1. How to growA special report on the world economyOctober 9th 2010

2. The Economist October 9th 2010A special report on the world economy 1How to growAlso in this sectionWithdrawal symptomsAfter the stimulus, the hangover. Page 3The cost of repairA battered nance sector means slowergrowth. Page 6From hoarding to hiringSome countries have successfully preservedjobs. Now they must create new ones.Page 9Pass and moveSpain o ers a test case for labour-marketreform in Europe. Page 12Smart workFaster productivity growth will be animportant part of rich economies revival.Without faster growth the rich worlds economies will be stuck. But whatPage 13 can be done to achieve it? Our economics team sets out the optionsA better wayThe rich world should worry about growth-WHAT will tomorrows historians see as the de ning economic trend of theearly 21st century? There are plenty of po- The next few years could be de ned asmuch by the stagnation of the West as bythe emergence of the rest, for three mainpromoting reforms more than short-termtential candidates, from the remaking of -reasons. The rst is the sheer scale of the re- scal austerity. Page 16nance in the wake of the crash of 2008 to cession of 2008-09 and the weakness ofthe explosion of sovereign debt. But the list the subsequent recovery. For the advancedwill 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 farTen years ago rich countries dominatedthe deepest since the 1930s. It has left an un-the world economy, contributing aroundprecedented 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 mostthen 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 backThe bulk of global output will be producedto work quickly (see chart 1, next page). Thein the emerging world.OECD, the Paris-based organisation thatThe pace of the shift testi es to these tracks advanced economies, does not ex-countries success. Thanks to globalisation pect this output gap to close until 2015.and good policies, virtually all developingThe second reason to worry about stag-countries are catching up with their richer nation has to do with slowing supply. Thepeers. In 2002-08 more than 85% of devel- level of demand determines whetheroping economies grew faster than Ameri- economies run above or below theircas, compared with less than a third be- trend rate of growth, but that trend ratetween 1960 and 2000, and virtually none itself depends on the supply of workersin the century before that. and their productivity. That productivity inThis rise of the rest is a remarkable turn depends on the rate of capital invest-achievement, bringing with it unprece-ment and the pace of innovation. Acrossdented improvements in living standards the rich world the supply of workers isfor the majority of people on the planet. about to slow as the number of pensionersBut there is another, less happy, explana-rises. In western Europe the change will beA list of acknowledgments and sources is attion for the rapid shift in the global centre especially marked. Over the coming de- Economist.com/specialreports of economic gravity: the lack of growth incade the regions working-age population,the big rich economies of America, west-which until now has been rising slowly,An audio interview with the authors is atern Europe and Japan. That will be the fo-will shrink by some 0.3% a year. In Japan, Economist.com/audiovideo/specialreportscus of this special report. where the pool of potential workers is al- 1 3. 2 A special report on the world economy The Economist October 9th 20102 ready shrinking, the pace of decline willnow reckons that the fallout from the - 2 more than double, to around 0.7% a year.Onwards, ever upwards nancial crisis will, on average, knock some Americas demography is far more favour-US real GDP per person, 2009 $000 Log3% 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 the60The longer that demand remains weak, coming two decades, will be less than a 40the greater the damage is likely to be. Ja- third of the post-war average.pans experience over the past two de-20 With millions of workers unemployed,cades is a cautionary example, especially an impending slowdown in the labour10 to fast-ageing European economies. The supply might not seem much of a problem. 8countrys nancial crash in the early 1990s But these demographic shifts set the 6contributed 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 of2 vice their public debt. Unless more immi- policy mistakes caused the hangover from grants are allowed in, or a larger propor- 1 the nancial crisis to linger. The economy tion of the working-age population joins1869 90 1910 3040 5060 7080 90 2009 1900 20 failed to recover and de ation set in. The the labour force, or people retire later, orresult was a persistent combination of Sources: US Department of Commerce; BLS; The Economist their productivity accelerates, the ageingweak demand and slowing supply. population will translate into perma- To avoid Japans fate, rich countries nently slower potential growth.world. Growth in output per worker inneed to foster growth in two ways, by sup- Calculations by Dale Jorgenson of Har- America, which had risen sharply in theporting 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 theformation technology, and again in the ear-days policymakers often see these two point starkly. They show that the averagely part of this decade as the gains from ITstrategies as alternatives rather than com- underlying annual growth rate of the G7spread throughout the economy, began toplements. 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, butmand think that concerns about econo- graphic trends, and assuming that produc-that boost may not last. Japans 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 growthly 1990s. Western Europes, overall, has Krugman, a Nobel laureate and commen- will come down to 1.45% a year over thealso 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 richPresident Barack Obamas economic team. second world war.worlds stagnation is that the hangover Faster productivity growth could helpfrom the nancial crisis and the feebleness Stimulus v austerity to mitigate the slowdown, but it does notof the recovery could themselves dentEuropean 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 thaning reforms such as making labour markets growth was at or slowing in many richaugment the pool of potential workers. more exible. They tend to reject further countries even as it soared in the emergingThe 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 of1 Yawningsheets that follows a nancial bust makes structural reforms in Europe. But he is alsoOutput gap* as % of potential GDP, forecast credit more costly and harder to come by.one of the most ardent champions of the2010 2011 Optimists point to Americas experi- idea that cutting budget de cits will itself 7 654 3 21 0 ence over the past century as evidence thatboost growth. All this has led to a passion- 1Japan recessions, even severe ones, need not dolasting damage. After every downturn the 3Germany economy eventually bounced back so that All right for somefor the period as a whole Americas under-GDP per person employed*Francelying growth rate per person remained re- % increase on previous yearUnitedmarkably stable (see chart 2). Despite a lack 5Statesof demand, Americas underlying produc-OECDtivity grew faster in the 1930s than in any 4other decade of the 20th century. TodaysEmerging economiesCanada3high unemployment may also be prepar-Italy ing the ground for more e cient processes.2Most economists, however, reckon thatSpain rich economies capacity has already sus- 1 Advancedtained some damage, especially in coun- economiesBritain 0tries where much of the growth came from1970 7580 859095 2000 0510 *Difference between actual bubble industries like construction, as in ForecastSource: OECDand potential GDP Source: The Conference Board *Structural trendSpain, and nance, as in Britain. The OECD 4. The Economist October 9th 2010 A special report on the world economy 32 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 forible as many people believe. This special report will argue that bothgrowth-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 samepreviousnancial crises: they havecountry can simply grow its way out of time. The exact priorities will di er fromcleaned 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 areregulation deserve higher billing, especial- of economic gravity to the emerging right to observe that, for the rich world as aly in services, which in all rich countriesworld. 