And then we got this financial crisis, which seems on track to becoming the most severe economic downturn since the depression in the nineteen thirties. Some have simply tried to describe it as an aberration that should not be taken too seriously, like some extreme natural disaster that is unlikely to repeat itself for the next 100 years (“a once in a century event ” according to former US Central Bank president Alan Greenspan). Even if many of the events leading to the present disaster can perfectly be explained without recurring to too sophisticated economic theory, the crisis was not foreseen, stressing once again that existing economic and econometric models are extremely poor in predicting the occurrence of crises. They are often useful in predicting whether next year's growth will be one percent higher or lower than the presents year's, but not in predicting the turning of the tides.
What I shall provide here are some modest reflections on what may be some more systemic problems that have been accumulating during the last decades. The reason for this modesty is that it seems that there are a lot of things in the international economy we do not understand very well. Not to say that the issues, which will be addressed here necessarily are the most important, but they are definitely worth reflecting about.
I shall here only discuss two phenomena, which may be important in the short to medium run, and one that I think is important in the long run.
Income distribution and purchasing power
The first one is related to income distribution. If we look at the way income is distributed between labour and capital (what is called the functional income distribution), this distribution has in the developed countries evolved in favour of labour in the period from the second world war to the late sixties or beginning of the seventies, after which labour's share has been dropping. The drop is seen almost everywhere, and it is not negligible (typically from 5-10% of GDP). Furthermore, there is also a tendency to increased income inequality, i.e. an increased spread between high and low-earning households.
This is not surprising at all. It is a likely and predictable outcome of the processes of globalisation and migration. Hundreds of millions of new workers in developing countries have been included in the global economy through increased trade, and that has weakened labour's bargaining power in the developed countries, particularly in the case of low-skilled workers in sectors exposed to competition (foremost in low and medium-tech industry). This has been reinforced by migration, which also typically has increased competition in low-skilled jobs, and particularly in services. The unsurprising corollary has been a weakening of the trade unions. There is no need to recur to complicated explanations for the decline of the unions, as e.g. the increased individualistic attitudes among the young wage earners or the lack of capacity of the trade unions to modernise and adapt to the new times (even if that has definitely also contributed). And, also unsurprisingly, the effect has generally been strongest where the opening up to trade and migration has been most radical.
When distribution becomes more unequal, savings normally go up and consumption down, as the better-off generally use a lower share of their income for consumption. This has not happened in the developed countries during the last decade, and the reason for this is the easier access to credit. So to put it bluntly: many wage earners have got a loan instead of a wage increase (and – a bit difficult to understand - seem to have been happy with that). Generally in the developing countries, but in particular in the US, this has lead to a steadily falling overall savings rate in the economy and to households being increasingly indebted. So the present credit crisis should not be so much of a surprise as over-indebted households fail to pay their loans back.
Wage has a dual character of representing a cost for the individual employer, and at the same time the wages collectively represent the purchasing power for what the employer is producing. So it is good for an employer if other employers increase their workers' wages, but he himself can escape from doing so. The development during the last couple of decades has therefore been the best of all worlds for the employers: profit has been growing faster than the economy in general, and still demand has grown also. This is what creates optimism among investors and hence more investment and more growth. But of course this can't go on indefinitely, at some moment labour's share of the income has to stabilise and the extraordinary profit growth comes to an end.
It may on this background be argued that to overcome the present crisis, what is needed in the developed countries (and in some developing countries also, particularly China) is – oh horror! – a general increase in wages. But given the present balance of power between labour and capital, this will no be easy to achieve. This is not likely to change, as the weak position of labour to a high degree is the result of the increased ability of capital to move around and relocate production. It could be argued that centralised wage setting at EU level could be a way of increasing labour's bargaining position, but this seems to be very far away. In the US it is at present even unthinkable.
The Asian savings craze
The second phenomenon is the interminable accumulation of foreign exchange reserves in principally (but far from only) the Asian countries. Almost all countries in the world, expect the US, have been running current account surpluses the last couple of years (which have been matched by the abysmal US deficit), but the biggest reserves have been accumulated by Japan, China and other Asian countries. In the case of China this surplus defies all logic. China is a developing country with an immense need for investments in infrastucture, education and health, but has instead been using an important part of its savings to finance the US government deficit and provide capital to US firms. According to economic theory, this makes sense only if the capital is used more profitably in the US than in China. But that is difficult to believe.
It is of course impossible for all countries to run a current account surplus – for any surplus there must be a deficit somewhere, as the sum is zero. Somebody has to buy what is produced – if not, it will not be produced at all. The question then is, why the Asian countries are so obsessed with running a current account surplus and accumulate reserves. At a global level, this is self-defying.
One of the reasons for this obsession can be found in the Asian financial crisis in 1997. In the years before the crisis, a liberalisation of the capital flows had resulted in an inflow of foreign capital, creating easy access to cheap loans (often denominated in foreign currency), bubbles in the real estate markets and rising current account deficits. The crisis led to a run on several Asian currencies (among these the Thai Bath, the Indonesian Rupiah and the Korean Won) that consequently were heavily devalued, and to avoid defaulting on their foreign debt several countries had to ask for help from the International Monetary Fund (IMF) (among these Thailand, Indonesia, South Korea and the Philippines). The crisis in these countries was not very different from the crisis hitting the US today, but the response required by the IMF was very different from what everybody now seems to agree is necessary in the US. Instead of providing liquidity, money supply was restricted. Instead of an expansionary fiscal policy to avoid a too severe drop in demand, government expenditure was cut back. Furthermore, a series of so-called “structural policy measures” were required, among these privatisation, breaking up and selling of crisis hit conglomerates and deregulation of the economy. In short, a neoliberal offensive.
