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Economic stagnation in the rich countries

By now, the beginning of 2003, the United States and Western Europe are well into the second year of economic stagnation. Japan has been in an almost continuous recession for close to 15 years. In spite of frequent predictions, over the past year, of a global economic upturn, it hasn’t happened yet.

Question: What are the causes of current economic stagnation in the rich countries?
Answer: A structural shortage of money with the parties who generate the type of demand that is the major drive of economies: lower and middle class consumers, and governments.

The structural gap between productive capacity and purchasing power

The main obstacle to sustained economic growth is that the past twenty years have seen a growing gap between productive capacity and income-derived purchasing power (i.e., not counting - additional - purchasing power obtained by borrowing) On the one hand, due to technological development, production capacity keeps rising. On the other, lower and middle income groups see stagnation or only limited growth in real incomes, due to a downward pressure on wages. The latter is caused by increasing national and international competition and the increased mobility of business, with as a result, reduced bargaining power for employees.

Over the past two decades, the downward pressure on wages has been compensated by working more hours: the number of hours worked per household, by men as well as women, has increased. Also, consumers have borrowed heavily, and for a time, a sizeable group made windfall profits in stock markets. All this has allowed, until recently, for demand to keep up with production capacity. However, there are limits to the number of hours people can work, the amount of money they can borrow, and the extent to which the stock market can rise. As these limits are being reached, the structural imbalance between production capacity and demand becomes clear. What’s more, there is the prospect of a deepening economic recession as the economic downturn results in layoffs and a further downward pressure on wages and salaries. With demand remaining stagnant or decreasing, business is pushed to operate more efficiently by raising productivity and laying off employees. Thus, the gap between productive capacity and purchasing power increases further.

What goes for lower and middle class consumers is also valid, to a certain extent, for governments. Demand from governments stagnates because, in the worldwide drive of the last two decades to lower taxes, government income stagnates or decreases. The situation worsens as the economy slows. Tax income is reduced and social security payments increase, leaving governments less money to spend on goods and services. That slows the economy further – and again, we have a self-reinforcing process, contributing to the further growth of the gap between productive capacity and purchasing power.

See also: Global Development, Chapter I: Wages, productivity and demand

Question: Will standard economic recipes, notably tax cuts and liberalizing trade and capital flows, reboot economies into sustained economic growth?
Answer: No, they will not, because they do not address the fundamental problem in the global economy: the lack of purchasing power. Indeed, freeing trade will contribute to increasing the gap between productive capacity and purchasing power – and hence, demand.

The effects of free trade and tax cuts on economic growth

Current economic policies contribute to worsening the gap. Freeing trade and liberalizing the international flows of capital depress wages and profits and hence, demand. Economists usually link economic growth, especially that of the last two decades, to economic globalization, that is, increasing international trade. Freeing trade and capital flows, so it is argued, increases competition and allows capital to flow there where it can be used most productively. That increases productivity and efficiency, leading to better quality products and services for lower prices. It also allows new investments and consumption, which further fuels the economy.

There is truth to this theory. However, it only paints part of the picture. No doubt consumers benefit from competition between producers leading to greater choice, lower prices and better quality. However, no account is taken of the fact that before consumers can buy products they have to earn the money to do so. And as was already said, that’s where the problem lies: whereas consumers benefit from free trade, workers suffer as jobs are lost and wages remain stagnant or decrease. As for the idea of international trade being the driving force of the global economy: one only has to take a look at the recent economic downturn to see that it doesn’t hold. In spite of increasing liberalization and growing trade, the economy has slumped. And as most economists will confirm: the main problem, especially in the U.S. and Japan, is weak consumer spending and business investment. In other words: sluggish demand.

So which policies are advocated to increase demand? Lowering interest rates, the further freeing of trade, and reducing taxes. Lowering interest rates helps, but not enough – as the example of Japan shows. Freeing trade was already discussed: good for consumers, but not for increasing demand. Tax cuts may also help, but the disadvantages are greater than the benefits. They lead to reductions in government spending, thus reducing demand for goods and services. Or they result in increasing budget deficits, which will do the same in the somewhat longer run.

Moreover, the effects on increasing demand among tax payers are doubtful. Especially in times of economic uncertainty, tax rebates are more likely to be put in savings accounts or used to reduce debts. Most likely to be spent, and therefore most effective, are tax cuts for the lower incomes. However, in most countries the middle and especially the upper incomes, who are less likely to consume more, benefit the most.