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. Excessiveemployment 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 joblessor stagnation depends on the pace of to the structure of taxation and spending more employable should be higher on thegrowth in the rich countries. For the mo- matter as much as the short-term de cits. list, especially in America, where recordment, 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. 7Withdrawal symptomsAfter the stimulus, the hangover SOME Americans have always taken thenational debt personally. During the 1940 census (according to the late David McCord Wright, an American economist) a housewife was asked if she had a mort- gage on her home. Yes, she replied. For $40 billion. That gure (about 40% of 1940 GDP) now seems quaint. The federal debt held by the public was $8.9 trillion in August 2010, or about 60% of GDP. Add to that the Treasury debt held by Americas public- pension scheme, and the national debt reached $10 trillion back in September 2008. The extra digit obliged the national debt clock near New Yorks Times Square to move its dollar sign to make room. Many of todays 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 joinedthis 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 tickingaway by the recession. Their net worth is The most remarkable thing about thatremorselessly 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 andcome, 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 theholds will probably try to set aside a stash tion: upwards. Then, in the second quarter1930s 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 theirIMF and Jirka Slacalek of the European ation, but in everyday dollars and cents. disposable income, compared with justCentral Bank. If that gure is right, their Between March 1st 2008 and June 30th2.7% in the years before the crisis. Com-balance-sheet repairs are currently only 2010 households reduced their debts bybined with the stockmarkets tful rallies, half completed.1 5. 4 A special report on the world economyThe Economist October 9th 20102 This new thrift is not con ned to Amer-under no obvious pressure from nancial 4ica. Household debt is also falling in Spain.Chipping away at the mountain markets, especially Britain, where the newIn Britain households saved 6.3% of theirUS non-government debt, $trncoalition government announced tax in-disposable income in 2009 (though less in Households BusinessFinancial creases and dramatic cuts in spending. Ac-the rst half of 2010), compared with 2% in sectorcording to the Institute for Fiscal Studies,502008. Nor is the frugality limited to house- these are even tougher than the cuts im-holds. In the wake of the nancial crisis,40 posed on Britain by the IMF in 1976.companies across the rich world have In America bond yields are near recordbeen piling up cash. Small rms have been 30lows and the economy is slowing, but theunable, and many big rms have been un- governments e orts to introduce a secondwilling, to borrow. In Japan and Britain cor-20stimulus have foundered (though it is nowporate investment fell by about a quartertrying again). Much of the political debatefrom peak to trough. The pace of invest- 10in 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 the2004 050607 080910tories and machinery when so much of end of this year, as scheduled. Source: Federal Reservetheir existing capacity lies idle. Even though the rich worlds econo-All told, across the OECD households mies continue to operate below capacity,and businesses are forecast to spend $2.6 accounting sense, these eye-popping de - in 2011 they are heading for what is likely totrillion less than their incomes this year, cits are simply the counterpart of private be their biggest collective budget squeezethe equivalent of 7% of GDP. This follows surpluses. In an economic sense, their re- in at least four decades. The appetite foranother huge private-sector surplus, of markable increase is less the outcome of government releveraging is coming to an7.2%, the year before. In 2007, by contrast,government pro igacy than private thrift.end before private deleveraging is over.the rich worlds households and business- According to the IMF, when the nales ran a combined de cit. This astonishingbill 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 answercovery 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 ofate-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 cuttingnow facing their governments is whether Regardless of its source, borrowing on back and economies are operating so farto embrace some austerity of their own. this scale plays havoc with the public - below their potential, governmentsnances. According to the IMF, gross gov- should not try to trim public de cits.Squirrel it awayernment debt in the worlds big rich econo-Nonsense, say the advocates of auster-Squirrels save by burying nuts in the mies reached 97% last year and is rising atity, pointing to the ckleness of nancialground. In sophisticated economies, peo-its fastest pace in modern history. By 2015markets and to the dangers governmentple save by amassing nancial claims onthe IMF expects them to have a combineddebt poses to long-term growth. Manysomeone else. Savers therefore need bor-debt burden of 110% of GDP, against less claim that scal austerity could even boostrowers. In textbook economics house-than 70% in 2007.growth in the short term. By reducing theholds save and banks use those savings to Earlier this year fears about soaringspectre of massive government debt, itlend to rms. For both households andpublic de cits and debt in some countrieswould lift private con dence and unlockrms 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 acial meltdown, thanks to Greeces brushboldened to invest and households mightforeign nation. But none of the economies with default. More than 200 years agofeel freer to spend, without fear of futureoutside the OECD is big enough to absorbAmericas rst treasury secretary, Alex-tax increases to help repay the debt.the excess private saving of the rich world.ander Hamilton, warned of the extrava- Keynesians are right that de cits, so far,China would have to run a current-ac- gant premium countries must pay if their have been more a symptom than a sourcecount de cit of over 40% of GDP to o set acredit is questionable . This spring of economic distress. The scal swing un-$2.6 trillion surplus. Even if the task wereGreeces credit was severely questioned. doubtedly helped to contain the damagespread 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-tors determination to save would have de-Korea are members), they would have totravagantly, from about 2% at the start of pressed spending across the economyrun de cits of over 25% each. the year to almost 10% at the height of theeven further. That would have caused aThe only other possibility is govern- crisis in May. Spreads on Irish, Portuguesecorrespondingly steeper fall in incomes,ments. That is why the rich worlds private and, to a lesser extent, Spanish debt also making it harder for households to repairsurpluses have been mirrored by equally spiked. These fears re-emerged in Septem-their balance-sheets.vast public de cits. Last year the OECDs ber, particularly in Ireland.Nor are most rich countries anywheregovernments ran a combined de cit ofGreece had to be bailed out by the EUclose 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 thatonly marginally less. Among the big econ- euro-zone borrowers, it was forced tomost advanced economies still have plen-omies, Britains de cit will be the largest, at make radical budget cuts. But the Greek cri- ty of scal space . In America and Britain,11.5%, with America not far behind. In an sis had a palpable e ect even on countries for instance, the funds economists calcu- 1 6. The Economist October 9th 2010 A special report on the world economy 52 late that public debt will not reach its abso-stay there for a decade, even as ageing pop- Germanys 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 worthfar higher than its current levels. The wolfcosts. In America, Britain, Greece, Ireland, about 6.8% of GDP. The following year itsis not at the door. Japan and Spain a swing of 9% or more of budget seemed to improve dramaticallyBut termites are in the woodwork, asGDP is required. after that one-o event even though thereCharles 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 IMFs 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. Risingjust growing slowly. Numerous studiesing and found no evidence that such mea-health-care and pension spending will put suggest that consolidation based onsures boosted growth. In fact, they reckonrelentless pressure on government debt. spending cuts is more likely to stick, and that a scal contraction worth 1% of