This Changes Everything (part 3)

April 19, 2017

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A key question in the political debate over energy is whether governments should have a strong energy policy at all. The conservative answer is essentially no. Government should not “pick winners and losers,” but remain neutral toward different energy sources and let the market decide. It is the “invisible hand” of the market that is most rational and fair. If fossil fuels are what sell, then we should continue extracting them.

Naomi Klein, on the other hand, sees our heavy reliance on environmentally dangerous sources of energy as a massive market failure. Fossil fuels are both more profitable for producers and cheaper for consumers than they should be, because market participants are not paying the full environmental cost. The planet, not the market, will dole out the consequences, including heavy costs for poor people who never got the benefits of high consumption. In this case, the market outcomes are neither rational nor just. Klein doesn’t say it in exactly these words, but the root of the problem is capitalism’s propensity to privatize benefits while socializing costs.

That is the basic argument for strong public policies–local, national and international–to facilitate a transition to cleaner energy as soon as possible.

Democratic resistance

Since the fossil fuel industry has accumulated enormous economic and political power, the only solution Klein sees is a massive democratic resistance movement. She sees such a movement emerging as the conflict between private interests and the public interest becomes clearer.

The fossil fuel industry is on a collision course with the climate, since it is planning to extract and burn far more carbon than scientists say the atmosphere can safely absorb. The valuation of fossil fuel companies on the stock market is based on the future profits projected on the basis of those plans, so they have strong incentive to keep going.

What really encourages resistance is that extractors are “pushing relentlessly into countless new territories, regardless of the impact on the local ecology (in particular, local water systems), as well as the fact that many of the industrial activities in question have neither been adequately tested nor regulated, yet have already shown themselves to be extraordinarily accident-prone.”

Resistance is growing especially in the Pacific Northwest, led especially by “resurgent Indigenous Nations, farmers, and fishers whose livelihoods depend on clean water and soil, and a great many relative newcomers who have chosen to live in that part of the world because of its natural beauty.”  For many people, climate change is still a somewhat abstract notion, but a threat to the local water supply is not.

And what could be more democratic than a popular demand for clean water? “Having the ability to defend one’s community’s water source from danger seems to a great many people like the very essence of self-determination.”

Of course, the success of a broad environmental movement remains to be seen. Truly transformative social movements are historically rare. Klein cites the example of anti-discrimination movements that achieved only partial victories. The movement for African American rights succeeded in outlawing the most obvious forms of discrimination. But it has not achieved the “massive investment in jobs, schools, and decent homes” that would be needed to eliminate the large racial gap in wealth and income. On the other hand, the labor movement of the 1930s achieved more substantial economic gains. In that instance, the crisis of the Great Depression shifted popular opinion dramatically to the left, producing the New Deal wave of progressive legislation. The climate crisis may require a political change of that magnitude.

Global responsibility

What makes the challenge of climate change so daunting is that it requires developed countries not only to curb their own fossil fuel emissions but to help poorer countries curb theirs. Klein believes that this is a matter of both economic necessity and moral justice.

“Developed countries, which represent less than 20 percent of the world’s population, have emitted almost 70 percent of all the greenhouse gas pollution that is now destabilizing the climate.” The richer countries not only have a history of appropriating other peoples land, labor and resources (especially through slavery and colonialism), but they have also appropriated the sky, “gobbling up most of our shared atmosphere’s capacity to safely absorb carbon.”

That puts developing countries in a real bind. They are told that they must limit their fossil fuel emissions just when they are starting to industrialize. But the cheapest and easiest way for them to develop is to use the most readily available sources of energy, without bearing the costs of environmental protection or innovative technologies.

They cannot break this deadlock without help, and that help can only come from those countries and corporations that grew wealthy, in large part, as a result of those illegitimate appropriations….With many of the biggest pools of untapped carbon on lands controlled by some of the poorest people on the planet, and with emissions rising most rapidly in what were, until recently, some of the poorest parts of the world, there is simply no credible way forward that does not involve redressing the real roots of poverty.

The United Nations Framework Convention on Climate Change (1992) recognized this when it asserted a principle of “common but differentiated responsibilities.” The nations of the world are all in this together, but the countries that have gotten the richest on fossil fuels have a special responsibility to switch to cleaner energy, as well as to help finance that transition in poorer countries.

