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

worldeconomy.indd 1 28/09/2010 12:52 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 HAT will tomorrow’s historians see The next few years could be de†ned as as the de†ning economic trend of the much by the stagnation of the West as by The rich world should worry about growth• W early 21st century? There are plenty of po• 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 Œoutput 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• Œtrend 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 Œrise 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 †• more than double, to around 0.7% a year. Onwards, ever upwards 2 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• With millions of workers unemployed, 20 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 vice their public debt. Unless more immi• 2 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 901900 1910 20 30 40 50 60 70 80 90 2009 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 Yawning 1 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 high unemployment may also be prepar• 3 Italy ing the ground for more eˆcient processes. 2 Most economists, however, reckon that Spain rich economies’ capacity has already sus• 1 Advanced tained some damage, especially in coun• economies Britain tries where much of the growth came from 0 1970 75 80 85 90 95 2000 05 10 † *Difference between actual bubble industries like construction, as in Source: OECD and potential GDP Source: The Conference Board *Structural trend †Forecast Spain, and †nance, as in Britain. The OECD The Economist October 9th 2010 A special report on the world economy 3

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

OME Americans have always taken the Snational 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. ŒYes, she replied. ŒFor $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 4 A special report on the world economy The Economist October 9th 2010

2 This new thrift is not con†ned to Amer• under no obvious pressure from †nancial ica. Household debt is also falling in Spain. Chipping away at the mountain 4 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, 2008. Nor is the frugality limited to house• 50 these are even tougher than the cuts im• IMF holds. In the wake of the †nancial crisis, 40 posed on Britain by the 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 2011they 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 Œextrava• 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 Œquestionable. 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 Œ†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 The Economist October 9th 2010 A special report on the world economy 5

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 Recovery position 5 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 Œexceptionally low for an Œex• FORECAST 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 IMF World Economic Outlook – in the ’s latest assets, such as government bonds, a pro• 2 shows that in some of their examples the cess known as Œquantitative 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. 200506 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 6 A special report on the world economy The Economist October 9th 2010

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 Œis 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 Œexcessive 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 Œmerely 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 Œbecause 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• forciblyðno 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 Œan 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 Œperil 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

LL recessions are painful, but the hang• crises, growth was a lot slower and credit swer will make a di erence to the rich Aovers that follow †nancial crises are growth stagnated‹whereas after normal world’s growth prospects and to the way particularly long and grim. Growth is sub• recessions it soared (see chart 6, next page). policymakers should respond. People’s stantially lower than it is during Œnormal 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 eˆciently 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 The Economist October 9th 2010 A special report on the world economy 7

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 Œwe 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 Œpoten• 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 Œharmed 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 Œextend credit to insolvent borrowers, gambling that somehow these †rms The worst kind 6 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 in a 2006 paper. 110 110 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 8 A special report on the world economy The Economist October 9th 2010

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 Œbad 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. ŒFortunately 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 Nothing ventured, nothing gained 7 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 tors agreed on a new set of requirements deal with this concern, the new Basel rules 100 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 199798 99 2000 2001 02 03 04 05 06 07 08 09 10 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 The Economist October 9th 2010 A special report on the world economy 9

2 markets and demand greater disclosure Paul Volcker, a former Fed chairman, has bank have led the way in issuing Œcontin• 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. ŒI 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. ŒEngi• †rms are currently dabbling in buying in the deal document. The deal went neers contribute to the economy, lawyers deeply discounted Œunderwater mort• ahead when the Securities and Exchange and bankersðsubtract. 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 Œproperty 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•eˆcient. 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 Œtradable 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

IGH unemployment is the most visi• ingly, the damage is not as bad as it might it applied with a vengeance: Spanish em• Hble scar left by the recession. In the 32 have been. ployment fell by twice as much as output. rich OECD countries the downturn and its When output falls, employment fol• 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 Œundergone 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 10 A special report on the world economy The Economist October 9th 2010

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 Œpersis• 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• 05 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 Œscle• 2007 Spain per hour fell, reducing the input of labour rosis, an accumulation of scar tissue that 2009 by the equivalent of 1m people. makes the market more rigid. 2007 France The German government encouraged One obvious reason why American 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• 2007 for only about a quarter of the reduction in ployment will remain high. That is anoth• OECD 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 Japan for labour falls, †rms want to hang on to And in the †rst months of this year vacan• 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 eˆcient 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 Œdisposable. 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 Œmoral 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 2010Dec 2000- 15/6/2007 Jul 2010 lay o workers. Pierre Cahuc of France’s New York Fed. Discarded American work• 15/5/200715/4/200715/8/2007 15/2/200715/7/200715/9/200715/11/2007 École Polytechnique and his colleagues ers have not rusted on the scrapheap, as so 3.5 15/10/200715/12/2007 15/2/200815/1/200815/3/2008Mar 2007 Apr 15/4/200815/7/2008 point to Spain’s rules on †ring permanent many do in Europe. 15/6/2008 2010 3.0 15/8/2008 sta , which are particularly tough, though At its best, then, the American labour 15/9/200815/10/2008Jul 2010 15/11/2008 15/12/200815/5/201015/1/2010 recent reforms have eased them slightly. market does not dispose of its workers; it 15/2/200915/3/2010 2.5 15/1/200915/3/200915/2/201015/9/2009 That has been good for those lucky enough recycles them. Sadly, the market is now far 15/11/200915/12/200915/5/200915/6/2009 Jan 2007 15/8/200915/4/200915/7/2009 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 Job openings rate, % Jan 2009 workers. So employers hired lots of them‹ escaped their predicament within a 1.5 they made up about 30% of all employees month, an historic low. The harder it is to Oct 2009 before the crisis‹and †red them when the escape joblessness, the longer people re• 4 5 6 7 8 9 10 downturn arrived. main unemployed; and the longer they re• Unemployment rate, % But what made the biggest di erence main unemployed, the harder they †nd it Sources: BLS; Thomson Reuters The Economist October 9th 2010 A special report on the world economy 11

