For a year or so following the financial crisis, the recovery strategy in most countries was based on a renewed belief in activist government—stimulus packages, bailout of key industrial and financial firms and even talk of (and some action on) industrial policy, notably related to “green growth”.
Since then, however, a different kind of recovery strategy has been on the ascendancy. This strategy believes that recovery requires a dramatic cut in government spending, minimal tax increases (ideally tax cuts for the rich) and deregulation.
Unfortunately, this strategy is not going to lead to a sustainable recovery. Why? Because it is based on false premises. Here are five of them.
1. Reduction in government deficits is the prerequisite for recovery.
The assumption underlying the current dominant recovery strategy is that there is a private sector rearing up to rush in, as soon as the government makes way by reducing deficits. However, at the moment, the problem is of weak private sector demand, not the crowding-out of private sector by an aggressively expanding government.
The dramatic slowdown of the U.S. and the U.K. economy in the last few quarters, following the exhaustion of earlier stimulus packages, is a reminder of such realities. Reduction in government deficits in the face of weak private sector demand will weaken, or even reverse the recovery.
Moreover, cutting deficits in the short run may not even reduce the deficits very much in the long run because the resulting economic slowdown will reduce government revenue. The financial market knows this, even while it clamours for deficit reduction, as evidenced by the continued downgrading of the European periphery countries by credit rating agencies despite their heroic efforts at massive spending cuts.
2. Deficits should mainly be reduced by cutting welfare spending. The current strategy recommends deficit cuts to be achieved mainly by cutting expenditure, especially welfare spending, rather than raising revenues. This is on the grounds that current deficits are mainly due to excessive “populist” spending on social welfare.
However, with the possible exception of Greece, much of the current deficits have been generated by the fall in tax revenues due to the economic downturn, rather than by excessive welfare spending. So the ultimate solution should be an increase in government revenue through growth.
If demand shortfall is the problem, as it is at the moment, cutting welfare spending can exacerbate the problem. People who are net welfare recipients, generally poorer people, have a higher propensity to consume, so taking money away from them will reduce demand, at least in the short to medium run.
3. Cutting welfare spending is good for growth in the long run.
But how about the long-term impacts? Whatever the effects of welfare spending cuts in the short run, don’t we need to reduce the welfare state in order to promote growth in the long run since it diverts valuable investible resources into consumption? And does it not make workers less flexible and resistant to changes in the work place and jobs by diminishing their fear of unemployment?
No, the view that welfare spending is anti-growth is unwarranted. For example, using World Bank data it is possible to show that Scandinavian countries, despite having welfare states more or less double the size of that in the U.S. (as proportions of GDP), have grown faster than the U.S. throughout the post-World War II period. Even after 1990 (1990-2008), when the U.S. was supposed to have entered an economic renaissance (well, at least until the 2008 crisis), the two fastest growing economies, in per capita terms, in the core OECD group were Finland (2.6%) and Norway (2.5%), with the U.S. notching up only 1.8%, tied with Sweden. If we count only the 2000s (2000-2008), the growth rates of Sweden (2.4%) and Finland (2.8%) were far superior to that of the U.S. (1.8%).
The Scandinavian experiences have been possible because a well-designed welfare state can make people more, rather than less, accepting of changes. When assured that they can have a second or even a third chance in their lives through the welfare state, people become more adventurous with their career choices and more easily accept job restructuring and redundancies. All of this can promote economic growth.
4. Taxes for the rich should not be raised, if we are to promote growth.
As most strikingly manifested in the recent U.S. budget deal, the strong presumption behind the current recovery orthodoxy is that tax increases for the rich should not be used for deficit reduction so that these wealth creators can invest and generate growth; making the rich richer (at least no less poorer than they are now) will in the end make all of us richer, is the belief.
However, the record of the current generation of the rich in this regard has been dismal. Despite the rise in income inequality in most countries in the last three decades, economic growth has slowed down rather dramatically—the world economy grew at 3.2% in per capita terms between 1960 and 1980, while it grew at 1.4% between 1980 and 2009.
