This wide-ranging interview by Wharton finance professor Jeremy Siegel with Raghuram Rajan, an economics professor at the University of Chicago and former Governor of the Reserve Bank of India, covers topics ranging from his new book to the economic future of China and India. Joining the discussion, which occurred on Wharton Business Radio’s Behind the Markets show on SirusXM, were Jeremy Schwartz, Liqian Ren and Gaurav Sinha from WisdomTree ETF Investments. Schwartz is also the regular moderator for the show, which features Siegel.
In summarizing his new book, The Third Pillar: How Markets and the State Leave the Community Behind, Rajan explained how the deterioration of support for people from their local communities, themselves left behind by markets and governments, has been the key reason for the rise in different varieties of populism, which he says now threaten capitalistic economic systems.
Rajan became one of the world’s most-respected economists in the wake of the financial crisis. That is because not long before the crisis — in 2005 at the Jackson Hole economic conference — he warned about significant gathering risks to the world’s financial system. His warnings went ignored and were dismissed by most prominent economists at the time. He came to be viewed as one of the very few economists to foresee the worst financial and economic collapse since the Great Depression. (Listen to the podcast of the show above).
An edited transcript of the conversation appears below.
Jeremy Siegel: Your book is wonderful. Would you summarize it?
Raghuram Rajan: It’s a book which says much of the debate in the 20th century was about “how much government, how much markets?” I argue that a critical component of a well-functioning capitalist society is not just the markets, not just the state or the government — but the third pillar, which is the community. That’s central to preparing people to participate in markets that are giving them the early childhood education, the values, the nutrition, the health that makes them adequate market participants, but also in many countries in supporting them, when they fall off the markets.
When you lose your job, when you run out of your savings — where did people in Southern Europe, for example, go during the Great Recession? They went back to their families. They went back to their villages, because that was the structure that supported them. And similarly in the U.S., we have this phenomenon of many kids not leaving home and living in their parents’ basement post-Great Recession, because they simply couldn’t find jobs.
So the community in a sense is both pre-market preparation — helps you become adequate market participants — but also it’s post-market support. It’s a kind of safety net. And perhaps most important of all, it is also the basis for democratic action. What I document in the book is that many times, the basis for capitalism — opportunity for all — has been protected by democratic protests, for example, in the 19th century by the early populist movement — the farmers protesting against the monopolies — the railroad monopolies, the banking monopolies — and in that process trying to open up capitalism wider and preventing the nexus between the big capitalists and various aspects of the government.
“The way to deal with this very differentiated impact of technological and globalization across communities within a country is to start at the community level itself — to repair our communities.”
So the central thesis in the book is the reason we feel uneasy about capitalism today — the reason there is so much protest across the world — why we see the rise of populist nationalism – I relegate it all largely to weakness in the community.
Across the industrial world, we have communities that have been hit three times. First because trade and technology have hit some communities really hard. Granite City, Illinois — which is a steel city — essentially lost an enormous number of jobs. And you can find places like that across the industrial world. The places that, for example, the French Gilets Jaunes are protesting from. Second, in these very places, you also see that soon after there’s an economic loss of jobs, you also see social dysfunction creeping in. Because people don’t have jobs, you see marriages breaking up. You see substance abuse. You see teenage pregnancies. And as social dysfunction sets in, the local institutions start breaking down. Schools no longer are adequate and don’t teach as well as other places.
And then what you have is the third problem, which is in order to get the jobs in a technologically advanced economy, you need superior skills in order to move up from where you were. And that’s much harder when your local institutions aren’t functioning, when your schools aren’t providing — or your community colleges aren’t providing the kind of training that you actually need.
So essentially I would argue the way to deal with this very differentiated impact of technological and globalization across communities within a country is to start at the community level itself — to repair our communities. And that’s the way we’re going to deal with technological change. In part, the reason I keep saying we need to start in the community, rather than in Washington, is because each community has a different problem, and the specific problems of the community have to be dealt with there itself, by the people who know it best. And how do we make that happen in these communities which are breaking down? This is the key problem, to my mind, of industrial countries today.