2 against a risk such as joblessness, they will and skill mismatches reinforce each other. try less hard to escape it. But Raj Chetty of As a result, they say, America’s underlying, Harvard has a subtler answer. or Œstructural, rate of unemployment rose He points out that workers who receive from 5% before the †nancial crisis to be• generous lump•sum severance payments tween 6% and 6.75% in 2009. So even if the also take longer to †nd a new job. The recovery gathers steam, almost one•third lump•sum payouts are theirs to keep of the rise in joblessness may endure. whether they take another job or not, so by Few policymakers think that America’s taking their time they are spending their jobless problem is mainly structural. An own money. They may †nd this worth exception is Narayana Kocherlakota, presi• their while because by waiting for the right dent of the Minneapolis Fed, who reckons job they will secure higher earnings. In an that Œmost of it is. And Edmund Phelps, a ideal world the unemployed would †• Nobel prize•winning economist at Colum• nance their own job search by borrowing bia University, worries that the focus on against these higher future wages. In the de†cient demand Œlulls us into failing to real world, however, bene†ts have to †ll ‘think structural’ in dealing with long•term the gap. problems. The economy is not like a skat• Some economists do not take the Bever• er who just needs help to get up after a fall, idge curve too literally. They point out that he wrote recently in the New York Times. there may be a ‡oor below which vacan• may also require a change of mindset as ŒOur skater has broken some bones and cies will not fall, however dire the state of much as skillset. ŒToo often the construc• needs real attention. the job market. Even shrinking †rms post tion worker does not think of himself as a What kind of attention? Among a long vacancies for about 2% of their jobs, ac• health technician, says Larry Katz of Har• list of proposals, he advocates tax credits cording to Steven Davis of the University vard University. for companies employing low•paid work• of Chicago, Jason Faberman of the Phila• The new jobs may also be in a di erent ers. In January Mr Obama proposed a delphia Fed and John Haltiwanger of the place. But the recession has left Americans $5,000 credit for †rms that hired people in University of Maryland. And in the early uncharacteristically Œ‡at•footed, accord• 2010. As a ‡at sum, the credit would have stages of an upturn there is often a lag be• ing to William Frey of the Brookings Insti• represented a bigger subsidy to low•paid tween vacancies rising and unemploy• tution. The share of people moving house workers. But scepticism about a stimulus ment falling. It takes time to †ll the posts from March 2007 to March 2009 was the forced him to scale the tax break back to the recovery opens up. Moreover, for every lowest since †gures were †rst collected in $1,000 for hiring people who had been un• jobless worker who †lls a vacancy, a dis• 1947. The share moving across state bor• employed for 60 days or more. That may couraged worker may renew his job ders, at 1.6%, was half that in 1999•2000. be a pity. According to a study by Ms Sahin search, rejoining the labour force and add• Mr Frey puts much of the blame on the and two colleagues, the $1,000 credit could ing to the oˆcial unemployment tally. So it housing market. If you cannot †nd a buyer cut the unemployment rate by almost one is just a matter of time before the Beveridge for your home, you cannot move to a new percentage point. But a $5,000 credit might curve snaps back into shape. one. Almost one in four Americans with have cut it by over three points, at least in mortgages have Œnegative equity, owing the short run. Redrawing the Beveridge curve more than their house is worth. They often Hiring incentives might tempt employ• Other economists are worried that the odd decide to stay put rather than default. Ac• ers, but they will not help if workers have behaviour of the Beveridge curve suggests cording to Marcello Estevão and Evridiki the wrong skills or are stuck in the wrong a mismatch between the skills of jobseek• Tsounta of the IMF, geographic immobility part of the country. That is why the IMF’s ers and those required for new jobs. David economists also advocate an overhaul of Autor, of the Massachusetts Institute of federal training programmes and more ef• Technology, believes that the recession has Europe’s job miracle 10 fort to deal with negative equity, for in• reinforced trends that began 30 years ago. Sources of job creation/destruction, 1995-2008, m stance by changing America’s bankruptcy He reckons the American labour market Population Change in law to allow judges to restructure mort• has polarised, creating jobs for the well• growth unemployment rates gage debt. America spends only 0.17% of educated and the low•paid but o ering lit• Change in Shifts in GDP on active labour•market policies, participation rates age structure tle in between. Janitors and managers such as training and job search, far less 30 weathered the recession, but white•collar than the OECD average. Such schemes as it sales, oˆce and administrative jobs‹the has are fragmented and not particularly ef• Œproduction jobs of the information age‹ 20 fective. That may need to change. Having fell by 8% between 2007 and 2009. The long taken their labour market’s ‡exibility production jobs of the manufacturing age, 10 for granted, Americans may now have to such as craftsmen’s, repairmen’s and + work at it. machine operators’, fared even worse. Even as Americans are beginning to Even as the economy has regained (and 0 fear that their labour market is turning surpassed) its former size, it has not recov• – European, Europeans still feel under pres• ered its shape. So workers †red from a sun• 10 sure to turn Anglo•Saxon. The American set industry may have to break into sunrise EU-15 United States labour market may be less dynamic than it Source: McKinsey Global Institute industries to get a job. A shift in occupation was, but it is still more dynamic than Eu•1 12 A special report on the world economy The Economist October 9th 2010

