If that gure is right, their
Between March 1st 2008 and June 30th 2.7% in the years before the crisis. Com- balance-sheet repairs are currently only
2010 households reduced their debts by bined with the stockmarket’s tful rallies, half completed. 1


2 This new thrift is not con ned to Amer- under no obvious pressure from nancial
4
ica. Household debt is also falling in Spain. Chipping away at the mountain markets, especially Britain, where the new
In Britain households saved 6.3% of their US non-government debt, $trn coalition government announced tax in-
disposable income in 2009 (though less in Households Business Financial creases and dramatic cuts in spending. Ac-
the rst half of 2010), compared with 2% in sector cording to the Institute for Fiscal Studies,
50
2008. Nor is the frugality limited to house- these are even tougher than the cuts im-
holds. In the wake of the nancial crisis, 40
posed on Britain by the IMF in 1976.
companies across the rich world have In America bond yields are near record
been piling up cash. Small rms have been 30 lows and the economy is slowing, but the
unable, and many big rms have been un- government’s e orts to introduce a second
willing, to borrow. In Japan and Britain cor- 20 stimulus have foundered (though it is now
porate investment fell by about a quarter trying again). Much of the political debate
from peak to trough. The pace of invest- 10 in Washington, DC, is about the scale of s-
ment has recovered somewhat, but com- cal tightening; in particular, whether to al-
panies are still not rushing to add new fac- 0 low any of the Bush tax cuts to expire at the
2004 05 06 07 08 09 10
tories and machinery when so much of end of this year, as scheduled.
Source: Federal Reserve
their existing capacity lies idle. Even though the rich world’s econo-
All told, across the OECD households mies continue to operate below capacity,
and businesses are forecast to spend $2.6 accounting sense, these eye-popping de - in 2011 they are heading for what is likely to
trillion less than their incomes this year, cits are simply the counterpart of private be their biggest collective budget squeeze
the equivalent of 7% of GDP. This follows surpluses. In an economic sense, their re- in at least four decades. The appetite for
another huge private-sector surplus, of markable increase is less the outcome of government releveraging is coming to an
7.2%, the year before. In 2007, by contrast, government pro igacy than private thrift. end before private deleveraging is over.
the rich world’s households and business- According to the IMF, when the nal
es ran a combined de cit. This astonishing bill for the budgetary cost of the crisis is Too soon to tighten?
rise in private saving is the main reason calculated a few years hence, the unpopu- Is this a mistake? Economists are deeply di-
why the recession was so deep and the re- lar bank bail-outs and scals splash-outs vided. Many Keynesians think the answer
covery is so muted. After two years of priv- will account for less than 30% of it. The rest is yes. They fret that the costs and risks of
ate-sector austerity in the rich countries, will be down to the crisis itself, which higher public debt are wildly exaggerated,
the biggest macroeconomic controversy squeezed revenues and reduced growth. and that as long as households are cutting
now facing their governments is whether Regardless of its source, borrowing on back and economies are operating so far
to embrace some austerity of their own. this scale plays havoc with the public - below their potential, governments
nances. According to the IMF, gross gov- should not try to trim public de cits.
Squirrel it away ernment debt in the world’s big rich econo- Nonsense, say the advocates of auster-
Squirrels save by burying nuts in the mies reached 97% last year and is rising at ity, pointing to the ckleness of nancial
ground. In sophisticated economies, peo- its fastest pace in modern history. By 2015 markets and to the dangers government
ple save by amassing nancial claims on the IMF expects them to have a combined debt poses to long-term growth. Many
someone else. Savers therefore need bor- debt burden of 110% of GDP, against less claim that scal austerity could even boost
rowers. In textbook economics house- than 70% in 2007. growth in the short term. By reducing the
holds save and banks use those savings to Earlier this year fears about soaring spectre of massive government debt, it
lend to rms. For both households and public de cits and debt in some countries would lift private con dence and unlock
rms to run a surplus, someone else must seemed about to bring on another nan- spending. Entrepreneurs would be em-
run a de cit. That someone else could be a cial meltdown, thanks to Greece’s brush boldened to invest and households might
foreign nation. But none of the economies with default. More than 200 years ago feel freer to spend, without fear of future
outside the OECD is big enough to absorb America’s rst treasury secretary, Alex- tax increases to help repay the debt.
