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The Role of Economists in Causing Economic Stagnation

Alan Moran

Sep 01 2013

13 mins

There is a long history of governments with activist policy agendas, and they have had no shortage of economists to offer them advice. But the economic approaches Keynes developed or amplified, inspired by a respect he and many other economists held for the Soviet and German planning systems, provided a major boost to legitimising government economic policy activism. As well as a belief in a greater role for planning, Keynesianism also reflected a popular belief that free enterprise entailed considerable waste and that the Great Depression was evidence that it could become chronically unstable.

From the 1920s at least until the 1980s, faith in the ability and selflessness of officials and politicians persuaded most people that wise government manipulations of interest rates and money supply, and taxation and spending, would squeeze more out of an economy’s potential output. Such policies also entailed using preferential levels of taxes and credit supply to promote particular industries and to finance social programs.

While the failure of the communist experiment brought a roll-back of government ownership, interventionist policy remained strongly embedded and was reinvigorated with unfortunate results as the 2007 Global Financial Crisis unfolded.

The Keynesianism that dominated economic policy advice in the modern era brought an abandonment of the understandings previously held about how prosperity arises and is maintained. The Keynesian revolution cut the previous link between savings, investment and economic growth. Its approach classified investment as an expenditure no different from consumption, saving as a residual of unspent income and capital expenditure as an automatic outcome of increased demand. This relegated the association of growth with investment (and innovation and skill formation) into some long-run irrelevancy.

In fact, investment is a key determinant of growth and wealth. The relationship is, however, imprecise and depends on the efficiency with which the economy generates savings and allocates these savings among investment opportunities. Reserving some portion of production from immediate consumption so that investment in capital, skills and new techniques can be undertaken is the reason why the capitalist societies came to dominate the world.

Regulatory impediments can distort this—investment can offer a poor return to economic growth when market rewards funnel a large share of the expenditure into areas of poor productivity. Only rarely does this persist in situations other than where the investment is subject to government direction or incentive mechanisms.

The importance of investment for economic growth was always recognised by the socialistic economists and systematised in planning approaches normally associated with input-output modelling of the econometrician Wassily Leontief and the Harrod–Domar model. But these models addressed special cases of “development economics” and their use was in planning these economies.

Sequential waves of economic success stories demonstrate the importance of policies that encourage savings and market-based investment in bringing about prosperity, without conscious plans to direct savings into pre-determined areas of investment. The “economic miracles” in Germany and Japan after the Second World War came on the back of freeing up markets, and an associated massive hike in national savings and productive investment. However, many analysts discounted these countries’ successes, arguing that they were special cases—economies that already had the basic infrastructural characteristics of the developed world on which prosperity could be built. Indeed, establishment economists counselled against liberalisation. John Kenneth Galbraith wrote: 

there never has been the slightest possibility of getting German recovery by this wholesale repeal, and it is quite possible that its reiteration has delayed German recovery. The question is not whether there must be planning—the assignment of priorities for reconstruction and rehabilitation, the allocation of materials and manpower, the supplying of incentive goods and all the rest—but whether that planning has been forthright and effective. 

The rise of the Newly Industrialised Countries (NICs) of Hong Kong, Taiwan, Singapore and Korea following economic liberalisation brought forth a new set of rationalisations for the success of such policies. Some argued that, as relatively small countries, the NICs were able to exploit widening trade opportunities in the West that would only be available to small niche players. Others, especially socialists, argued that there were unique conditions associated with these countries, largely due to their positions on the frontier of Chinese and Russian communism. What is beyond dispute is that the four NICs, having been utterly devastated economically and having never had any of the basic industrial infrastructure of the defeated Axis powers, had by the turn of the millennium achieved living standards comparable to those of the established First World.

That their success has been followed by similar achievements by China and India, the two most populous countries in the world, has required new explanatory theories. Some argue that these countries’ growth cannot be sustained; others that India’s is built on fragile service provision and that China’s owes much to the central direction of the Communist Party. Both explanations are easily refuted by the enduring nature of the economies’ growths, while the idea that China is a centrally directed economy enjoying success leaves a vast vacuum in attempting to explain the failures of pre-Deng Xiaoping communism.