Spain o ers a test case for Pass and move labour•market reform in Europe

HEN Spain won the World Cup in isting workers are una ected.) This could WJuly, it con†rmed its reputation for Easy come, easy go 11 fall to 20 days’ pay for all workers at †rms ‡uid and eˆcient football. If only its econ• Temporary* employment, 2009, % of total that can show they face large and persis• omy worked as well. GDP growth is slug• tent losses. Spain’s complex wage•bar• gish and a †fth of the workforce is unem• 0 10 20 30 gaining system remains intact but †rms ployed. Two features of Spain’s jobs Poland can now opt out if their employees agree. market share much of the blame: the high Spain How e ective these new rules will be cost of †ring permanent workers, and a Portugal depends on how they are interpreted. ŒIt wage system that binds †rms to industry• could take years to clarify under what cir• wide pay deals. On June 16th, the day Germany cumstances †rms can †re workers and Spain played its †rst World Cup match, Japan pay only 20 days’ compensation, says the government set out its plans to cure France Luis Garicano, of the London School of these ills. The reform bill, passed by parlia• Italy Economics. In the past, Spain’s labour ment on September 9th, falls well short of OECD courts have taken a dim view of †rms what was needed but may nevertheless seeking to cut jobs. Firms may †nd it tricky do some good. Britain to persuade workers to accept lower Changes were long overdue. Because it United States † wages than mandated by national pay *Jobs with a pre-set termination date is so costly to lay o workers, businesses † deals. Spain’s jobless bene†ts are quite are reluctant to hire them in the †rst place. Source: OECD 2006 generous and are paid for long periods, so A 1994 measure to promote jobs made it many workers may opt for redundancy easier to hire temporary workers and led Madrid•based bank, shows that Spanish rather than take a pay cut. to a sharp rise in their numbers. But only a †rms are less productive than American A lot also depends on how actively the small proportion of them move on to ones partly because they tend to be small. government promotes the reforms. A big Œprotected jobs. Most are laid o at the Ideally the rules would allow wage worry is that the labour ministry seems end of their contract. The high churn bargaining to take place locally and pro• just as attached to the status quo as labour among temporary workers, most of them mote a good balance between job ‡exibil• unions and business groups are. And young, female or migrant, means †rms ity and security for all workers. A group of even if oˆcials support the changes, few have little incentive to train them. 100 Spanish economists had pushed for a economists expect Spain’s jobless rate to This has pushed many into low•skilled Œsingle contract, with employment rights plummet. But a fall in the share of tempo• work. The impact on Spain’s productivity that rise gradually with tenure. That rary employees in the workforce, and is compounded by rigid wage rules. Last would make it cheap and easy to get rid of weaker wage growth in response to high year nominal pay rose by 3% despite the recent recruits that turn out to be ‡ops unemployment, would be promising weak economy. Firms have to pay the (which is an appealing feature of tempo• signs that the reforms are working. rates that are negotiated centrally be• rary contracts), but †rms would also have Since only a year ago the possibility of tween unions and employer groups, rath• an incentive to invest in the workers they any reform at all seemed remote, even er than tailor pay to prevailing business hold on to. such mild progress has been greeted with conditions. That costs jobs and hurts eˆ• The reforms fall short of that. A change relief. ŒThis takes Spain from worst to bet• ciency. Firms cannot undercut rivals on in the main contract for new permanent ter, says Angel Ubide, at Tudor Invest• wages, which limits their ability to grow. workers lowers severance pay from 45 to ment Corporation. But it may not catch up Research by Rafael Doménech, at BBVA, a 33 days’ wages for each year worked. (Ex• with its football team for a while.

2 rope’s. America’s exit rate from unemploy• the most of their working•age population, only 1.6% a year over the next two decades, ment, at 24% a month, is still far faster than even as that population is poised to shrink. other things equal, according to the McKin• rates in recent decades in France (8%), Ger• In Germany it has already contracted by sey Global Institute (MGI). many (6%) and Italy (4%). And although 2.2% over the past decade. Countries with Governments are not entirely power• long•term unemployment in America has an unfavourable demography grow more less to deal with the e ects of demo• risen markedly (at the end of 2009 2.2% of slowly not only because fewer people graphic trends. They can raise the retire• workers had been out of a job for more work but also because they save and invest ment age, open the doors to immigration than a year, compared with 0.5% before the less. From 1990 to 2008 the combined GDP and tempt more people into the labour recession), a bigger proportion of workers of the EU•15 (the 15 members of the EU prior force. Japan, for instance, is greying faster in Germany, France and Italy has been job• to its 2004 enlargement) grew by about 2% than Europe, but its employment rates are less for more than a year. a year on average. Thanks to a less favour• better than America’s. In Denmark the Many European countries fail to make able demography it can expect to grow working•age population is already shrink•1 The Economist October 9th 2010 A special report on the world economy 13