the excess private saving of the rich world. ander Hamilton, warned of the extrava- Keynesians are right that de cits, so far,
China would have to run a current-ac- gant premium countries must pay if their have been more a symptom than a source
count de cit of over 40% of GDP to o set a credit is questionable . This spring of economic distress. The scal swing un-
$2.6 trillion surplus. Even if the task were Greece’s credit was severely questioned. doubtedly helped to contain the damage
spread across all the Asian countries out- The premium, or spread, it had to pay on its from the crisis. Without it the private sec-
side the OECD (of which Japan and South bonds, relative to German bunds, rose ex- tor’s determination to save would have de-
Korea are members), they would have to travagantly, from about 2% at the start of pressed spending across the economy
run de cits of over 25% each. the year to almost 10% at the height of the even further. That would have caused a
The only other possibility is govern- crisis in May. Spreads on Irish, Portuguese correspondingly steeper fall in incomes,
ments. That is why the rich world’s private and, to a lesser extent, Spanish debt also making it harder for households to repair
surpluses have been mirrored by equally spiked. These fears re-emerged in Septem- their balance-sheets.
vast public de cits. Last year the OECD’s ber, particularly in Ireland. Nor are most rich countries anywhere
governments ran a combined de cit of Greece had to be bailed out by the EU close to the limits of what they can borrow.
7.9% of GDP, and this year it is likely to be and the IMF. Along with other wobbly A new study from the IMF suggests that
only marginally less. Among the big econ- euro-zone borrowers, it was forced to most advanced economies still have plen-
omies, Britain’s de cit will be the largest, at make radical budget cuts. But the Greek cri- ty of scal space . In America and Britain,
11.5%, with America not far behind. In an sis had a palpable e ect even on countries for instance, the fund’s economists calcu- 1


2 late that public debt will not reach its abso- stay there for a decade, even as ageing pop- Germany’s government took on east Ger-
lute limit until it hits 160% of GDP or more, ulations add 4-5% of GDP to their scal man housing and industrial debts worth
far higher than its current levels. The wolf costs. In America, Britain, Greece, Ireland, about 6.8% of GDP. The following year its
is not at the door. Japan and Spain a swing of 9% or more of budget seemed to improve dramatically
But termites are in the woodwork, as GDP is required. after that one-o event even though there
Charles Schultze, a former White House of- Given the scale of the task, it seems best had been no squeeze.
cial, once put it. Governments have big not to put it o for too long, especially The IMF’s researchers looked at coun-
underlying structural budget gaps that will since economies are no longer shrinking, tries that actually raised taxes or cut spend-
not be lled by economic recovery. Rising just growing slowly. Numerous studies ing and found no evidence that such mea-
health-care and pension spending will put suggest that consolidation based on sures boosted growth. In fact, they reckon
relentless pressure on government debt. spending cuts is more likely to stick, and that a scal contraction worth 1% of GDP
Eventually the rich world’s economies will will do more to boost medium-term typically cuts output by about 0.5% after
return to full employment, and when they growth, than measures involving tax in- two years. To cut public debt below 60% by
do, public borrowing will crowd out priv- creases. Cutting public-sector wages and 2030, as the IMF advocates, America
ate investment and hurt growth. welfare payments is better than cutting would have to endure that kind of scal
How much damage can these termites government investment. pain every year for ten years.
do, and when does it get serious? Carmen Putting in place reforms that slow
Reinhart of the University of Maryland down the rise in pension and health-care Ration the morphine
and Ken Rogo of Harvard University spending ought to be a particular priority, Fiscal tightening hurts less if o set by mon-
have examined the e ects of a couple of since the net present value of govern- etary easing. Central banks typically cut in-
centuries of sovereign debt. Their verdict is ments’ promises to the elderly dwarf to- terest rates and the currency weakens
that public debt does little discernible day’s debts. Raising the retirement age is a when governments tighten scal policy.
harm until it reaches about 90% of a coun- particularly good idea because it simulta- These lower interest and exchange rates
try’s GDP, but then the e ect on growth neously cuts governments’ liabilities and roughly halve the pain of budgetary re-
can be sudden and big. boosts future growth and tax revenue as pairs, the IMF calculates.
people work longer. If revenues must be But governments cannot expect as
So far and no farther raised, taxes on consumption and proper- much monetary morphine this time. If
Other scholars reach somewhat grimmer ty are less harmful to growth than those on households are paying back debt, cheaper
conclusions. Looking at 99 countries since income or saving. credit may provide less of a stimulus than
1980, Mehmet Caner and Thomas Grennes By these standards most rich-country at other times. Since so many governments
of North Carolina State University with scal-consolidation plans score reason- are tightening at once, and not every coun-
Fritzi Koehler-Geib of the World Bank ably well. Britain’s government plans to try’s currency can cheapen against every
identi ed a threshold of 77% of GDP. Every squeeze three-quarters of its budget ad- other’s, they may not bene t from much of
member of the G7 will breach that limit justment from spending cuts. In Greece the a depreciation.
