A Crisis in Two Narratives

by Raghuram Rajan

Project Syndicate
January 27, 2012

With the world’s industrial democracies in crisis, two competing narratives of its sources – and appropriate remedies – are emerging. The first, better-known diagnosis is that demand has collapsed because of high debt accumulated prior to the crisis. Households (and countries) that were most prone to spend cannot borrow any more. To revive growth, others must be encouraged to spend – governments that can still borrow should run larger deficits, and rock-bottom interest rates should discourage thrifty households from saving.

Under these circumstances, budgetary recklessness is a virtue, at least in the short term. In the medium term, once growth revives, debt can be paid down and the financial sector curbed so that it does not inflict another crisis on the world.

This narrative – the standard Keynesian line, modified for a debt crisis – is the one to which most government officials, central bankers, and Wall Street economists have subscribed, and needs little elaboration. Its virtue is that it gives policymakers something clear to do, with promised returns that match the political cycle. Unfortunately, despite past stimulus, growth is still tepid, and it is increasingly difficult to find sensible new spending that can pay off in the short run.

Attention is therefore shifting to the second narrative, which suggests that the advanced economies’ fundamental capacity to grow by making useful things has been declining for decades, a trend that was masked by debt-fueled spending. More such spending will not return these countries to a sustainable growth path. Instead, they must improve the environment for growth.

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