2 ing, but a larger proportion of this smaller ca’s 913). But the gap is closing. To narrow it A larger share of Sweden’s older peo• population is actually working. further, Europe does not necessarily have ple, too, remain in the labour force than Indeed, a number of European coun• to become like America. It could greatly anywhere else on the continent, not least tries have changed far more than many (es• improve its performance simply by adopt• because they accrue higher retirement pecially Americans) give them credit for. In ing its own continent’s best practice every• bene†ts for each year they work after the a forthcoming report the MGI heralds the where. Some progress along those lines is age of 61. If other Europeans aged between Œunsung progress in European labour being made. Greece is overhauling its la• 55 and 64 were as industrious as older markets. Despite a far smaller growth in bour rules; Spain has just passed a modest Swedes, the continent could reduce the their population, the 15 west European reform (see box, previous page). But there gap in hours with America by almost a member states of the EU created more jobs is much more to be done. quarter, according to the MGI. than America between 1995 and 2008. The rest of Europe could also learn from They countered their adverse demography Taking up the slack Denmark’s e orts to beat unemployment by reducing their jobless rates and boost• In Sweden 88% of women aged between and from the Netherlands’ success in get• ing participation in the labour market. For 25 and 54 take part in the labour market. It ting youngsters into work. To echo an old example, the share of working•age women helps that the country’s extensive day•care joke, heaven is where women and older in the labour force rose by 11 percentage facilities for children are largely reserved people work like the Swedes, the young points between 1990 and 2010. for workers, and that couples †le their tax work like the Dutch and the unemployed The EU•15 still get less out work out of returns separately so that households do †nd jobs like the Danes. Hell is where their population than America does (733 not get hit by higher marginal tax rates on workers get into unemployment like the hours per person per year against Ameri• their second incomes. Americans and out of it like the Italians. 7 Smart work

Faster productivity growth will be an important part of rich economies’ revival

RODUCTIVITY growth is the closest boost the pace of eˆciency gains as weak France’s Minitel, an attempt to create a gov• Peconomics gets to a magic elixir, espe• demand forces †rms to rethink their pro• ernment•run national communications cially for ageing advanced economies. ducts and cost structures and the weakest network, to Spain’s expensive subsidies to When workers produce more for every companies are winnowed out. According jump•start solar power, suggest that gov• hour they toil, living standards rise and to Alexander Field of Santa Clara Universi• ernments are not much good at picking governments have more resources to ser• ty, the 1930s saw the fastest eˆciency im• promising sectors or products. vice their debts and support those who provements in America’s history amid More important, the politicians’ current cannot work. As the rich world emerges large•scale restructuring. focus on fostering productivity growth via from the †nancial crisis, faster productivity exciting high•tech breakthroughs misses a growth could counteract the drag from ad• Here we go again big part of what really drives innovation: verse demography. But slower productivi• Almost every government in the rich the di usion of better business processes ty growth could make matters worse. world has a spanking new Œinnovation and management methods. This sort of in• Workers’ productivity depends on their strategy. Industrial policy‹out of fashion novation is generally the result of compet• skills, the amount of capital invested in since its most credible champion, Japan, itive pressure. The best thing that govern• helping them to do their jobs and the pace lost its way in the 1990s‹is staging a come• ments can do to foster new ideas is to get of Œinnovation‹the process of generating back. But mostly such policies end up sub• out of the way. This is especially true in the ideas that lead to new products and more sidising well•connected industries and most regulated and least competitive parts eˆcient business practices. Financial cri• products. ŒGreen technology is a favour• of the economy, notably services. ses and deep recessions can a ect these ite receptacle for such subsidies. To see why competition matters so variables in several ways. As this special In 2008 France created a sovereign• much, consider the recent history of pro• report has argued, workers’ skills may wealth fund as part of its response to the †• ductivity in the rich world. On the eve of erode if long•term unemployment rises. nancial crisis; it promises to promote bio• the recession the rate of growth in workers’ The disruption to the †nancial sector and technology ventures, though it has also output per hour was slowing. So, too, was the reluctance of businesses to invest in sunk capital into conventional manufac• the pace of improvement in Œtotal factor the face of uncertain demand may also re• turers that happened to need money. In productivity (a measure of the overall eˆ• duce the rate of capital formation, delaying 2009 Britain followed suit with a Œstrategic ciency with which capital and workers are the factory upgrades and IT purchases that investment fund. The Japanese too are used which is economists’ best gauge of would boost workers’ eˆciency. back in the game. In June the newly invigo• the speed of innovation). But that broad Financial crises can a ect the pace of in• rated Ministry of Economy, Trade and In• trend masks considerable di erences. novation, too, though it is hard to predict dustry (METI) unveiled a plan to promote Over the past 15 years America’s under• which way. Deep recessions can slow it †ve strategic sectors, ranging from environ• lying productivity growth‹adjusted for down as †rms slash their spending on re• mental products to robotics. However, past the ups and downs of the business cycle‹ search and development. But they can also experiments with industrial policy, from has outperformed most other rich econo•1 14 A special report on the world economy The Economist October 9th 2010

