Democracy and Prosperity (part 4)

July 22, 2019

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Previous posts on Iversen and Soskice’s Democracy and Prosperity have discussed the symbiotic relationship between democracy and capitalism, democratic support for capitalism during the revolution in information and communications technology, and variations among advanced capitalist democracies (ACDs) in their original path to democracy, electoral systems, economic inequality and educational opportunity.

This final post will discuss three challenges facing ACDs today: global financial instability, populism, and artificial intelligence/robotics. The focus will be on the United States as a country with a relatively weak and politically fragmented labor movement; a two-party, majority-rule electoral system; and a recent trend toward high inequality and low social mobility.

Global financial instability

The financial crisis of 2008 occurred around the time that “governments were implementing the broad set of reforms that we have argued created the foundation for the knowledge economy.” That raises the question, “If the reforms were intended to produce prosperity, how did the crisis happen?”

Iversen and Soskice focus on the fact that different democracies responded to the opportunities presented by technological change by promoting different segments of their economies. While Germany and Japan promoted their “high value-added export sectors,” the U.S. and U.K. promoted their “high-risk financial sectors.” In the U.S., loose financial regulations allowed highly leveraged financial institutions (HLFIs) to accumulate high-risk assets such as bundles of shaky mortgages. Americans became global debtors, consuming more than they produced, while exporting countries became global creditors. This could work because creditor nations were willing to accept payment for their goods in dollars and then lend those dollars back to us, often providing “short-term loans to the HLFIs to cover the acquisition of a large proportion of the risky assets–that is, securitized loans–that financed the consumption.” Government fiscal policy sustained the imbalance by running deficits–also partly financed by foreigners–spending more dollars than it took out in taxes. Government too thus enabled Americans to consume more than they produced.

The market value of risky financial assets collapsed once debtors became overextended and started to default, triggering the global financial crisis. Although the global economy has recovered–more or less–from the Great Recession that followed, the fundamental imbalance remains, portending additional instability in the future.

How could the U.S. economy be put on a more solid footing? If all that the government would do is balance the budget by cutting spending, the result might only be lower incomes and economic contraction, without a real increase in national production. Sustainable economic growth may require both more private investment in productivity-enhancing innovations and public investment in education and training. However, such changes may lack the support of capitalists who are already making money accumulating financial assets they think are sound, or those workers who already have good educations and incomes.


The authors define populism as:

…a set of preferences and beliefs that rejects established parties and elites, that sees established politicians as gaming the system to their own advantage, and that at the same time sees the poor as undeserving of government support. Above all it opposes immigrants, who are always counted among the undeserving…,and it rejects the cosmopolitan outlook associated with the rising cities in favor of the traditional family, conforming sexual orientations, and nationalism.

The authors see the re-emergence of populism as the most important shift in politics of the last forty years. They see growing economic inequality, falling social mobility, and the aftermath of a major economic crisis as especially conducive conditions. They find populist values especially widespread in democracies relatively low on educational opportunity, such as the United States, South Korea, Japan and Italy.

The adherents of populism are usually members of the “old middle classes,…those who have experienced stagnating wages because of skill-biased technological change, outsourcing, or import competition.” Although populism is not simply a backlash against cultural changes like racial integration, feminism, or gay rights, it does have a cultural dimension that is related to economic change. The urban “agglomerations of knowledge” that are at the center of the new economy encourage a “tolerance of diversity and cosmopolitan values.” The industrial work ethic that encouraged simple conformity and submission to authority has given way to a more flexible lifestyle, one that is open to new ideas wherever they come from. But workers who lack the education and income to live in the cities remain in–or move to–smaller towns containing old middle-class enclaves. There they practice “a nativist version of the old social contract, which is based on notions of working hard…, obeying the rules, observing traditional family values, and attachment to the nation.” They may become encapsulated, and feel both economically and culturally devalued outside of those enclaves.

In electoral systems with proportional representation, populists can achieve influence by forming a minority party, just as socialists often do. In a majoritarian system like the U.S., populists need the support of a major party, and they have currently found it in the Republican Party. Iversen and Soskice see populists as a minority even there, and they do not explain why so many Republicans would find common ground with Donald Trump. I think it’s because Republican economic policies are increasingly blamed for growing inequality–their previous presidential candidate ran on trickle-down economics and lost–and they have increasingly appealed to white nativists and Christian conservatives in the hope of saving their Reagan-Bush era majority.