One reason why emissions are falling in the United States (although not enough) but rising in poorer countries is that we have offshored so much manufacturing, especially to countries with weak environmental policies. The system is very profitable, but it complicates efforts to combat global warming.

In Klein’s view, the solution is not just for richer countries to contract their economies, while poorer countries expand theirs on the same old fossil-fuel model. That would just redistribute emissions, not reduce them. The challenge is for all countries, rich and poor alike, to agree to develop differently.

What kind of populism?

In a previous post, I mentioned Klein’s point about bad timing: Climate change became an issue just “at the peak of free market, end-of-history triumphalism.” She is hopeful, however, that other social problems such as growing inequality have helped discredit that ideology. If so, conservative politicians may be losing some of their cultural legitimacy, and a progressive counter-revolution may be in the making.

In this context, what should we make of Donald Trump’s “populism”, which arrived on the scene after Klein’s book was written? It is a little different than mainstream conservatism, since it encourages some government interventions in markets, especially restrictions on global free trade to protect US. manufacturing. (What exactly those restrictions would be is not clear.) When it comes to energy, it is worse than conservatism, since it is not so much energy neutral as pro-fossil fuel. Our new EPA Administrator is Scott Pruitt, who as Attorney General of Oklahoma consistently represented the interests of fossil-fuel companies. Our Secretary of State is Rex Tillerson, the former CEO of Exxon-Mobil. Neither Trump nor Pruitt has accepted the scientific consensus on climate change.

Trump seems obsessed with jobs in coal mining and pipeline construction. He has not shown much interest in creating new kinds of jobs or training workers to perform them.  Klein, on the other hand, points to the economic potential of clean energy. One study she summarizes is from the Canadian Centre for Policy Alternatives:

[I]f $5 billion is spent on a pipeline, it produces mostly short-term construction jobs, big private sector profits, and heavy public costs for future environmental damage. But if $5 billion is spent on public transit, building retrofits, and renewable energy, economies can gain, at the very least, three times as many jobs in the short term, while simultaneously helping to reduce the chances of catastrophic warming in the long term.

Trump’s brand of populism is a reactionary one favoring traditional industries and jobs. But the very fact that many of his supporters are disillusioned with establishment conservatism may create some room for a more progressive populism favoring a more innovative and sustainable economy. Whether public opinion will shift in that direction in time is hard to say. If history is any guide, the old economy may have to show even more signs of failure before people will turn to something new.

This Changes Everything

April 17, 2017

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Naomi Klein. This Changes Everything: Capitalism vs. the Climate. New York: Simon & Schuster, 2014

Journalist Naomi Klein spent five years delving deeply into the problem of climate change and what it may mean for our capitalist way of life. She concludes that up until now the world has been failing to tackle the problem effectively, and that’s mainly because the necessary steps “fundamentally conflict with deregulated capitalism, the reigning ideology for the entire period we have been struggling to find a way out of this crisis.”

The first part of her statement is widely accepted, at least among scientists and most world leaders. The 2009 climate summit in Copenhagen set a goal of limiting average global temperature to no more than 2 degrees Celsius above what it was when countries first turned to coal to power the industrial revolution. That would require the richer countries to reduce their carbon emissions “in the neighborhood of 8-10 percent a year.” So far that isn’t happening. According to the EPA, US carbon emissions dropped only 2.9% between 2014 and 2015, and only 11.7% over the ten-year period from 2005 to 2015. In the world as a whole, that drop was offset by increased emissions from developing countries.

Much more controversy surrounds the question of what to do about it. Many people hope for a technological fix that could solve the problem with minimal impact on our habits of production and consumption. Economic conservatives want to limit changes to what can occur through market mechanisms such as consumer demand for greener products, while minimizing the role of government regulation. Liberals are willing to entertain government measures like a carbon tax, but are suspicious of calls for a more radical economic transformation.

Klein is willing to think more radically, since she regards climate change as a real game changer. It poses  a massive threat; it is happening rapidly; and it forces us to rethink how we have related to nature and organized our economic lives.