So there we are: traditional economic recipes for addressing an economic downturn do not work. That's because they do not address the key problem: the lack of demand, due to stagnating income for lower and middle income groups, and the drive to reduce government spending. The problem is structural: the fact that it has only now appeared in the rich countries is because, especially over the past decade, it has been obscured by the effects of borrowing and speculation. Lower and middle class consumers have masked their lack of purchasing power by borrowing heavily. Middle and higher incomes became, at least on paper, richer through the spectacular but speculative rise of stock markets, and used part of the gains for consumption. But spending more than you earn through borrowing cannot go on indefinitely. With people now more indebted than ever, savings at all-time lows, and the stock market in the doldrums the bills are coming due.

See also: Global Development, Chapter I: Tax cuts and Globalization

Question: So freeing trade contributes to the loss of jobs and downward pressure on wages. So what’s to do: should trade barriers be resurrected or maintained permanently?
Answer: No, they should not. Freeing trade is good for consumers: it forces producers to compete on quality and price. Therefore trade should be liberalized. However, for hitherto protected sectors of the economy this should happen gradually, to allow producers to adapt to international competition. Moreover a "bottom line", in the form of a minimum of social and environmental standards all producers should adhere to, should be agreed upon and effected worldwide, to avoid competition at the cost of workers and the environment.

For more click on: From free trade to free and fair trade

Question: So free trade should be promoted – under conditions. But will that help us to get out of the current economic downturn soon?
Answer: No, it will not. Freeing trade does not address the fundamental problem of lack of income-derived buying power. Worse, the problem is aggravated by currently popular policies such as tax cuts promoted by mainstream politicians, economists and other opinion leaders.

Question: But aren’t tax cuts supposed to increased buying power and thus, increased demand?
Answer: Yes, and to some extent, it works, if the money ends up with middle and especially lower incomes. On the other hand tax cuts lead, sooner or later, to a decrease in government consumption and investment, which reduces demand. Worse, tax cuts that largely benefit the rich are unlikely to lead to increased demand. That’s because the people who benefit are few and already consumes a lot.

Question: But aren’t tax cuts or the rich supposed to lead to increased investment, which creates jobs and profits, and thus, demand?
Answer: In economic theory, yes. In practice, to some extent. Problem is, especially in a bullish economy the rich are likely to use much of the additional income from tax cuts for speculation rather than productive investment. On the other hand, in a stagnant economy the rich are likely to put their additional wealth in financial safe heavens such as gold or real estate. Overall, the loss in government demand is unlikely to be compensated by the extra demand created by the rich.

How inequality leads to lack of demand and speculation instead of investment

With current economic policy, the economies of the rich nations are likely to remain stagnant for a long time to come, and may well enter a recession that will last for years. We’ve already seen how traditional economic policies, notably the freeing of trade and capital flows, can contribute to stagnating demand. But we’ve not yet discussed how the skewed distribution of wealth and the resulting poor allocation of capital affect demand.

Over the past two decades, there has been a worldwide drive to channel wealth to the rich. Citing the need for countries to remain competitive in attracting business and expert managers and technicians, political and economic decision makers have relentlessly driven down upper bracket tax rates and increased their own salaries and benefits. Also, there has been a drive to reduce corporate taxes and offer tax breaks to business. To attract corporate investment national and local governments have been going to extremes to humor corporate investors. This, in combination with the already discussed downward pressure on lower and middle income wages, has led to the concentration of wealth in those sectors where it is least needed: rich people and corporations.

Many economists think concentration of wealth is a good thing: the rich and corporations, so it is argued, will invest the money in productive enterprises and thus, create economic growth, employment and through taxes, additional government revenues. That is true – but only to a limited extent. What happens in practice is that the money flowing to rich individuals and corporations is used not so much for productive investment as for speculation: witness the rise in stock markets and the mega-mergers and take-over’s of the last two decades. Thus money is, as it were, sucked out of the "real", productive economy and drawn into a virtual economy that is based on speculation. Profits to be made in that virtual economy are often much higher, or perceived to be much higher, than those of the "real" economy.