As former World Bank Chief Economist, Joseph Stiglitz, explains: "I thought this was a mistake. For one thing, unlike the Latin American nations, the East Asian countries were already running budget surpluses. In Thailand, the government was running such large surpluses that it was actually starving the economy of much-needed investments in education and infrastructure, both essential to economic growth. And the East Asian nations already had tight monetary policies, as well: inflation was low and falling. (.. ) The problem was not imprudent government, as in Latin America; the problem was an imprudent private sector - all those bankers and borrowers, for instance, who'd gambled on the real estate bubble.” Evidence suggests that countries, which succeeded in avoiding an agreement with IMF, fared considerably better, among these China (which had not liberated capital flows) and Malaysia (which rejected an agreement with the IMF and chose to manage the crisis itself by introducing control with capital flows).
The conclusion that many Asian countries have drawn from this is that the worst that can happen to them is to have to ask IMF for help - “fall into the claws of the IMF” - , and to avoid that they have therefore started accumulating reserves of foreign exchange. And not only Asian countries, but also Middle East countries, Russia and many of the eternally “irresponsible” Latin American countries have run big surpluses and built up reserves.
This is a disaster for the international monetary system, but it is self-inflicted. The leading developed countries have for decades irresponsibly abused the IMF to impose their preferred economic model on other countries, and the consequence is that the organisation now fails to do what it was created for in the first place: maintining the stability of the international monetary system. During the last decade IMF has therefore become increasingly irrelevant. It has been losing its clientèle except for the poorest 25-30 developing countries that have no other choice than to continue to sign the conventional structural adjustment programmes with the organisation, while most middle-income countries have paid their loans back and cut relations with the IMF. The present crisis implies that the IMF suddenly has got some of the old clients back. It reacted more swiftly this time and has provided emergency loans with no onerous requirements as a condition. Priority has been given to the good pupils in the class, who are deemed to have “sound economic policies” (among these Mexico, El Salvador, Turkey, Iceland and some Eastern European countries), and where economic policy may not be deemed so sound, but where it is considered politically convenient, as Ukraine and Pakistan.
The lack of confidence of the middle-income developing countries in the IMF is a serious problem for the international financial system. When an important part of these countries try to accumulate reserves to withstand coming financial crisis they are actually provoking new crises. To save capitalism from itself, it is therefore paramount to completely redefine the IMF or to create another mechanism to fill that role. No serious attempt has been made yet (despite all the talk about the need for a new Bretton-Woods agreement), and as geopolitics is involved, it will not be easy. The Asian countries are mulling over the possibility of creating regional monetary mechanisms, which can fill part of the void, and so are the bigger Latin American countries (particularly Argentina and Brazil, the core countries of the MERCOSUR). If no action is taken, the whole international financial system built after the Second World War may fall apart.
The interminable drive for growth
The third issue, which is a long-term issue of increasingly less philosophical character, is the question of the relation of capitalism with economic growth. Capitalism has historically been an extremely forceful power creating economic growth. The limits to this growth are now showing up. Most resources on which growth has been based are not renewable and will be exhausted at some point in time. Some are particularly stressed, among these oil and water. To this comes that external effects (what we normally call pollution) are creating threats to the future of the planet, most importantly the climate change provoked by the emission of CO₂.
Capitalism seems to be closely linked to growth. As the famous expression by Marx states it: “Akkumuliert, akkumuliert! Das ist Moses und die Propheten!” (Accumulate, accumulate! That is Moses and the Prophets!). Can capitalism adapt to a world where accumulation is restrained? There is nothing in economic theory that indicates that this should be impossible. But in practice it is more doubtful.
The present problems with climate change could in principle be solved by putting a worldwide tax on hydrocarbons, highest for the most contaminating, as coal (and Canadian oil sands). Say a 200-dollar tax was put on each barrel of oil (or equivalent) with a commitment to keep it there. A lot of alternative solutions would then become profitable and use of hydrocarbons should start falling quite quickly as the world turns to wind, sun, hydropower or whatever, and total energy demand should also fall as energy becomes more expensive. This is a no-brainer - and even so it is unlikely to happen. The first reason is the vested interests in the energy and energy using sectors (as the car and airplane industry), which are extremely powerful. The second is that many tend to think that it will impede economic growth, i.e that the system is not compatible with high energy prices. The third is that there is no worldwide mechanism for concerted and binding action, so even if some countries agree, others will be free riders (as e.g. the US and Australia in the present Kyoto agreement). This is not to say that there is no way forward, but it is unfortunately likely that trying to accommodate everybody in a consensus agreement, the measures will be too little, too late. The first reactions to the present economic crisis are not very enticing as several countries are now subsidising their car industries or paying incentives to car-buyers, among these China (which has also lowered the already low gasoline price). So there are few signs of willingness to change the economic model based on cheap and abundant energy.
A corollary to the claimed impossibility to reconcile capitalism with low or no growth is the discussion on immigration in Europe. It is often claimed that immigration is a necessity as the population is greying. This amounts to saying that a society cannot function if the population is not growing, meaning that we are heading towards a crash somewhere in the future as everybody (except for madmen and quite a number of economists) knows that exponential growth cannot go on forever. If the way our society is organised really is incompatible with a stabilising population, then we have better start looking for some other way of organising it before it is too late.