Rajan Says Governments Can’t Afford Another Crisis

by Mark Whitehouse

Wall Street Journal
March 30, 2011

The financial strains created by the very different crises in Japan and Europe — one brought on by nature, the other man-made — raise a question: How many more disasters can the rich world bear?

The costs of supporting aging populations, together with increasingly expensive bailouts and reconstruction efforts, are driving government debt in advanced nations to levels not seen since the aftermath of World War II. On average, general government gross debt in the Group of Seven industrialized countries stands at about 110% of annual economic output, up from about 73% a decade ago, the International Monetary Fund estimates. Economists at the IMF calculate that several countries — Japan, Italy, Greece, Portugal and Iceland — have already reached or exceeded the highest debt levels they have handled in the past without defaulting.

To get a better grasp of the state of the rich world’s finances, the Journal’s Mark Whitehouse spoke with one of the world’s leading authorities on financial crises: Raghuram Rajan, a professor at the University of Chicago who served as chief economist at the IMF from 2003 to 2007.

How did the world’s richest nations also become its most indebted?

Rajan: This has been building for a long time. If you look at public debt in the G-7 countries, there’s been a consistent upward trend since the 1970s. It’s ironic, because the buildup came at a time when the free-market ideas of Milton Friedman were dominant, and Keynesian policy — which recommends that the government step in as the spender of last resort in times of crisis — was supposedly discredited.

In actuality we’ve had a fair amount of fiscal stimulus over time, sometimes due to automatic stabilizers such as unemployment insurance, which were strengthened in the 1960s. Also, there has been somewhat more intervention in times of crisis — certainly in the U.S. in recent times on fiscal policy.

The flip side is that government should have paid the debt down as economies recovered. It turns out that didn’t happen, so you kept accumulating debt in small doses. We had countercyclical policy in downturns, but we didn’t reverse it in the upturns.

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