The effect of this reallocation of capital from the real to the virtual economy is a further reduction in purchasing capacity of lower and middle income groups, small and medium sized enterprises, and governments. For sustainable economic development, that’s bad: as we’ve seen, demand from these sectors is what drives the economy. But the negative effects of the virtual economy on the real economy go further than that. In a rising stock market, speculation is not a problem. Its effects are positive: as stock prices rise the wealth of the higher and part of the middle income groups increases. Consequently, overall purchasing capacity and demand for goods and services in the real economy also increase. However, these effects are temporary: unavoidably each speculative bubble will, at some point, burst. The result of such a collapse is that enormous amounts of capital are destroyed: as stock prices tumble the corresponding wealth simply vanishes into thin air. That has serious consequences for the real economy: as they see their wealth diminish people spend less, companies start cutting costs, investment tanks, and the whole economy can slip into a recession or worse.

In conclusion, channeling wealth to the rich amounts to a poor allocation of capital. Instead, policies should be implemented that keep money in the real economy, where it can generate demand among lower and middle income groups and especially, on the part of governments. After all, we are at a point in time in which major public investment is needed in such fields as the environment – notably, the conversion to sustainable energy, reduction of energy use and pollution, protection of natural environments, and sustainable land and water management. Also, major investments are needed in public education, health care, safety and, in many countries, infra-structure. Most of the needed investments are for the long-term public good, and therefore not commercially viable. They are, therefore, the task of governments. But under the currently predominant economic regimes, governments do not have that money.

Within conventional economic thinking, the only way for governments to raise money for public investment would be to raise taxes – considerably. But in today’s economic and political constellation raising taxes is a hard sell – to put it mildly. Economists argue that it withdraws money from the private sector, where is it used more productively, and thus depresses growth. Politicians don’t like to raise taxes because a major, and often even a minor hike is political suicide. Major tax hikes for business will result, in a global economy where there is frenzied competition between countries to attract investment, that companies able to do so move elsewhere. That means a major raise in taxes would be possible only in case of a global agreement on corporate taxation and higher upper bracket tax rates. Considering current levels of international co-operation, such an agreement is a long way off indeed. Moreover, it would have to be initiated taken by power holders who in almost all cases, belong to the upper income groups – and would thus see their own interests affected directly.

See also: Global Development, Chapter I: Wealth concentration and speculation and Tax cuts

Question: So what can we expect in the short run, say, the coming one or two years? Will we get out of the current economic downturn?
Answer: For the time being, capital flows in the direction of rich individuals and corporations will continue, at the cost of governments and lower and middle income groups. That means that overall purchasing power and – with a stock market in the docks and consumers and governments heavily indebted - demand will progressively fall behind productive capacity. And that, in turn, means that chances of a rapid economic recovery are slim: indeed, the economy may remain in a slump for years.

Question: So what is the outlook for the medium and longer term, i.e., the coming ten to twenty years?
Answer: If in the coming years in some way or another, the above described problems sort themselves out and demand and economic growth pick up again, there are more problems ahead. First there is the debt problem in Japan, where many banks have such huge amounts of bad debt that they are threatened by insolvency. This, and the enormous debts of the government run up in attempts to boost the economy, may evolve in a major economic and financial crisis. Then there is the indebtedness of the United States that likewise, especially in the case of a collapse in Japan, can lead to a major financial and economic crisis. Third, in the longer run, graying populations in Europe, Japan and to a lesser extent, the US will demand such increases in pension payments that public and to a lesser extent, private pension funds will be unable to meet their obligations. The outlook is especially worrisome for countries where pensions are paid from current accounts rather than savings.

The longer term risks: bad debts, indebtedness, and graying populations

The key obstacle to rebooting sustained economic growth in the short run, then, is the structural deficit in purchasing power of the parties that, with their demand for goods and services, fuel the economy: the lower and middle income groups and governments. But that not the only problem. Additional dangers loom, due to factors that affect all three of the major economic powers: Japan, the US, and Europe.

The first problem is the financial system in Japan. The speculative craze of the 1980s (at one point, the value of the real estate of downtown Tokyo was equivalent to that of all of the US) led to a collapse that left the banking system in disarray. To this day many of the major Japanese banks are close to insolvency, and some may already be salvation because of huge amounts of bad debt. To this must be added the enormous government debt, caused by over a decade of attempts by the Japanese government to reboot economic growth through large-scale investment projects. Though these projects did provide temporary stimuli to the economy most of them were ill conceived, generating little spin-off and insufficient returns to pay back the loans. The consequence of this still growing mountain of public and bank debt may be a financial crisis that is likely to have worldwide implications, especially if Japanese banks and governments are forced to sell of foreign currency holdings - notably, dollar-denominated stocks and bonds.