Siegel: It’s a very interesting question — is this rise of this populist/nationalist really due to a pushback on capitalism or markets, or is its source something different?
Now there was an interesting article recently suggesting that the rise is not really anti-capitalist, but more anti-immigrant, anti-others imposing their way of life. If you’re anti-capitalist, you wouldn’t vote for Republicans and Trump. I don’t think you’d vote for Boris Johnson and Brexit. And even Modi — these populist leaders are seen as more pro-market or more capitalist. In Poland they wanted to purge the Communists that they thought were still running. And it was more of a “Don’t tell us what to do. There’s this liberal elite world that’s all integrated, and they all have their set of values, and they think everyone should have this set of values. And I don’t agree with that.”
Rajan: Professor Siegel, I didn’t say it was anti-capitalist. I said it was a threat to capitalism. And I’ll tell you why. The premise of capitalism is largely open markets — that means open flows of people, goods, capital, et cetera. And there are various forms of populism. There’s the populism of the left, which is more about redistribution. “We’re losing, therefore we want redistribution, even while erecting barriers to trade.” There’s populism of the right, which is certain forms of nationalism. Again, there are many varieties of that.
But often the component that’s most anti-market is the protectionism in that populism of the right. But there’s also anti-competition — “Oh, these migrants are taking our jobs, so let’s keep out the migrants.” Or “Oh, these foreigners are competing with us, let’s keep out foreign trade.” So those are elements of the anti-market. And this goes back to my point about the community. One of the features of integrated markets and technological change is precisely that markets come together across the world. And what market participants want essentially is a common playing field. But they also want it to be the same pretty much where they go. They want the same rules, because they want to be able to essentially minimize transaction costs as they go across markets.
So the tendency of markets when they integrate is to essentially imply an integration of governance, also. To give an example, it used to be when banks were in a town, the town used to set capital requirements for banks. That used to be regulation for banks. Now as banks became state-wide, the state capital used to set capital requirements. As banks became national, they were set at the national capital. Today they’re international, so Basel — a small town in Switzerland where central bankers meet — that’s where capital requirements are set for banks internationally.
The point here is that governance tends to migrate up. In fact, if you think about the European Union, the entire project is about harmonization of governance across European countries so that there is a common market. And that will allow for the free flow of goods and people across that market — the “four freedoms” that Europe talks about. The problem with that is people are not happy when they don’t have control, when they see decisions being made.…
Siegel: There’s a backlash against this moving up of control.
Rajan: Exactly.
Rajan: Think of Brexit. Brexit at one level is saying, “Let’s take power back from Brussels.” But it’s not about leaving power in London. Northern England wants to take power from London also, because London has usurped too much power over the last so many years. So in a sense, the community has become disempowered. And when you’re tackling these big forces which you have no control over, part of what you want to say is, “Look, somebody else is making these decisions for me, and I feel unhappy.” So some of the populism is tapping into that also…. And that hits at the notion of markets also, because markets want an integrated government. And in fact people are saying, “Maybe it has gone too far.”
Jeremy Schwartz: It’s interesting — one of the conversations happening from, let’s say, [Democratic Presidential candidate Elizabeth] Warren on the Democrat’s side and Trump talking about [European Central Bank President Mario] Draghi’s currency manipulations [is about wanting a weaker dollar]…. From your seat as having been the head of the Central Bank, how do you just look at the currency interventions that are being attempted on these sides?
Rajan: I was worried about this day coming, because one of the effects of monetary policy is to spill over across countries, right? When the U.S. cuts interest rates, the dollar depreciates. Now one of the effects of lower U.S. rates is the hope that the U.S. economy gets stronger. And as the U.S. economy gets stronger, it draws in imports from other countries, and that’s good for the rest of the world.
But the immediate impact is for the dollar to depreciate, which tends to reduce the extent to which the U.S. would want to import from the rest of the world. So monetary easing tends to have an adverse effect on the rest of the world — hopefully balanced over time by your own stronger growth, which results in your buying more goods from the rest of the world and helps them.