[T]he real reason we are failing to rise to the climate moment is because the actions required directly challenge our reigning economic paradigm (deregulated capitalism combined with public austerity), the stories on which Western cultures are founded (that we stand apart from nature and can outsmart its limits), as well as many of the activities that form our identities and define our communities (shopping, living virtually, shopping some more).

No doubt people prefer little problems with little solutions to big problems requiring big solutions. That makes Klein’s book a tough sell. Nevertheless, it’s worth reading, just in case she may be right.

The “greatest market failure”

The roots of the climate problem lie deeper than capitalism, in the relationship to nature that Klein calls “extractivism”.  She defines this as “a nonreciprocal, dominance-based relationship with the earth, one purely of taking. It is the opposite of stewardship….” Both Western religion and Western science conceived nature as a subordinate thing to be used for the benefit of spiritually or mentally superior humanity. Although these ideas preceded industrial capitalism, “the ability to harness the power of coal to power factories and ships is what, more than any single other factor, enabled these dangerous ideas to conquer the world.” The expansion of production and consumption in the modern market economy was built on the foundation of fossil fuel extraction.

Implicit in the notion of the “free market” was the freedom to dominate nature. (Klein also sees domination in the relationship of capital to labor and rich countries to poor countries, a point I’ll return to later.) As long as producers and consumers of fossil fuels “pay nothing for the privilege of treating our shared atmosphere as a free waste dump,” the “invisible hand” of the market fails to channel self-interest toward the general good. Since the true cost of burning fossil fuels is not factored in when calculating corporate profits or consumer prices, neither producers nor consumers have enough incentive to change their behavior. That’s especially true if much of the environmental damage they are causing hasn’t happened yet or is happening somewhere else on the planet. Klein quotes the Stern Review on the Economics of Climate Change when it calls that problem “the greatest market failure the world has ever seen.”

Part One of Klein’s book is called “Bad Timing.” The world was starting to hear about scientific evidence of global warming in the 1980s, around the same time that “neoliberal” economic policies were on the ascendancy. Those policies aimed to use low taxes and deregulation to free up private capital while restricting public action. After the collapse of the Soviet Union, conservatives declared the historical struggle among economic ideologies over and free-market capitalism the winner. A grand market failure was not something they wished to consider, let alone correct. “A belief system that vilifies collective action and declares war on all corporate regulation and all things public simply cannot be reconciled with a problem that demands collective action on an unprecedented scale and a dramatic reining in of the market forces that are largely responsible for creating and deepening the crisis.”

That is why the debate over climate change is so deeply polarizing. For social critics, the climate issue is the most powerful argument against deregulated capitalism. And for precisely that reason, the defenders of that retrograde brand of capitalism have strong motives to deny or minimize the problem.

Global climate and global trade

Another bit of bad timing is that the era of global climate agreements is also the era of global free-trade agreements, and the two have conflicting goals. Klein describes Ontario’s Green Energy and Green Economy Act, which Al Gore praised as the “single best green energy [program] on the North American continent.” In order to promote renewable energy and give manufacturers of materials like solar panels incentives to come to Ontario, it included a requirement that a certain percentage of materials be locally sourced. However, the World Trade Organization ruled that this “protectionist” provision violated the terms of the North American Free Trade Agreement. Global free-trade pacts have stronger enforcement mechanisms than international agreements to reduce carbon emissions, so “trade trumps climate.”

Global free trade contributes to climate problems in other ways. China has become “a free trader’s dream…and a climate nightmare.” Corporations feeling burdened by environmental regulations or high labor costs can offshore their manufacturing operations to developing countries. There costs can be contained by low environmental and labor standards, which go together in a package deal. “The same logic that is willing to work laborers to the bone for pennies a day will burn mountains of dirty coal while spending next to nothing on pollution controls because it’s the cheapest way to produce.” That is certainly a capitalist logic, at least in one form. Producing cheap goods for export is not the only way to compete in the global marketplace, but it is an obvious way for a poor country wishing to industrialize quickly.

The resulting loss of manufacturing jobs in countries like the United States puts pressure on less educated workers to hold onto jobs in the fossil fuel industry if they have them, and to oppose environmental regulations that threaten those jobs. (Instead of working to raise environmental standards internationally, President Trump proposes to lower them domestically, protecting coal jobs by joining the global race to the bottom.) Another downside is that the goods imported from overseas that could have been produced at home have to be shipped, another big contributor to fossil fuel emissions.

