Hal Weitzman: The Trump administration has gutted central government, lashed out at the Federal Reserve, and is attempting to dismantle the international trading order. Can America's institutions survive? Welcome to the Chicago Booth Review Podcast, where we bring you ground-breaking academic research in a clear and straightforward way.
I'm Hal Weitzman, and today I'm talking with Chicago Booth's Raghuram Rajan about the role of institutions in political economy. Are we seeing a reversal of fortunes in which the U.S. is looking more and more like a caricature of a poor country with poorly regarded institutions, growing inequality, and a looming sovereign debt crisis?
We're at a point in a political history where some people feel that institutions in the United States in particular are under attack, that they're kind of besieged. Is that fair? And if so, how worried should we be about that?
Raghuram G. Rajan: I think that's right. I think it's reflective of a political movement which feels these institutions are dominated by the other side, and they've become elite institutions. They're not paying enough attention to the needs of this group, and therefore attacking them, bringing them under control, so to speak, is the right thing to do. Whether we are talking about the judiciary, the educational institutions, or the Federal Reserve.
Hal Weitzman: Right. And so, this is important, right? Because if we look back to the history of political science, political economy, there are a lot of economists who have argued that institutions are key driver of economic differences between emerging markets and industrialized countries.
One of the things that emerging markets just didn't have was strong economic political institutions. That was the argument that has been made. Maybe you can remind us about that approach and talk about how it's shaped the economic thinking.
Raghuram G. Rajan: Right. And if you look at the countries that have done well economically, developed countries, they tend to have strong institutions, or tended to have, maybe a past tense is useful to use here, for example. When it came to budgets, you had budgetary rules, budgets had to be balanced over the cycle. Often there was a authority outside who would evaluate the quality of the budgets and the parties would respect that. So budgetary negotiations were done in an attempt to get consensus saying, "We need to keep budgets under control."
Similarly, central banks were independent, were given the authority to determine interest rates, and a mandate to keep inflation low. But that's just some examples. Of course, there are political institutions which maintain free and fair elections, a free press, et cetera, a variety of institutions. And the feeling was to be developed, you got to create the institutions.
Some of our colleagues, Jim Robinson, along with Daron Acemoglu and Simon Johnson, won the Nobel Prize for showing, in a plausible way, that institutions matter. Of course, the sense that institutions matter, there's a whole literature around it, but they had a nice way of showing it by using the way colonies were actually colonized. Did settlers go over there or did they sort of maintain a more extractive structure with very few settlers there?
Bottom line, however, is there's a feeling these were straight jackets that essentially allowed you to flourish. Within the straight jacket, it sort of pointed you towards development. I think if I were to talk about institutions, I'd say they're not so much straight jackets, but they sort of tight garments which keep your body broadly looking reasonable, but you can escape their confines, and the politics of the moment matter very much as to whether institutions work or they don't.
And what I have in mind is there was a period when the World Bank and the IMF convinced that institutions mattered, essentially told a bunch of developing countries and emerging markets, "Hey, this is the way to development, adopt these institutions." It turns out they weren't really ready, and I'll talk about what ready means in just a second. The institutions didn't really really matter. You could run roughshod over them.
A classic example, Liberia has the U.S. Constitution, but Liberia succumbed to a variety of civil wars, et cetera. Didn't develop the way the U.S. did, even though it had one very important institution which looked the same. You can't transplant institutions without figuring out what else is part of the ecosystem that makes the institution work. And it may well be that the ecosystem creates the institution rather than the institution creates the ecosystem. It's better to think of them as being symbiotic.
So for example, when you have extreme inequality in a country, reaching budgetary consensus is difficult. The guys who are constituents of the poor basically say, "We need more. These guys aren't eating. And I really find it unconscionable you giving away tax breaks to the very rich." And the very rich know that there are a lot of hungry people in the country, and once they give way, it's going to be a free for all and they could get dispossessed very quickly. So budgetary processes are confrontational.
And those institutions, we say balance budget over the cycle, they eroded very quickly. You can find also ways to get around them. Much as the U.S. Congress is doing today in trying to redefine what it means, for example, for reconciliation to go through, it's basically the consensus there are too many constituents wanting a piece of the action.
And so, the point I'm trying to make is there needs to be a political consensus that the institutions need to be supported, need to work. And if you don't have that political consensus, the institutions by themselves don't really have bite of their own. Again, they're not straight jackets. You can't just apply them.