The authors do not regard populism as a serious threat to the technologically advanced economy or the democratic state, for several reasons:

  1. Populist economic resentments are directed less at the advanced economy itself than at poor people and immigrants, who I would say get unfairly blamed for middle-class status anxiety;
  2. Too many people are benefiting from economic and cultural change to give the populists a sustained majority;
  3. “Populism can be readily undermined by public policies designed to open educational opportunities for more people.”

I suspect that mainstream political parties will need to address the legitimate opportunity concerns that are fueling populism, but also repudiate many of its reactionary and undemocratic sentiments. If a major party can remain popular while doing neither of those things, as the Republicans are attempting, then democracy is in more trouble than this book acknowledges.

Artificial intelligence and robotics

The revolution in information and communications technology is only in its early stages. Further transformations of work and economic organization are to be expected, especially in the areas of artificial intelligence and automated mechanical systems.

Many of those who try to anticipate further change are technological optimists but social pessimists. Writers such as Martin Ford (The Rise of the Robotshave a very expansive view of what AI can do, but are very worried about the prospects for human displacement and unemployment. On the other hand, Robert Gordon (The Rise and Fall of American Growth) sees information and communication technologies as only modest contributions to the history of economic change, not transformative enough to make huge difference to human work or productivity.

Iversen and Soskice take an intermediate position. They do think that new technologies can substantially change how work is done, but they stress their potential to complement human labor rather than substitute for it. As they pose the issue, “[I]f AI and robots can replicate the cospecificity of skill clusters by essentially generating de novo the knowledge that otherwise emerges from human inter-action and exchange of ideas, then educated workers and technology would no longer be necessary complements to technology.” What computers do best is implementing algorithms, that is, slavishly following a routine that humans have already come up with. But “a key function of decentralized production networks is to develop new solutions to complex problems in uncertain environments. The objective of innovation is to develop new algorithms, as opposed to merely optimizing old ones.”

Only when and if computers can be taught to think as creatively as humans can we speak of massive substitution rather than complementarity. The authors don’t even rule out a merger of humans and machines into a new species through bioengineering, but such dreams seem a long way off.

In the meantime, workers will increasingly need the education and skills to work with the machines. There will be winners and losers, but ultimately the results will depend on democratic politics, not just technology.

This points to an optimistic conjecture: even as new technology replaces more jobs, the advanced sectors are location-specific and can support policies that ensure broad sharing of the benefits of a more productive economy based on broad, although never all-encompassing, electoral coalitions.

What those coalitions can demand is public investments in human capital to make citizens productive contributors to the knowledge economy. The authors see that as the key to sustaining the mutually beneficial relationship between capitalism and democracy. “What ultimately makes democratic capitalism resilient in the face of technological change and the rise of the populist challenge is the continued expansion of education combined with opportunity in the advanced sectors.”

Even if the number of workers displaced by technology becomes very large, democratic politics could demand a new form of welfare state, not to pay people not to work, but to support them in meaningful forms of work that are not rewarded by the market. Maybe they could stay home and care for their children, and yet share the benefits of a high-productivity, automated society, because society agreed that they deserved to.

Viking Economics (part 2)

June 26, 2017

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How did the Nordic countries, which are in many ways similar to other developed countries, arrive at their unusual blend of economic equality and prosperity? Lakey tries to answer that question with a narrative featuring some of the key events and personalities, but he does not attempt any serious comparative analysis of countries to sort out causes and effects.

One thing that is clear is that the Great Depression of the 1930s was a significant turning point, as it was in the United States. Strong pro-labor parties succeeded in moving politics to the left and gradually building mass support for egalitarian policies. For some reason, those policies went further in the Nordic countries, perhaps because those countries were economically weaker to begin with and more vulnerable to economic downturns. Once a distinctive Nordic model became established, it was able to weather some counterattacks from more conservative elements, as well as financial crises that forced governments to make tough political choices.

From conflict to consensus in Norway and Sweden

Lakey emphasizes that the more egalitarian Nordic model did not emerge without a struggle. He describes the countries a century ago as having huge wealth gaps and politically dominant elites.

In Norway, the early twentieth century was a period of trade union organization, formation of cooperatives, and rising nationalism. Norway dissolved its union with Sweden in 1905. The Norwegian Labor Party flirted with radicalism, joining the Communist International in 1918. Five years later, however, the movement split over the communist issue. Some workers left to form the Communist Party of Norway, but the Norwegian Labor Party became more dominant by attracting many farmworkers, small farmers and students as well as politically moderate workers.