Managing the economic transition

Klein maintains that running the economy on renewable energy is becoming technically feasible, but the private sector will not make the transition fast enough on its own. The profits from using fossil fuels are too great, and the profits from large-scale investments in solar or wind power are too uncertain. She sees an expanded role for governments and community cooperatives in fighting carbon emissions and promoting cleaner alternatives.

Some fossil fuel production can be curbed through carbon taxes that reflect the true cost to society of that production. Government can also charge higher royalty rates for oil, gas, and coal extraction. These additional revenues can then be devoted to investing in the “post-fossil fuel future, as well as to helping communities and workers adapt to these new realities.” Some forms of production are so irrational from an environmental perspective that they need to be banned outright. In order to get at the least accessible coil, oil and gas, companies are “blasting the bedrock of our continents, pumping our water with toxins, lopping off mountaintops, scraping off boreal forests, endangering the deep ocean, and scrambling to exploit the melting Arctic.”

Until the day comes–if it ever does–when renewables can provide as much energy as fossil fuels do now, we will need to reduce energy consumption. Here too, Klein believes that private self-interested decisions will have to be supplemented by new public policies. For example:

That means cheap public transit and clean light rail accessible to all; affordable, energy-efficient housing along those transit lines; cities planned for high-density living; bike lanes in which riders aren’t asked to risk their lives to get to work; land management that discourages sprawl and encourages local, low-energy forms of agriculture; urban design that clusters essential services like schools and health care along transit routes and in pedestrian-friendly areas….

Although she is a critic of contemporary capitalism, Klein is not as radical as some authors I have read. She does not call for an end to capitalism as such, or an end to economic growth altogether. That would be a problem especially for the less developed countries, which contain a majority of the world’s people and are counting on economic growth to lift millions out of poverty. She summarizes what she does hope for in a section called “Growing the Caring Economy, Shrinking the Careless One”:

Obviously a huge number of jobs would be created in the sectors that are part of the green transition—in mass transit, renewable energy, weatherization, and ecosystem restoration. And those sectors that are not governed by the drive for increased yearly profit (the public sector, co-ops, local businesses, nonprofits) would expand their share of overall economic activity, as would those sectors with minimal ecological impact (such as the caregiving professions…).

The richer countries, which are farther along in the transition to a service economy, might center their lives less around acquiring–and powering–material things. But they could be compensated by living lives richer in human relationships and services. (I wouldn’t be the first sociologist to suggest that modern urbanites and suburbanites sacrificed a degree of human community in their rush toward material prosperity.) Meanwhile the locus of material progress could shift more to the poorer countries. But higher standards of environmental protection would need to spread everywhere.





Global Inequality (part 3)

August 8, 2016

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This final post on Branko Milanovic’s Global Inequality will focus on the future prospects he sees for reducing economic inequality in the world. He discusses three kinds of inequality: inequality among countries, inequality within poorer countries, and inequality within richer countries, especially the United States.

Inequality among countries

Milanovic expects the median incomes of countries to continue to converge as the economies of poorer countries continue to grow faster than those of richer countries. However, he expects this convergence to be limited in several ways. Currently “it is only Asian countries that have been catching up with the rich world.” Progress has been much slower in other parts of the world, especially Africa. And although growth in China accounts for a lot of the global convergence in incomes, this may not always be the case. In a few years, China may be so far above average that further development there may increase global inequality rather than reduce it. Then continued convergence will depend on what other countries do.

Although the narrowing gap between rich and poor countries is encouraging, it is occurring so slowly that “one cannot expect global inequality to be reduced by more than one-fifteenth of its current level” over the next twenty years.

Inequality within poorer countries

Milanovic suggests that countries like China are passing through a phase of the first Kuznets wave that more developed countries experienced at least a century ago. They are experiencing a familiar pattern in which industrialization initially increases opportunities for the few, and only later for the many, as discussed in the previous post. Although the data are somewhat sketchy, Milanovic sees signs that economic inequality has peaked in China and is beginning to subside. Mass education and a reduced supply of cheap, unskilled labor would be among the reasons for the transition.

On the other hand, many poor countries are still in an even earlier phase of the transition, in which inequality is increasing because the benefits of economic development have yet to be experienced by large portions of their populations.