That brings us to the second major problem: the indebtedness of the United States. For several decades, an important part of the growth in the US has been financed by foreigners: through direct investment in the United States, buying U.S. securities, and purchasing dollars. The corresponding inflow of money has allowed Americans – consumers, companies, government - to spend more than they earn. Every month imports exceed exports by tens of billions of dollars, and each year seems to bring new highs in the gap between the two. As a result, the US is now the greatest debtor in the world. So far, this has not been a problem: money keeps flowing to the US which overall, is still seen as both the place with the best investment opportunities and a safe haven for capital. But if for some reason this inflow would stop, and foreigners would start withdrawing from the U.S. by selling their dollars and dollar-denominated securities on a major scale, the consequences would be dire. The dollar would drop in value, making imports more expensive, causing both inflation and a decline in purchasing power. To support the value of the dollar and limit inflation the Federal Reserve Board would have to raise interest rates, which would hamper economic activity. Stocks would plummet, with as a result financial and economic mayhem. The US economy could slip into a recession and possibly, a depression. With the US economy accounting for close to 40% of global production, the rest of the world would follow.

So what could trigger such an event? Already mentioned was a need for funds by banks strapped for cash in case of a financial crash in Japan. Another cause could be a loss of confidence in the value of the dollar, or in the profitability of investing in the US. The great danger of such events is that they are self-reinforcing: once triggered, the selling of dollars and securities will lead to further loss of confidence, triggering more sales, a further loss of confidence, and so on. It is, of course, hard to predict if a massive withdrawal from the US will ever happen. However, as trade deficits and the corresponding debt increases, and especially, if due to a stagnating economy, US debt to the rest of the world rises as a percentage of gross national product, chances increase that it will.

A third, and perhaps even larger threat to the economies of the rich nations – and hence, the global economy – is the graying of its populations. In Europe, Japan, and to a lesser extent, the US, large numbers of people – the so-called baby-boom generation, born in large numbers in the first two decades after World War II - will retire in the coming twenty years. That implies an enormous rise in expenditure on old age benefits and health care, a large part of which will have to be financed with public funds. The generations that follow the baby boom crowd will have to pay for most of these costs: for some countries, it has been estimated that by 2020, three working people will have to "maintain" one retiree – as against today’s five or six. In some countries, notably the US, Britain, and some smaller countries such as The Netherlands, the situation is somewhat mitigated by the fact that through private pension funds, people have already saved for their own retirement. Even so, major problems are expected in the financing of a huge rise in health care costs and old age-related social security payments. In other countries, such as Germany, France, and Italy, pensions are not paid from savings generated by the pensioners themselves. Instead, they are paid by working people paying retirement premiums that, via a special retirement fund, are channeled straight away to the retirees. With the number of working people reducing both in absolute terms and relatively, i.e., in relation to the number of retirees, this system is untenable. The situation is worsened by the fact that in the mentioned countries, retirement age is often low – in some cases, as low as 55.

To fulfil its obligations towards pensioners governments will have to reduce pensions, cut public investment and borrow heavily. All these measures will have a depressing effect on demand and thus, on the economy overall. A major economic recession, or depression, may occur. That will reduce government income, leading to a further need to borrow and trim pensions and public investment. Again, a self-reinforcing process of economic deterioration will occur.

Question: So what must be done to reboot the economies of the rich nations, and avoid the economic crises that may be in store in the coming twenty years?
Answer: The key lies in generating extra demand for goods and services. That should be done through a large-scale public investment program aimed at converting to a socially equitable and environmentally sustainable society. Socially, the program should focus on improving public education and health care, providing all citizens with a minimum income, and improving safety through fighting and preventing crime. Environmentally, the program should aim to minimize harmful emissions and convert to an environmentally sustainable economy, driven completely by renewable energy. The increased demand such a program would generate would provide the impetus needed to get the currently stagnating economies of the rich countries going again, and result in sustained economic growth.

See also Global Development - Chapter VI: A global investment program for sustainable development

Question: That would cost a bundle. Where would the money come from?
Answer: Part of the money can be generated through conventional means: savings on other types of government expenditure, and (progressive) taxation. The remainder should be financed by money creation. The money involved should be created by the IMF and made available to countries under strict conditions, in such quantities that the extra demand generated would not exceed productive capacity - nationally and internationally.

For more, click on:
Financing sustainable development - the conventional way
Money creation for sustainable development

 

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