Investment comprises domestic saving plus net capital inflow. It tends to decline when residents and foreigners judge that its returns are falling. Cycles of falling and rising returns have been recognised ever since economies have been studied, indeed, a severe recession hit the Roman empire in the famous year AD 33, when investment dried up, probably as a result of a trade imbalance. In that case, anticipating banking practices 1900 years later, the Emperor Tiberius made interest-free loans to eligible banks which could pledge real estate as collateral, and confidence was restored.

Financial market management became far less passive after the First World War. The US government’s credit creation led to the unsustainable boom of the roaring twenties in the world’s dominant economy, followed by the Great Recession. With international trade falling by two thirds and mass unemployment, this was probably the most severe contraction the world has seen.

But general agreement has never been reached about the reasons behind the causes of the Great Depression. The Keynesian revolution and its successors thought that it could have been averted by increased government spending to reignite the cycle of demand and investment and sustained growth.

Economists contesting this for the most part preferred the less direct but still activist approach, fostered by Milton Friedman, which involves steady money supply growth and, where necessary, interest rate manipulations. David Stockman argues in The Great Deformation that the 1929 crash was an inevitable consequence of the necessary unwinding of the previous excessive money creation which had fostered an unsustainable boom on Wall Street. Friedman’s approach, according to Stockman, would have prolonged and worsened the bubble economy by forcing liquidity into the system, as is presently occurring with policy of “quantitative easing” overseen by Friedman’s disciple, the Federal Reserve’s chairman Ben Bernanke.

Most would contest Stockman’s apparent view that the financial crisis following the 1929 crash had a negligible effect in itself on the real economy but Friedman and even some Keynesians would share his view that the 1930s Depression was greatly exacerbated by a US-initiated global tariff war, new regulatory measures, and deficit financing.

Few economists have argued that the solution to resolving the imbalances caused by the credit creation during the First World War and the 1920s lay in allowing the overheated economic embers to cool. Doing nothing other than reducing spending and regulation (and, Tiberius-style, ensuring credit is available to those with sound collateral) was considered too passive and ineffective in a world where government economic management had been elevated to unwarranted perceived levels of success.

Steady growth up until the 1970s persuaded most economists that skilful management by governments had made the world safe from recessions. This complacency was undercut as stagflation destroyed the credibility of Keynesian deficit financing. Allegiances were switched towards promoting a steady expansion of the money supply as the new guarantor of economic stability. But a lack of “philosopher kings” to administer this Friedmanite solution and concerns that money is undefinable created doubts about its applicability. These doubts were intensified by a recognition that misapplied monetary policy created the 2007 Global Financial Crisis. Even so, at least among the major OECD economies, undeserved confidence remains in active government management. A crescendo of disillusionment in the monetarist lever will surely be reached once its failure to reignite economic growth is recognised.

The steady increase in government spending and credit creation which brought debt-stimulated growth among the wealthier countries has run its course. Unprecedented growth in debt, high levels of unproductive government expenditure, much of it deficit-financed, and an increased complexity of business regulations, have combined to undermine the previous seemingly effortless ever-increasing growth in prosperity.

Since 2006, the developed countries of the world have shown negligible economic growth. According to IMF data, the Eurozone countries, Japan and the UK have all grown by less than 2 per cent in the six years to 2012; the USA has grown by almost 5 per cent (though the growth rate appears to have been recently revised downwards). By contrast, the NICs have shown real growth of 23 per cent, and India and China a colossal 54 and 78 per cent respectively.

Unsurprisingly, the rapidly growing developing countries have much higher levels of investment than the increasingly sclerotic First World economies. Investment, in terms of share of GDP, in the established major economies (the Eurozone, the USA, UK and Japan) is at 20 per cent and less. None of this group of countries has restored the share of investment to levels that approach those before the GFC. Cannibalising savings to fund budget deficits is an important factor in this.