this year. If the authors have got it right, share is 51% and in Spain 62%. Several Euro- Moreover, central banks cannot cut
these debts will knock half a percentage pean countries are raising their statutory their policy rates by as much as govern-
point o the collective growth rate of the retirement ages, albeit in small steps. ments might like. Rates in America, Britain
G20’s rich members. Where there have been tax increases, they and Japan are already at or near zero. In
The IMF says governments should as- have mostly been on VAT. By comparison, such cases a scal contraction of 1% of GDP
pire to cut their debt ratios back to 60% by America’s scal plans a rise in taxes on in- is more damaging to growth, knocking
2030. To do so they will have to perform come and capital if the Bush cuts expire, about 1% o output in the following year,
some scal heroics. Their budgets will and no progress on reforming pensions or according to the IMF’s researchers.
have to swing from a projected underlying health-care spending are much worse. This lack of leeway is a real constraint
primary de cit of 4.9% of GDP in 2010 (see However, the advocates of austerity on recovery. But although central banks
chart 5) to a surplus of 3.8% by 2020 and tend to exaggerate the bene cial e ect on cannot lower their policy rates any further,
short-term growth of such contractions they are not impotent. They can, and do,
(even if properly designed). Alberto Ale- ease monetary policy in other ways. Some
5
Recovery position sina and Silvia Ardagna of Harvard Uni- have tried to steer in ationary expecta-
Advanced economies, general government versity have identi ed many examples of tions with words. The Fed has promised to
balances, % of GDP economies that expanded even as their keep rates exceptionally low for an ex-
F O R E C A S T
2
de cits were squeezed through spending tended period . Several have swelled their
Cyclically adjusted primary balance + cuts (though not tax increases), yet a study balance-sheets by printing money to buy
0 in the IMF’s latest World Economic Outlook assets, such as government bonds, a pro-
–
2 shows that in some of their examples the cess known as quantitative easing .
de cits were not really squeezed. The biggest easer, relative to the size of
4
For instance, in 1998 Japan’s govern- the economy, has been the Bank of Eng-
6 ment injected over ¥24 trillion into Japan land. Since March 2009 it has bought al-
Overall balance
8 National Railway; in the following year it most £200 billion-worth of government
did not. Between those two years its bud- bonds, or gilts, equivalent to 14% of GDP, as
10 get balance appeared to improve by about well as a smattering of corporate bonds.
2005 06 07 08 09 10 11 12 13 14 15
4.8% of GDP even though it had neither cut The Bank’s research shows that its pur-
Source: IMF
spending nor raised taxes. Similarly, in 1995 chases of gilts raised their price, as well as 1


2 that of other securities that compete with neered by New Zealand’s central bank 20 cause in ation was already too low. Mr
government paper. When prices go up, years ago before being taken up by bigger Bullard argues that America is closer to a
yields go down: they fell by about one per- institutions such as the Bank of England. Japanese-style outcome today than at any
centage point on gilts and 0.7 points on the America’s Federal Reserve is still suspi- time in recent history .
safest corporate bonds and by 1.5 points on cious of it. Similarly, much of the best re- Others worry not that the Fed will pro-
riskier junk bonds. search on PLT is being conducted at the long the slump but that it may sow the
But it is not clear whether quantitative Bank of Canada. It will take time to catch seeds of the next crisis. Low rates are sup-
easing on its own changes people’s expec- on even if its theoretical appeal survives posed to help the economy mobilise its re-
tations of monetary policy and in ation. A contact with reality. sources, but they can also cause it to misal-
more direct way to do so would be to raise What seems clear is that if the eco- locate them. After the 2001 recession they
the Bank’s in ation target, currently set at nomic weakness persists and in ation generated excessive growth of sectors
2%. A gure of 4-5% might make central rates fall further, central banks may be- that rely on either xed-asset investment
bankers’ lives easier, according to some come more willing to experiment. Policies or credit , argues Raghuram Rajan of the
economists. But most central bankers do that look outré today may seem necessary University of Chicago. He fears that by set-
not like the idea. They think that the costs tomorrow. It is worth recalling that less ting rates at zero the Fed may merely
of higher, and possibly more volatile, in a- than two years after it began quantitative pump up growth in the short term only to
tion would outweigh any gains. A less-dis- easing in March 2001 the Bank of Japan see it collapse later . Low rates subsidise
cussed but potentially more useful innova- was buying equities. And in 2003 it was ad- borrowers at the expense of savers. If this
tion would be price-level targeting (PLT), vised to adopt price-level targeting by transfer were easier for voters to see, they
meaning that a central bank targets the lev- none other than Ben Bernanke, now the might nd a lot to dislike. But because the
el of prices, not their rate of change. Target- Fed’s chairman. Fed picks investors’ pockets silently and
ing a price level that rises by 2% a year is dif- forcibly no one asks questions about
ferent from targeting an in ation rate of 2% Beware self-ful lling prophecies cost, he writes.
