I usually don’t comment when an economist responds to what I am supposed to have said in press quotes because it leads to more confusion than clarity.  However, Professor Paul Krugman has a large following, and he has criticized me repeatedly for my stance on Fed policy, especially my exhortation for the Fed to exit its policy of ultra-low interest rates sooner rather than later. I will try and address his latest concerns (http://krugman.blogs.nytimes.com/2010/08/23/making-it-up/), which are in response to a Bloomberg article (http://www.bloomberg.com/news/2010-08-22/bernanke-must-raise-benchmark-2-points-in-prescient-rajan-s-latest-warning.html). But before I start, let me declare that I am as much for getting out of this recession as anyone else. However, I would like to get out of this recession in a way that is sustainable, that does not merely pump up growth in the short term only to see it collapse later. This is where Krugman and I differ the most.

Krugman (and many others) have in mind a Keynesian world where some distortion is keeping aggregate demand unnaturally low. The favorite Keynesian explanation is sticky wages. Because corporations cannot reduce wages to the level commensurate with the (now low) value added by additional labor, corporations will not hire. Hence the Keynesian answer to the problem of continued unemployment seems to be to give corporations an interest rate subsidy to offset the additional burden caused by  excessively high wages.  Hopefully, this will make investment profitable, and induce corporations to invest and create jobs.

What is the appropriate level of this subsidy? Whatever it takes to bring jobs back according to Krugman. We have had short term interest rates at negative real levels for two years (which means anyone invested in money market funds gets less back than they put in).  Whether this has had sizeable beneficial effect on corporate investment and employment is anyone’s guess, but it certainly has not brought unemployment down, so Krugman wants more. Most people cannot see anything wrong with this, so let me try an analogy to make my point.

Since the problem is of getting more demand, any subsidy applied to a general input should work. So following the Keynesian/Krugman model,  why not subsidize energy  – for example, cut oil, gas, and coal prices substantially and keep them low “for an extended period”?   For corporations will see their energy bills cut substantially, and see profits rise, so they can employ more people. Unemployment will come down, and we will move out of recession. Eventually, we can withdraw the subsidy when the economy is healthier. The benefits are clear.  We will get out of the recession and put many unfortunate people back to work.  And the sooner we put people back to work, the less long term damage is done to their employability. So why not do it now?

The sensible economist will, of course, have some objections.  

Reason 1: The cost. Someone has to pay for the energy subsidy. If the government simply declares fuel prices to be half of what they currently are and enforces the lower price, fuel suppliers will shut down and refuse to sell anything. So the government has to pay the subsidy upfront to suppliers for them to supply at the mandated price. Even if the government absorbs the cost today, the taxpayer will have to fork out sometime.  So the obvious and immediate cost will make taxpayers (and the government) think carefully about whether they want fuel subsidies.

Why cannot the same argument be made for the subsidy implicit in low rates? After all, there is a direct cost to maintaining ultra-low rates, and it is paid by anyone who has financial assets and is forgoing the normal return on them. Assume owners of financial assets hold 20 trillion dollars worth of them (this is an underestimate) and are paid 2% lower real rates per year than they would otherwise obtain because of the Fed’s policy of maintaining zero nominal rates.  This implies an annual stimulus of $400 billion in real money, off the backs of those who own financial assets. Given that it has been going on for two years, this is a subsidy that is now bigger than TARP (and coincidentally, also goes largely to bankers who are the biggest short term borrowers in the market). If the government raised taxes explicitly to provide the interest subsidy, everyone would scrutinize the use this money was being put to carefully. Because the Fed picks investors’ pockets silently and forcibly through its ability to set the short term interest rate, no one asks questions about cost.

Reason 2. The short term distortions.  A second reason not to subsidize fuel is that it will distort activity. Drivers who are environmentally conscious will be penalized while those with Hummers will be rewarded, with consequent damage to the environment.  The biggest subsidies will go to those who are most irresponsible about their energy use. This will keep the economy from becoming more energy efficient, and make it uncompetitive in the longer run.