So this has been the dilemma for monetary policy, that in general, in normal times, monetary policy cuts are both good for you and good for the rest of the world. But there are times when it may seem as if you’re cutting interest rates in order to steal an advantage over others.
Siegel: It’s called the “beggar-thy-neighbor” policy.
Rajan: Exactly.
Siegel: This goes all the way back even before floating exchange rates. Even during fixed exchange rates, devaluations took place with exactly that goal in mind.
“If you are in an area which has had very few jobs, where crime is now rampant, where drug abuse is rampant, you’re not going to be lifted. No business is going to come in just because interest rates are low.”
Rajan: Well, the IMF was structured to try and prevent that. So if you want to move away from your fixed exchange rate, you had to ask the IMF, and it usually — unless you had a strong case — would say no. But you’re absolutely right. In the 1930s, when you didn’t have these rules of the game which were set in place with the IMF, there was the “beggar-thy-neighbor” strategy. Everybody was trying to steal demand from their neighbor, and after all, it’s a zero-sum game. There’s only so much demand to go around.
Well, this is precisely what President Trump has been saying — that, “Oh, when Draghi talks about weaker monetary policy, he’s attempting to weaken to the euro.” Now obviously the Europeans immediately said, “That was not our intent,” but in a sense, every monetary action has this spillover effect. And for some time I’ve been saying we need to think about how we communicate about this, and under what conditions certain monetary actions are okay, and when they’re not. And unfortunately, if we don’t have that kind of dialogue, and if we don’t make clear how our monetary actions are going to affect others, we’re going to have politicians starting to comment on it — which may not be very useful.
Schwartz: Are you supportive of the type of thing Trump’s trying to do in these trade deals with China, with Japan — in trying to make currency policies as part of the trade negotiation?
Rajan: At this point, even China is not really manipulating its currency. If anything, it’s trying to keep it from weakening. And if you look at China’s current account surplus, it’s close to balanced. So the days when China was running a huge current account surplus are gone.
I doubt that currency intervention is a big part of what China is doing. There are other issues, of course, with how it treats intellectual property and what kinds of requirements it places on countries to come into the Chinese markets — what companies have to do to enter those markets. Those are fair issues to have a dialogue over.
My thought, which is not original — is if you wanted to do that, the right thing would have been to go along with Japan, go along with Europe, and deal with China. At this point, unfortunately, the U.S. is engaged in bilateral discussions with each one of these countries, and that may not result in the most effective deal.
Siegel: I agree. I’ve always thought that on this intellectual property issue — which I think is a very valid point against China — that a multilateral approach led by the U.S. would have been more effective then, although we didn’t have any real leadership to push that issue until Trump. But is he going about it in the best way or not?
I think he has totally the wrong idea about a trade deficit being just by itself a bad thing. We as economists understand that that’s a fallacy. It’s particularly a fallacy when you have a full-employment economy such as we have today. But on the intellectual property side, we did need a little more force in leadership. The question is whether Trump is going about it the right way or not. And I’m not at all convinced on that.
Liqian Ren: In your book, you mentioned the gentry was able to be a check on the state. And in China, over the last 30 years, one of the disappointments is that the Chinese middle class has not acted as a check on the state. People feel the idea that this middle class against the state may not be the future of China, but much more like the Taiwanese models, that somebody from the inside — a top leader — realized that he himself wants to make change. How do you view this?
Rajan: It’s a great question — what will drive a Chinese movement to democracy? And one of the Chinese concerns is what happens when there’s a weak state — which has happened occasionally during China’s history and hasn’t turned out well for the country. There were horrendous wars during those periods.
In China today, the private sector, as in many emerging markets, is not independent of the government. In fact there are party cells in various private sector firms. The party itself wants to keep the private sector — especially the large private sector firms — under some kind of control. And even for small to medium-sized private sector firms — often their ability to enter the market initially is facilitated by local government officials, and therefore there is a connection with the government yet again there. And given the preponderance of big national or government-led banks, credit also becomes a function of government favor.
