Arnold Kling  

Rajan and Reinhart

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Raghu Rajan spoke at Cato about his new book, Fault Lines. One of the discussants was Carmen Reinhart, of Reinhart and Rogoff fame. I found it interesting, and it might be worth checking out when Cato puts up a recording, probably by early next week. Meanwhile, you can read my thoughts, which are below.

Start with Reinhart. I find her a bit like Paul Samuelson, in that she seems to have a lot of thoughts running through her mind, and only a sample of those thoughts get processed through her vocal cords. This leaves many thoughts unexpressed.

For example, here are three things I thought I heard her saying.

1. Large capital inflows end badly. They are the predecessor for financial crises.
2. Financial liberalization promotes capital inflows.
3. Financial liberalization is a good thing.

The opposite of financial liberalization is financial repression. Under financial repression (think China), about the only savings vehicle available is government bonds. The government then allocates capital. Private capital inflows are minimized, because who wants to invest overseas in low-yielding bonds? Domestic savers get stuck with low yields and low incomes. Reinhart thinks we will see more financial repression in debt-ridden western countries, so that governments can continue to market their debt. Have a nice day.

I assume that some of Reinhart's unexpressed thoughts help to explain how to reconcile the benefits of financial liberalization with a desire to avoid crises caused by large capital inflows. Maybe somebody can look up what she has written and find the answer.

Rajan was able to explain why he favors fiscal and monetary restraint. He thinks that the U.S. economy is too consumption-oriented and bubble-prone. Bigger deficits would accentuate our lack of savings. Low interest rates set us up for another bubble.

(By the way, did you see the chart Greg Mankiw reprinted suggesting that the U.S. stock market is 50 percent overvalued? Rajan did not mention the chart, but he asked the audience rhetorically if they were keeping savings in money market funds where the yield is close to zero, or instead taking risks to try to earn a return. I personally have more in money market funds than I ever had before, but my personal risk premium is high at the moment. I sold some of my "inflation-bets" portfolio at a profit, and I gave up on TBT as being the right vehicle to take a long-term short position in Treasuries.)

So Rajan is willing to tolerate low aggregate demand now, because he thinks that stimulating demand would just set us up for a worse crisis in the medium term. Scott Sumner thinks that if we do not stimulate aggregate demand, we will instead get more socialist policies. They may both be right, in which case we are damned if we do and damned if we don't.

Rajan also thinks that some of our higher unemployment is long-term and structural. Without using the term Recalculation, I asked him if he had any solutions for this, and he said nothing beyond generosity with unemployment benefits. Yes, this will add to the incentive for people to remain unemployed, but that is a price he is willing to pay to be more compassionate. I think I would come out on the same side on that one.

Rajan is really focused on income inequalities. He thinks that the credit boom was the government's way of throwing a sop to the median family (the ratio of income at the 90th percentile to the 50th percentile has shot up in recent decades). During the Q&A, I suggested that he was committing an intellectual swindle here, because I do not think the government subsidizes mortgage lending to benefit borrowers. I think it is rent-seeking by the housing lobby. He took offense at the term "swindle," and afterwards I apologized. But I stand by the substance of my disagreement.

He points out that in the world of outsourcing, the U.S. is probably a net exporter. We provide high-end business services, such as consulting. So, he argues, globalization helps Americans at the top end and hurts Americans at the bottom end. He thinks we need to fix our education system to do anything about that, and of course the payoff would not come for another generation or more. He also likes entrepreneurial solutions to education--he mentioned one start-up that will offer basic college courses on line at low cost, so that the student only needs to attend a standard university for a couple of years to complete advanced courses. (My thought: isn't this just another version of Community College?)

Anyway, the three fault lines, as Reinhart summarized them, are:

1. The U.S. saves too little and borrows too much.
2. Other countries, notably China, save too much.
3. The U.S. has an ineffective education system for the bottom part of the population.

Many books on the financial crisis start with the way Lehman was handled, or somesuch, and ignore any root causes. On the other hand, I think looking at these three fault lines may be trying to find roots that are too deep. I prefer to look at intermediate causes, like housing policy and the Basel capital standards.



COMMENTS (5 to date)
Jim Glass writes:

Rajan ... thinks that the credit boom was the government's way of throwing a sop to the median family (the ratio of income at the 90th percentile to the 50th percentile has shot up in recent decades) ... I do not think the government subsidizes mortgage lending to benefit borrowers. I think it is rent-seeking by the housing lobby.

The two ideas are not contradictory.

If politicians can please both the median voters and an influential lobby with the same policy, why not?

John Fast writes:
1. The U.S. saves too little and borrows too much.

2. Other countries, notably China, save too much.

3. The U.S. has an ineffective education system for the bottom part of the population.

I don't know what impresses me more (in a negative way, of course): the fact that these three things have all been true for at least three decades, or the fact that many of the solutions proposed by the political class are actually harmful.

To me, the solutions for all three are simple:

1. Replace the current Social Security system with a privatized one, or at least with a system of self-directed accounts which people could invest in the stock market -- basically, just like an IRA or 401(k).

(As part of this, reform the current Social Security system to: 1. remove the "Social Security Wage Base" cap on FICA; 2. index benefits to inflation, i.e. CPI instead of AWI; 3. raise the age for full retirement benefits by two months every year, which essentially reduces Social Security benefits by approximately 1.67% every year, and will phase out the system within 30 years.)

2. This is their problem, not ours (and not necessarily a problem for anyone).

3. School choice, plus (for government schools) a system like that recommended by Charles Murray in both Losing Ground and Real Education.

BZ writes:

#2 bothers me only due to the datum read elsewhere that the only place the chinese have to save is in government bonds. No capital creation == Less economic growth == less productivity for all of us to enjoy.

Ned Baker writes:

Arnold, thanks for the write-up. Interesting read.

John Fast, currently via FICA most Americans are forced to save 12.4% of their income in essentially inflation indexed treasury bonds. And according to the CBO, the median earner gets his money back 100%, low earners get up to 200% what they paid in, and the highest earners receive 50% of their contributions back. Meanwhile most employees with 401k's can't find the will to save anything themselves, unless they are auto-enrolled, in which case the status-quo bias improves their savings rate. Do you really believe the median earner would save 12%+ if FICA were lifted? I personally doubt it. Let's ignore other concerns like redistribution and solvency for now. I just don't think it's plausible that Social Security reduces the savings rate.

John Fast writes:

Ned Baker wrote:

Do you really believe the median earner would save 12%+ if FICA were lifted?
Almost certainly not: I was talking about keeping the requirement for people to save that amount, but putting it into individual accounts rather than into the Social Security slush fund, because that "lock box" is actually used to pay for general government spending rather than used for capital investment. Sooner or later that's going to -- oops, wait!

Hmm, I wonder if anyone has done an article discussing the difference (in standard macroeconomic terms) between *real* saving and the way the slush fund is handled.

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