Again similar arguments can be made about ultra-low interest rates. Ultra-low rates encourage people to borrow to acquire assets, and are partly responsible for both the over-building in housing, the over-indebtedness of households, as well as the over-leveraging of the financial sector. More generally, a subsidy to capital will imply greater capital intensity (and waste) of capital, greater short term leverage, and excessive growth of sectors that rely on either fixed asset investment or credit. Is this the appropriate way to go (especially if we want more labor intensive sectors to grow to provide the jobs that are needed), and is it sustainable?

Reason 3.  The long term distortions.  Suppose every time the population splurged on Hummers, and caused energy prices to go through the roof, the government, seeing the damage to the economy, came through with its energy subsidy scheme. The government would justify its actions saying it was not willing to see the economy crash simply to uphold a vague theoretical ivory tower principle such as “moral hazard”.  Such actions would reinforce the incentives of people to buy Hummers (provided they could see enough others doing so), and reduce the incentives for people to buy a Prius.  In other words, the prospect of periodic subsidies could create the very actions that bring about the need for subsidies.

 The analogy to the moral hazard that is engendered in financial markets should be clear: The asymmetric Fed policy of cutting rates sharply when the economy is in trouble and not raising them quickly when it recovers gives the financial sector lower incentives to worry about credit or liquidity risk. The financial sector has come to rely on the Fed to bail it out through ultra-low interest rates whenever it gets into trouble and the Fed has developed a reputation of obliging. Indeed, the Fed is now trapped because of the expectations it has set -- because the market “expects” ultra-low rates, the Fed cannot even return to normal low rates without the market taking fright. And it is hard to find a Wall Street economist who is not urging the Fed to undertake stronger, unorthodox actions.    

I don’t want to push the analogy too far. But you get the point – cutting rates is not without cost. But what about the benefits? Are they as large as the Keynesians state them to be?

The real problem is corporations are not hiring quickly. But corporations did not hire quickly following the recession of 2001 (or that of 1990-91), and the sustained monetary stimulus that many economists supported then led, in no small part, to the housing boom and bust. It did not, however, lead to an explosion in corporate investment.  Before saying the real problem is we are not providing enough monetary stimulus, should we not worry about why corporations did not invest then and what other problems will emerge as we  keep rates ultra-low while hoping corporations will see the light?  I am not arguing that ultra-low interest rates will have no effect on investment, only that I am not convinced the effect (relative to merely low interest rates) is huge, and recent history bears me out.

I would rather that more emphasis be placed on improving skill levels in the unemployed work force, and assisting the unemployed to both prepare for, and look for, the jobs that are being created in the economy. This will take time, but probably be more effective than praying ultra-low rates bring back the jobs.

Before concluding, let me emphasize that even though I discussed the direct costs of ultra-low rates above, my greater concern is with indirect costs. The way low interest rates work (apart from the direct cost of capital effect), is by raising asset prices and incentivizing investment in riskier assets. Even as corporations proved unwilling to invest last time, house prices rose, households could borrow more, and lending became increasingly crazy. Of course, bond prices aside, there are not many hints of asset bubbles in industrial countries today. But by the time a central banker stares a bubble in its face, it is too late. After a few years of rising house prices in the period 2001-2004, every broker was peddling houses as a dream investment that could never fail. So what if the Fed was raising interest rates at a measured pace from 2004? By that time, house prices were clipping along at double digits every year, and Fed rate increases made little difference. Of course, the Fed now disingenuously claims that the worst excesses in the housing market were committed when it had already started raising rates, and therefore it is not responsible for the housing boom. But it was complicit in setting off the boom by keeping interest rates too low for too long before then!  