GDPEventually the rich worlds economies willwill do more to boost medium-termtypically cuts output by about 0.5% afterreturn to full employment, and when theygrowth, than measures involving tax in-two years. To cut public debt below 60% bydo, public borrowing will crowd out priv- creases. Cutting public-sector wages and 2030, as the IMF advocates, Americaate investment and hurt growth. welfare payments is better than cuttingwould have to endure that kind of scalHow much damage can these termitesgovernment investment. pain every year for ten years.do, and when does it get serious? CarmenPutting in place reforms that slowReinhart of the University of Marylanddown the rise in pension and health-care Ration the morphineand Ken Rogo of Harvard Universityspending 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 weakensthat public debt does little discernibledays 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 ratestrys GDP, but then the e ect on growth neously cuts governments liabilities androughly halve the pain of budgetary re-can be sudden and big.boosts future growth and tax revenue aspairs, the IMF calculates.people work longer. If revenues must beBut governments cannot expect as So far and no fartherraised, taxes on consumption and proper- much monetary morphine this time. If Other scholars reach somewhat grimmerty are less harmful to growth than those onhouseholds 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 GrennesBy these standards most rich-country at other times. Since so many governments of North Carolina State University withscal-consolidation plans score reason- are tightening at once, and not every coun- Fritzi Koehler-Geib of the World Bankably well. Britains government plans to trys currency can cheapen against every identi ed a threshold of 77% of GDP. Every squeeze three-quarters of its budget ad- others, they may not bene t from much of member of the G7 will breach that limitjustment 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 theretirement ages, albeit in small steps.ments might like. Rates in America, Britain G20s rich members.Where there have been tax increases, theyand 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 Americas 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 willand no progress on reforming pensions or according to the IMFs researchers. have to swing from a projected underlyinghealth-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 austerityon recovery. But although central banks chart 5) to a surplus of 3.8% by 2020 andtend to exaggerate the bene cial e ect oncannot 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. Some5 Recovery positionsina and Silvia Ardagna of Harvard Uni-have tried to steer in ationary expecta- Advanced economies, general government versity have identi ed many examples oftions with words. The Fed has promised to balances, % of GDP economies that expanded even as theirkeep rates exceptionally low for an ex-F O R E C A S T 2de cits were squeezed through spending tended period . Several have swelled theirCyclically adjusted primary balance+cuts (though not tax increases), yet a study balance-sheets by printing money to buy 0in the IMFs latest World Economic Outlook assets, such as government bonds, a pro- 2shows that in some of their examples the cess known as quantitative easing .de cits were not really squeezed.The biggest easer, relative to the size of 4For instance, in 1998 Japans govern-the economy, has been the Bank of Eng- 6ment injected over 24 trillion into Japan land. Since March 2009 it has bought al- Overall balance 8National Railway; in the following year it most 200 billion-worth of governmentdid not. Between those two years its bud-bonds, or gilts, equivalent to 14% of GDP, as 10 get balance appeared to improve by about well as a smattering of corporate bonds. 2005 06 07 08 09 10 11 12 13 14 154.8% of GDP even though it had neither cut The Banks research shows that its pur- Source: IMFspending nor raised taxes. Similarly, in 1995chases of gilts raised their price, as well as 1 7. 6 A special report on the world economy The Economist October 9th 20102 that of other securities that compete with neered by New Zealands central bank 20cause in ation was already too low. Mr government paper. When prices go up,years ago before being taken up by biggerBullard argues that America is closer to a yields go down: they fell by about one per- institutions such as the Bank of England.Japanese-style outcome today than at any centage point on gilts and 0.7 points on theAmericas 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 thelong the slump but that it may sow the But it is not clear whether quantitativeBank of Canada. It will take time to catch seeds of the next crisis. Low rates are sup- easing on its own changes peoples expec- on even if its theoretical appeal survives posed to help the economy mobilise its re- tations of monetary policy and in ation. Acontact 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 Banks in ation target, currently set atnomic weakness persists and in ation generated excessive growth of sectors 2%. A gure of 4-5% might make central rates fall further, central banks may be-that rely on either xed-asset investment bankers lives easier, according to somecome more willing to experiment. Policiesor credit , argues Raghuram Rajan of the economists. But most central bankers do that look outr today may seem necessary University of Chicago. He fears that by set- not like the idea. They think that the coststomorrow. It is worth recalling that lessting rates at zero the Fed may merely of higher, and possibly more volatile, in a-than two years after it began quantitative pump up growth in the short term only to tion would outweigh any gains. A less-dis-easing in March 2001 the Bank of Japan see it collapse later . Low rates subsidise cussed but potentially more useful innova-was buying equities. And in 2003 it was ad-borrowers at the expense of savers. If this tion would be price-level targeting (PLT),vised to adopt price-level targeting bytransfer were easier for voters to see, they meaning that a central bank targets the lev-none other than Ben Bernanke, now themight nd a lot to dislike. But because the el of prices, not their rate of change. Target- Feds chairman.Fed picks investors pockets silently and ing a price level that rises by 2% a year is dif-forcibly no one asks questions about ferent from targeting an in ation rate of 2%Beware self-ful lling prophecies cost, he writes. a year because rather than washing itsSome economists argue that central banksGiven that the main reason for the re- hands of past mistakes, the central bankdetermination to avoid de ation couldcession and the weakness of the recovery has to make up for past errors, returning have the opposite e ect. The Feds pledgeis the dramatic increase in private thrift, prices to their prescribed path.to keep interest rates low for an extended this seems an odd short-term concern. The That should make in ation expecta-period , for instance, suggests that it be-rich world is short of private borrowing tions a more powerful stabilising force. In a lieves the economy will remain underem-and awash with saving. Overall credit has slump, in ation often falls uncomfortably ployed (and in ation subdued) for an ex- been shrinking. Nonetheless, Mr Rajans low: prices might rise by only 1% over thetended period. If its pessimism spreads, itworries 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, sohoard 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 economys weakness.beware of overly fast scal tightening. It is contrast, the central bank must promise in- This is the peril that befell Japan, ac- also a reason to look for antidotes to stag- ation no higher than 2% in each and every cording to James Bullard of the St Louis nation beyond macroeconomic policy. year, regardless of the rate the year before. Fed. The private sector came to expect de- The longer-term remedy must be creating In central banking, as in many indus- ation and its expectations were duly ful-new jobs and increasing productivity, but tries, the most innovative out ts are often lled. The central bank could not cut rates the most urgent need is to hurry up the re- the small ones. In ation-targeting was pio- below zero, and it did not raise them be-pairs to a broken nancial system. 