So as in many emerging markets, the private sector is much more indebted to the government than elsewhere, which then suggests, where is the move going to come from to reduce the impact of the party or the influence of the party? And I think you’re right — that it may well be that change in China comes from within the party.
Of course the Chinese remember very well the example of Gorbachev in the Soviet Union and don’t think that is a good example of an internal reformer breaking things down. But perhaps they may conclude that Gorbachev did it too early in the Soviet Union, and there may come a time when a measured relaxation in China — just like, for example, the PRI gave up power in Mexico, or the Liberal Party in Japan gave up its dominance — maybe there may come a day when that realization will happen.
Gaurav Sinha: I want to ask about this increasing friction between capitalism and the communities and the democracies. Each of these three pillars is not exactly at loggerheads with having increasingly more friction between them. Now if I understand it correctly, the middle class is generally a stabilizing pillar between let’s say capitalistic infrastructure and a well-functioning democracy, because the middle class sees that if capitalistic society grows, they would benefit from that. They’re a powerful political bloc, so they want to work for a government that is leaning towards not being super-leftist. Generally middle classes worldwide have grown in every country, except barring a few exceptions here and there. So why do we now see that there is a friction between general communities, as well as the capitalistic sort of institutions, and to an extent the governments, as well?
Rajan: The first place to start is to recognize that not all communities are benefiting, right? So there is a wide difference, even within industrial countries, between the old manufacturing communities, for example, and the service-oriented megacities that are doing very well.
“The angst is precisely that we’re no longer middle class. And even though we want to cling to that middle class status, the economics don’t allow us to do that. And that causes great anger.”
First, jobs have disappeared from some places, even while they’ve been created elsewhere, and the overall level of unemployment hides a lot of differences across areas. And in areas that have lost jobs, a lot of people have left the labor force, so they are no longer counted as unemployed, also. Some are coming back, in this period of strong employment, but relatively a large number has left.
So that’s one. There are islands of underdevelopment inside industrial countries. A second point to note is this is not something that is remedied by stimulus — either fiscal or monetary stimulus. If you are in an area which has had very few jobs, where crime is now rampant, where drug abuse is rampant, you’re not going to be lifted. No business is going to come in just because interest rates are low. It doesn’t really want to create employment, and even if it does create jobs, you may not have in that community the people who are trained enough to take those jobs.
And this is true even of reasonable communities. Think about Long Island City in Queens. When Amazon came in with 25,000 jobs paying $150,000 apiece, they weren’t that interested — I would guess in part because many in the community wouldn’t have been able to get those jobs. They required far more qualifications than the average person had.
Second, even considering these differences between communities — one of the things you mentioned was the middle class — well, across the industrial world, middle class jobs are shrinking relative to jobs at either margin — both relatively low-scale jobs and relatively high-scale jobs. Think about the factory worker who is laid off. He may go work for Amazon, but the work he does for Amazon is in a warehouse with a microphone in his ear, telling him which stack to go to, to pick up which object, to put into the package that he’s assembling. That’s a relatively low-skill job. But once you lose that middle class factory job, you fall a fair distance.
So you could argue middle-income jobs are shrinking relative to jobs on either margin. But to get from the low-skill job to that relatively high-skill job requires a big jump in capabilities. And that’s where you don’t find the right structures to allow you to get those capabilities. You don’t find in these communities where the jobs have vanished — it’s very hard to get retooled.
The angst is precisely that we’re no longer middle class. And even though we want to cling to that middle class status, the economics don’t allow us to do that. And that causes great anger.
Schwartz: Why has India not progressed as fast as China? And from your perch of having been at the head of the Central Bank of India, what does India need to do to catch up and excel?
Rajan: The problem India has is it’s got a society structured to grow beyond middle income. It’s got a democracy. It’s now got a basically capable government. It’s relatively small — the size of the government relative to the country. And it’s perhaps overly bureaucratic. And it doesn’t have a very strong private sector, certainly not a private sector that is independent of the government.
But it does have a fairly strong democratic structure. And what that does is it allows for a discussion of ideas and so on. It is something which is very good when a country wants to move away from middle income because that democratic structure helps you in a world where you are at the front — you’re about innovation, you’re about ideas — and democratic discussion helps the sense of freedom that it brings.