Inequality within richer countries

I found Milanovic’s views on this topic a bit confusing. On the one hand, he maintains that information technology and globalization have initiated a new Kuznets wave of economic change, in which inequality is rising again but will ultimately fall. To make that case, he needs reasons for the fall as well as the rise. Otherwise, he cannot distinguish his theory from more pessimistic assessments like Piketty’s Capital in the Twenty-first Century, which sees rising inequality as a fundamental feature of capitalism. However, when Milanovic tries to identify mechanisms by which inequality might fall, he expresses little confidence that they will work any time soon.

Milanovic identifies five “benign forces” that could theoretically reduce inequality:

  1. Political changes could result in higher and more progressive taxation. However, the global mobility of capital makes it easier for the wealthy to escape taxation. In addition, many citizens of modest means have trouble supporting higher taxes, even when that might be in their own best interest.
  2. The widening wage gap between more and less educated workers could be narrowed by improvements in the quantity and quality of education. However, Milanovic has trouble imagining that average years of education could rise above thirteen. He also thinks that improvements in the quality of education “face natural limits, given by the aptitude and interest of students to excel in whatever they choose to do.” Some would object that if better education were more widely available, more students would rise to the occasion.
  3. As the technological revolution proceeds, innovations that originally profited the few can be more widely adopted. On the other hand, the ownership of capital has become more concentrated lately, so the control of profitable innovations remains largely in the hands of a few.
  4. As wages rise in poorer countries, workers in richer countries should face less competition from foreign low-wage labor. However, it could be a long time before poor countries outside of China and a few other Asian countries experience much wage growth.
  5. Technological progress could raise the productivity of low-skill workers specifically. But this would go against the historical experience of capitalism, in which technological change normally boosts the income of the more skilled over the less skilled.

I found the last point especially troublesome, since it seems to me to undercut one of the strongest reasons for a Kuznets curve in the first place. Surely the mass-production technologies of the twentieth century helped bring many blue-collar workers into the middle class by boosting their productivity, raising their wages, and making former luxuries like automobiles more affordable. If we are looking for mechanisms for reducing inequality in the new wave of change, shouldn’t we be looking for a new productivity revolution along the lines suggested by Rifkin’s The Zero Marginal Cost Society or Paul Mason’s Postcapitalism? Milanovic  doesn’t anticipate anything that radical, but maybe the falling inequality phase of the alleged Kuznets curve won’t work without some fairly dramatic change. Ironically, Milanovic begins his chapter on future inequality by criticizing previous attempts at prediction for assuming too much continuity from the present to the future.

The United States: A “perfect storm of rising inequality”?

Milanovic is especially pessimistic about reducing inequality in the United States. He provides five reasons he expects the rise in inequality to continue:

  1. The share of national income going to capital rather than labor will remain high, especially since businesses find it economical to replace labor with machinery.
  2. The income from capital will remain highly concentrated.
  3. The people with the highest incomes will also be the ones who can save and invest the most, so the same people will be getting most of the benefits from both labor income and capital income.
  4. These labor-rich and capital-rich individuals will also tend to marry each other, so that wealth and income are even more concentrated for households than they are for individuals.
  5. The rich will use their political power to support policies that protect their economic interests at the expense of those of the middle class and the poor.

Milanovic concludes:

It is hard to see where any forces might come from that could counter rising income inequality in the United States….Forces promoting offsetting policies such as more widespread education, a higher minimum wage, and more generous welfare benefits seem weak compared with the almost elemental forces that favor greater inequality.

By this time, the reader who has followed the argument from the beginning may be wondering what happened to the original idea of the Kuznets curve, with its rise and fall of inequality. Well, “the second Kuznets curve will have to repeat the behavior of the first if inequality is to decline again. But it is doubtful whether this second decline will be accomplished by the same mechanisms as those that reduced inequality in the twentieth century….” What mechanisms Milanovic does suggest are mostly political, especially changes in tax policies and improvements in public education, changes that seem unlikely in the light of his previous remarks. The reliance on political rather than economic mechanisms sounds more like Piketty than Kuznets.