During the Depression, some business owners and right-wing politicians supported violent measures to suppress the labor movement, but the movement proved too popular for them. In 1935, owners and labor leaders forged the “Basic Agreement” recognizing the rights of both capital and labor. “Labor leaders agreed that the owners could continue to own and guide their firms. Labor expected that their political instrument, the Labor Party, would restrict owners through government regulation and control the overall direction of the economy.”

For the next three decades, labor dominated politics. By the time the Conservatives got a change to govern, the basic elements of the Nordic model were established, with policies to promote full employment, regulate markets, and provide universal benefits paid for by taxpayers.

Similarly in Sweden, a violent government crackdown on striking workers in 1931 led to the fall of the government and the election of the labor-based Social Democrats. “Swedish voters reelected the Social Democrats to lead their society almost without a break until 1976, by which time the Nordic model was firmly established.”

Counter-movements and financial crises

In the 1980s, around the same time that Ronald Reagan and Margaret Thatcher were promoting tax cuts, reductions in government spending, and financial deregulation, similar policies were tried in Nordic countries. The failure of the Labor government to curb “stagflation,” a period of high unemployment and inflation, helped the Norwegian Conservative Party take control. In Sweden, the Social Democrats continued to govern, but also adopted some conservative measures to limit the power of government.

Lakey sees a direct link between financial deregulation in the 1980s and financial crisis in the 1990s. Banks had more freedom to make riskier and more speculative investments, often resulting in asset bubbles with prices reaching unsustainable levels. When the bubbles burst and banks experienced massive losses, Nordic governments moved to re-regulate banks and protect depositors, but not to bail out the banks and their shareholders. Both Norway and Sweden nationalized some of the largest banks, at least temporarily. By the time of the 2008 financial crisis, both countries were in a relatively strong position to handle it. “By 2011, the Washington Post was calling Sweden ‘the rock star of the recovery,’ with a growth rate twice that of the United States, much less unemployment, and a strong currency.”

The story in Iceland is different because it was less an exemplar of the egalitarian Nordic model than Norway or Sweden. Its labor-based political party, the Social Democratic Alliance, had always been a minority party, and the government spent less on health and education. Iceland did have collective ownership of major banks, through government and cooperatives, but they moved toward financial deregulation and privatization in the late 1990s. “The now-private banks leveraged their capital base [that is, used it to borrow and speculate] to buy up assets worth several times Iceland’s gross national product.” When the crash came in 2008, the entire banking sector collapsed, taking the country’s currency with it. The political result was Iceland’s first left-wing government, a coalition of the Social Democratic Alliance and the Left Green Movement. Although Iceland needed assistance from the International Monetary Fund and other countries, the new government resisted IMF demands for austerity, insisting on a deal that protected workers, homeowners and depositors while letting banks fail. Lakey describes the Icelandic recovery as an economic success, getting unemployment down to 3.2% by 2015.

Having come through a time of political and financial upheaval with their social democratic principles largely intact, Nordic countries may now be in a good position to tackle the challenges of the global, high-tech economy.





May 3, 2016

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Paul Mason. Postcapitalism: A Guide to Our Future. New York: Farrar, Straus and Giroux, 2016.

Paul Mason is a British freelance journalist and economics writer. He is a bold, creative thinker who challenges a lot of mainstream economic thinking. Here he has written an especially insightful and thought-provoking book, one that deserves serious attention and debate.

Mason’s title may make his book sound like a speculative, utopian work, but the future he envisions doesn’t drop out of the sky. It emerges naturally from his understanding of both the recent and earlier history of capitalism. For those who think that something as pervasive and entrenched as capitalism cannot possibly wind down, he offers this observation: “It is absurd that we are capable of witnessing a 40,000-year-old system of gender oppression begin to dissolve before our eyes, and yet still seeing the abolition of a 200-year-old economic system as an unrealistic utopia.”

Another stumbling block for readers may be Mason’s frankly Marxian perspective, although his is a revised version with no “dictatorship of the proletariat.” (Today he sees the educated and networked individual as the key agent of change.) I have some reservations about a few of his arguments, especially concerning the labor theory of value, but that hasn’t stopped me from agreeing with many of his conclusions about the future.

Capitalism’s bleak prospects

Mason begins his book by saying that “the long-term prospects for capitalism are bleak. According to the OECD, growth in the developed world will be ‘weak’ for the next fifty years. Inequality will rise by 40 per cent.”