7The cost of repairA battered nance sector means slower growth ALL recessions are painful, but the hang- overs that follow nancial crises are particularly long and grim. Growth is sub- crises, growth was a lot slower and credit growth stagnated whereas after normal recessions it soared (see chart 6, next page).swer will make a di erence to the richworlds growth prospects and to the waypolicymakers should respond. Peoples stantially lower than it is during normal So far the current recovery is following unwillingness to borrow bodes ill for recoveries as households and rms reduce this post-crisis script. Output is sluggishshort-term demand. Firms reluctance to their debt burdens. That is the depressingand credit is growing weakly or shrinkinginvest 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 systems in- search on the aftermath of big nancialbecause over-leveraged households andability to allocate capital e ciently has busts. In one such study, Prakash Kannan,rms have become less willing to borrow, bigger long-term consequences. an economist at the IMF, looked at 83 reces-or because banks have become less willing In practice, both supply and demand sions in 21 countries since 1970. He foundto lend? In other words, is the credit pro-probably play a role. There is plenty of evi- that in recessions that followed nancialblem one of demand or supply? The an-dence that consumers and rms have be- 1 8. The Economist October 9th 2010 A special report on the world economy 72 come less willing to borrow. A study byversity of Chicago, argued that the more a would be another matter. In the mid-1970s Atif Mian of the University of California atcompany depends on external nancingthe dearth of venture capital and IPOs set Berkeley and Amir Su of the Universitysuch 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 healthhave such a revolutionary impact in the the level of household debt. In placesof the nancial system. Mr Kannan of the1980s 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 percentagecrisis 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 Augusttant, 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 onmist 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 Americas total stockmarket listings, are nance of 4,000 American start-ups, The historical record suggests that the heavily dependent on external nancefound 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 Vincentfrom a withdrawal of credit than that of age, new rms borrow seven times as Reinhart estimate that in past crises it took the overall economy. As Mr Laeven says,much from banks as they do from friends an average of seven years for households we may only see the real impact ve yearsand 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 ostart-up nancing from the crisis is poten- tive to income. In many countries that pro- and generated new products.tially quite severe . The collapse in house cess has yet to begin. In America, whereVenture-capital raising, which never prices has undercut the many entrepre- progress has been fastest, the Reinhartsfully recovered from the bursting of the in- neurs who rely on home-equity loans. reckon that about half the rise in the ratioternet bubble in 2000, has been harmed This will also depress jobs growth, which of credit to GDP accumulated during the immensely by the latest crisis, says Steve over time depends disproportionately not boom era has been unwound.Jurvetson at Draper Fisher Jurvetson, aon either small or large rms but on small At the same time the supply of credit isventure-capital rm (see chart 7, next page). rms that become large, according to work clearly constrained. Banks in the euro zone Endowments, foundations and pensionby the Kau man Foundation. continue to tighten credit standards, and infunds, enthusiastic participants in ventureJapan 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 holdingscognise 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 toket 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), theso they kept zombie borrowers alive on a Rajan and Luigi Zingales, also of the Uni-harm will be small. A prolonged droughtdrip-feed of fresh money. They continuedto extend credit to insolvent borrowers,gambling that somehow these rms6The worst kindwould recover or that the governmentDeveloped-world recessions*, trough =100 After financial crises Without financial criseswould bail them out , according to RicardoGDPBank creditCaballero, Takeo Hoshi and Anil Kashyap 110110in a 2006 paper.They estimate that zombie companies 108108 those getting by on subsidised credit 106106 which had made up 5-15% of banks bor- 104104 rowers in the early 1990s, increased theirshare to 25% later that decade. The e ects 102102were variable. Zombies were much less 100100 prevalent in manufacturing, which was 98 98constantly exposed to international com--4 -3 -2 -1 012 34 5 6 7 8 -4 -3 -2 -1 0 1 23 456 7 8 petition, than in construction and retailing,Quarters from recession trough Quarters from recession troughwhere job turnover and productivitySource: Prakash Kannan, IMF *Based on 83 recessions in 21 industrial countries since 1970growth were lower.1 9. 8 A special report on the world economy The Economist October 9th 20102 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 inhave imposed stress tests to see how vul- loans may come to constitute a drain on America in the early 1990s, according to anerable their banks are to bad loans. Ire-banks resources that inhibits lending to 2000 study by the Bank for Internationalland and Germany have set up badmore 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 hurttor, 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 worlds bigStill, there is a widespread belief thatnoble intent, federal subsidies that keep banks, argued in a report published in Junebanks have not fully owned up to theirstressed owners in their homes delay thethat the rules then being contemplatedproblems, partly because of political pres- necessary reallocation of capital awaywould trim annual economic growth bysure. Germanys Landesbanken, which from property. Fortunately weve been 0.5 percentage points in America, 0.9 in thehave ties to local politicians and rms, are pretty unsuccessful, says Mr Jorgenson, a euro area and 0.4 points in Japan over vewidely thought to be in deeper troubleproductivity 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 temporarydicted a far more modest e ect: less thanIn America, banks and Fannie Mae andmortgage modi cations that have become0.2 percentage points in most countries,Freddie Mac, the nationalised mortgagepermanent.though in the medium term there wouldcompanies, have been discouraged by fed-Weak banks are not the only reason forbe a gain from greater stability.eral and state governments from foreclos- a credit squeeze. There is also uncertaintying on homeowners unable to keep up over the e ect of new regulations on the -Make me virtuous, but not yettheir payments. Banks do not mind all thatnancial systems ability to channel savers Compelling banks to set aside a lot morefunds into investments. America recentlycapital without much warning is clearlypassed its biggest overhaul of nancialrisky. The Federal Reserve found it would7 Nothing ventured, nothing gained rules since the 1930s, known as the Dodd- have to lower short-term interest rates by Venture capital, net funds raised, $bn Frank act after its leading congressional 40 basis points to soften the impact of big- United States Europe sponsors. On September 12th the Basel ger capital bu ers on growth an impossi-120 Committee of international bank regula- bility now that rates are, in e ect, at zero. To100tors agreed on a new set of requirementsdeal with this concern, the new Basel rulesfor banks liquidity and capital. These have a long lead time. The minimum level80rules, known as Basel 3, will require globalfor common equity is not due to take e ect60banks to have common equity equal to at until 2015, and the additional bu er not un-least 7% of their risk-weighted assets, til 2019.40against 2% now. That includes a minimumEqually contentious is the e ect of the20common-equity standard of 4.5% plus a post-crisis regulatory clampdown on high-countercyclical bu er of another 2.5%.octane nance. Americas new nancial0 Experience shows that higher capitalrules compel banks to trim their holdings 1997 99 2001 03 04 05 06 07 08 09 1098 2000 02requirements do dent credit growth, atof private equity and hedge funds. They re- Source: Thomson Reutersleast in the short term. The rst Basel agree- quire greater transparency in derivatives 1 10. The Economist October 9th 2010A special report on the world economy 92 markets and demand greater disclosure Paul Volcker, a former Fed chairman, has bank have led the way in issuing contin- from hedge funds. These new rules are as caustically called the ATM cash dispensergent 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 widelybecome undercapitalised. In theory, this