a year because rather than washing its Some economists argue that central banks’ Given that the main reason for the re-
hands of past mistakes, the central bank determination to avoid de ation could cession and the weakness of the recovery
has to make up for past errors, returning have the opposite e ect. The Fed’s pledge is the dramatic increase in private thrift,
prices to their prescribed path. to keep interest rates low for an extended this seems an odd short-term concern. The
That should make in ation expecta- period , for instance, suggests that it be- rich world is short of private borrowing
tions a more powerful stabilising force. In a lieves the economy will remain underem- and awash with saving. Overall credit has
slump, in ation often falls uncomfortably ployed (and in ation subdued) for an ex- been shrinking. Nonetheless, Mr Rajan’s
low: prices might rise by only 1% over the tended period. If its pessimism spreads, it worries about the medium term are rea-
year, for example. Under PLT, the central may become self-ful lling. People will sonable. Years of ultra-loose monetary
bank has to make up this lost ground, so hoard cash because they expect prices to policy are likely to have unwelcome side-
prices might rise faster than 2% to catch up. fall and investments to fail, thus prolong- e ects. That is a reason for governments to
With a conventional in ation target, by ing the economy’s weakness. beware of overly fast scal tightening. It is
contrast, the central bank must promise in- This is the peril that befell Japan, ac- also a reason to look for antidotes to stag-
ation no higher than 2% in each and every cording to James Bullard of the St Louis nation beyond macroeconomic policy.
year, regardless of the rate the year before. Fed. The private sector came to expect de- The longer-term remedy must be creating
In central banking, as in many indus- ation and its expectations were duly ful- new jobs and increasing productivity, but
tries, the most innovative out ts are often lled. The central bank could not cut rates the most urgent need is to hurry up the re-
the small ones. In ation-targeting was pio- below zero, and it did not raise them be- pairs to a broken nancial system. 7

The cost of repair
A battered nance sector means slower growth

A LL recessions are painful, but the hang-
overs that follow nancial crises are
particularly long and grim. Growth is sub-
crises, growth was a lot slower and credit
growth stagnated whereas after normal
recessions it soared (see chart 6, next page).
swer will make a di erence to the rich
world’s growth prospects and to the way
policymakers should respond. People’s
stantially lower than it is during normal So far the current recovery is following unwillingness to borrow bodes ill for
recoveries as households and rms reduce this post-crisis script. Output is sluggish short-term demand. Firms’ reluctance to
their debt burdens. That is the depressing and credit is growing weakly or shrinking invest also risks denting productivity
conclusion from a growing body of re- across much of the rich world. But is this growth. But a broken nancial system’s in-
search on the aftermath of big nancial because over-leveraged households and ability to allocate capital e ciently has
busts. In one such study, Prakash Kannan, rms have become less willing to borrow, bigger long-term consequences.
an economist at the IMF, looked at 83 reces- or because banks have become less willing In practice, both supply and demand
sions in 21 countries since 1970. He found to lend? In other words, is the credit pro- probably play a role. There is plenty of evi-
that in recessions that followed nancial blem one of demand or supply? The an- dence that consumers and rms have be- 1


2 come less willing to borrow. A study by versity of Chicago, argued that the more a would be another matter. In the mid-1970s
Atif Mian of the University of California at company depends on external nancing the dearth of venture capital and IPOs set
Berkeley and Amir Su of the University such as bank loans or issues of stocks and back the development of computer and
of Chicago, for instance, shows a close cor- bonds, rather than internal cash ow, the network technologies that would prove to
relation between American car sales and more sensitive its fortunes are to the health have such a revolutionary impact in the
the level of household debt. In places of the nancial system. Mr Kannan of the 1980s and 1990s, says Josh Lerner of Har-
where households had heavier debt bur- IMF came to the same conclusion in his vard University. Venture-capital rms raise
dens at the start of the recession, subse- study. In the 13 recessions caused by nan- only about a third as much money in Eu-
quent car sales were weaker. cial crises, the industries most dependent rope as in America. The aftermath of the
Across the rich world, companies, par- on external nance grew 0.8 percentage crisis could widen the gap by reinforcing
ticularly big ones, have been piling up points more slowly, on average, than those continental mistrust of free-wheeling An-
cash. Firms’ cash stockpiles are at, or near, least dependent. There was no such gap glo-Saxon nance.