I have been making these points long enough that quotes should not be taken out of context. I am not advocating that the Fed raise rates to 2 percent overnight. That would be irresponsible. I am saying that as worries (largely about financial turmoil emanating from Europe) settle down and we return to expecting steady but slow growth, we should not wait for employment to come back substantially before we start the process of raising rates to a low normal. The Fed should, of course, give the markets a clear sense of the path to expect, and perhaps indicate it will pause after reaching the "normal" low rate. If asked what a "normal" low rate is, I would say one candidate is zero real short term rates. With inflation between 1.5 to 2 percent, that would mean 1.5 percent to 2 percent nominal before the Fed pauses again.

Post script: Professor Krugman asks if I have a model or if I am making things up as I go. He clearly knows the vast literature in banking and finance that makes some of these points about the costs of low rates. But specifically, Douglas Diamond (the father of the modern study of banking) and I, as well as Emmanuel Farhi and Jean Tirole have been writing models about the adverse consequences of sustained low Fed rates. Bill White, for whom I have great admiration for his prescient warnings when he was at the BIS during the bubble years, as well as his able colleague, Claudio Borio, have an enormous body of well-argued papers as well as empirical work warning about the effects of ultra-loose monetary policy. There are a number of papers now showing that low interest rates induce risk taking. And this is just the tip of the iceberg. Professor Krugman, there is a lot of work out there for anyone who cares to read it!

There is a fair amount of consensus that the world economy is in need of rebalancing. Countries like Iceland, Greece, Spain, and the United States overspent prior to the crisis, financing the spending with government or private borrowing, while countries like Germany, Japan, and China supplied those countries goods even while financing their spending habits. Simply put, the consensus now requires U.S. households to save more and Chinese households to spend more in order to achieve the necessary rebalancing.  Indeed, many believe that if only the United States toned down its consumerist culture and its households tried to stay within a monthly budget instead of having a Micawberish optimism about the future, and if only Chinese households stopped fearing Armageddon and started spending more, all would be well.

Of course, it is simplistic to reduce global trade imbalances to a bilateral imbalance between two countries. But since this is how the popular debate is posed, it is useful to ask whether rectifying the imbalances is only a matter of U.S. and Chinese households switching personalities?

Clearly consumer behavior is driven by habits formed over time, many of which are culturally determined – driving a Hummer, the gigantic low-mileage SUV, used to be an acceptable means of signaling the size of your wallet in the United States before concerns about global warming spread. No longer! However, the focus on consumer behavior misses the deeper policy underpinnings of the behavior we see.

In the United States, for example, credit-fuelled consumption may have been exacerbated by the government’s push to expand home ownership, especially among low-income households. As house prices rose, households felt wealthier, and borrowed against the home equity they had built to finance their lifestyle. Indeed, this bought successive administrations political peace as debt-fueled consumption helped paper over the fact that incomes for the median household barely increased.

 A second factor pushing U.S. households to take on debt and consume has been the Federal Reserve’s policies. With U.S. recoveries proving slow in creating jobs, and with consumption accounting for about 70 percent of demand, the political pressure on the Fed to revive the economy forces it to try and discourage household savings in downturns by keeping policy rates at ultra-low levels for sustained periods of time. But if households do not save in downturns, how likely are they to save as the economy recovers and euphoria kicks in?

Finally, as other countries come to see that the United States is willing to be the world’s consumer of first and last resort, they are happy to rely on it to provide the extra demand to lift the world out of recessions, even while they get their finances in order.  So policies around the world make the United States household the world’s designated spender. With the Obama administration intent on propping up the housing market as best as it can with government credit, with the Fed on hold at near-zero rates, and with the U.S. exhortations to other countries to spend eliciting little enthusiasm at the recently concluded G-20 meetings, change seems very far away.

What about the Chinese household?  Here again, policies are important. While undoubtedly, the absence of a significant old age safety net (and the paucity of children, the traditional Asian safety net) offers Chinese households a strong incentive to save, Chinese household savings rates are not significantly higher than savings rates in other Asian countries.  China’s overall savings rate has gone up in recent years because Chinese corporations are earning and saving more, while Chinese household consumption is low because Chinese households earn a much lower fraction of the income generated by the economy than in other countries.