To summarize, Milanovic starts with a Kuznets theory emphasizing economic reasons why inequality first rises and then falls. He does broaden it by suggesting that extreme inequality generates malign forces like violent conflicts that can destroy the wealth of some and create opportunity for others. Yet he ends with a pessimism that economic forces will reduce inequality either benignly or malignly. This leaves it an open question whether what we are living through is a second Kuznets wave at all. If it isn’t, then the first Kuznets curve was a unique historical event from which we cannot generalize, and the book’s theoretical framework falls apart.

In general, I found the book’s data very informative and its interpretations thought provoking. But in the end I found its theoretical position on the central question of falling inequality too ambiguous to be convincing.

Global Inequality

August 3, 2016

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Branko Milanovic. Global Inequality: A New Approach for the Age of Globalization. Cambridge: Harvard University Press, 2016.

Branko Milanovic is a Serbian-American economist specializing in economic development and inequality. His global perspective on inequality goes beyond the familiar idea that gaps in wealth and income always seem to be widening. There is some truth to that, but it is far from the whole truth.

Who is gaining from globalization?

Economists are in a much better position to talk about global income now that they have some decent global data. Milanovic’s data come from “more than 600 household surveys covering about 120 countries and more than 90 percent of the world’s population over the period 1988-2011.”

He uses the data to construct a remarkable chart, in which he plots percentiles of income on the horizontal axis and cumulative percentage growth in income on the vertical axis. The chart then shows which percentiles from poorest to richest have benefited the most in this period of globalization. The poorest people on earth, such as most Africans, have seen almost no improvement. However, the people in the middle of the distribution, from the 20th to the 70th percentiles, have experienced over 40% growth in income.

Who are these people? They are not the middle class in rich countries like the United States; they would be above the 70th percentile. They are the emerging middle class in rapidly developing countries. Ninety percent of them live in Asia, especially China, India, Thailand, Vietnam and Indonesia. They are not yet as rich as our middle class, but they are moving rapidly in that direction. In about three decades, the Chinese are expected to be as rich as citizens of the average European Union country.

Above the 70th percentile of global income, the recent gains in income rapidly fall off, reaching zero for people at the 80th percentile! (Remember that means zero gain, not zero income.) Who are they? They are mostly the lower middle classes within the richest countries, people who have been relatively well off historically but are not currently gaining from globalization. Think of the less-educated American blue-collar workers who are now in competition with foreign labor and haven’t seen wage gains in decades.

Above the 90th percentile of global income, income gains rapidly rise again, with a gain of over 60% at the top of the distribution. This group is the global 1%, the richest people on earth. Half of them are in the United States, and the other half are mostly from Europe and Japan. Together they receive 29% of the world’s entire income and control 46% of its wealth. They include the world’s billionaires, 1,426 individuals who together own twice as much as all the people of Africa.

For those of us who would welcome a reduction in economic inequality, globalization brings good news as well as bad news. The good news is some decline in inequality among countries, as the benefits of economic development spread to the developing world, especially Asia. The bad news is twofold. In the world as a whole, some countries remain stuck in poverty. And within the most developed countries, the benefits of globalization are going almost entirely to the upper class, at least so far.

Historical trends in inequality

Now let’s put these recent trends in historical perspective. How much of this is new, and how much of it have we seen before? The answer depends on which aspect of inequality we consider.

Milanovic makes a simple but important logical distinction: “Global inequality, that is, income inequality among the citizens of the world, can be formally considered as the sum of all national inequalities plus the sum of all gaps in mean incomes among countries.” This is just standard statistical logic: Whenever a population is divided into subgroups, the total variation within the population is the sum of the between-group variance and the within-group variance. In this case, the subgroups are countries. Milanovic refers to the between-country differences as “location-based inequality” and the within-country differences as “class-based inequality.”

The two kinds of inequality have developed differently in different historical periods:

  1. In the early 1800s, only about 20% of the total inequality in the world was due to location; far more was due to class differences within countries. But over the course of the century, as the industrial economy took shape, location-based inequality increased because the countries that industrialized first became much richer than the rest of the world. At the same time, the class divide within the industrializing countries got worse.
  2. From about the 1920s to the 1970s, country differences in income reached a peak, accounting for about 70% of all global inequality. However, class differences diminished as the middle class grew within the richer countries. The world seemed divided into largely prosperous Americans and Europeans and mostly poor Africans, Asians and Latin Americans.
  3. In the most recent period so far, globalization has reversed both twentieth-century trends. Country differences have started to decline, because growth has accelerated in Asia while decelerating in Europe and North America. But at the same time, internal inequality has increased in many rich countries, especially the US, UK and Italy. The middle class has been shrinking and the rich have been getting richer.