Motors credit arm pulled an asset-backedshared by venture capitalists and non- - lessens the risk of future insolvency and bond deal because credit-rating agencies,nancial businesses. I cant think of any - taxpayer bail-out and lowers the cost of fearful of new liabilities under the Dodd- nancial or banker product or service thatsraising fresh equity capital. Private-equity Frank act, forbid the use of their opinionsever helped us, says Mr Jurvetson. Engi- rms are currently dabbling in buying in the deal document. The deal wentneers contribute to the economy, lawyers deeply discounted underwater mort- ahead when the Securities and Exchange and bankers subtract.gages from banks, then restructuring the Commission temporarily suspended the In a new book Amar Bhid, a professorterms to prevent foreclosure. There is even requirement that deal documents includeat Tufts University, argues that moderna edgling market in bonds explicitly such ratings.banks reduced loan decisions to arms- backed by delinquent mortgages. Mean- In Britain and America sophisticated - length algorithms based on credit scores while, American local governments are is- nance is ingrained enough to survive and asset values, biasing them towards ho- suing property assessed clean energy or tighter regulation. Continental Europe,mogeneous loans such as residential mort-PACE bonds, then lending the proceeds to however, has never had Americas 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 summarisedenergy-e cient. Homeowners repay the panies such as junk bonds, mezzanine in a credit score; a bank manager must loans through their property tax. debt and private equity, note Thomas Phil- sample its wares, kick the delivery vansThere are many more ideas on the ippon and Nicolas Vron in a 2008 report tyres and meet the founders. Mr Bhid 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 beention 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 creditposed their use in developing home- rules currently being negotiated by theto 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 andThe uses of noveltysetts Institute of Technology would like to private-equity funds from marketingHowever, this too easily dismisses the con-see governments sell tradable insurance themselves to EU investors unless they ac- tribution of nancial innovation. Work by credits which give any nancial institu- cept certain restrictions. But Mr VronMr Laeven of the IMF with Ross Levinetion the right to buy a government guaran- notes that they have yet to pass, and Britainand 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 byneeds 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 Americas 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 Americas new rules. vestment in property, whereas preferredited 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 eras 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. Itthe 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. 7From hoarding to hiringSome countries have successfully preserved jobs. Now they must create new ones HIGH unemployment is the most visi-ble scar left by the recession. In the 32 rich OECD countries the downturn and itsingly, the damage is not as bad as it mighthave been.When output falls, employment fol- it applied with a vengeance: Spanish em- ployment fell by twice as much as output. But in most countries its e ect was merci- aftermath threw over 17m people out of lows. This link is predictable enough to fully mild. In Germany unemployment by work. There was a comparable rise in the qualify as an economic law, named afterthe end of 2009 was lower than it had number of people who would take a full-Arthur Okun, who showed that whenbeen two years earlier. time job if it were available but insteadAmericas GDP fell by 2%, its unemploy-These disparate outcomes have chal- have settled for part-time work or given upment rate rose by about half that. In this re- lenged long-held stereotypes. The German looking altogether. This rise in unemploy- cession, however, Okuns law did not labour market has undergone a strange ment matches that in the deepest of thework as expected in a number of coun-mutation from a bulwark of eurosclerosis OECDs post-war recessions. But, astonish- tries. In America, New Zealand and Spain into a champion of exibility , writes Joa- 1 11. 10 A special report on the world economyThe Economist October 9th 2010 was companies response to the crisis. Into escape. Mr Elsby and his co-authors fearMore misery8 most rich countries they cut hours morethat America will be stuck with a persis-Labour market, Q4than bodies. German rms last year re-tent residue of long-term unemployedUnemployment as % of labour force duced working time by the equivalent ofworkers with relatively weak search e ec-of which: unemployed for 12 months or more 1.4m full-time employees. And even whentiveness, depressing the strength of the re-05 10 1520 their sta did clock in, they worked less covery . Students of Europes stubborn hard. For the rst time in decades output unemployment in the 1980s call this scle-2007Spain2009 per hour fell, reducing the input of labourrosis , an accumulation of scar tissue that by the equivalent of 1m people.makes the market more rigid.2007 The German government encouraged One obvious reason why AmericanFrance2009 this labour-hoarding with its celebrated workers are taking longer to escape fromUnited2007 Kurzarbeit scheme that subsidises shorterunemployment is a lack of job openings.States2009 working weeks. But this was responsibleAs long as vacancies remain low, unem-OECD2007 for only about a quarter of the reduction in ployment will remain high. That is anoth-2009 working hours. Firms were not forced orer economic relationship stable enough to2007 bribed to keep their workers; they chose tocarry someones name: the BeveridgeItaly2009 do so. Before the recession industries suchcurve, named after William Beveridge, a2007 as metals, chemicals and machinery had British economist. His curve is, however, aBritain2009 found it hard to ll vacancies. Workers inpoor guide to the recent behaviour of these industries are highly trained and spe- Americas labour market. In 2009 a fairly2007Germany2009 cialised and can cost up to 32,000 steady stream of job openings did not stop ($42,000) each to replace. When demand unemployment rising from 7.7% to 10%.2007 for labour falls, rms want to hang on to And in the rst months of this year vacan-Japan2009 them, just as they might mothball an ex- cies jumped, with little e ect on the joblessSource: OECD pensive piece of machinery.rate (see chart 9). In America, in contrast, rms proved 2 chim Mller of the Institute for Employ-keener to cut workers than hours. In the Keep them keen ment Research (IAB). America, long the1973-75 recession, the OECD calculates, em-What explains this puzzle? Some econo- poster child for e cient labour markets,ployment cuts accounted for less than amists blame the extension of unemploy- suddenly looks sclerotic. Not only is itthird of the reduction in man-hours. The ment bene ts, which Americas 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 outworking week or year. In the recent reces- France. European bene ts will buy you of work for more than six months, the sion the split was reversed. Robert Gordon European sclerosis, argues Robert Barro, an highest share since the Depression. of Northwestern University says that economist at Harvard University. He reck-What explains this divergence of for-American rms have come to view their ons that the unemployment rate would be tunes? First, the e ects of the recession employees as disposable .6.8% rather than 9.5% if bene ts had re- were unevenly spread. In countries such asMr Gordons judgment on the Ameri- mained at 26 weeks. Most other econo- America, Spain or Ireland, the bursting ofcan labour market is one-sided. If Ameri-mists think the e ect is much smaller. housing bubbles caused construction tocan rms are quicker to re their workers Whatever the magnitude, there is slump, with the loss of many jobs that arethan their European rivals, they are alsobound 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 provedhave exited from it ten times as fast: somebut why. Mr Barro thinks it is a case of more temporary. 