If we keep going as we have been, we face two alternative futures, neither very pleasant:

  1. Economic globalization continues, but only the wealthy in the developed countries get much benefit from it; or
  2. Popular opposition to globalization grows, global cooperation breaks down, and more nationalist and authoritarian governments emerge, as in the 1930s. Each country tries to save itself at the expense of others, such as by putting up trade barriers to other country’s manufactured goods [See Trump, Donald].

And either way, things get worse in mid-century when the full effects of climate change and demographic change (the challenge of supporting larger and older populations) are felt.

New technologies yes, capitalism maybe not

Mason believes that a better alternative is to take advantage of the potential for new technologies to end capitalism as we know it. Economic problems such as over-reliance on fossil fuels and stagnating wages result from trying to perpetuate a system that no longer works very well. “Capitalism is a complex, adaptive system which has reached the limits of its capacity to adapt.” Although capitalism has a long history of generating technological change, it can no longer adapt to such change because it is now creating technologies that are ultimately incompatible with capitalism itself.

“Information is different from every previous technology,” Mason declares. “Its spontaneous tendency is to dissolve markets, destroy ownership and break down the relationship between work and wages.” Information is different because, unlike other means of production, it can be reproduced at near-zero cost. If I were to give you my car I would lose a car, but what have I lost if I give you an idea? It costs me nearly nothing to share these thoughts with you, so why should I expect you to pay for them? Why would people buy an encyclopedia when Wikipedia is free, or buy a newspaper when so much news is available online?

In addition to widely disseminating “information goods,” the information revolution also “adds a high information content to physical goods, sucking them into the same zero-price vortex….” In a fully automated production system, the key resource is the set of instructions for turning raw materials into finished products. “The knowledge content of products is becoming more valuable than the physical elements used to produce them.” Once the knowledge exists, many users can apply it with little additional cost.

A world of abundant information should also be a world of abundant things produced by automated, information-driven processes. That undermines capitalist markets, since “markets are based on scarcity while information is abundant.” As industrial robots proliferate, the need for paid human labor should diminish. Earlier technological innovations like the assembly line already shortened the work week while simultaneously raising living standards for workers. The more radical change Mason envisions now will free vast amounts of labor from paid employment. Much of that labor can go into voluntary but socially useful activity, whether it is caring for a loved one or making music. Consumers too should experience some liberation from capitalist markets, as more goods and services become available at little or no cost. “We are seeing the rise of non-market production: horizontally distributed peer-production networks that are not centrally managed, producing goods that are either completely free, or which…have very limited commercial value.”

Capitalists can impede this transition, but only by monopolizing information in order to restrict its free flow and maintain its artificial scarcity. Intellectual property rights will be a key issue. Society will have to balance the need to grant such rights in order to reward the producers of new knowledge, against the need to limit such rights in order to facilitate the free spread of information. In the end, Mason doesn’t think that capitalists will be able to own or control the intellectual means of production the way they have owned and controlled other means of production. “The main contradiction today is between the possibility of free, abundant goods and information and a system of monopolies, banks and governments trying to keep things private, scarce and commercial.”

Dramatic changes, conflicts and crises have been common in the history of capitalism. As profit-making opportunities have declined in old industries, capital has repeatedly sought out new markets and new technologies. Always, however, the assumption of industrial capitalism was that people would depend on the owners of centralized means of production for both employment and products. What makes the current crisis different is that knowledge is so easily decentralized, and networked individuals can create so much of value on their own. Global corporations continue to make their profits for now, but they do so increasingly by squeezing the workers and damaging the environment. New technologies that could produce more freedom and abundance for all while better protecting the planet are not yet allowed to do so.

Mason’s argument that abundance will reduce market activity and expand non-market activity makes a lot of sense to me, but I’m not sure how far to take it. The most obvious example is the displacement of human labor from manufacturing production as automation takes control. Many low-skill service jobs could also be automated, although the availability of cheap labor reduces the incentive to make the transition. But I would expect there to be a continuing market for skilled services because not everyone will be willing or able to provide them. A lot of free legal information is available online, but that doesn’t mean that everyone is comfortable being their own lawyer. And although an abundance of goods and services may make them cheaper, only if they become entirely free will the need for money and marketplace exchanges disappear entirely. While some people, especially the more educated, may experience a reduction in paid work hours as a blessing, others may experience it as the curse of unemployment or poverty. Mason’s postcapitalist world will require massive investments in human capital and a stronger safety net for the economically displaced.