To put it simply, the recent decline in inequality among countries is new in the industrial era. The recent increase in inequality within wealthy countries is not quite as new, but it’s a return to something last seen in the nineteenth and early twentieth centuries.

Next we will turn to Milanovic’s attempt to make sense out of these developments and anticipate where the two components of global inequality may go next.


The Shifts and the Shocks (part 3)

December 19, 2014

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The last part of Martin Wolf’s book deals with solutions to financial instability and the sluggish economic recovery. This is the hardest part to summarize, since Wolf discusses a great many ideas, organizes them rather loosely, provides little in the way of prioritization, and conveys little confidence that some of the more promising ideas will actually be adopted. In keeping with Wolf’s interest in underlying macroeconomic causes of financial crisis, I will highlight the solutions that would address those causes.

To review some of the main themes, Wolf describes a global economy in the aftermath of a great credit boom and bust. Underlying the financial crisis was a global savings glut that was really an excess of saving over investment. When an economy generates more income than is spent on current consumption, the surplus should sustain economic activity through investment in future production and consumption. Also, some people’s savings can go to finance other people’s consumption, as long as the loans are sound and the debtors can repay them out of future earnings. But in the global economy prior to the crisis, not enough of the world’s savings was used for either sound investment or sound consumer borrowing, and too much was used to finance high-risk consumer loans and asset bubbles, especially in housing.

The world became more divided into creditors and debtors: creditor and debtor countries (such as Germany in relation to peripheral Europe and China in relation to the US), creditor and debtor economic classes (increasingly unequal households, especially in the US), and creditor and debtor economic sectors (the corporate sector with surplus income and the government and household sectors running deficits). When the credit boom got too far out of hand, some debtors defaulted, some creditors stopped lending, and the system crashed.

The challenge for the future is then to tighten financial rules to discourage credit excesses, but also to reform the system to make better use of economic resources. It isn’t enough just to stop creditors from making risky loans and force debtors to pay down debt. If something else isn’t done to put excess savings to good use–in either investment or consumption–austerity will only weaken economic demand, increase surplus savings and produce long-term economic stagnation. That is what Wolf fears:

Far more likely [than adequate reform] is an enduring slump in high-income countries, at least relative to pre-crisis expectations. That would impose huge costs – of investments unmade, of businesses not started, of skills atrophied and of hopes destroyed. Should that fate be avoided, another temporary credit-driven boom might emerge, followed by another and still bigger crash.

Wolf argues that the long-term costs of failing to sustain high economic output are greater than the costs of wars, and also greater than the costs of inflation (relevant because fighting inflation has often been such a high priority of economic theorists and policymakers).

Banking reform

Throughout his discussion of solutions, Wolf is willing to entertain more radical reforms than have been adopted so far, although he acknowledges the difficulties of implementing them. For example, he would like to make fundamental changes in the way bankers do business:

So the business model of contemporary banking is this: employ as much implicitly or explicitly guaranteed debt as possible; employ as little equity as one can; invest in high-risk assets; promise a high return on equity, unadjusted for risk; link bonuses to the achievement of this return target in the short term; ensure that as little as possible of those rewards are clawed back in the event of catastrophe; and become rich. This is a wonderful business model for bankers….For everybody else, it was a disaster.

The solution seems clear: force banks to fund themselves with equity to a far greater extent than they do today.

Before the crisis, the median ratio of debt to equity in UK banks was 50:1. That meant that a mere 2% drop in the value of the typical band’s assets would make it insolvent. Wolf would like to see a maximum ratio of 10:1.

Wolf also devotes considerable space to a discussion of the even more radical “Chicago Plan,” which would eliminate the role of bank lending in the creation of money and dramatically increase the government’s control over the money supply. But he acknowledges that this would be too disruptive, and that more moderate reforms should be tried first.