The NICs, China and India have shares of investment in their economies at 26 per cent, 48 per cent and 36 per cent respectively. And all three have restored their investment shares back to pre-GFC levels. Moreover, all three not only have increased their domestic investment but have also become major lenders to the established developed nations, which even with this supplement to their own savings are unable to restore their previous levels of investment.

One reason for this economic failure on the part of the First World is the ceaseless growth in the size of government and regulation. Establishing a barometer for the latter is notoriously difficult but the government share in the major developed economies ranges between 38 per cent (Japan) and 49 per cent (Eurozone). By contrast, the NICs and China get by with government spending at little more than 20 per cent of GDP, and India has 28 per cent.

 

Key economic indicators in selected economies

                      A          B           C          D

Euro area      1.8        18.7     0.86      49

Japan            1.3        20.3     0.89      38

UK                0.7        14.7     0.85      44

USA              4.9        16.2     0.79      40

NICs                         23.3      25.8     0.98      21

China            77.8      47.8     1.11      22

India                         53.6      36.0     1.02      28

Australia       17.6      28.4     1.04      36

A = GDP growth 2007–12, per cent

B = Investment percentage share of GDP, 2012

C = Investment share ratio, 2012 minus 2006

D = 2006–12 average government share of GDP

Source: IMF, World Economic Database.

Government spending comprises largely health, education, welfare and administration, and offers less in terms of productivity gains than private sector spending.

Moreover, the productivity of aggregate government spending has been diminished over recent decades because governments have largely exited from capital investment expenditures. Although public sector capital expenditure usually offered poor productivity—a reason why governments have privatised and out-sourced such activities—it remained expenditure with some payoff. Within government expenditure, investment has been replaced by more income redistribution expenditures and more intensive regulatory appraisals that offer no—indeed even negative—productive increment.

Similarly, the potency of private investment is diminished by government actions. Most obviously, these are manifest in the energy sector, where low-productivity wind and solar investments are mandated across the Western world. Wind turbines may have a productivity of one third that of the fossil-fuel plants they are displacing and solar even less. For energy as a whole wind and solar have been growing at 20 per cent and 60 per cent a year respectively. They now account for 10 per cent of electricity in the EU. Other green-stipulated wasteful investments would include hybrid cars and mandatory energy-saving features of buildings.

How do First World nations rediscover the path to growing prosperity? The answer does not lie inside the mainstream economists’ toolbox involving activist fiscal and monetary policies. These fatally flawed policies have ill-served economic management. Moreover, their intrinsic deficiencies have been aggravated because they have providing cover to politicians seeking to win popularity by handouts and cheap credit.

The answer to growth restoration in the First World lies with emulating the successes of the rapidly growing developing nations and the NICs by reducing the size and role of government in their economies, balancing budgets and lowering taxation. This is clearly proving difficult even for those governments that accept it as the only path forward. The rise of social expenditure and the regulatory barriers to business innovation, once in place, are very difficult to remove, even to reduce. And the path is made infinitely more difficult by the many voices of influence domestically, and from agencies like the IMF, counselling against “austerity”, even though the notion has little logic in the case of spending restraint by governments which have persistent budget deficits.

Australia, as a resource supplier to the more successful economies, has fared better than other First World economies in the post-2007 GFC, but with mining growth faltering this seems unlikely to last.

Australia must also reduce the size and role of government and lower taxation. But the Australian government, like that of many other countries, has failed to realise that deficit spending and loose money supply not only offer no route to recovery but actually consign their economies to greater failure. Indeed, the Rudd government, in foreshadowing spending increases on education, health and disabilities, is moving Australia in the opposite direction to that needed to restore economic resilience.

Alan Moran is the Director of the Deregulation Unit at the Institute of Public Affairs. His work can be seen on the IPA website at www.ipa.org.au/people/alan-moran.

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