Why is this? Because the Chinese economy has a strong bias favoring its corporations and against its households; Interest rates on household bank deposits are really low so that corporations can get cheap credit and so that the central bank can maintain an undervalued exchange rate; Corporations get cheap inputs like energy, natural resources, and land; Taxes on corporations are low, so their after-tax profit is high; And state-owned corporations pay very little of the gigantic profits they generate back to the state as dividends. As a result, household after-tax income is low, and consumption is low.

All this means that if China is to rebalance growth, it has to start being kinder to its households.  The recent willingness of the Chinese authorities to tolerate worker strikes for higher wages suggests they want to increase household incomes. Higher deposit interest rates, higher corporate taxes, (with a commensurate reduction in household taxes), and fewer subsidized inputs for corporations will also help. But these changes will not come easily.

For they will put enormous pressure on corporate profits, something corporations will resist. And profitable corporations have a lot of power of resistance, even in a one-party state. Moreover, the Chinese authorities will be wary of imposing large adjustment costs on corporations too quickly and causing large job losses. The recent crisis has convinced the Chinese of the dangers of relying so much on foreign demand, so they do want to boost household consumption, but the steps they take will again be gradual.

The bottom line is that rebalancing requires more than cultural change, it requires policy changes that will imply considerable political pain in the short term.  After this brutal recession, the natural tendency is to try to go back to the old patterns of growth before attempting change – the U.S. is trying to revive consumption while China is trying to revive exports. Unfortunately, though, it is unlikely that if the will to change is not found in the midst of a deep crisis, it will be found as the recovery gathers steam. It is easier for politicians to emphasize the need for other countries to change while neglecting their own responsibilities. Watch this space, but don’t hold your breath.

Even as the world becomes more integrated, the word “security” crops up again and again, as in “food security” or “energy security.” Typically, this means a country creating and controlling production facilities no matter what the cost. Thus, Arab countries grow water-hungry grain in the desert, and China acquires part ownership of oil companies in Sudan. Are these economically sensible actions? If not, what should the world do to reduce the need for them?

Let’s start with ownership of foreign resources. One might think that a country that owns foreign oil can use the profits from sales to insulate its economy from high world oil prices. But this makes no economic sense. The world market prices oil according to its opportunity cost. Rather than subsidizing the price in the domestic oil market (and thus giving domestic manufacturers and consumers an incentive to use too much oil), it would make far better sense to let the domestic price rise to the international price and distribute the windfall profits from foreign oil assets to the population.

The key point is that fundamental economic decisions should not be affected by the ownership of additional foreign oil assets. But, because of political pressure exerted by small, powerful interest groups, windfall profits will inevitably be spent at home in unwise subsidies. As a result, the acquiring country will, if anything, make suboptimal economic decisions.

Could the purchase of foreign resources lead to smoother national income? A purchase will always look beneficial if one looks backward after the resource price has risen. But if the price of oil falls, citizens suffer a loss of income and wealth (relative to having invested the money elsewhere). Assuming the foreign oil assets are priced fairly at the time of purchase, the country benefits only when the purchase helps smooth its income; however, purchases may increase income volatility even for a country that relies heavily on oil.

For example, in large countries like the United States or China, which account for a significant portion of world demand, the world price of oil is likely to be high when the country is growing strongly and citizens have lots of income, whereas the price is likely to be low when the country is doing poorly. Foreign oil assets are a bad hedge in such cases, for they subtract from citizens’ income when it is already low and add to it when it is high.