Macroeconomic reforms

The deeper problem is how to stimulate demand and put savings to constructive use, so that excessive credit is not needed to maintain economic activity.

Wolf deplores the almost exclusive reliance on monetary policy (low interest rates and bond purchases by central banks) to bring about economic recovery. At least in the short run, increases in government spending would have accomplished more in a shorter time. “The decision to withdraw fiscal support for the recovery, taken at the G – 20 Summit of June 2010, delivered a longer and deeper slump than necessary….It has also meant relying on a more uncertain tool – that of unconventional monetary policy – and abandoning a less uncertain one – that of fiscal policy.” The notion that government borrowing and spending interferes with private investing lives on, although it made more sense when capital was scarce and expensive than it does now, when capital is abundant and cheap.

In the longer run, total economic demand must be increased by reducing the excess savings of creditors and increasing the income of debtors. High-saving, high-export countries like China and Germany need to stimulate domestic demand by allowing their workers to consume more, while debtor countries need to stimulate foreign demand by becoming more globally competitive and earning more income abroad. Corporations should be discouraged from accumulating excess savings, but encouraged by changes in corporate governance and taxation to distribute profits not needed for investment. Government should have the tax revenue it needs to create needed social goods. Low-income households should get a larger share of income through higher wages or progressive taxation, so they can maintain consumption without relying so heavily on debt.

Saving the Eurozone

Wolf minces no words in his discussion of the European Monetary Union; he regards it as a “bad marriage,” since it created a unified currency without first creating a unified state. “Proponents thought that creating a currency union would bring the peoples of the Eurozone closer together. Crises divided them into contemptuous creditors and resentful debtors instead. This has been a march of folly.”

As I discussed in the first post, the common currency made it easier for strong economies to export and weaker ones to borrow. But when the credit bubble burst, there was no central state to help repair the damage. Wolf notes that in the United States, some states are economically weaker than others, but their citizens participate in a federal safety net and their bank deposits are federally insured. The European Central Bank was very slow to intervene to maintain liquidity in the countries hardest hit by the financial crisis. Wolf maintains that since “the creditor countries bear a full share of the responsibility for the mess, they should expect to bear a full share in its resolution as well,” by refinancing some debt with lower interest rates and longer terms. Wolf also wants to see a strengthening of the central bank, with stronger powers to regulate banks and issue eurobonds “for which the Eurozone states are jointly and severally liable.”

From a macroeconomic perspective, the Eurozone will suffer from weak demand if Germany continues to rely for its prosperity on its high level of exports while weaker economies import less in order to pay down debt. If all of Europe is trying to consume less than it produces, that will in turn aggravate the problem of weak demand in the global economy. Austerity may work for some countries, but it cannot work for all.

The implications of the attempt to force the Eurozone to mimic the path to adjustment taken by Germany in the 2000s are profound. For the Eurozone it makes prolonged stagnation, particularly in the crisis-hit countries, probable….Not least, the shift of the Eurozone into surplus is a contractionary shock for the world economy.

Wolf thinks that the chances are good that many European countries will suffer from economic stagnation for a long time, putting an economic drag on the entire European and global economies.

Secular stagnation?

Clearly Wolf regards many of our economic problems as secular (long-term) rather than just cyclical (tied to phases of expansion and contraction). He believes that developed countries with aging populations can expect to experience slower economic growth from now on. “Not only will the labour force shrink absolutely in many countries, as the population falls, but the proportion of it that is young, flexible and innovative will decline further.”

I’m not entirely convinced of that, especially the part about innovation. Age may be related to innovation, but so are education and occupation; consider Richard Florida’s The Rise of the Creative Class. Slower population growth does reduce one obvious reason for new investment–the need to expand the quantity of existing goods and services–but there can still be innovations in type and quality. And even if businesses do find it harder to come up with things to invest in–which I gather is Wolf’s point–a thriving economy remains possible as long as enough income finds its way into the hands of those who will use it for something useful. These could be working families trying to raise children, or governments trying to fund improvements in infrastructure or education. They certainly don’t have to be wealthy financiers squandering the world’s income on risky loans.

Neither economic evil–stagnation on the one hand or credit binge on the other–is inevitable. Wolf helps us understand how we might avoid them, if we have the wisdom and the will. However, the author himself is not sure that we do.