Nowhere has the failure of the rich been as evident as in the U.S.. According to the Economic Policy Institute, a Washington D.C. think-tank, between 1979 and 2006 (the latest year of available data), the top 1% of earners in the U.S. more than doubled their share of national income, from 10% to 22.9%. The top 0.1% did even better, increasing their shares by more than three times from 3.5% in 1979 to 11.6% in 2006. Despite getting such a bigger share of national output, the rich in the U.S. have failed to increase the growth rate. The U.S. growth rate in per capita terms since 1980 has been around 1.8%, which is the same rate as the one seen between 1950 and 1980.
So, figuratively speaking, the Americans have been paying their “wealth creators” two to three times more than before to get the same outcome. What makes people think that they will behave differently this time around?
5. Further deregulation is necessary for economic growth.
Another plank in the current recovery strategy is deregulation, so that the wealth creators have less constraints. In Britain, there is talk of another bout of deregulation to cut the “red tape” away. In the U.S., there is a growing call to dilute and/or delay the Dodd-Frank financial reform act in order to aid recovery.
However, regulations can actually promote growth by limiting the ability of firms to engage in activities that bring them greater profits in the short run but harm the overall economy and thus, the firms themselves in the long run.
For example, individual banks may benefit from lending more aggressively. But when all of them do the same, they may all suffer in the end, as such lending behaviors may increase the chance of systemic collapse, as we have seen in the 2008 crisis. Given this, the proposal to dilute the Dodd-Frank is highly misguided.
Moreover, many governments have actually helped economic growth by doing things that the private sector wouldn’t do. The success of activist industrial policies conducted by countries like Japan, France, Korea until the 1980s and China today are probably well known, but many other governments have also helped economic growth through spending on infrastructure and R&D.
The U.S. is a prime example. Most of the industries where the U.S. maintains an international technological edge have been created, and often maintained, by aggressive federal funding of R&D and public procurement programs—aircraft, computer, semi-conductors, Internet, pharmaceutical, just to name the most important ones.
Source: http://blogs.wsj.com
Since then, however, a different kind of recovery strategy has been on the ascendancy. This strategy believes that recovery requires a dramatic cut in government spending, minimal tax increases (ideally tax cuts for the rich) and deregulation.
Unfortunately, this strategy is not going to lead to a sustainable recovery. Why? Because it is based on false premises. Here are five of them.
1. Reduction in government deficits is the prerequisite for recovery.
The assumption underlying the current dominant recovery strategy is that there is a private sector rearing up to rush in, as soon as the government makes way by reducing deficits. However, at the moment, the problem is of weak private sector demand, not the crowding-out of private sector by an aggressively expanding government.
The dramatic slowdown of the U.S. and the U.K. economy in the last few quarters, following the exhaustion of earlier stimulus packages, is a reminder of such realities. Reduction in government deficits in the face of weak private sector demand will weaken, or even reverse the recovery.
Moreover, cutting deficits in the short run may not even reduce the deficits very much in the long run because the resulting economic slowdown will reduce government revenue. The financial market knows this, even while it clamours for deficit reduction, as evidenced by the continued downgrading of the European periphery countries by credit rating agencies despite their heroic efforts at massive spending cuts.
2. Deficits should mainly be reduced by cutting welfare spending. The current strategy recommends deficit cuts to be achieved mainly by cutting expenditure, especially welfare spending, rather than raising revenues. This is on the grounds that current deficits are mainly due to excessive “populist” spending on social welfare.
However, with the possible exception of Greece, much of the current deficits have been generated by the fall in tax revenues due to the economic downturn, rather than by excessive welfare spending. So the ultimate solution should be an increase in government revenue through growth.
If demand shortfall is the problem, as it is at the moment, cutting welfare spending can exacerbate the problem. People who are net welfare recipients, generally poorer people, have a higher propensity to consume, so taking money away from them will reduce demand, at least in the short to medium run.