record levels, and bond investors are clam- after other kinds of recession. What will ultimately be more impor-
ouring for more corporate debt. In August tant, though, is the health of banks. Early-
Johnson & Johnson, a top-rated American Cash conundrum stage entrepreneurs are generally thought
pharmaceutical, medical device and con- The latest recession is likely to have similar to rely on them less than on friends, family,
sumer-products company, issued $1.1 bil- e ects. For example, Luc Laeven, an econo- venture capitalists and angel investors. But
lion in bonds at the lowest yields then on mist at the IMF, and Randy Kroszner of the Alicia Robb at the University of California
record for ten- and 30-year corporate debt, University of Chicago have found that list- at Santa Cruz and David Robinson of Duke
even though its operating cash ow far ex- ed biotech companies, which make up 10% University, who examined the sources of
ceeds its investment needs. of America’s total stockmarket listings, are nance of 4,000 American start-ups,
The historical record suggests that the heavily dependent on external nance found that bank loans are far more impor-
lack of demand for credit is likely to persist. and their growth is likely to su er far more tant than other sources of nance. On aver-
In a recent paper Carmen and Vincent from a withdrawal of credit than that of age, new rms borrow seven times as
Reinhart estimate that in past crises it took the overall economy. As Mr Laeven says, much from banks as they do from friends
an average of seven years for households we may only see the real impact ve years and family.
and businesses to bring their debts and from now when, without a crisis, some of Mr Robinson says the damage to
debt service back to tolerable levels rela- those investments would have paid o start-up nancing from the crisis is poten-
tive to income. In many countries that pro- and generated new products. tially quite severe . The collapse in house
cess has yet to begin. In America, where Venture-capital raising, which never prices has undercut the many entrepre-
progress has been fastest, the Reinharts fully recovered from the bursting of the in- neurs who rely on home-equity loans.
reckon that about half the rise in the ratio ternet bubble in 2000, has been harmed This will also depress jobs growth, which
of credit to GDP accumulated during the immensely by the latest crisis, says Steve over time depends disproportionately not
boom era has been unwound. Jurvetson at Draper Fisher Jurvetson, a on either small or large rms but on small
At the same time the supply of credit is venture-capital rm (see chart 7, next page). rms that become large, according to work
clearly constrained. Banks in the euro zone Endowments, foundations and pension by the Kau man Foundation.
continue to tighten credit standards, and in funds, enthusiastic participants in venture Japan o ers a sobering case history.
America they have only just begun to ease capital before the crisis, pulled back after Regulators were slow to force banks to re-
standards after several years of tightening. their stock and private-equity holdings cognise the problem of collapsed collateral
Most worrying is the potential damage were clobbered. The moribund IPO mar- values, but they did require banks to meet
that starving companies of credit will do to ket makes it harder for venture funds to new international standards for capital.
productivity. cash in their investments. Banks that acknowledged non-performing
Credit crunches do not a ect all compa- If the bear market in IPOs proves transi- loans risked falling below those standards,
nies the same way. In a paper in 1996, Mr tory (which is what usually happens), the so they kept zombie borrowers alive on a
Rajan and Luigi Zingales, also of the Uni- harm will be small. A prolonged drought drip-feed of fresh money. They continued
to extend credit to insolvent borrowers,
gambling that somehow these rms
6
The worst kind would recover or that the government
Developed-world recessions*, trough =100 After financial crises Without financial crises would bail them out , according to Ricardo
GDP Bank credit Caballero, Takeo Hoshi and Anil Kashyap
110 110
in a 2006 paper.
They estimate that zombie companies
108 108 those getting by on subsidised credit
106 106 which had made up 5-15% of banks’ bor-
104 104 rowers in the early 1990s, increased their
share to 25% later that decade. The e ects
102 102
were variable. Zombies were much less
100 100 prevalent in manufacturing, which was
98 98 constantly exposed to international com-
-4 -3 -2 -1 0 1 2 3 4 5 6 7 8 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 petition, than in construction and retailing,
Quarters from recession trough Quarters from recession trough
where job turnover and productivity
Source: Prakash Kannan, IMF *Based on 83 recessions in 21 industrial countries since 1970
growth were lower. 1


2 Policymakers have laboured to learn much since it allows them to put o recog- ment on bank capital contributed signi -
these lessons. In America and Europe they nising losses. But the non-performing cantly to a steep decline in loan growth in
have imposed stress tests to see how vul- loans may come to constitute a drain on America in the early 1990s, according to a
nerable their banks are to bad loans. Ire- banks’ resources that inhibits lending to 2000 study by the Bank for International
land and Germany have set up bad more productive borrowers. Settlements (BIS).