Even if owning oil assets is a useful hedge (as in a small, oil-consuming country), it is not clear that buying stakes in opaque companies in foreign countries is the best strategy. A country’s property rights in foreign oil assets are likely to diminish as the oil price rises. Even if the foreign company does not start squeezing out its minority owners, its government will be tempted to expropriate foreign owners through windfall taxes (if the government is sophisticated) or nationalization (if it is unsophisticated) – especially if its voters feel, with the benefit of hindsight and populist incitement, that the assets were sold too cheaply. Indeed, perhaps the best way to protect against oil price increases is to buy shares of large oil companies, such as Exxon, traded in liquid markets.

But perhaps what countries really fear is not so much high prices but a total market breakdown and descent into an autarkic “Mad Max” world in which oil is scarce, no country is willing to allow trade in the oil it produces, and there is no world market clearing price. If such a situation were to occur, ownership of oil assets abroad would most likely become worthless, as each country would only get to use oil produced within its political borders (or within nearby borders that could be invaded).

It is in this kind of world that seemingly nonsensical behavior like growing grain in the desert to ensure food security begins to make sense. Of course, other alternatives should be explored before countries decide to produce so inefficiently, including trying to use the resource more efficiently, diversifying into more easily accessible substitutes, and reducing overall consumption (though in all these cases, it is easier to deal with energy shortages than food shortages).

Moreover, even in such a bleak world, it is difficult to imagine the market breaking down completely or for long. Indeed, one can imagine black marketeers and smugglers buying where grain is available and transporting it to sell to countries where it is not. Unless governments build leak-proof barriers around their countries – and the costs would likely be prohibitive – an implicit world market would be re-established.

Nevertheless, and understandably, many countries make decisions to locate production locally fearing market breakdown through war, trade sanctions, or simply shortsighted decisions by foreign governments to protect their own populations from price increases -- Russia's decision to ban wheat exports makes this issue particularly topical. Paradoxically, once a country ensures its own security, it has weaker incentives to avoid the market breakdown that prompts the initial search for security.

International agreement to ensure that countries do not prohibit exports, especially of critical commodities, except under severely (and verifiably) adverse domestic circumstances, would help reduce fear of market breakdown. Similarly, the creation of international strategic resource reserves on neutral territory and under neutral management could help alleviate concerns about politically motivated disruptions. Unfortunately, all of this requires substantial international political consensus, cooperation, and goodwill – all of which are in short supply today. Until we find the collective will, the drive for national economic security will continue to lead to collective insecurity.

The world is clearly slowing in the second half of 2010 as the effects of the corporate inventory rebound come to an end, and as the fiscal stimulus across the world stops growing. As the fiscal stimulus starts winding down across the world, there will clearly be headwinds to world growth. For this biweekly post, I thought I would summarize my views on where the world is headed, with all the caveats that accompany forecasts.

United States

In the United States, the high levels of unemployment (around 10 percent, with an additional possibly equivalent number either discouraged from seeking employment or underemployed in part-time jobs) are creating strong pressures for continued stimulus. Unemployment is particularly painful in the United States because of the thin safety net (unemployment benefits last only 6 months unless extended, and the unemployed typically have no healthcare). Moreover, many more of the unemployed have been unemployed for a long time, a specially worrisome aspect of this recession.

While it might seem that Keynesian fiscal stimulus is the way to go, and if successful, will be politically popular given the impending mid-term elections, there are a number of factors that suggest spending is likely to be more circumspect. First, as much as a shortfall in aggregate demand, the United States seems to have a problem with supply. The pre-crisis boom exaggerated demand for housing (as well as commercial real estate), for durable goods, as well as for financial services. Many of the unemployed were employed in housing related activities, many of them relatively low skill jobs like construction. They need to move to find jobs elsewhere, and perhaps need to be retrained. Newspapers are full of stories about how many high skilled jobs are going a begging because there are not enough people trained to fill them. So unlike the ordinary recession, just boosting demand may not do the trick unless the intent is to recreate the unsustainable patterns that prevailed before the crisis.

