NEW YORK – The world’s high-income countries are in economic trouble, mostly related to growth and employment, and now their distress is spilling over to developing economies. What factors underlie today’s problems, and how appropriate are the likely policy responses?
The first key factor is deleveraging and the resulting shortfall in aggregate demand. Since the financial crisis began in 2008, several developed countries, having sustained demand with excessive leverage and consumption, have had to repair both private and public balance sheets, which takes time – and has left them impaired in terms of growth and employment.
The non-tradable side of any advanced economy is large (roughly two-thirds of total activity). For this large sector, there is no substitute for domestic demand. The tradable side could make up some of the deficit, but it is not large enough to compensate fully. In principle, governments could bridge the gap, but high (and rising) debt constrains their capacity to do so (though how constrained is a matter of heated debate).
The bottom line is that deleveraging will ensure that growth will be modest at best in the short and medium term. If Europe deteriorates, or there is gridlock in dealing with America’s “fiscal cliff” at the beginning of 2013 (when tax cuts expire and automatic spending cuts kick in), a major downturn will become far more likely.
The second factor underlying today’s problems relates to investment. Longer-term growth requires investment by individuals (in education and skills), governments, and the private sector. Shortfalls in investment eventually diminish growth and employment opportunities. The hard truth is that the flip side of the consumption-led growth model that prevailed prior to the crisis has been deficient investment, particularly on the public-sector side.
If fiscal rebalancing is accomplished in part by cutting investment, medium- and longer-term growth will suffer, resulting in fewer employment opportunities for younger labor-market entrants. Sustaining investment, on the other hand, has an immediate cost: it means deferring consumption.
But whose consumption? If almost everyone agrees that more investment is needed to elevate and sustain growth, but most believe that someone else should pay for it, investment will fall victim to a burden-sharing impasse – reflected in the political process, electoral choices, and the formulation of fiscal-stabilization measures.
The core issue is taxes. If public-sector investment were to be increased with no rise in taxation, the budget cuts required elsewhere to avoid unsustainable debt growth would bein implausibly large.
The most difficult challenge concerns inclusiveness – how the benefits of growth are to be distributed. This is a longstanding challenge that, particularly in the United States, goes back at least two decades before the crisis; left unaddressed, it now threatens social cohesion.
Income growth for the middle class in most advanced countries has been stagnant, and employment opportunities have been declining, especially in the tradable part of the economy. The share of income going to capital has been rising, at the expense of labor. Particularly in the US, employment generation has been disproportionately in the non-tradable sector.
These trends reflect a combination of technological and global market forces that have been operating over the last two decades. On the technology side, labor-saving innovations in network-based information processing and transactions automation have helped to drive a wedge between growth and employment generation in both the tradable and non-tradable sectors.
In the tradable part of advanced economies, manufacturing automation – including expanding robotic capabilities and, prospectively, 3D printing – has combined with the integration of millions of new entrants into rapidly evolving global supply chains to limit employment growth. Multinational companies’ growing ability to decompose these global supply chains by function and geography, and then to reintegrate them at ever lower transaction costs, removes the labor-market protection that used to come from local competition for workers.
This challenge is particularly difficult, because economic policy has not focused primarily on the adverse distributional trends arising from shifting global market outcomes. And yet the income distributions across advanced economies, presumably subject to similar technological and global market forces, are, in fact, startlingly different, suggesting that a combination of social policies and differing social norms does have a distributional impact. Although the theory of optimal income taxation directly addresses the tradeoffs between efficiency incentives and distributional consequences, the appropriate equilibrium remains a long way off.
A healthy state balance sheet could help, because part of the income flowing to capital would go to the state. But, with the exception of China, fiscal positions around the world are currently weak.
As a result, deleveraging remains a clear priority in a range of countries, reducing growth, with fiscal countermeasures limited by high or rising government debt and deficits. Thus far, there is little evidence of willingness on the part of politicians, policymakers, and perhaps the public to reduce current consumption further via taxation in order to create room for expanded growth-oriented investment.
In fact, under fiscal pressure, the opposite is more likely. In the US, few practical measures that address the distributional challenge appear to be part of either major party’s electoral agenda, notwithstanding rhetoric to the contrary.
To the extent that this is true of other advanced economies, the global economy faces an extended multi-year period of low growth, with residual downside risk coming from policy gridlock and mistakes in Europe, the US, and elsewhere. That scenario implies slower growth – possibly 1-1.5 percentage points slower – in developing countries, including China, again with a preponderance of downside risk.