banks to shift bad loans to the public sec- In Japan bad loans were to corpora- Bankers say the new rules will also hurt
tor, as Sweden and Korea successfully did tions rather than households, but the pro- lending. The Institute of International Fi-
after their respective crises in the 1990s. blem is essentially the same. Despite their nance, which is backed by the world’s big
Still, there is a widespread belief that noble intent, federal subsidies that keep banks, argued in a report published in June
banks have not fully owned up to their stressed owners in their homes delay the that the rules then being contemplated
problems, partly because of political pres- necessary reallocation of capital away would trim annual economic growth by
sure. Germany’s Landesbanken, which from property. Fortunately we’ve been 0.5 percentage points in America, 0.9 in the
have ties to local politicians and rms, are pretty unsuccessful, says Mr Jorgenson, a euro area and 0.4 points in Japan over ve
widely thought to be in deeper trouble productivity expert at Harvard University, years. But in a study of its own the BIS pre-
than the stress tests suggest. noting the small number of temporary dicted a far more modest e ect: less than
In America, banks and Fannie Mae and mortgage modi cations that have become 0.2 percentage points in most countries,
Freddie Mac, the nationalised mortgage permanent. though in the medium term there would
companies, have been discouraged by fed- Weak banks are not the only reason for be a gain from greater stability.
eral and state governments from foreclos- a credit squeeze. There is also uncertainty
ing on homeowners unable to keep up over the e ect of new regulations on the - Make me virtuous, but not yet
their payments. Banks do not mind all that nancial system’s ability to channel savers’ Compelling banks to set aside a lot more
funds into investments. America recently capital without much warning is clearly
passed its biggest overhaul of nancial risky. The Federal Reserve found it would
7
Nothing ventured, nothing gained rules since the 1930s, known as the Dodd- have to lower short-term interest rates by
Venture capital, net funds raised, $bn Frank act after its leading congressional 40 basis points to soften the impact of big-
United States Europe sponsors. On September 12th the Basel ger capital bu ers on growth an impossi-
120 Committee of international bank regula- bility now that rates are, in e ect, at zero. To
100
tors agreed on a new set of requirements deal with this concern, the new Basel rules
for banks’ liquidity and capital. These have a long lead time. The minimum level
80 rules, known as Basel 3, will require global for common equity is not due to take e ect
60 banks to have common equity equal to at until 2015, and the additional bu er not un-
least 7% of their risk-weighted assets, til 2019.
40 against 2% now. That includes a minimum Equally contentious is the e ect of the
20 common-equity standard of 4.5% plus a post-crisis regulatory clampdown on high-
countercyclical bu er of another 2.5%. octane nance. America’s new nancial
0 Experience shows that higher capital rules compel banks to trim their holdings
1997 99 2001 03 04 05 06 07 08 09 10
98 2000 02
requirements do dent credit growth, at of private equity and hedge funds. They re-
Source: Thomson Reuters
least in the short term. The rst Basel agree- quire greater transparency in derivatives 1


2 markets and demand greater disclosure Paul Volcker, a former Fed chairman, has bank have led the way in issuing contin-
from hedge funds. These new rules are as caustically called the ATM cash dispenser gent convertible bonds which can be con-
yet imperfectly understood, but are al- the only worthwhile nancial innovation verted to equity if the bank is about to
ready having an e ect. For example, Ford of recent decades, a sentiment widely become undercapitalised. In theory, this
Motor’s credit arm pulled an asset-backed shared by venture capitalists and non- - lessens the risk of future insolvency and
bond deal because credit-rating agencies, nancial businesses. I can’t think of any - taxpayer bail-out and lowers the cost of
fearful of new liabilities under the Dodd- nancial or banker product or service that’s raising fresh equity capital. Private-equity
Frank act, forbid the use of their opinions ever helped us, says Mr Jurvetson. Engi- rms are currently dabbling in buying
in the deal document. The deal went neers contribute to the economy, lawyers deeply discounted underwater mort-
ahead when the Securities and Exchange and bankers subtract. gages from banks, then restructuring the
Commission temporarily suspended the In a new book Amar Bhidé, a professor terms to prevent foreclosure. There is even
requirement that deal documents include at Tufts University, argues that modern a edgling market in bonds explicitly
such ratings. banks reduced loan decisions to arm’s- backed by delinquent mortgages. Mean-
In Britain and America sophisticated - length algorithms based on credit scores while, American local governments are is-
nance is ingrained enough to survive and asset values, biasing them towards ho- suing property assessed clean energy or
tighter regulation. Continental Europe, mogeneous loans such as residential mort- PACE bonds, then lending the proceeds to
however, has never had America’s breadth gages. Yet the prospects of young, innova- homeowners to make their homes more
of nancing options for fast-growing com- tive businesses are not easily summarised energy-e cient. Homeowners repay the
panies such as junk bonds, mezzanine in a credit score; a bank manager must loans through their property tax.