Second, the public, aided and abetted by the Republicans, wonders what happened to the previous stimulus package, which the administration (unfortunately) predicted would keep unemployment from going above 8 percent. Moreover, fears of unbridled spending, high levels of public debt and the taxes to come, are energizing “small government” movements like the Tea Party movement. Some Democrats have also started worrying, especially because of alarming projections about the growth of public debt, and the even greater unfunded promised entitlements on healthcare and social security (about five times public debt).

In this environment, it is proving difficult for the administration to even support extensions of unemployment benefits, which would have a humanitarian role (remember, many of the unemployed also have very low savings, and are likely to be rendered homeless by foreclosures), as well as some effect in boosting spending. Clearly, there is a danger that continuous extensions of benefits could reduce the incentive to search for work, especially work that entails lower pay or tougher conditions than what the unemployed worker has been used to. At the same time, if jobs are not being created for a variety of reasons, temporary extensions, especially for those who have been unemployed for shorter periods, may do some good, and not a lot of damage. For the long term unemployed, though, some well-designed retraining assistance would be more useful.

Other proposals that would make sense would be targeted infrastructure expenditure, some aid to the states, and a more forceful effort to clean up (and potentially recapitalize the solvent) small and medium sized banks, so as to get credit flowing to small businesses when they are ready to borrow. Again, the problem is there is little faith that these expenditures will be conducted effectively given recent experience, and hence there is not a lot of political support for them. Given that this administration has already been successfully labeled by the Republicans as a “tax and spend” administration, my sense is we are unlikely to see much new fiscal action before the mid-term election in November.

Monetary policy is therefore likely to be the primary source of stimulus. It is on hold at close to zero rates, and is likely to remain on hold for the foreseeable future. Real short term rates are negative. Once (and if) the risk aversion caused by the European turmoil dissipates, easy monetary conditions are likely to provide a strong boost to asset prices and eventually to credit and consumption. I worry that the creation of unsustainable asset price booms is precisely how the United States got into the current mess, but for most economists, the immediate trumps the long term. Indeed, the deflation scare is again being used to support the need for monetary policy to remain on hold. Deflation for a few months should not be a cause for concern – what should worry us is the prospect of sustained deflation a la Japan. But Japan went into its asset price bust in the early 1990s with a very different economy than the United States (Japan had extremely high domestic costs, especially of services). While one cannot rule out sustained deflation entirely when we have highly indebted households, as we have in the United States, I still think it is small probability.

Monetary accommodation would make more sense if it were prompting corporations to invest. Yet corporate investment and hiring are proving slow in picking up (much as in the previous two recessions), even though many large corporations flush with cash. This suggests other factors weigh on corporate decisions, including regulatory uncertainty, fear of further financial stress, and concerns about the costs of investing in the U.S. versus elsewhere. The strengthening dollar has not helped.

Bottom line: The United States probably needs more structural transformation, including improving the quality of its rundown infrastructure, and more investment in improving education and retraining. More crisis spending could have been oriented towards these goals. Unfortunately, there is little appetite now for even sensible additional spending. Instead, the United States will probably stay with easy money as its answer. This will create problems over time, though not just yet. Growth is likely to slow in the second half of this year, but a double dip is still low probability. Recovery will proceed slowly and steadily but President Obama’s plans to make U.S. exports double over the next five years seem to be overly optimistic on current path.

Euro Area

Western Europe’s total factor productivity growth had been falling steadily even before this crisis. With little growth in the labor force, and substantial amounts of capital per employee, it is hard to see where trend growth will come from. Add to this the effects of the high debt load and the weak banking system, and it is hard not to be pessimistic about Europe. Yet, in all this pessimism, there may be a silver lining in that it prompts structural reforms and greater liberalization of closed markets in Europe.

