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. Whatfactors underlie today’s problems, and how appropriate are the likely policyresponses?
The first key factor is deleveraging and the resulting shortfall in aggregate demand. Since the financialcrisis began in 2008, several developed countries, having sustained demand withexcessive leverage and consumption, have had to repair both private and publicbalance sheets, which takes time – and has left them impairedin 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 nosubstitute for domestic demand. The tradable side could make up some of thedeficit, but it is not large enough to compensate fully. In principal,governments could bridge the gap, but high (and rising) debt constrains theircapacity to do so (though how constrained is a matter of heated debate).
The bottom line is that deleveraging will ensure thatgrowth will be modest at best in the short and medium term. If Europedeteriorates, or there is gridlock in dealing with America’s “fiscal cliff” at thebeginning of 2013 (when tax cuts expire and automatic spending cuts kick in), amajor downturn will become far more likely.
The second factor underlying today’s problems relates toinvestment. Longer-term growth requires investment by individuals (in educationand skills), governments, and the private sector. Shortfalls in investmenteventually diminish growth and employment opportunities. The hard truth is thatthe flip side of the consumption-led growthmodel that prevailed prior to the crisis has been deficient investment,particularly on the public-sector side.
If fiscal rebalancing is accomplished in part by cuttinginvestment, medium- and longer-term growth will suffer, resulting in feweremployment opportunities for younger labor-market entrants. Sustaininginvestment, on the other hand, has an immediate cost: it means deferringconsumption.
But whose consumption? If almost everyone agreesthat more investment is needed to elevate and sustain growth, but most believethat someone else should pay for it, investment will fallvictim to a burden-sharing impasse –reflected in the political process, electoral choices, and the formulation offiscal-stabilization measures.
The core issue is taxes. If public-sector investment wereto be increased with no rise in taxation, the budget cuts required elsewhere toavoid unsustainable debt growth would be implausiblylarge.
The most difficult challenge concerns inclusiveness – how the benefits of growth are tobe distributed. This is a longstandingchallenge that, particularly in the United States, goes back at leasttwo decades before the crisis; left unaddressed, it now threatens social cohesion.
Income growth for the middle class in most advancedcountries has been stagnant, and employmentopportunities have been declining, especially in the tradable part of theeconomy. The share of income going to capital has been rising, at the expenseof labor. Particularly in the US,employment generation has been disproportionately in the non-tradable sector.
These trends reflect a combination of technological andglobal market forces that have been operating over the last two decades. On thetechnology side, labor-saving innovations in network-based informationprocessing and transactions automation have helped todrive a wedge between growth and employment generation in both thetradable and non-tradable sectors.
In the tradable part of advanced economies, manufacturingautomation – including expanding robotic capabilities and, prospectively, 3Dprinting – has combined with the integration of millions of new entrants intorapidly evolving global supply chains to limit employment growth. Multinationalcompanies’ growing ability to decomposethese 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 competitionfor workers.
This challenge is particularly difficult, because economicpolicy has not focused primarily on the adverse distributional trends arisingfrom shifting global market outcomes. And yet the income distributions acrossadvanced economies, presumably subject to similar technological and globalmarket forces, are, in fact, startlinglydifferent, suggesting that a combination of social policies and differingsocial norms does have a distributional impact. Although the theory of optimalincome taxation directly addresses the tradeoffs between efficiency incentives and distributionalconsequences, the appropriate equilibriumremains a long way off.
A healthy state balance sheet could help, because part ofthe income flowing to capital would go to the state. But, with the exception ofChina,fiscal positions around the world are currently weak.
As a result, deleveraging remains a clear priority in arange of countries, reducing growth, with fiscal countermeasureslimited by high or rising government debt and deficits. Thus far, there islittle evidence of willingness on the part of politicians, policymakers, andperhaps the public to reduce current consumption further via taxation in orderto create room for expanded growth-oriented investment.
In fact, under fiscal pressure, the opposite is morelikely. In the US,few practical measures that address the distributional challenge appear to bepart of either major party’s electoral agenda, notwithstandingrhetoric to the contrary.
To the extent that this is true of other advancedeconomies, the global economy faces an extended multi-year period of lowgrowth, with residual downside risk coming from policy gridlock andmistakes 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.