58% of workers who are unemployed one moral hazard : if people are insured 1Second, 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 Okuns law with legislation of theirversity of Michigan, Bart Hobijn of the San Slightly out of line Trend line 9 own, making it costly or cumbersome toFrancisco Fed and Aysegl Sahin of theUS Beveridge curve, Jan 2007-Jul 2010 2000-Dec 15/6/2007Jul 2010 lay o workers. Pierre Cahuc of Frances New York Fed. Discarded American work- 15/5/200715/4/2007 15/8/200715/2/2007 15/7/2007 15/11/2007 15/9/2007 cole Polytechnique and his colleaguesers have not rusted on the scrapheap, as so3.515/10/2007 15/12/2007Mar 2007Apr15/2/2008 15/1/200815/3/2008 point to Spains rules on ring permanentmany do in Europe.15/4/200815/7/200815/6/2008 2010 Job openings rate, % 3.015/8/2008 sta , which are particularly tough, thoughAt its best, then, the American labour 15/9/2008 2010Jul15/10/2008 recent reforms have eased them slightly. 15/11/2008 market does not dispose of its workers; it 2.5 15/12/2008 15/1/2010 15/5/2010 15/3/2010 15/2/2009 That has been good for those lucky enough recycles them. Sadly, the market is now far 15/2/201015/1/200915/3/200915/9/2009 15/12/2009 15/11/200915/5/200915/6/2009 Jan 200715/8/200915/4/200915/7/2009 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 Jan 2009 workers. So employers hired lots of themescaped their predicament within a 1.5Oct 2009 they made up about 30% of all employees month, an historic low. The harder it is to before the crisis and red them when the escape joblessness, the longer people re-4 5 6 7 8 9 10Unemployment rate, % downturn arrived. main unemployed; and the longer they re- Sources: BLS; Thomson ReutersBut what made the biggest di erencemain unemployed, the harder they nd it 12. The Economist October 9th 2010A special report on the world economy 112 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, Americas underlying,Harvard has a subtler answer. or structural , rate of unemployment roseHe points out that workers who receivefrom 5% before the nancial crisis to be-generous lump-sum severance paymentstween 6% and 6.75% in 2009. So even if thealso take longer to nd a new job. The recovery gathers steam, almost one-thirdlump-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 Americastaking their time they are spending their jobless problem is mainly structural. Anown money. They may nd this worth exception is Narayana Kocherlakota, presi-their while because by waiting for the rightdent of the Minneapolis Fed, who reckonsjob they will secure higher earnings. In an that most of it is. And Edmund Phelps, aideal world the unemployed would -Nobel prize-winning economist at Colum-nance their own job search by borrowing bia University, worries that the focus onagainst these higher future wages. In the de cient demand lulls us into failing toreal world, however, bene ts have to ll think structural in dealing with long-termthe 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 asOur skater has broken some bones andcies will not fall, however dire the state ofmuch as skillset. Too often the construc-needs real attention.the job market. Even shrinking rms posttion worker does not think of himself as a What kind of attention? Among a longvacancies for about 2% of their jobs, ac-health technician, says Larry Katz of Har- list of proposals, he advocates tax creditscording to Steven Davis of the Universityvard 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 adelphia Fed and John Haltiwanger of theplace. But the recession has left Americans$5,000 credit for rms that hired people inUniversity of Maryland. And in the early uncharacteristically at-footed , accord- 2010. As a at sum, the credit would havestages of an upturn there is often a lag be- ing to William Frey of the Brookings Insti-represented a bigger subsidy to low-paidtween vacancies rising and unemploy- tution. The share of people moving house workers. But scepticism about a stimulusment falling. It takes time to ll the postsfrom March 2007 to March 2009 was theforced him to scale the tax break back tothe 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 maycouraged worker may renew his jobders, at 1.6%, was half that in 1999-2000. be a pity. According to a study by Ms Sahinsearch, rejoining the labour force and add-Mr Frey puts much of the blame on theand two colleagues, the $1,000 credit coulding to the o cial unemployment tally. So ithousing market. If you cannot nd a buyer cut the unemployment rate by almost oneis just a matter of time before the Beveridgefor your home, you cannot move to a newpercentage point. But a $5,000 credit mightcurve snaps back into shape. one. Almost one in four Americans with have cut it by over three points, at least in mortgages have negative equity , owing the short run.Redrawing the Beveridge curvemore than their house is worth. They often Hiring incentives might tempt employ-Other economists are worried that the odddecide to stay put rather than default. Ac-ers, but they will not help if workers havebehaviour of the Beveridge curve suggestscording to Marcello Estevo and Evridiki the wrong skills or are stuck in the wronga mismatch between the skills of jobseek-Tsounta of the IMF, geographic immobilitypart of the country. That is why the IMFsers and those required for new jobs. Davideconomists also advocate an overhaul ofAutor, of the Massachusetts Institute offederal training programmes and more ef- 10Technology, believes that the recession has Europes job miraclefort 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 Americas bankruptcyHe reckons the American labour marketPopulation Change in law to allow judges to restructure mort-has polarised, creating jobs for the well- growth unemployment ratesgage debt. America spends only 0.17% ofeducated and the low-paid but o ering lit- Change inShifts in GDP on active labour-market policies, participation ratesage structuretle in between. Janitors and managers30such as training and job search, far lessweathered the recession, but white-collar than the OECD average. Such schemes as itsales, o ce and administrative jobs the has are fragmented and not particularly ef- production jobs of the information age20 fective. That may need to change. Havingfell by 8% between 2007 and 2009. The long taken their labour markets exibilityproduction jobs of the manufacturing age,10 for granted, Americans may now have tosuch as craftsmens, repairmens and +work at it.machine operators, fared even worse. Even as Americans are beginning to 0Even as the economy has regained (and fear that their labour market is turningsurpassed) 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 AmericanEU-15 United Statesset industry may have to break into sunrise labour market may be less dynamic than itSource: McKinsey Global Instituteindustries to get a job. A shift in occupationwas, but it is still more dynamic than Eu- 1 13. 12 A special report on the world economyThe Economist October 9th 2010Spain o ers a test case for Pass and movelabour-market reform in Europe WHEN Spain won the World Cup in July, it con rmed its reputation foruid and e cient football. If only its econ-Easy come, easy goTemporary* employment, 2009, % of total 11isting workers are una ected.) This couldfall to 20 days pay for all workers at rmsthat can show they face large and persis-omy worked as well. GDP growth is slug- tent losses. Spains complex wage-bar-gish and a fth of the workforce is unem- 0 10 20 30 gaining system remains intact but rmsployed. Two features of Spains jobsPolandcan now opt out if their employees agree.market share much of the blame: the highSpain How e ective these new rules will becost of ring permanent workers, and a Portugaldepends on how they are interpreted. Itwage system that binds rms to industry- could take years to clarify under what cir-Germanywide pay deals. On June 16th, the day cumstances rms can re workers andSpain played its rst World Cup match, Japan pay only 20 days compensation, saysthe government set out its plans to cureFranceLuis Garicano, of the London School ofthese ills. The reform bill, passed by parlia-Italy Economics. In the past, Spains labourment on September 9th, falls well short ofOECDcourts have taken a dim view of rmswhat was needed but may neverthelessseeking to cut jobs. Firms may nd it trickyBritaindo some good. to persuade workers to accept lowerChanges were long overdue. Because it United Stateswages than mandated by national payis so costly to lay o workers, businesses*Jobs with a pre-set termination date2006deals. Spains jobless bene ts are quiteSource: OECDare reluctant to hire them in the rst place.generous and are paid for long periods, soA 1994 measure to promote jobs made itmany workers may opt for redundancyeasier to hire temporary workers and led Madrid-based bank, shows that Spanishrather than take a pay cut.to a sharp rise in their numbers. But only a rms are less productive than AmericanA lot also depends on how actively thesmall proportion of them move on toones partly because they tend to be small. government promotes the