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Feb 3rd 2016, 16:08 by Buttonwood
POLITICAL leaders, central bankers and economists are grappling with a whole
range of problems at the moment, while simultaneously facing a challenge to
their authority from populist parties who feel that the prevailing approach has
been mistaken. More than that, they argue that policies have been set more with
reference to the interest of the governing classes than to the concerns of the
ordinary voters.
Certainly, it is possible to look at economic history as a variant on the old
saying; he who pays the piper calls the tune. What determines economic policy?
Politicians will tack with the prevailing winds to ensure they stay in office.
Economic ideas will be adopted when they are useful to that process. To the
extent that groups gain economic power, political power will follow; think of
how, in 19th and early 20th century Britain, the middle classes and then the
factory workers got the vote. In turn, economists will try to grapple with the
problems that seem most relevant to the societies in which they live, but those
issues will be seen through the prism of the political power structure.
The dominant classical school of the 19th century emphasised the
self-stabilising nature of the economy. That approach suited the dominant
political class wealthy creditors who had little interest in an active
government, with the high taxes that implied. Their interest was in maintaining
the real value of their money, something that showed up in the use of the gold
standard and in the one area where official intervention was encouraged the
use of central banks to backstop the financial system.
America was an exception to this rule, with the Federal Reserve not established
until 1913. But America had a much more democratic political system than
Europe, with universal male franchise; there was strong support for free
banking, which allowed farmers easy access to credit. European political
leaders, who had fewer democratic constraints, paid more attention to the
rights of creditors.
The first world war, with its massive government intervention, along with high
taxes, debts and inflation, destroyed the old system. The attempts to rebuild
it in the 1920s were overwhelmed by the Great Depression; mass democracies were
simply unwilling to impose the kind of pain on workers that the gold standard
required.
The Depression also forced economists to deal with a new problem; the failure
of the economy to return to full employment. Keynes came up with the proposed
solution of government spending to boost demand. His approach was widely
adopted after the second world war, a period which saw rapid growth of
government involvement in the economy. Economic management was all about
keeping unemployment down. Political elites also saw the creation of welfare
states as a small price to pay to head off the rival appeal of communism.
Stagflation and the middle-class revolt
The rise of inflation in the 1960s and 1970s caused another economic rethink.
Previously there had seemed to be a trade-off between inflation and
unemployment; the stagflation era showed both could be high. The new wave of
economists led by Milton Friedman argued that governments were trying to do too
much; the focus should be on keeping inflation down by controlling the money
supply. Rather than trying to boost the economy via fiscal policy, governments
should focus on the supply side ; encouraging growth through lower taxes and
eliminating inefficiencies and rigidities. Structural reform, as this newspaper
dubs it.
This political movement drew on support from middle-class voters who were angry
about higher taxes and concerned about the growth of trade union militancy. The
US and the UK were the first to change tack under Ronald Reagan and Margaret
Thatcher but Europe eventually shifted policy direction after growing concern
about its sluggish growth; Eurosclerosis as it was known.
Structural reform may boost long-term growth but it is little help with
managing the vicissitudes of the economic cycle. In this respect, the focus
shifted to monetary policy. Hence the rise of active and independent central
banks and the near-worship of Alan Greenspan and his ilk.
This shift coincided with the fall in inflation in the 1980s and 1990s (a
change that boosted the reputation of central bankers although it may have owed
much to the disinflationary forces unleashed by China s entry into the global
economy.) The result was a big fall in bond yields, and a big rise in equity
prices. At the same time, the structural reforms brought in by Reagan and
Thatcher liberalised the financial sector. That led to the huge expansion of
finance (including the rise of the hedge fund and private equity sectors), a
step change in pay levels relative to the rest of the economy, and a big rise
in debt relative to GDP across the private sector.
Higher debt levels increased the riskiness of the system and encouraged central
banks to cut rates when markets wobbled. This was made clear in 1987 when after
Black Monday (a 23% one-day fall in the Dow), central banks, led by Greenspan,
cut rates. With central banks appearing to underwrite asset prices, fortunes
were made by the simple tactic of using borrowed money to buy assets,
particularly property. Those who rose to the top of the banking sector the
Dick Fulds and the Jimmy Caynes were risk-takers by nature.
Meanwhile, the end of fixed exchange rates and the associated abolition of
capital controls, made global finance all the more powerful, in the sense that
it could inflict damage as it shifted in and out of economies and sectors.
Appeasing capital became a key government priority. Simultaneously, the wealth
of the financial sector gave it the ability to fund the political elite and to
peraide politicians to favour policies that were in the interests of finance.
Indeed, such was the reputation of financiers for wisdom (if you re rich, you
must be smart), that they were brought into government Rubin, Paulson et al.