3. Cutting welfare spending is good for growth in the long run.
But how about the long-term impacts? Whatever the effects of welfare spending cuts in the short run, don’t we need to reduce the welfare state in order to promote growth in the long run since it diverts valuable investible resources into consumption? And does it not make workers less flexible and resistant to changes in the work place and jobs by diminishing their fear of unemployment?
No, the view that welfare spending is anti-growth is unwarranted. For example, using World Bank data it is possible to show that Scandinavian countries, despite having welfare states more or less double the size of that in the U.S. (as proportions of GDP), have grown faster than the U.S. throughout the post-World War II period. Even after 1990 (1990-2008), when the U.S. was supposed to have entered an economic renaissance (well, at least until the 2008 crisis), the two fastest growing economies, in per capita terms, in the core OECD group were Finland (2.6%) and Norway (2.5%), with the U.S. notching up only 1.8%, tied with Sweden. If we count only the 2000s (2000-2008), the growth rates of Sweden (2.4%) and Finland (2.8%) were far superior to that of the U.S. (1.8%).
The Scandinavian experiences have been possible because a well-designed welfare state can make people more, rather than less, accepting of changes. When assured that they can have a second or even a third chance in their lives through the welfare state, people become more adventurous with their career choices and more easily accept job restructuring and redundancies. All of this can promote economic growth.
4. Taxes for the rich should not be raised, if we are to promote growth.
As most strikingly manifested in the recent U.S. budget deal, the strong presumption behind the current recovery orthodoxy is that tax increases for the rich should not be used for deficit reduction so that these wealth creators can invest and generate growth; making the rich richer (at least no less poorer than they are now) will in the end make all of us richer, is the belief.
However, the record of the current generation of the rich in this regard has been dismal. Despite the rise in income inequality in most countries in the last three decades, economic growth has slowed down rather dramatically—the world economy grew at 3.2% in per capita terms between 1960 and 1980, while it grew at 1.4% between 1980 and 2009.
Nowhere has the failure of the rich been as evident as in the U.S.. According to the Economic Policy Institute, a Washington D.C. think-tank, between 1979 and 2006 (the latest year of available data), the top 1% of earners in the U.S. more than doubled their share of national income, from 10% to 22.9%. The top 0.1% did even better, increasing their shares by more than three times from 3.5% in 1979 to 11.6% in 2006. Despite getting such a bigger share of national output, the rich in the U.S. have failed to increase the growth rate. The U.S. growth rate in per capita terms since 1980 has been around 1.8%, which is the same rate as the one seen between 1950 and 1980.
So, figuratively speaking, the Americans have been paying their “wealth creators” two to three times more than before to get the same outcome. What makes people think that they will behave differently this time around?
5. Further deregulation is necessary for economic growth.
Another plank in the current recovery strategy is deregulation, so that the wealth creators have less constraints. In Britain, there is talk of another bout of deregulation to cut the “red tape” away. In the U.S., there is a growing call to dilute and/or delay the Dodd-Frank financial reform act in order to aid recovery.
However, regulations can actually promote growth by limiting the ability of firms to engage in activities that bring them greater profits in the short run but harm the overall economy and thus, the firms themselves in the long run.
For example, individual banks may benefit from lending more aggressively. But when all of them do the same, they may all suffer in the end, as such lending behaviors may increase the chance of systemic collapse, as we have seen in the 2008 crisis. Given this, the proposal to dilute the Dodd-Frank is highly misguided.
Moreover, many governments have actually helped economic growth by doing things that the private sector wouldn’t do. The success of activist industrial policies conducted by countries like Japan, France, Korea until the 1980s and China today are probably well known, but many other governments have also helped economic growth through spending on infrastructure and R&D.
The U.S. is a prime example. Most of the industries where the U.S. maintains an international technological edge have been created, and often maintained, by aggressive federal funding of R&D and public procurement programs—aircraft, computer, semi-conductors, Internet, pharmaceutical, just to name the most important ones.
Source: http://blogs.wsj.com
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