reforms. A big protected jobs. Most are laid o at theIdeally the rules would allow wage worry is that the labour ministry seemsend of their contract. The high churnbargaining to take place locally and pro-just as attached to the status quo as labouramong temporary workers, most of themmote a good balance between job exibil-unions and business groups are. Andyoung, female or migrant, means rmsity and security for all workers. A group of even if o cials support the changes, fewhave little incentive to train them. 100 Spanish economists had pushed for aeconomists expect Spains jobless rate toThis has pushed many into low-skilledsingle contract , with employment rights plummet. But a fall in the share of tempo-work. The impact on Spains productivity that rise gradually with tenure. Thatrary employees in the workforce, andis compounded by rigid wage rules. Lastwould make it cheap and easy to get rid of weaker wage growth in response to highyear nominal pay rose by 3% despite therecent recruits that turn out to be opsunemployment, would be promisingweak 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 oftween unions and employer groups, rath-an incentive to invest in the workers they any reform at all seemed remote, evener than tailor pay to prevailing businesshold on to.such mild progress has been greeted withconditions. That costs jobs and hurts e -The reforms fall short of that. A change relief. This takes Spain from worst to bet-ciency. Firms cannot undercut rivals onin 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 toment Corporation. But it may not catch upResearch by Rafael Domnech, at BBVA, a33 days wages for each year worked. (Ex-with its football team for a while. 2 ropes. Americas 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 thaneven 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 bysey Global Institute (MGI). many (6%) and Italy (4%). And although2.2% 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% ofslowly not only because fewer people graphic trends. They can raise the retire- workers had been out of a job for morework but also because they save and invest ment age, open the doors to immigration than a year, compared with 0.5% before theless. From 1990 to 2008 the combined GDP and tempt more people into the labour recession), a bigger proportion of workersof 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 Americas. In Denmark the Many European countries fail to makeable demography it can expect to growworking-age population is already shrink- 1 14. The Economist October 9th 2010 A special report on the world economy 132 ing, but a larger proportion of this smaller cas 913). But the gap is closing. To narrow itA larger share of Swedens older peo-population is actually working.further, Europe does not necessarily have ple, too, remain in the labour force thanIndeed, a number of European coun- to become like America. It could greatlyanywhere else on the continent, not leasttries have changed far more than many (es- improve its performance simply by adopt-because they accrue higher retirementpecially Americans) give them credit for. In ing its own continents best practice every-bene ts for each year they work after thea forthcoming report the MGI heralds the where. Some progress along those lines is age of 61. If other Europeans aged between unsung progress in European labourbeing made. Greece is overhauling its la- 55 and 64 were as industrious as oldermarkets. Despite a far smaller growth in bour rules; Spain has just passed a modestSwedes, the continent could reduce thetheir population, the 15 west European reform (see box, previous page). But theregap in hours with America by almost amember states of the EU created more jobsis much more to be done.quarter, according to the MGI.than America between 1995 and 2008. The rest of Europe could also learn fromThey countered their adverse demographyTaking up the slack Denmarks e orts to beat unemploymentby 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. For25 and 54 take part in the labour market. Itting youngsters into work. To echo an oldexample, the share of working-age womenhelps that the countrys extensive day-care joke, heaven is where women and olderin the labour force rose by 11 percentagefacilities for children are largely reservedpeople work like the Swedes, the youngpoints between 1990 and 2010.for workers, and that couples le their taxwork like the Dutch and the unemployedThe EU-15 still get less out work out of returns separately so that households dond jobs like the Danes. Hell is wheretheir population than America does (733not get hit by higher marginal tax rates on workers get into unemployment like thehours 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 PRODUCTIVITY growth is the closest economics gets to a magic elixir, espe-cially for ageing advanced economies. boost the pace of e ciency gains as weak demand forces rms to rethink their pro- ducts and cost structures and the weakest Frances Minitel, an attempt to create a gov- ernment-run national communications network, to Spains expensive subsidies toWhen workers produce more for everycompanies are winnowed out. According jump-start solar power, suggest that gov-hour they toil, living standards rise andto Alexander Field of Santa Clara Universi- ernments are not much good at pickinggovernments have more resources to ser-ty, the 1930s saw the fastest e ciency im-promising sectors or products.vice their debts and support those who provements in Americas history amidMore important, the politicians currentcannot work. As the rich world emerges large-scale restructuring.focus on fostering productivity growth viafrom the nancial crisis, faster productivity exciting high-tech breakthroughs misses agrowth could counteract the drag from ad-Here we go againbig part of what really drives innovation:verse demography. But slower productivi- Almost every government in the rich the di usion of better business processesty growth could make matters worse.world has a spanking new innovation 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 insince 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 getof innovation the process of generatingback. But mostly such policies end up sub-out of the way. This is especially true in theideas that lead to new products and more sidising well-connected industries andmost regulated and least competitive partse cient business practices. Financial cri- products. Green technology is a favour- of the economy, notably services.ses and deep recessions can a ect theseite receptacle for such subsidies.To see why competition matters sovariables 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 oferode if long-term unemployment rises. nancial crisis; it promises to promote bio- the recession the rate of growth in workersThe disruption to the nancial sector and technology ventures, though it has also output per hour was slowing. So, too, wasthe reluctance of businesses to invest insunk capital into conventional manufac- the pace of improvement in total factorthe face of uncertain demand may also re-turers that happened to need money. Inproductivity (a measure of the overall e -duce the rate of capital formation, delaying 2009 Britain followed suit with a strategic ciency with which capital and workers arethe factory upgrades and IT purchases that investment fund . The Japanese too areused which is economists best gauge ofwould boost workers e ciency. back in the game. In June the newly invigo- the speed of innovation). But that broadFinancial 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 predictdustry (METI) unveiled a plan to promoteOver the past 15 years Americas under-which way. Deep recessions can slow it ve strategic sectors, ranging from environ- lying productivity growth adjusted fordown as rms slash their spending on re-mental products to robotics. However, pastthe ups and downs of the business cyclesearch and development. But they can alsoexperiments with industrial policy, fromhas outperformed most other rich econo- 1 15. 