The limits of neoliberalism

Standing against Mason’s vision of the future is the set of ideas and policies known as neoliberalism. That is the most recent incarnation of the free-market economics that was considered liberal in the eighteenth and nineteenth centuries, but is associated with conservatism today. Mason defines it as a commitment to uncontrolled markets, the pursuit of self-interest through the market, the small state, and a high tolerance for financial speculation and inequality. On the one hand, he credits neoliberalism for unleashing the information revolution and promoting economic development, especially in poorer countries. On the other hand, he blames the uncontrolled pursuit of profit for aggravating economic inequality and endangering the global environment.

Although neoliberal policies have brought capitalism to a crisis point, neoliberal theory is poorly equipped to understand crisis or radical transformation. Neoliberals believe that markets are essentially rational and self-correcting. If left to their own devices, they tend toward equilibrium, not crisis. For neoliberals, capitalism is just the normal state of affairs, a “continuous present.” Writing with more than a little sarcasm, Mason says that neoliberal economics has a “brilliant model for understanding forms of capitalism that do not change, mutate or die. Unfortunately these do not exist.”

Neoliberal policy and practice has kept capitalism as we know it limping along by relying on loose monetary policy, dramatic growth of the financial sector, and global imbalances between creditor and debtor nations. Specifically:

  1. “Fiat money,” which is money that a state can create freely as long as people have confidence in it, has allowed central banks to counteract stock market drops by pumping cheap money into the economy. When this money inflates the prices of stocks and other assets beyond realistic earnings prospects, boom becomes bust.
  2. As real wages have stagnated, consumer spending has been sustained more by credit and borrowing. By the time of the 2008 financial crisis, 40 percent of corporate profits were coming from the financial sector. Profits must eventually fall if they depend too much on the accumulation of debt.
  3. Neoliberal policies have created debtor countries as well as indebted consumers. “For countries that smashed organized labor, offshored large parts of their productive industries and fueled consumption with rising credit, the outcome was always going to be trade deficits, high government debts and instability in the financial sector.” Debtor nations like the United States require other countries, such as China, Germany and Japan, to be creditor countries. When the burden of debt becomes too great to sustain, countries resist and the system breaks down.

Since the recent financial crisis, neoliberal policy has turned toward imposing austerity on the debtors, while not addressing the reasons for the expansion of debt in the first place. Mason regards the economic recovery as only a temporary fix, since the underlying weaknesses have not been corrected. The real existential crisis of capitalism itself is only beginning.

The most important limit on the neoliberal system is information technology, which is put to the service of the existing capitalist system in the short run, but undermines it in the long run.

And that’s just the introduction and Chapter 1! My next post will look at the historical part of Mason’s argument, his interpretation of the “long cycles” in capitalist history.


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.

The Shifts and the Shocks (part 2)

December 17, 2014

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The second part of Martin’s Wolf’s The Shifts and the Shocks examines the deeper economic causes of the financial crisis. “This crisis was the product not just of easily fixable failings in the financial sector….It was also the product of failings of the global economic system….Moreover, both are among the consequences of fundamental shifts in the world economy.”

Wolf’s interest in looking for deeper causes sets his book apart from more superficial treatments that just blame the crisis on easy credit, foolish borrowing, and loose monetary policy by the Federal Reserve. Wolf regards these as symptoms rather than underlying causes. Returning to full employment and high economic output may be harder than most people realize, since it will require addressing some fundamental economic problems.

This part of the book is divided into two chapters: “How Finance Became Fragile” and “How the World Economy Shifted.” Again, his approach is to examine financial effects before economic causes, so the reader must follow the argument all the way through to arrive at the key conclusions.

How finance became fragile

Financial crises have been endemic to capitalism. The financial system often fluctuates between phases of boom and bust, optimism and pessimism, credit expansion and credit contraction. Wolf summarizes Hyman Minsky’s description of five stages in a financial bubble:

‘displacement’ – a trigger event, such as a new technology or falling interest rates; ‘boom’ – when asset prices start rising; ‘euphoria’ – when investors’ caution is thrown to the wind; ‘profit-taking’ – when intelligent investors start taking profits; and ‘panic’ – a period of collapsing asset prices and mass bankruptcy.