debt and private equity, note Thomas Phil- sample its wares, kick the delivery van’s There are many more ideas on the
ippon and Nicolas Véron in a 2008 report tyres and meet the founders. Mr Bhidé says drawing board. Robert Shiller of Yale Uni-
for Bruegel, a Brussels-based think-tank. that is how banks worked before deregula- versity, whose theories led to the develop-
So far the European response has been tion in the 1980s and 1990s, and thinks a re- ment of property derivatives, has pro-
less draconian than many feared. New turn to that old model would boost credit posed their use in developing home-
rules currently being negotiated by the to young businesses. equity insurance for homeowners. Mr Ca-
European parliament and EU nance min- ballero and Pablo Kurlat of the Massachu-
isters could stop foreign hedge funds and The uses of novelty setts Institute of Technology would like to
private-equity funds from marketing However, this too easily dismisses the con- see governments sell tradable insurance
themselves to EU investors unless they ac- tribution of nancial innovation. Work by credits which give any nancial institu-
cept certain restrictions. But Mr Véron Mr Laeven of the IMF with Ross Levine tion the right to buy a government guaran-
notes that they have yet to pass, and Britain and Stelios Michalopoulos suggests that - tee in a nancial crisis.
has raised objections. New proposals for nance innovates to meet the changing Nothing may come of these ideas, yet
regulating derivatives trading, released by needs of the economy as it evolves; wheth- their potential should not be dismissed. In
the European Commission on September er that innovation is bene cial depends on the early 1990s America’s Resolution Trust
15th, were less onerous than expected, and the economic purpose it serves. Subprime Corporation used securitisation to o oad
in some ways less likely to discourage in- CDOs helped facilitate a reckless overin- billions of dollars in property loans inher-
novation than America’s new rules. vestment in property, whereas preferred ited from busted banks more quickly and
Nonetheless, increased regulation is shares, a 19th-century innovation, - at better prices than if it had disposed of
likely to slow the pace of nancial innova- nanced that era’s railroad boom. them one at a time. It would be ironic if -
tion. How much that matters depends on Financial innovation may even help nancial innovation, so reviled for helping
whether such innovation boosts growth. It the economy cope with the aftermath of to bring on the latest crisis, were to play a
has become fashionable to say it does not. the crisis. Lloyds Banking Group and Rabo- part in cleaning up the mess. 7

From hoarding to hiring
Some countries have successfully preserved jobs. Now they must create new ones

H IGH unemployment is the most visi-
ble scar left by the recession. In the 32
rich OECD countries the downturn and its
ingly, the damage is not as bad as it might
have been.
When output falls, employment fol-
it applied with a vengeance: Spanish em-
ployment fell by twice as much as output.
But in most countries its e ect was merci-
aftermath threw over 17m people out of lows. This link is predictable enough to fully mild. In Germany unemployment by
work. There was a comparable rise in the qualify as an economic law, named after the end of 2009 was lower than it had
number of people who would take a full- Arthur Okun, who showed that when been two years earlier.
time job if it were available but instead America’s GDP fell by 2%, its unemploy- These disparate outcomes have chal-
have settled for part-time work or given up ment rate rose by about half that. In this re- lenged long-held stereotypes. The German
looking altogether. This rise in unemploy- cession, however, Okun’s law did not labour market has undergone a strange
ment matches that in the deepest of the work as expected in a number of coun- mutation from a bulwark of eurosclerosis
OECD’s post-war recessions. But, astonish- tries. In America, New Zealand and Spain into a champion of exibility , writes Joa- 1


was companies’ response to the crisis. In to escape. Mr Elsby and his co-authors fear
More misery 8 most rich countries they cut hours more that America will be stuck with a persis-
Labour market, Q4 than bodies. German rms last year re- tent residue of long-term unemployed
Unemployment as % of labour force
duced working time by the equivalent of workers with relatively weak search e ec-
of which: unemployed for 12 months or more 1.4m full-time employees. And even when tiveness, depressing the strength of the re-
0 5 10 15 20 their sta did clock in, they worked less covery . Students of Europe’s stubborn
hard. For the rst time in decades output unemployment in the 1980s call this scle-
2007
Spain
2009
per hour fell, reducing the input of labour rosis , an accumulation of scar tissue that
by the equivalent of 1m people. makes the market more rigid.
2007 The German government encouraged One obvious reason why American
France
2009
this labour-hoarding with its celebrated workers are taking longer to escape from
United 2007 Kurzarbeit scheme that subsidises shorter unemployment is a lack of job openings.
States 2009 working weeks. But this was responsible As long as vacancies remain low, unem-
OECD
2007 for only about a quarter of the reduction in ployment will remain high. That is anoth-
2009 working hours. Firms were not forced or er economic relationship stable enough to
2007 bribed to keep their workers; they chose to carry someone’s name: the Beveridge
Italy
2009 do so. Before the recession industries such curve, named after William Beveridge, a
2007 as metals, chemicals and machinery had British economist. His curve is, however, a
Britain
2009 found it hard to ll vacancies. Workers in poor guide to the recent behaviour of
these industries are highly trained and spe- America’s labour market. In 2009 a fairly
2007
Germany
2009
cialised and can cost up to 32,000 steady stream of job openings did not stop
($42,000) each to replace. When demand unemployment rising from 7.7% to 10%.