However, in getting to that middle income, where you need to build highways, where you need to build airports, where you need strong manufacturing — all that is held back because to some extent, because democracy has to be navigated. In India, when you want to build out infrastructure, immediately you have people protesting because you need to take their land in order to build that infrastructure out. And enterprising politicians find a reason, then, to protest.
Now if you had a very capable government, this wouldn’t be a problem. You would figure out ways to buy the land and pay off the people you need to pay off. But our government is not very capable, and so it takes a long, long time to deal with these protests.
Siegel: Dr. Rajan, you’re giving very good examples. Heathrow Airport in the U.K. wants to add another airstrip. There has been seven years of political infighting, so even in an advanced democratic country, you have political wars over infrastructure. If the Chinese want to build another airstrip, it will get done in six months. There won’t be any complaints, or they’ll be ignored.
Rajan: You’re absolutely right. What the U.K. has is still a more capable, effective government than India has. And India deals with NGOs and political parties that are as committed as any in the first world, but with a government which is more second, rather than first world. As a result, the government is over-matched and these kinds of actions take too long. I would say China had a much better path towards middle income because it could build out all this stuff. When decisions were taken, they were acted upon.
“And the mistake in India that some people make is saying, ‘We have to become authoritarian in order to reach that middle income.’ And my sense is, maybe, but that is going to hold up growth beyond that.”
Because the party in China wants to maintain its position at the head of the economy going forward, that to my mind is China’s greatest challenge. That as it wants to reach the frontier, can it afford to have a dominant party as opposed to a more competitive electoral or political system? And I would only note that no country has actually achieved that. And if China does, it would be the first. That makes me more skeptical that the party can continue dominating as China reaches the frontiers. It will have to give. And I would argue that what’s been happening in China in the last few years is going in the opposite direction. And there could well be some course correction going forward.
India, on the other hand, has to do what China has already done — which is reach middle income — which means build out that infrastructure, frustratingly slowly given the kinds of issues that it has to deal with. But I would say that once it does that, it is really well positioned. And the mistake in India that some people make is saying, “We have to become authoritarian in order to reach that middle income.” And my sense is, “Maybe, but that is going to hold up growth beyond that.” And if we’ve already got a good democratic system, let’s work with the democracy to make it work more efficiently, rather than dispense with it.
Siegel: Do you rank Indian’s Prime Minister, Narendra Modi, as one of those populist leaders? In your book, you talk about more radical people — on the Hindu nationalist front. And you don’t put him in that category. And growth under Modi has been good. In fact, I think for the first time ever, it actually exceeded GDP growth in China for a few years. What is your opinion of his government, now that he even has a stronger position in the Parliament?
Rajan: Well, I think it’s not easy to put Mr. Modi and his economic beliefs into a particular box. He is not — as others have commented — your Margaret Thatcher or Ronald Reagan, going to liberalize India into a market economy. He’s got very much the instincts of the gradualist sort of reformer, more trying to make the existing system work more efficiently, rather than significantly reducing the size of the public sector or privatized entities, or bringing more market forces into play.
That said, the record of the first five years of the Modi government was very mixed. And part of the problem, I think, was he was overly centralized and trying to work from a central office, rather than decentralize the process of reform and growth. And the net result is, yes, there have been some important reforms — the Goods and Services Act, the bankruptcy code. There have been some not-so-good actions like the demonetization.
Siegel: I thought demonetization would cost Modi more in popularity, but it doesn’t seem to have really done that in the last election. But you also thought that was not well done. Should it have been done to begin with?
Rajan: I didn’t think it should have been done and I said that at that time — before it was done, when I was still governor. But the reality is the election — you’re right, it was very strongly in his favor. It’s not clear how much economics played a role in the election but also I would say that we have to be a little careful about the economic numbers coming out of India. There is a lot of debate about what these really mean, and what the true level of economic growth is, and also unemployment is. The government recognizes that it has an economic problem to deal with.