2 mies’ by a wide margin (see chart 12). section of this report has described, was Workers’ output per hour soared in the late It’s getting harder 12 the failure to deal decisively with the bad 1990s, thanks largely to investment in com• GDP per hour worked* loans clogging its banks, which propped puters and software. At †rst this advance % increase on previous year up ineˆcient Œzombie companies rather was powered by productivity gains within than forcing them into liquidation. That 3.5 the technology sector. From 2000 onwards Japan meant less capital was available to lend to eˆciency gains spread through the wider 3.0 upstart †rms. Another problem was the economy, especially in services such as re• 2.5 lack of competition. Japan’s service sector, tailing and wholesaling, helped by the de• 2.0 unlike its world•class manufacturers, is regulated and competitive nature of Amer• 1.5 fragmented, protected from foreign com• ica’s economy. The improvements were United States petition and heavily regulated, so it failed 1.0 extraordinary, though they slowed after Euro area to capture the gains of the IT revolution. the middle of the decade. 0.5 Over the years Japan made various ef• The recent history of productivity in 0 forts at regulatory reform, from freeing up † Europe is almost the mirror image of 1980 85 90 95 2000 05 10 the energy market and mobile telephony America’s. Up to the mid•1990s the conti• Source: The Conference Board *Structural trend †Forecast in the mid•1990s to liberalising the †nan• nent’s output per hour grew faster than cial sector in the late 1990s. These have America’s (see chart 13), helped by imports a new company, assigning a score to each borne some fruit. Japan’s total factor pro• of tried and tested ideas from across the market of between 0 and 6 (where 0 is the ductivity growth, unlike Europe’s, began to water. Thanks to this process of catch•up, least restrictive). Overall the absolute level improve after 2000. But coupled with the by 1995 Europe’s output per hour reached of product regulation fell between 1998 continuing weakness of investment, the over 90% of the American level. But then and 2008, and the variation between reforms were too modest to bring about a Europe slowed, and by 2008 the †gure was countries lessened. America and Britain decisive change in the country’s overall back down to 83%. This partly re‡ected Eu• score joint best, with 0.84. The EU average productivity prospects. rope’s labour•market reforms, which is 1.4. But when it comes to services, the va• brought more low•skilled workers into the riation is larger and Europe has made Learn Swedish workforce. That seemed a price well worth much less progress. Sweden o ers a more encouraging lesson. paying for higher employment. But the In professional services, the OECD’s In the aftermath of its banking bust in the main reason for Europe’s disappointing score for Europe is fully twice as high as for early 1990s it not only cleaned up its banks productivity performance was that it America (meaning it is twice as restrictive). quickly but also embarked on a radical failed to squeeze productivity gains from As the McKinsey report notes, many Euro• programme of microeconomic deregula• its service sector. pean countries are rife with anti•competi• tion. The government reformed its tax and A forthcoming history of European tive rules. Architects’ and lawyers’ fees in pension systems and freed up whole growth by Marcel Timmer and Robert In• Italy and Germany are subject to price swaths of the economy, from aviation, tele• klaar of the University of Groningen, ‡oors and ceilings. Notaries in France, communications and electricity to bank• Mary O’Mahony of Birmingham Universi• Spain and Greece and pharmacies in ing and retailing. Thanks to these reforms, ty and Bart Van Ark of the Conference Greece are banned from advertising their Swedish productivity growth, which had Board, a business•research organisation, services. Such restrictions limit the ability averaged 1.2% a year from 1980 to 1990, ac• carefully dissects the statistics for individ• of eˆcient newcomers to compete for celerated to a remarkable 2.2% a year from ual countries and industries and †nds con• market share, cosseting incumbents and 1991 to 1998 and 2.5% from 1999 to 2005, ac• siderable variation within Europe. Finland raising costs across the economy. cording to the McKinsey Global Institute. and Sweden improved their productivity In Japan productivity growth slumped Sweden’s retailers put in a particularly growth whereas Italy and Spain were par• after the country’s asset bubble burst at the impressive performance. In 1990, McKin• ticularly sluggish. Europe also did better in start of the 1990s. One reason, as an earlier sey found, they were 5% less productive some sectors than in others; for example, than America’s, mainly because a thicket telecommunications was a bright spot. But of regulations ensured that stores were overall, compared with America, Euro• Not catching up 13 much smaller and competition less in• pean †rms invested relatively little in ser• GDP per hour worked tense. Local laws restricted access to land vices and innovative business practices. A As % of US GDP per hour worked for large stores, existing retailers colluded new McKinsey study suggests that around France Germany Britain on prices and incumbent chains pressed Spain Italy Japan two•thirds of the di erential in productivi• 110 suppliers to boycott cheaper competitors. ty growth between America and Europe But in 1992 the laws were changed to weak• between 1995 and 2005 can be explained 100 en municipal land•use restrictions, and by the gap in Œlocal services, such as retail 90 Swedish entry into the EU and the creation and wholesale services. of a new competition authority raised Europe’s service markets are smaller 80 competitive pressures. Large stores and than America’s, fragmented along nation• 70 vertically integrated chains rapidly gained al lines and heavily regulated. The OECD market share. By 2005 Sweden’s retail pro• has tracked regulation of product and ser• 60 ductivity was 14% higher than America’s. vices markets across countries since 1998. It The restructuring of retail banking ser• 1980 85 90 95 2000 05 10 * measures the degree of state control, barri• vices was another success story. Consoli• Source: The Conference Board *Forecast ers to competition and obstacles to starting dation driven by the †nancial crisis and by 1 The Economist October 9th 2010 A special report on the world economy 15

moving in the opposite direction as the Obama administration pushes through new rules on industries from health care to †nance. So far the damage may be limited. Many of Mr Obama’s regulatory changes, from tougher fuel•eˆciency requirements to curbs on deep•water drilling, were meant to bene†t consumers and the envi• ronment, not to curb competition and pro• tect incumbents. Some of the White House’s ideas, such as the overhaul of broadband internet access, would in fact increase competition. The biggest risk lies in †nance, where America’s new rules could easily hold back innovation.