So, one example is what happened in Brazil. The World Bank, IMF went in and kept saying, "You need better institutions. You need inflation targeting." Central Bank, "You've got these periods of hyperinflation. You need to get better and you need fiscal reform." Turned out that I think more right of center government under President Cardoso set up the institutions in the early 2000s, but it was the advent of the Lula government, which was left of center-
Hal Weitzman: The first administration, the first Lula-
Raghuram G. Rajan: The first Lula government in the early 2000s, which basically said, "Yeah, we need our constituents to get food." And the early part of their program was essentially various forms of targeted transfers to poor people, which essentially put a safety net under them. And that happened because Brazil was undergoing a commodity boom, which allowed them to generate significant funding without breaking the budget.
But once that was done, once you took care of your worst off, you were in a mood to say, "Okay, how do we prevent this cycle of constant booms and busts?" And so they were more open to appointing a good central banker to target inflation, of adopting budgetary rules, and the institutions started getting heft.
So, emerging markets, which are the classic sort of institution-free economy which went from boom to bust, which was unconstrained, a lot of emerging markets adopted institutions. I remember when I went to India's central bank governor, we adopted inflation targeting. And since then, our inflation has been much steadier than it used to be in the past.
So, what made the difference, certainly in India, it was similar, we were able to transfer funds to the poorest targeted transfers. And as a result, the more radical parties came on board. Yes, macro stability is important. Let's not break the budget every time we have a downturn because we need more smoothness over the cycle.
Unfortunately, even as emerging markets like Brazil and India have become more responsible in terms of these macro variables, and responding to the institutions, the kind of inequality that used to plague the emerging markets, the kind of precarity... Now, all of this is relative. There are very few people in the U.S. who can't find enough food on their table, but it is true, there are a lot of relatively poor people who can't get to work because they don't have a car, who can't put good food on the table for their kids because they don't have enough to afford meat and so on.
So, precarity has increased in industrial countries, and certainly the perception of precarity has increased. And so, that expands the radicalism of the political establishment and makes it much harder to reach consensus, especially when a significant part of the people think those institutions are dominated by people who don't care for them.
Hal Weitzman: So it sounds like what you're saying is there's a strong connection between populism and attack on institutions. Is that right?
Raghuram G. Rajan: I think populism used to be much more prevalent in emerging markets. There still is a fair amount of populism, and it comes back up when things get really tough, but it's been tamped down a little, little is the important word, while it's increased quite a bit in industrial countries.
And so industrial countries, remember we started by saying, "They're the guys with good institutions"? It turns out those institutions are still in place, but they're much less effective in this different political environment where there's a lot more anxiety, a lot more precarity, and a lot less consensus that these institutions are doing the right thing.
Hal Weitzman: Yeah, so obviously the political context is supremely important, and I get that point. I'm just wondering, when you talked about Brazil, for example, and Lula and breaking certain fiscal rules, you could say, couldn't you,, that that's strengthening the institutions that Lula at one point, as I seem to remember, was outside the mainstream political system and then came in? And that's true of many emerging markets. You get a figure who starts out on the radical left or right and then becomes much more mainstream. So isn't that, in a sense, strengthening the institution of democracy, they're able to gain power rather than a revolution or whatever the incentive is?
Raghuram G. Rajan: For sure. Part of what's going on is the democratic system is a way of bringing in the people who are on the extremes, but also adopting policies which get them more in, as I said, these transfers that Lula set up, which made him very popular, but also were very necessary to bring the left out in Brazil into the mainstream. I think that was very good.
But what it did, was also it changed the political environment to make it a little less radicalized than it used to be. And there was more faith that the system would work for everyone. And once that was there, demands became a little more realistic. "Okay, we got to balance the budget. Now let's try and work out how much we give each other, and let's not break it every time."
So it's sort of a virtuous cycle of political accommodation, strengthening the existing institutions. And the institutions then creating a more reasonable macroeconomic environment, which prevents the booms and busts, which cause the radicalization, so to speak.
This is the sweet spot that industrial countries were in with good macro, good institutions, good politics. And of course, what changed you will ask is technology. There was technological change. There was, to a lesser extent, global trade. Both those affected jobs. And that has affected the kind of precarity, the kind of confidence that households have in industrial countries.
Emerging markets, while being at a much lower level, didn't have the kind of loss that industrial country households have experienced or are perceived to have experienced, and therefore, their politics hasn't got eroded as badly as it has gotten eroded in some industrial countries.