During this economic era (c1980-2007), the political climate shifted to the
right, with centre-left politicians adapting their case to the new regime. Just
as politicians of the centre-right had accepted the welfare state after 1945 as
a means of seeing off the communist threat, the centre-left accepted
free-market friendly policies as a way of financing the social programmes they
desired. The demise of the Soviet Union seemed to signify, if not the end of
history , but a decisive shift in political and economic thought.
Trade union membership declined in many countries; the number of strikes
declined. This may have been partly down to globalisation, and the ability of
companies to shift production to lower cost areas. But it was also down to the
relative decline of manufacturing, both as a proportion of economic output and
of total employment. Union power increased with the emergence of factory-based
industrial production and it fell when the factories closed. It is far harder
to organise and motivate dispersed workers in shops, offices and call centres.
The decline in the economic power of blue collar voters thus led to a decline
in their political power. Interest in the democratic process also fell. Voting
turnout headed lower, from around 80% to 70% in the typical Western democracy.
It is significant that the most powerful actors in the modern developed economy
are central banks, quintessentially undemocratic institutions.
During this long period, the economics profession went off in different
directions, focusing on micro-economic problems, emphasising the importance of
theoretical models and mathematical rigour. (Of course, this is a
generalisation. We also saw the rise of behavioural economics and the work of
Hyman Minsky, who focused on the destabilising nature of debt.)
The debt crisis and after
The debt crisis of 2007 and 2008 is undoubtedly as important a turning point in
economic and political thought as was the stagflationary episode of the 1970s.
We are still working though its effects. But a number of issues have arisen;
debt and the finance sector should play a more important role in macro-economic
modelling. Debt is not just a zero sum game ; finance is not just a channel
but can have seriously destabilising effects. Markets can lose touch with
fundamental values.
Economists will also have to grapple with the big issues that have led to the
rise of the populists in the post-crisis economy. Why has real income growth
been so sluggish for the median worker? Has globalisation only benefited the
elite (at least within developed economies)? What are the economic gains and
costs associated with the free movement of capital and labour and how are they
distributed? Is the growth of inequality solely the result of skill-biased
technological change (ie that new technologies favour more educated workers)?
If so, what will be the impact of forthcoming technological change (the
automation of office work, self-driving cars)? If not technology, could rising
inequality be related to structural factors within the economy (rent-seeking
activity by financiers, for example)? How will the ageing of developed world
populations affect economic growth and the wages of young (and thus scarce)
workers? Indeed, is technological change as good for growth as it used to be
(the Gordon thesis)? And how will debt affect all these issues; is a rising
debt/GDP level necessary to generate economic growth? As yet, no new Keynes or
Friedman has come along to rethink economic theory in a way that answers all,
or even the majority, of these questions.
When it comes to the interaction of economics and politics, the big issue is
whether the rise of populism will actually shift the balance of power.
Populists resist many elements of globalisation, disliking the free movement of
capital, labour and (in some cases) goods because of the effects on voters.
Workers fear being displaced not just by immigrants but by lower-paid employees
in Asia; anti-austerity campaigners resent the spending cuts needed to placate
markets (or overseas creditors).
The problem here is that the global economy has already been integrated and
voters are affected by issues far beyond their borders; whether the global
economy prospers over the next couple of years depends on how well the Chinese
authorities manage their financial system and on whether the Federal Reserve
makes a mistake in withdrawing monetary stimulus. There is not much Francois
Hollande, Angela Merkel and David Cameron (or Hillary Clinton, Ted Cruz and
Marco Rubio) can do about that.
Politicians have to campaign at a national level, making promises that global
factors may prevent them from keeping. In this sense, globalisation has
separated political from economic power and made the average voter feel more
hopeless (and thus even more angry). In addition, the nationalistic element of
populism creates the potential for 1930s-style beggar-thy-neighbour policies
one thinks of Donald Trump s musings on a 45% tariff on Chinese goods. We have
the examples of Venezuela and Argentina to show us how much economic damage
populism can cause. Furthermore, solutions to some economic problems run foul
of populist opposition; countries that have seen extensive immigration have
better demographic profiles but (some) voters are highly resistant, for
cultural as well as economic reasons.
At the domestic level, how does the rise of the populists fit in with the
thesis that political power follows economic power? Surely the rich should
prevent the populists from succeeding? Well, of course, that might be the case;
so far populists have only taken power in eastern Europe and Latin America. But
the internet may have given populism a leg up. Not only is it easier to
organise like-minded souls, people can become aware of populist arguments that
they might not hear from fellow workers or family members.
The 20-30% vote share that populists seem to attract across a broad range of
countries will probably only reach the crucial 40%+ level need for power if the
developed world sees another downturn. Of course, this makes the recent market
turmoil all the more interesting (in the Chinese curse sense). Perhaps the
post-crisis era will end with a decisive shift away from globalisation and
towards economic nationalism. The omens are emerging.