Before the great financial crash of 2007-2008 there was a solid consensus as to the sorts of economic policies governments should pursue. In fact the underlying realities have been changing for some time. These new realities now dominate in developed economies, and yet the political mainstream hasn’t caught up. It is one of the reasons that populist politicians, not least Donald Trump, are doing relatively well when they defy the old rules.
What were those rules? First is that GDP growth is a critical indicator of economic wellbeing, and that increased productivity is the driver of this. Politicians should push through “supply-side” policies that improve productivity, which will allow income per head to grow, and with it individual incomes and wellbeing. With productivity apparently in the doldrums since the crash, especially here in Britain, there is much shaking of heads. Before the crash economists had thought something they referred to as “trend growth” of about 2% per annum was practically a law of nature. Many still think its disappearance is a failure of policy.
Second, governments must maintain a prudent fiscal policy that does not allow high levels of public debt to pile up. Public spending must be paid for through higher taxes. High levels of public debt can destabilise an economy, it was thought. This went alongside the idea that if public spending was not restrained it would be wasted, and cause low productivity.
Third: free trade is essential to a healthy economy. This follows from basic economics: the principle of comparative advantage. During the years of rapid globalisation of trade from the 1980s to the early 2000s, this idea received a terrific boost as new Asian economies entered the mix, with comparative advantage particularly evident in basic manufacturing. This generated huge gains in trade for both developed and developing economies.
And fourth, interest rate policy is the right way to manage the business cycle to ensure that recessions were smoothed out. This replaced the older post-war idea that fiscal policy was the right way to do this. Interest rate policy (or “monetary policy”) allowed the private sector to expand and contract as required, through an efficient market mechanism, rather than inefficient government direction.
What changed? First of all, the conventional wisdom on monetary policy, which evolved after the old system of fixed exchange rates and capital controls, known as Bretton Woods, collapsed in the early 1970s, led to an explosion of private debt. While policy makers liked to think that the policy was sustainable, there was a clear trend towards higher private debt and lower interest rates. This contributed to the great financial crash. Now interest levels can’t go lower, and people worry more about financial stability. This means that monetary policy is pretty much done for as means of regulating the cycle, with fiscal policy coming back into the picture, sometimes disguised as monetary policy with such ideas as “quantitative easing”.
Perhaps the most important change, though, was that productivity in manufactured and other tradable goods has advanced so far that they have ceased to have such an important role in the economy as a whole. This is known as the Baumol effect, and it is something I have been banging on about for ages. The modern economy is in fact dominated by things like health care, social care, and services, with status goods and land also playing a larger overall role. The old conventional wisdom around productivity doesn’t really work here.
On top of this environmental degradation, and especially climate change is posing a question that was always there. Is producing and consuming more and more stuff actually advancing human wellbeing? We all need to eat and wear clothes, but do we need to get through quite so much as we do? And yet an economic mindset in which consuming stuff is central to the way we measure wellbeing refuses to die.
A couple of other factors are worth mentioning. First is that the Asian economies are developing fast and converging with the western developed ones. This means that there are fewer gains from trade available, and that the globalisation boom is over; indeed many of those gains will actually reverse as the two worlds converge and comparative advantage diminishes. Second modern industry is not as hungry for capital investment as it used to be. This is partly to do with the Baumol effect, as the relative size of capital intensive industry shrinks, but also to do with the nature of modern technology, which uses more human capital. There are fewer opportunities in the private sector for savings to invest in, at any rate for things that aren’t outright speculative. The main cause of the great crash was an excess of private sector speculation as the relative scale of productive investment diminished.
So what does all this mean? First that it is OK to play fast and loose with fiscal policy. High levels of public debt are quite sustainable because the availability of private investment is diminished. Public debt is safer than private speculation. This is clearly evident in the USA and Japan. In Britain it is a little less clear because the country has a high current account deficit, meaning that is more vulnerable to international changes of mood – but surely there is much more scope than the government is currently using. Second, it is much less damaging than before to play fast and loose with trade policy. Once again Donald Trump is taking full advantage of this. His trade policy is mostly economic nonsense, but he can get away with it. Likewise Brexit is likely to be less dire for Britain than many predict – though the potential upside for “global Britain” is very slim. Trade just doesn’t matter so much, and the opportunities in Asia are disappearing.
All this is good news for populists. Mainstream policy needs to catch up. Policymakers need to drop their obsession with GDP and productivity, and start looking at wider quality of life instead. This includes the prevalence of poverty (I prefer not to focus on inequality, though that is clearly part of the picture), mental health problems and the environment. There needs to be a bigger drive on public investment, but not so much on roads, railways and airports, but on hospitals and healthcare therapies, social housing, and sustainable energy. There is scope for increased private investment here too, but the public element is vital.
There are other ideas, such as universal basic income, though I personally don’t favour this. But a rethink of state benefits is surely important. My instinct is for stronger set of social interventions to reduce poverty and its malign effects, rather than trying to make the problem go away by spraying money everywhere.
How does this work politically? It should be an opportunity for the left. And indeed Britain’s Labour manifesto in last election wasn’t quite as daft as it looked – in theory anyway. Bernie Sanders is making headway in the US in spite of defying conventional wisdom. But politics isn’t just about economics, and the left don’t really seem to grasp the demand for increasing personal autonomy. Besides so much of leftwing activism seems to be a rage against efficiency. Productivity may be an overrated issue, but the need for efficient and effective services remains as vital as ever.
Liberals, meanwhile, are badly compromised by their attachment to the old conventional wisdom. They have not yet found a new vision. Personally I think there is an opportunity for a grand bargain between the left and liberals, but there is no clear sign of this emerging. Meanwhile the political right has a clear opportunity. In the US they seem to be wasting it by failing to recognise that an efficient and effective state is critical to the future. They are failing to face up to the challenge on healthcare and the environment. In the UK the picture is different. The Conservatives are interested in courting more liberal-minded voters, and have not abandoned the idea of reducing carbon emissions, for example, or investing more in healthcare.
But at the moment the new rules of economics are providing more opportunities for the unscrupulous than they are to those genuinely want to make the world a better place. it is no wonder that the political centre is in such a mess.