Hal Weitzman: If you're enjoying this podcast, there's another University of Chicago Podcast Network show that you should check out. It's called Entitled, and it's about human rights. Co-hosted by lawyers and law professors, Claudia Flores and Tom Ginsburg, Entitled explores the stories around why rights matter and what's the matter with rights.
Okay, Raghu, in the first half we talked about institutions and how the history of institutions has been kind of difficult in emerging markets particularly, and with international institutions like the IMF and the World Bank imposing this somewhat simplistic, perhaps framework of, "Oh, you just have the institutions or these particular practices and everything will be okay." And of course, the reality wasn't quite as simple as that.
But you also talked about how there's been a kind of reversal of the global North and South to a certain extent, where if I think about my own native country, the UK, pulled out of Brexit, which you could say is a big institution or institutional failure. And there's much more populism across Europe, and certainly in the U.S. there's been more populism in recent years as well. And we talked right at the beginning about how that affects institutions.
Many people feel institutions, ranging from the Fed and the departments of government, which have obviously been slashed under the Trump administration. Two, the global trading order are all under attack. So let's talk a bit more. And you talked about how inequality is fed into that, but just explain a bit more about what you see happening in that dynamic.
Raghuram G. Rajan: Well, I think what you see is a broad sense that these institutions are biased. They work for a few, not for the many. At least that's the rhetoric that's put out. And how the Fed is unnecessarily holding rates up, who benefits from higher rates, and why don't they cut rates and make us all happy?
Of course, if the Fed had to explain its position, it would say, "Look, really, if we cut rates now there's a possibility of higher inflation, and you guys hate higher inflation because it hurts the relatively worse off the most, and so you should be... Yeah, it's not an ideal situation where we have to hold rates up, but it's better than us cutting rates and setting off a whole lot of inflation."
But that requires people to believe that the Fed has their interests in mind, and it can be quickly eroded if you tell somebody, "Oh, no, no, what the Fed has in mind is it wants to give all those fat cats having large deposits in banks higher interest rates, and it's coming off your car loans and so on." Once you lose trust that they have your best interests at heart, then any kind of policy can be chastised as something that is biased and is for a few.
And that's how the institutional trust erodes, that, "Oh, Congress, these guys just want to favor the big industrialists. That's how they're going to set policy. It's not for you. Or they're going to favor the minorities and the immigrants. That's why Medicaid is so generous, and it's not for you."
So once trust is eroded, then basically everybody's fighting for their corner. And as a result, your ability to make ends meet, to have policies which are reasonable, becomes much, much harder. Just as an example, if you don't trust the Fed, you're not going to be supportive if it raises interest rates. If inflation takes off and it says, "We got to raise interest rates to bring inflation under control," there's going to be a lot of pushback then, "Oh, do you really know what you're doing? Why do you need to raise interest rates?"
The kind of actions that Paul Volcker took in the early-1980s to kill inflation, he took interest rates up to 16, 17, 18%. That simply won't work in an environment where you don't trust the Fed. You have to have intimate trust in your institutions that they're working for the common good.
And so, my worry is that the institutions don't have the same kind of abilities today that they used to have in the past. Even if chairman of the Fed is protected from firing by the president, it may well be that the institution itself, when it loses public political support, has much less ability to achieve the outcomes that it desires.
Hal Weitzman: Yeah, and I think during the first Trump administration, there was a popular line that people would say, "Well, the institutions are robust." Now, you don't hear that so much because the central government itself has been gutted. And as you say, there is certainly pressure on the current Fed chair to step down. And even if he doesn't, then who knows who the next Fed chair will be and how that person will be forced or be pressured to behave. So, how confident are you in the robustness of U.S. institutions?
Raghuram G. Rajan: Well, so again, what happens first is the politics change. When the politics change, then the support for the institutions change, and eventually the institutions themselves can erode. So, I think that's what we have to be very wary of.
The U.S. today has a debt-to-GDP over 100%. There's very famous book, This Time is Different by Ken Rogoff and Carmen Reinhart, which basically said industrial countries generally have low levels of debt, but there are danger points. And the highest danger point in their book was 90% of GDP. Almost every industrial country is above that today.
The point is that yes, you can have a lot of debt when there's trust that you'll get your fiscal situation under control, you won't spend madly, and your central bank is going to keep inflation under control. When all of this is being questioned, then what happens is the holders of your debt eventually lose confidence that they will get their money repaid.
And then you can see interest rates can start spiraling up. No matter what the Fed sets the policy rate at, the long-term interest rate can start moving up. And then you're in an emerging market situation. A lot of emerging markets have had deep trouble refinancing their debt once they've lost the confidence of the markets.