An unlikely role model The country that is grasping the challenge of deregulation most energetically is Greece, whose debt crisis has earned it a reputation for macroeconomic misman• agement. Under pressure from the IMF and its European partners, the Greek gov• ernment has embarked on one of the most radical reforms in modern history to boost 2 EU entry increased competition. New tice would yield large bene†ts. The IMF its productive potential. niche players introduced innovative pro• has calculated that if countries could re• Again, this involves freeing up an his• ducts like telephone and internet banking duce regulation to the average of the least torically cushioned service sector. So far that later spread to larger banks. Many restrictive three OECD countries, annual the main battleground has been trucking. branches were closed, and by 2006 Swe• productivity growth would rise by some Before Greece descended into crisis, its lor• den had one of the lowest branch densities 0.2 percentage points in America, 0.3 per• ry drivers required special licences, and in Europe. Between 1995 and 2002 banking centage points in the euro area and 0.6 per• none had been granted for several de• productivity grew by 4.6% a year, much centage points in Japan. The larger gains for cades. So a licence changed hands in the faster than in other European countries. Europe and Japan re‡ect the amount of de• secondary market for about ¤300,000, Swedish banks’ productivity went from regulation left to be done. In both cases the driving up the costs of everything that trav• slightly behind to slightly ahead of Ameri• productivity gains to be achieved from elled by road in Greece. But under a reform can levels. moving to best practice would all but recently passed by the Greek government, All this suggests that for many rich counter the drag on growth from unfavour• the number of licences is due to double. countries the quickest route to faster pro• able demography. Greek lorry drivers went on strike in prot• ductivity growth will be to use the crisis to Even in America there would be bene• est, but the government did not budge. deregulate the service sector. A recent †ts. But, alas, the regulatory pendulum is Lawyers and pharmacists too are slated for study by the Bank of France and the OECD deregulation. looked at 20 sectors in 15 OECD countries If Greece can stick to its plans, it will, between 1984 and 2007. It found that re• Services with a smile 14 like Sweden, show that crises can o er ducing regulation on Œupstream services Productivity growth, 1995-2005 valuable opportunities. Without the coun• would have a marked e ect not just on Contribution by sector, % try’s brush with default and the conditions productivity in those sectors but also on Primary resources Services: attached to the resulting bail•out, its lead• other parts of the economy. The logic is Manufacturing Local ers would have been unlikely to muster simple: more eˆcient lawyers, distributors Infrastructure Business the necessary political will. or banks enable †rms across the economy Property Professional/ Other financial The sluggish progress of reform else• to become more productive. The size of the where underlines this point. Germany, 25 potential gains calculated by the Bank of which ranks 25th out of 30 OECD countries France is stunning. Getting rid of all price, 20 on the complications of its licence and per• market•entry and other competition•re• 15 mit system, approaches deregulation on stricting regulations would boost annual tiptoes: it recently reduced restrictions on total factor productivity growth by one 10 price•setting by architects and allowed percentage point in a typical country in 5 chimney•sweeps easier market access. their sample, enough to more than double + 0 Two French economists, Jacques Delpla its pace. – and Charles Wyplosz, have argued that in• Getting rid of all anti•competitive regu• 5 cumbent service providers should be paid United States EU-15 lation may be impossible, but even the o in exchange for accepting competition. Source: McKinsey Global Institute more modest goal of embracing Œbest prac• They reckon that compensating French 1 16 A special report on the world economy The Economist October 9th 2010

2 taxi drivers for deregulation would cost internet. Public spending on building and vard University puts it: ŒThink Google, not ¤4.5 billion. But buying o the losers from maintaining infrastructure also matters, lab coats. reforms may not hold much appeal. though economists argue about how In this more ‡uid world the old kind of Boosting European integration could be much. Governments can encourage priv• government incentives, such as tax credits another way to cut through national resis• ate R&D spending with tax credits and sub• and subsidies, may do less to boost inno• tance to deregulation. As Mario Monti, a sidies, and the evidence suggests that more vation than more imaginative induce• former EU competition commissioner, R&D spending overall boosts growth. Oth• ments, such as o ering †rms prizes for pointed out in a recent call for action, 70% er research shows that †rms which spend breakthrough innovations. Bigger e orts to of the EU’s GDP is in services but only 20% more on R&D are also often quicker to remove remaining barriers to collabora• of those services cross borders. The EU’s adopt other innovations. tion, from limitations on high•skilled im• Services Directive, which is supposed to But these traditional ways of encourag• migration to excessively rigid land•use boost cross•country competition in ser• ing innovation may be less relevant now rules, should also help. vices, has proved fairly toothless. that research has become more global and A smart innovation agenda, in short, more concentrated on software than on would be quite di erent from the one that How governments can help hardware. Since the mid•1990s China most rich governments seem to favour. It Activism on the part of governments is not alone has accounted for a third of the in• would be more about freeing markets and always misguided. Their investment in ba• crease in global spending on research and less about picking winners; more about sic research is important. The grants doled development. Big †rms maintain research creating the right conditions for bright out by America’s National Institutes of facilities in many countries. Dreaming up ideas to emerge and less about promises of Health, for example, generate the raw new products and services, as well as bet• things like green jobs. But pursuing that ideas that pharmaceutical †rms turn into ter ways of producing old ones, increasing• kind of policy requires courage and vi• pro†table medicines. America’s Defence ly involves collaboration across borders sion‹and most of the rich economies are Department created the beginnings of the and companies. As Mr Jorgenson of Har• not displaying enough of either. 7 A better way

The rich world should worry about growth•promoting reforms more than short•term †scal austerity