14 A special report on the world economyThe 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 Its 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 yearup ine cient zombie companies rather was powered by productivity gains within than forcing them into liquidation. That3.5 the technology sector. From 2000 onwardsJapanmeant less capital was available to lend to e ciency gains spread through the wider3.0 upstart rms. Another problem was the economy, especially in services such as re-2.5 lack of competition. Japans 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- icas economy. The improvements were United States petition and heavily regulated, so it failed1.0 extraordinary, though they slowed afterEuro 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 in0 forts at regulatory reform, from freeing up Europe is almost the mirror image of1980 85909520000510 the energy market and mobile telephonyForecast Americas. Up to the mid-1990s the conti- Source: The Conference Board *Structural trendin the mid-1990s to liberalising the nan- nents output per hour grew faster thancial sector in the late 1990s. These have Americas (see chart 13), helped by importsa new company, assigning a score to eachborne some fruit. Japans total factor pro- of tried and tested ideas from across themarket of between 0 and 6 (where 0 is the ductivity growth, unlike Europes, began to water. Thanks to this process of catch-up, least restrictive). Overall the absolute levelimprove after 2000. But coupled with the by 1995 Europes 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 wascountries lessened. America and Britain decisive change in the countrys overall back down to 83%. This partly re ected Eu- score joint best, with 0.84. The EU average productivity prospects. ropes labour-market reforms, whichis 1.4. But when it comes to services, the va- brought more low-skilled workers into theriation is larger and Europe has made Learn Swedish workforce. That seemed a price well worthmuch less progress. Sweden o ers a more encouraging lesson. paying for higher employment. But the In professional services, the OECDs In the aftermath of its banking bust in the main reason for Europes disappointing score for Europe is fully twice as high as forearly 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 fromAs 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 Europeantive rules. Architects and lawyers fees inpension systems and freed up whole growth by Marcel Timmer and Robert In- Italy and Germany are subject to priceswaths of the economy, from aviation, tele- klaar of the University of Groningen,oors and ceilings. Notaries in France,communications and electricity to bank- Mary OMahony of Birmingham Universi-Spain and Greece and pharmacies ining and retailing. Thanks to these reforms, ty and Bart Van Ark of the ConferenceGreece are banned from advertising theirSwedish 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 e cient newcomers to compete for celerated to a remarkable 2.2% a year from ual countries and industries and nds con-market share, cosseting incumbents and1991 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 productivityIn Japan productivity growth slumped Swedens retailers put in a particularly growth whereas Italy and Spain were par- after the countrys asset bubble burst at the impressive performance. In 1990, McKin- ticularly sluggish. Europe also did better instart of the 1990s. One reason, as an earlier sey found, they were 5% less productive some sectors than in others; for example,than Americas, mainly because a thicket telecommunications was a bright spot. Butof regulations ensured that stores were 13 overall, compared with America, Euro- Not catching upmuch smaller and competition less in- pean rms invested relatively little in ser- GDP per hour workedtense. Local laws restricted access to land vices and innovative business practices. AAs % of US GDP per hour worked for large stores, existing retailers colluded new McKinsey study suggests that aroundFrance Germany Britainon prices and incumbent chains pressedSpainItaly Japan two-thirds of the di erential in productivi- 110suppliers 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 local services , such as retail90Swedish entry into the EU and the creation and wholesale services.of a new competition authority raised Europes service markets are smaller 80competitive pressures. Large stores and than Americas, fragmented along nation- 70vertically integrated chains rapidly gained al lines and heavily regulated. The OECD market share. By 2005 Swedens retail pro- has tracked regulation of product and ser- 60ductivity was 14% higher than Americas. vices markets across countries since 1998. ItThe restructuring of retail banking ser- 1980 8590952000 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 16. The Economist October 9th 2010A 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 Obamas regulatory changes, from tougher fuel-e ciency 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 Houses ideas, such as the overhaul of broadband internet access, would in fact increase competition. The biggest risk lies in nance, where Americas 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 boost2 EU entry increased competition. Newtice 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, annualthe main battleground has been trucking. branches were closed, and by 2006 Swe-productivity growth would rise by someBefore Greece descended into crisis, its lor- den had one of the lowest branch densities0.2 percentage points in America, 0.3 per-ry drivers required special licences, and in Europe. Between 1995 and 2002 bankingcentage points in the euro area and 0.6 per-none had been granted for several de- productivity grew by 4.6% a year, muchcentage 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 fromelled 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 richcounter 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 OECDderegulation. 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- 14Services with a smilelike Sweden, show that crises can o er ducing regulation on upstream services Productivity growth, 1995-2005 valuable opportunities. Without the coun- would have a marked e ect not just onContribution by sector, % trys brush with default and the conditions productivity in those sectors but also on Primary resourcesServices:attached to the resulting bail-out, its lead- other parts of the economy. The logic isManufacturingLocalers would have been unlikely to muster simple: more e cient lawyers, distributorsInfrastructure Business the necessary political will. Property Professional/ or banks enable rms across the economy financialThe sluggish progress of reform else- Other to become more productive. The size of thewhere 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 annualtiptoes: it recently reduced restrictions on total factor productivity growth by one10 price-setting by architects and allowed percentage point in a typical country in 5chimney-sweeps easier market access. their sample, enough to more than double + Two French economists, Jacques Delpla0 its pace.and Charles Wyplosz, have argued that in- Getting rid of all anti-competitive regu-5cumbent service providers should be paidUnited States EU-15 lation may be impossible, but even theo in exchange for accepting competition.Source: McKinsey Global Institute more modest goal of embracing best prac-They reckon that compensating French 1 17. 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 andvard University puts it: Think Google, not 4.5 billion. But buying o the losers frommaintaining 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 morevation 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 EUs GDP is in services but only 20%more on R&D are also often quicker toremove remaining barriers to collabora- of those services cross borders. The EUsadopt 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 nowrules, should also help. vices, has proved fairly toothless.that research has become more global andA smart innovation agenda, in short,more concentrated on software than onwould be quite di erent from the one that How governments can help hardware. Since the mid-1990s Chinamost 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 andless about picking winners; more about sic research is important. The grants doleddevelopment. Big rms maintain research creating the right conditions for bright out by Americas National Institutes offacilities in many countries. Dreaming upideas to emerge and less about promises of Health, for example, generate the rawnew products and services, as well as bet- things like green jobs. But pursuing that ideas that pharmaceutical rms turn intoter ways of producing old ones, increasing-kind of policy requires courage and vi- pro table medicines. Americas 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. 7A better wayThe rich world should worry about growth-promoting reforms more than short-term scal austerity O NCE you start thinking aboutgrowth , said Robert Lucas, a No- bel prize-winning economist, its hard to Dont hang your hopes too high GDP, 2011 forecast, % increase on previous year15 for much the same reason. The OECDs September forecast reck- ons that the annual rate of GDP growth in think