In the short run, Greece and Spain (and to a lesser extent, Italy, which has substantially lower external debt), pose the greatest risks to the Euro area (see Figure 1). With tremendous skepticism about their ability to rein in budget deficits, they are out to prove their detractors wrong. Yet unless their economies become more competitive and grow, the pain of fiscal adjustment and continued high levels of unemployment are likely to be too heavy to bear politically. Both countries are undertaking structural reforms, in Greece to introduce more competition in the economy, and in Spain to make the labor markets more flexible. If these countries (and others making adjustments like Ireland and Portugal) can stay the course, and deal with their looming pension problems to boot, they may emerge far more competitive in the next three to five years. The betting though is that Greece will probably have to restructure its debts, once some calm has been restored to the European banking system.

The most immediate concern for European banks are the bank stress tests, whose results are due later this month. If done well – which means the tests should impose credible worst-case scenarios, be transparent about where the problems are, and have a politically and economically sustainable path for capital raising (or a resolution mechanism for the banks that utterly fail the tests), European recovery could be buoyed. The stress tests would restore calm to financial markets for they would, implicitly, indicate the Euro area governments are prepared to back banks that pass. If botched, though, they could create substantial turmoil, perhaps even a mild panic.

Interestingly, if the stress tests go well, Greek restructuring could be brought forward for there will be more willingness to deal with all potential headwinds to growth. If they go poorly, Europe will probably try and paper over financial sector problems for a while, which will mean continued slow growth.

Japan

Japan is still dependent on exports for growth. It still simply does not have the political will to fight the vested interests and undertake the domestic reforms needed to improve competition and efficiency in the domestic oriented production sectors. In the meantime, its growing public debt burden is proving to be very problematic – Japan has a relatively low government revenue share, so it can afford to raise taxes on consumption to narrow deficits, while reducing corporate taxes to promote growth. However, its slow growth, endemic deflation, and high debt means it has to do a lot of fiscal consolidation to bring government finances under control. There is little political support for more taxes on households, even while corporations get respite. Indeed, prime minister Kan has already been weakened by suggesting an increase in consumption taxes.

Without reforms, Japan is likely to continue on the path of genteel relative decline. And as domestic savings decline with the ageing population even as outside financial investment opportunities look even rosier, the current fortunate circumstances in which its public debt is willingly largely domestically financed at low rates could change. Continued tepid growth and fractured politics will raise the risks of adverse fiscal developments in Japan. That may, however, jolt Japan into the reforms it has postponed for the last two decades.

China

China is clearly trying to change from the investment and export led growth path to a more domestic-growth-led economy. Domestic consumption will have to rise from its low share of GDP. Interestingly, Chinese household savings rates are not excessively high, compared to some Asian savings rates (including India’s). The problem in China is that households get a much lower share of national income. Chinese rebalancing will require China to shift from favoring producers to favoring households more, so that household incomes rise. This will mean reforms to taxation (so that corporations pay more taxes), to government control over state-owned corporations (so they pay some of their hefty profits as dividends back to the state), to exchange rates (so that coastal export production is not unduly favored), and to wage bargaining (hence the tolerance for greater union action in recent months).

>Bottom line: World growth will slow in the second half. We do need to use the next few years to rebalance world growth in such a way that emerging markets provide more of world demand growth, and industrial countries reorient their production of goods and services so as to be able to supply what is demanded. Industrial countries have to find a way to leverage their highly trained, innovative work force, as well as their strong institutions, recognizing that these advantages are being continuously eroded, and recognizing that significant parts of their population are not equipped with the needed capabilities. If politics does not upset our calculations (and we have thin margins to absorb policy mistakes) then the structural changes that will happen augur well for all of us in the medium term. If, on the other hand, we focus on what is short term and politically expedient, we will succeed in postponing that future.

I apologize for the longish absence. I had to give grades in my course. I will try and write at least once every two weeks. I do read all the comments, and thank the commentators for them, but also confess that I cannot respond to all of them. Some comments are very thoughtful, some are critical, and some are both. I will respond whenever I have something thoughtful to say. Do keep the comments coming.