NCE you start thinking about for much the same reason. ŒOgrowth, said Robert Lucas, a No• Don’t hang your hopes too high 15 The OECD’s September forecast reck• bel prize•winning economist, Œit’s hard to GDP, 2011 forecast, % increase on previous year ons that the annual rate of GDP growth in think about anything else. Judging by the G7 group of big rich economies will fall March forecast September forecast their rhetoric, the world’s policymakers to 1.5% in the second half of this year, a full are indeed thinking about little else. The 0 0.5 1.0 1.5 2.0 2.5 3.0 percentage point below its forecast in May. statement released after the most recent Canada Gloomier analysts worry about a Œdouble• meeting of G20 leaders in Toronto in June dip recession. Even optimists no longer United mentioned the word Œgrowth 29 times in States expect anything more than tepid growth in nine pages. Mr Obama says his economic 2011(see chart 15). policy is all about Œlaying the foundations Britain Looking further ahead, towards the for long•term growth. Britain’s prime middle of this decade, the picture remains Germany minister, David Cameron, used his †rst dark as †rst debt and then ageing popula• speech in oˆce to lay out a Œstrategy for Japan tions will weigh heavily on the rich economic growth. Japan’s government world’s prospects. The fall•out of the †nan• unveiled a ten•year Œnew growth strategy France cial bust will weigh on private spending in June. for several more years as banking systems The task is immense. The rich world’s EU-13 are repaired and households and †rms pay nascent recoveries are losing momentum Italy down their debts. Even in America, where even though joblessness remains worry• households are moving out of the red fast• ingly high. The slowdown has been most Spain er than elsewhere, they have at best got obvious in America, where GDP growth only halfway there. The Economist shrank to a paltry 1.6% annual rate in the Source: poll of forecasters According to the analysis by Carmen second quarter and appears to have re• and Vincent Reinhart mentioned earlier in mained stuck at much the same level over of this year, but as the rebound in global this report, GDP per head, on average, the summer. The housing market has trade wanes, Germany’s export•depen• grows 1% a year more slowly in the decade turned down again and the pace of job cre• dent economy is slowing again. The coun• after big crises than in the decade before. ation remains painfully slow. try’s latest †gures for investor con†dence Since rich economies as a group grew by Led by a surge in German GDP, the euro look a lot feebler than they did earlier this an average of 2.5% a year before the †nan• area fared relatively better in the †rst half year. Japan’s economy, too, is weakening cial crisis and then slumped by more than 1 The Economist October 9th 2010 A special report on the world economy 17

2 3% during the recession, that suggests they cusing on trade. Japan recently intervened which refute the idea that †scal contrac• might grow by less than 1.7% a year over the in currency markets for the †rst time in six tions boost growth in the short term, sug• next few years. years to stem the yen’s rise. gest that such a tightening might reduce the Slower growth in advanced economies Nor is there much sign of a rapid rebal• rich world’s already weak growth next will mean lower private investment, high• ancing towards the emerging world. Chi• year by a percentage point or so. er unemployment and higher public debt, na, as the biggest saver, should bear the Is this a sensible trade•o ? Countries in all of which will hurt their longer•term ca• brunt of such a shift. Its current•account which †nancial markets have lost con†• pacity to grow. At the same time the ad• surplus declined sharply between 2008 dence, such as Ireland or Spain, have no verse e ect of ageing (and in many cases and 2009, but this year it is rising again. Al• choice. Others must weigh the costs of shrinking) populations on growth will be• though the government promised a more slower growth against the bene†ts of come much more noticeable, especially in ‡exible currency in June, the yuan has greater prudence, particularly the reduced Europe, where a big rise in the share of barely moved in recent months. risk of a sudden jump in bond yields and women in the labour force has hitherto More important, the structural barriers the prospect of lower public debt later. For concealed the demographic drag. that get in the way of higher domestic many individual economies, particularly The overall e ect of these various ele• spending‹from government monopolies open and indebted ones, that points to• ments is likely to be big. The grimmest pre• in many services to taxes, subsidies and wards earlier austerity. But what makes dictions of the consequences of demogra• corporate•governance rules that favour sense for individual countries may not phy, higher public debt and lower private pro†ts over wages‹will take years to re• make sense for the rich world as a whole. investment suggest that the potential move. Nor is there much sign that other More important, policymakers’ obses• growth rate of the big advanced econo• emerging economies are keen to run big sion with cutting de†cits in the short term mies as a group could halve, from above de†cits for now. In the longer term faster has de‡ected attention from the more im• 2% before the crisis to around 1% over the growth in poorer countries’ demand is portant question of how to do it. Some next few years. Small wonder that Mr Tri• bound to be good for the advanced econo• countries are setting about it the right way. chet, the president of the European Central mies, but it will take time. France, for instance, is pushing through Bank and a man not normally given to hy• pension reform; and in Britain three•quar• perbole, worries that the next ten years A dangerous squeeze ters of the †scal adjustment will come could be a Œlost decade. The rich countries also seem to underesti• from spending cuts. But America, if Mr Are today’s growth strategies good mate the risks that †scal austerity poses to Obama has his way and the Bush tax cuts enough to prove him wrong? There are domestic demand. Virtually all the ad• for high earners are eliminated, is heading three big reasons to doubt it. First, rich vanced economies are planning some for the worst possible outcome: raising tax• countries, collectively, are relying too combination of tax increases and spend• es on income and capital but failing to trim much on foreign demand as a source of ing cuts next year as their stimulus pack• the country’s pension liabilities and rising growth. Second, they are at risk of both ages expire and budget consolidation be• health•care costs. overdoing and mismanaging short•term gins. Collectively, says the IMF, these will In most rich countries the detailed †scal austerity. Third, most are paying far amount to a tightening of some 1.25% of plans for †scal austerity contrast sharply too little attention to structural reforms GDP. That would be the biggest simulta• with a lamentable lack of microeconomic that would speed up the pace of debt re• neous †scal squeeze since modern records ambition. Greece is the only rich economy duction, make high unemployment less began. The IMF’s own recent analyses, that is responding to the crisis with broad 1 likely to become entrenched and boost productivity growth. Begin with the wishful thinking on for• eign demand. At every international eco• nomic gathering there is talk of the impor• tance of Œrebalancing the pattern of global demand. The world economy must rely less on spending by over•indebted An• glo•Saxon consumers and cajole more spending out of thriftier Germans and Jap• anese, as well as †rms and households in fast•growing emerging economies, nota• bly China. Yet there is little sign that these e orts have done any good so far. The rich world’s de†cit countries, such as America and Britain, certainly want to push exports to counter weak consumer demand. The Obama administration has said it would like to double America’s ex• ports in †ve years. Britain’s new govern• ment has put export promotion at the heart of its foreign policy. But the surplus economies, particularly Germany and Ja• pan, are equally determined to go on fo• 18 A special report on the world economy The Economist October 9th 2010

