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Economics and democracy - Political power follows economic power

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.