For the most recent episode of credit boom and bust, Wolf identifies five factors that contributed to financial fragility:

  • a trend toward financial liberalization and weakening of financial regulations
  • globalization of banking, lending and holdings of assets
  • financial innovations such as derivatives and shadow banking (trading of asset-backed securities)
  • leveraging (holding more debt relative to equity, magnifying returns on the upside but also losses on the downside)
  • incentive systems that rewarded risk-taking and short-term success

He also identifies three failures of policymakers:

  • underestimating the need for regulation
  • focusing monetary policy on controlling inflation, while overlooking other sources of instability
  • not intervening in the banking collapse soon enough (specifically, letting Lehman Brothers fail)

How the world economy shifted

Once again, Wolf emphasizes that despite all of these financial weaknesses, “the failure does not lie only or even mainly within the financial system or with financial regulators. The crisis had wider economic causes–and consequences.” In particular, the boom in easy credit and excessive lending depended on what Ben Bernanke called–even before the crisis–a “global savings glut.” Wolf argues that this should also be thought of as an “investment dearth,” or a problem of balancing savings and investment. The issue is sustaining economic activity by using the money not spent on consumption for investments in future production.

To a degree, investment adjusts to savings through fluctuations in interest rates. If the desire to save is greater than the desire to invest in the means of production, interest rates fall, capital becomes cheap, and balance is restored by discouraging saving (through low return) and encouraging investment (through low cost). But in an economic slump, this balancing mechanism can fail to put capital to productive use. People may choose to sit on cash, neither spending it nor buying low-interest bonds, and businesses may refrain from investing in production because the demand for products is so weak. “In brief, Mr. Bernanke’s global savings glut would be visible in a combination of two phenomena: weak economies and/or low interest rates. Today, this combination is precisely what we see in the high-income countries.”

What caused the global savings glut was primarily a shift in many emerging economies, especially China, from being net importers of capital to being net exporters of capital. Although it has been common for investors in developed countries to find investment opportunities in less developed ones, some of the latter prefer to avoid dependence on foreign capital. They choose to strengthen their economies by encouraging saving over spending, financing their own industries, emphasizing exports over domestic consumption and running trade surpluses. At the same time, some developed countries, especially Germany and Japan, were also becoming net exporters of goods and capital, partly because their aging, slow-growing populations required less investment in new infrastructure and capital equipment at home. In the words of Raghuram Rajan, “So long as large countries like Germany and Japan are structurally inclined–indeed required–to export, global supply washes around the world looking for countries that have the weakest policies or the least discipline, tempting them to spend until they simply cannot afford it and succumb to crisis.”

The largest of such countries was, of course, the United States, whose own industries were threatened by the ease with which American consumers could buy foreign goods. Making that situation worse was the strong American dollar–still the world’s most popular currency for holding cash reserves–which made American products more expensive and foreign products cheaper. However, the glut of foreign savings seeking investment opportunity brought interest rates down, discouraging saving and making it easier for Americans to buy expensive things on credit, especially housing. Investors who were reluctant to invest in faltering American manufacturing could invest in mortgage loans, including very shaky ones, which were packaged in clever ways to disguise the risks. So there was a credit boom that took multiple forms: creditor countries like China and Germany lending to debtor countries like the United States and Greece, an exploding finance industry lending to consumers within the United States, and rich investors around the world financing the US government deficit.

For most of the years leading up to the financial crisis, US business remained highly profitable, and contributed to the savings glut by running large surpluses. “With rising profits and a weak desire to invest, the non-financial corporate sector became a net supplier of savings to the rest of the economy.” The only way to keep the economy humming was for households and government to absorb excess savings by running deficits. “Persuading the household sector to spend consistently more than its income is quite hard,” Wolf says, but it was managed with easy credit. I would add that getting a Republican administration to accept large deficits ought to be hard too, but it was managed with tax cuts and wars.

One additional contributor to the savings glut and credit boom was rising economic inequality. “Finally, there was a huge shift in the distribution of income inside many economies, notably including high-income countries, from wages to profits, and, within wages, from those at the middle and bottom towards the top, partly due to globalization, partly due to technology, partly due to financial liberalization, and partly due to changes in social norms, particularly corporate governance.” While those with higher incomes could afford to save more, those with lower incomes relied more on credit to sustain consumption.

In the end, the global savings glut resulted in a massive waste of economic resources, as too little capital was put to productive use. “Instead, the resources were wasted in building unneeded and unaffordable houses or in fiscal deficits caused by unfunded wars, unfunded entitlement spending and unfunded tax cuts. The capital imported by the US, in particular, was wasted on a colossal scale.”

The final post on Wolf’s book will deal with ideas for putting the global economy on a more sustainable footing.