I think the bottom line really is that we have a politics which is much more populist, much more less trusting of the institutions, but we also have an economic situation, which is difficult. The deficit, annual deficit is closing on 7% of GDP, the fiscal deficit. There's a trade deficit, which is big, and there is the worry that if you don't inspire confidence, and a lot of your government borrowing has to be financed from abroad, you're in an emerging market-like situation. And eroding institutions don't help.
Hal Weitzman: Right. Which makes me think that the ultimate institution is the market, which could, you might think, as it did in the UK with the Truss government, it might bring discipline.
The question I would have is, even if we were to have a sovereign debt crisis in the developed world, would that strengthen institutions or would it just lead to more populism of a different kind?
Raghuram G. Rajan: That's a very good question. It's unclear, right? In a world where sensible heads prevail, and that was the old word, the elite policymakers would get together and say, "Look, we need to restore macro stability, and here are the ways we do it." We have a fiscal commission which says, "Here are the ways we need to bring everything under control." And it happens.
But you could well imagine, and this is what happened in a bunch of emerging markets, crisis leads to worse outcomes, where you have a left-of-center radical Marxist who's running for government, and you have a right-of-center radical, something else, a populist who's running for government and all hell breaks loose. Both are possible, and I don't know that we should be confident that one will happen versus the other.
Hal Weitzman: So you mean the technocratic solution versus the popular solution?
Raghuram G. Rajan: Yeah. Everybody thinks the technocratic solution will help, will come about. And we've seen it in the crisis in 2012 when we had a debt crisis in Europe. The technocratic solution was what came about and now you see Greece is flourishing again. There was a time when there was fears about the future of the Euro area.
Draghi, the ultimate technocrat came out and said, "Trust me, we will preserve the Euro," and he did. But today, you've undermined the public view of the Chairman of the Fed. Can the chairman of the Fed say, "Trust me, we will take care of the financing of the United States"? Not so clear.
Hal Weitzman: And this is all making me think of the book you wrote a few years ago, The Third Pillar, which is all about communities that have been left behind, inequality, and how you really had to address the social and political economic problems, and the inequality you talked about, before you could, or in the same time as addressing these other issues. Have you seen any progress since you wrote that book in that area?
Raghuram G. Rajan: I think there's a lot more talk. The point of the book was, in developed countries, there were large pockets which looked really like poor countries, developing countries, communities that had been left behind. And let's start with these at the extreme. Of course, there are other many, many more disgruntled people, but let's start by saying it is a travesty that you should have these pockets of underdevelopment in a developed country.
Can we revive these by tying up these places to places that are more successful? And that should be easier done in a developed country? And you know that the UK was talking much more about this in recent years. Of course, the problem is no one strategy has really been carried out. This leveling up idea of the conservatives, taking places that have fallen behind and bringing them up. I think with a succession of governments that's been let go, once again. It's difficult. It's not easy.
It's not as simple as, "Let's fix the institutions." The institutions are already there, but it's sort of fixing the economic connections between that community, but also giving it more of an ability to hold its own when those economic connections are filled. It's not just bringing the national market to those communities, it's also giving people in those communities an ability to compete in the national market. And you need to do both at the same time.
But I think this really, to my mind, is why we are seeing the kind of divisiveness in industrial countries. If you think about the issues that are most divisive, things like immigration. Why? Because certain communities bear much more of a brunt of the immigrants than certain other people.
And so it's very easy to point a finger at those guys and say, "Oh, they benefit from having gardeners, but we actually have to compete with these people who are coming in, and to our detriment." So, there's a lot of angst, I think, which could be tackled if you could reduce the kinds of inequalities we're seeing happening. But that's a whole agenda in itself.
Hal Weitzman: Okay, Raghuram Rajan, this has been a little bit of a depressing ending, but we appreciate you coming on and talking about the importance of institutions, and perhaps how we can get them back and strengthen them a bit more. Thanks so much for coming back on the Chicago Booth Review Podcast.
Raghuram G. Rajan: Thanks for having me.
Hal Weitzman: That's it for this episode of the Chicago Booth Review Podcast, part of the University of Chicago Podcast Network. For more research, analysis, and insights, visit our website at chicagobooth.edu/review. When you're there, sign up for our weekly newsletter so you never miss the latest in business-focused academic research.
This episode was produced by Josh Stunkel. If you enjoyed it, please subscribe, and please do leave us a five-star review. Until next time, I'm Hal Weitzman. Thanks for listening.
