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Summary:
– Just as heterodox theories about the end of capitalism were beginning to gather dust, becoming mere witnesses to the wanderings of economic theory, Raghuram Rajan returns to the deep roots of the crisis, beyond simple economic common sense, by reflecting more broadly on the interaction between capitalism and democracy.
– Indeed, while economic development and democracy can go hand in hand, certain frictions can emerge despite laudable intentions; the search for consensus can thus hinder the smooth running of the economy, as did the political will to support the advent of a homeownership society in the United States through mortgage loans.
– Conversely, the current economic turmoil is generating intense tensions in democracies over the distribution of the very high costs to be borne, sometimes without much consideration for past responsibilities.
Professor Raghuram Rajan [1] was invited to the Paris School of Economics on April 10 for the release of the book « Crise: au-delà de l’économie » (translation of « Fault Lines ») published by Le Pommier [2].
The profound contradiction of capitalism is not so much the extraction of rent from the working masses, but paradoxically its inability to adjust to the challenges of technological progress while responding to the new needs of low-skilled workers. Is capitalism, with its many faces, which has replaced itself many times over, not flexible enough?
Disconnect between the marginal productivity of skilled workers and their wages
The crisis originated in the uncontrolled increase in the indebtedness of economic agents, both institutional and individual (see Figure 1). But this growing indebtedness is only a reflection of the increase in income inequality at the top of the distribution. Kumhof et al. (2012) [3] document the increase in inequality since the late 1970s in Anglo-Saxon countries (see Figure 2). They argue that financial liberalization has accentuated income distribution to the detriment of the middle classes, through a decline in their bargaining power. More broadly, Prof. Rajan considers that the increase in high incomes is the result of friction in the labor market; due to the rapid development of new professions following significant technological advances, the workforce is insufficiently skilled to meet the growing demand from businesses. This has led to a disconnect between the productivity of skilled workers and their wages: it is now the scarcity of skilled profiles that determines wages, rather than their marginal productivity alone.
Source: Banque de France, BS Initiative
The increase in the share of high incomes in distribution, which began in the late 1970s, partly reflects the crisis that followed the Trente Glorieuses. After post-war growth rates of 4-5%, which allowed for a better distribution of the fruits of growth, the average growth rate fell sharply after 1973 and it became increasingly difficult to ensure that the majority benefited from slowing growth (see Table 1). Only the most skilled and those whose profiles were most compatible with the new technological cycle were able to benefit from the advent of the post-industrial society.
Through the workings of democracy, the social success of some pushes others to take on unreasonable levels of debt.
If GDP growth alone can no longer ensure full employment for low-skilled or unskilled workers, nor guarantee an income considered sufficient by a kind of social contract, the solution is to go into debt:
– increasing public spending to support low-skilled employment, particularly in the construction sector;
– increasing the borrowing capacity of households that cannot directly benefit from the fruits of growth, particularly by supporting real estate prices to take advantage of a wealth effect, in the absence of an income effect.
Thus, it is indeed the game of democracy that has circumvented the initial allocation of income to implement an indirect transfer of wealth in favor of the middle classes. Democracy promotes the individual and gives them the right to a certain level of material comfort: the consumption level of the least well-off households will thus have continued to increase gradually, without the corresponding increase in income. Finally, while the indebtedness of various actors in society has been largely supported by the legislature, it is above all the convergence of excess savings on the part of the highest income earners (or faster-growing countries) and demand for credit on the part of households wishing to maintain their standard of living that has made this possible.
But such a situation could only be temporary.
Recourse to debt cannot compensate for a permanent loss of income. Worse still, the investments financed by such leverage mainly served to support real estate and other sectors protected from international competition that do not require a highly skilled workforce: the roots of the problem have therefore not been addressed.
Figure 2: Income concentration among the top 5% of the population
Source: Kumhof et al. (IMF, 2012)
Towards the end of property rights?
While democracy seemed to be able to guarantee a better allocation of resources than capitalism—which has been ailing since the 1970s—could provide,today democracy is at a crossroads. Who will have to pay? Prof. Rajan points out that property rights, the very foundation of capitalism, will have to be modified in one way or another:
– either by making high earners contribute more, for example by moderating incomes that are no longer related to marginal productivity (limiting dividends, bonuses, stock options), or by restructuring the principal as in the Greek or Cypriot scenarios;
– or by adjusting rights that were previously part of the democratic consensus, such as health coverage or retirement pensions, or by allowing wage moderation in the interests of economic pragmatism in times of crisis.
For a real » education campaign » in economics
Capitalism will probably survive the Great Recession, but to avoid sowing the seeds of a new crisis, Prof. Rajan urges us not to sacrifice democracy to economic pragmatism. Capitalism and democracy can only survive if agents retain the hope that they can get ahead by being innovative and thus achieve social success. If property rights are to be changed, care must be taken to preserve incentives for the years to come, without necessarily seeking individual responsibility for the excesses of the past.
Or rather, democracy and capitalism must once again go hand in hand. No, bankers have not necessarily corrupted democracy; it is the flawed incentive system, based in part on populist policies, that has allowed them to prosper, with, for example, the creation of the government mortgage agencies Fannie Mae, Ginnie Mae, and Freddie Mac in the United States.
The danger today is that the roots of the crisis are not really understood: there is a great temptation to find a scapegoat, whether it be the banks, China, or the euro. But if everyone asks their neighbor to make adjustments, no one is prepared to make the adjustments demanded by their neighbors. Only if the population becomes aware of the challenges and risks we face can governments be forced to act against their own interests in order to promote those of the global economy. More than just vocational training in line with the new needs of businesses, Prof. Rajan calls for a real « education campaign » in economics so that democracy can be the vehicle for future reforms.
In some cases, such public awareness has already demonstrated its ability to compel governments to cooperate… but » the issue of banning anti-personnel mines was far more appealing than the economic problems we face. »
Notes:
[1] Former Chief Economist of the International Monetary Fund, Raghuram Rajan is currently a professor at the University of Chicago Business School and financial advisor to the Indian Minister of Finance. Winner of the Fischer-Black Prize in 2003, he has just received the 2013 Deutsche Bank Prize in Financial Economics.
[2] Rajan R. (2013). Crise : au-delà de l’économie, Le Pommier, « Essays – Economic Knowledge and Debates » collection.
[3] Khumhof, M., Lebarz, C., Rancière, R., Richter, A., and Throckmorton, N. (2012). Income Inequality and Current Account Imbalances, IMF Working Paper 12/08.