2 and radical reforms to boost its productive increases and Democrats refuse to cut any potential. In Britain, whose economy is al• spending on entitlements, the best short• ready relatively deregulated, spending term remedy would be to extend the Bush cuts will help reduce the role of the state. tax cuts for another three years. But elsewhere progress has been limited. America’s structural reforms ought to Spain has gone some way towards freeing focus on encouraging households to re• its labour markets, and Japan’s Œgrowth duce their debts more quickly and tackling strategy proposes a series of small liberal• entrenched joblessness. By the standards ising steps, such as cutting rules around of previous †nancial crises America’s nursing care. But Germany’s politicians are banks have been recapitalised remarkably far keener to denounce de†cits than to de• quickly, but much less has been done to regulate domestic services. And in Ameri• deal with the $800 billion•worth of Amer• ca the policy debate revolves almost en• ican mortgages (almost 25% of the total) tirely around demand, the wisdom of where the house is worth less than the out• stimulus and the Bush tax cuts. Most oˆ• standing loan. Legal reforms that made it cials barely acknowledge that supply•side easier to reduce this debt overhang would reforms, such as an overhaul of training allow a more eˆcient allocation of capital schemes to help combat long•term jobless• and hence boost investment. They would ness, or bigger e orts to reduce household help to deal with high unemployment, too, debts, might even be necessary. by making it easier for workers to move to The economic case for a growth strat• new jobs. A comprehensive strategy to egy that combines hefty †scal cuts with counter structural joblessness would also timid structural reforms is not obvious, es• include things like hiring subsidies for the pecially when private demand is likely to hard•to•employ and an overhaul of train• stay weak. In the long run bold productivi• ing schemes. The recession and its grim aftermath o er ty•enhancing reforms will do more to Outside America the design of †scal an opportunity to do better. boost the rich world’s growth prospects consolidation is more sensible, though the If the rich world really wants to go for than short•term †scal austerity. And better scale may be excessive. In both continental growth, it must get away from its narrow growth prospects will, themselves, make Europe and Japan reform should concen• focus on public debt and embark on a government debt less onerous. In a recent trate on boosting growth by freeing up la• broader economic overhaul. Instead of study, economists at the IMF analysed the bour markets and services. Rules that sti‡e promising to halve their budget de†cits by respective impact of de†cit reduction, glo• competition should be struck out in indus• 2013, for instance, big rich economies could bal rebalancing and productivity•enhanc• tries from health care to road transport. decide to raise their retirement ages or free ing structural reforms on the growth pros• The to•do list is familiar, not least be• up their professional services. Fiscal con• pects of big rich economies and found that cause the OECD has spent years catalogu• solidation would not be ignored: it would by far the strongest positive e ect came ing and comparing the rich world’s supply• just not be the only priority. from structural reforms. side rigidities. It even produces a handy an• An American oˆcial famously There is also a political logic to favour• nual publication, called ŒGoing for quipped after the 2007•08 debacle that ing a bigger prop for demand along with Growth, that sets out priorities. But rich• you should Œnever let a serious crisis go to bolder action on structural reforms. The world governments have found it hard to waste. It is advice that the rich world contrasting stories of Sweden and Japan summon up the political courage to act. would do well to heed. 7 suggest that although big crises can o er an opportunity to overhaul an entire econ• O er to readers Future special reports omy, a prolonged period of sluggish Reprints of this special report are available from growth makes structural reforms increas• Turkey October 23rd 2010 the Rights and Syndication Department. Smart systems November 6th 2010 ingly diˆcult. Both politicians and voters A minimum order of †ve copies is required. become accustomed to gradual decline. In Japan November 20th 2010 Corporate o er many rich countries an extended bout of Security in Asia December 4th 2010 Customisation options on corporate orders of 100 Global elites January 22nd 2011 high unemployment could easily lead to or more are available. Please contact us to discuss policies such as protectionism that will your requirements. further hurt long•term growth. For more information on how to order special All told, there is a case for changing the reports, reprints or any queries you may have debate about growth in the rich world. Fis• please contact: cal consolidation should be more nuanced and supply•side reforms should be given The Rights and Syndication Department 26 Red Lion Square greater prominence. This is particularly London WC1R 4HQ true for America. In an ideal world, Ameri• Tel +44 (0)20 7576 8148 ca’s politicians would come up with a Fax +44 (0)20 7576 8492 package of medium•term spending cuts e•mail: [email protected] Previous special reports and a list of and tax reforms to †ll the country’s †scal www.economist.com.rights forthcoming ones can be found online gap. But since that is impossible, given that Economist.com/rights Economist.com/specialreports Republicans refuse to countenance any tax