2007 for labour falls, rms want to hang on to And in the rst months of this year vacan-
Japan
2009
them, just as they might mothball an ex- cies jumped, with little e ect on the jobless
Source: OECD pensive piece of machinery. rate (see chart 9).
In America, in contrast, rms proved
2 chim Möller of the Institute for Employ- keener to cut workers than hours. In the Keep them keen
ment Research (IAB). America, long the 1973-75 recession, the OECD calculates, em- What explains this puzzle? Some econo-
poster child for e cient labour markets, ployment cuts accounted for less than a mists blame the extension of unemploy-
suddenly looks sclerotic. Not only is it third of the reduction in man-hours. The ment bene ts, which America’s jobless
grappling with unemployment of 9.6%, remainder was achieved by shortening the can now claim for 99 weeks, as long as in
but almost half of its jobless have been out working week or year. In the recent reces- France. European bene ts will buy you
of work for more than six months, the sion the split was reversed. Robert Gordon European sclerosis, argues Robert Barro, an
highest share since the Depression. of Northwestern University says that economist at Harvard University. He reck-
What explains this divergence of for- American rms have come to view their ons that the unemployment rate would be
tunes? First, the e ects of the recession employees as disposable . 6.8% rather than 9.5% if bene ts had re-
were unevenly spread. In countries such as Mr Gordon’s judgment on the Ameri- mained at 26 weeks. Most other econo-
America, Spain or Ireland, the bursting of can labour market is one-sided. If Ameri- mists think the e ect is much smaller.
housing bubbles caused construction to can rms are quicker to re their workers Whatever the magnitude, there is
slump, with the loss of many jobs that are than their European rivals, they are also bound to be some impact. The sooner the
unlikely to return soon. By contrast, in ex- quicker to hire. Over recent decades Amer- money runs out, the sooner people grab a
porting countries such as Germany or Ja- icans have entered unemployment at sev- job. The interesting question is not wheth-
pan the damage was done mainly by the en times the rate of Germans, but they er longer bene ts delay re-employment,
collapse of global trade, which proved have exited from it ten times as fast: some but why. Mr Barro thinks it is a case of
more temporary. 58% of workers who are unemployed one moral hazard : if people are insured 1
Second, labour-market rules vary month will not be the next, according to
widely. Some countries have long tried to calculations by Michael Elsby of the Uni-
trump Okun’s law with legislation of their versity of Michigan, Bart Hobijn of the San Slightly out of line Trend line 9
own, making it costly or cumbersome to Francisco Fed and Aysegül Sahin of the US Beveridge curve, Jan 2007-Jul 2010 2000-
Dec
15/6/2007 Jul 2010
lay o workers. Pierre Cahuc of France’s New York Fed. Discarded American work- 15/5/2007
15/4/2007
15/8/2007
15/2/2007
15/7/2007
15/11/2007
15/9/2007
École Polytechnique and his colleagues ers have not rusted on the scrapheap, as so 3.5 15/10/2007
15/12/2007
Mar 2007 Apr
15/2/2008
15/1/2008
15/3/2008
point to Spain’s rules on ring permanent many do in Europe. 15/4/2008
15/7/2008
15/6/2008 2010
Job openings rate, %

3.0 15/8/2008
sta , which are particularly tough, though At its best, then, the American labour 15/9/2008 2010
Jul
15/10/2008
recent reforms have eased them slightly. 15/11/2008
market does not dispose of its workers; it 2.5
15/12/2008
15/1/2010
15/5/2010
15/3/2010
15/2/2009
That has been good for those lucky enough recycles them. Sadly, the market is now far 15/2/2010
15/1/2009
15/3/2009
15/9/2009
15/12/2009
15/11/2009
15/5/2009
15/6/2009
Jan 2007 15/8/2009
15/4/2009
15/7/2009
to hold a permanent contract. But Spanish from its best. For every 100 people unem- 2.0
rules give little protection to temporary ployed in the autumn of 2009, only 24 had Jan 2009
workers. So employers hired lots of them escaped their predicament within a 1.5
Oct 2009
they made up about 30% of all employees month, an historic low. The harder it is to
before the crisis and red them when the escape joblessness, the longer people re- 4 5 6 7 8 9 10
Unemployment rate, %
downturn arrived. main unemployed; and the longer they re-
Sources: BLS; Thomson Reuters
But what made the biggest di erence main unemployed, the harder they nd it

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