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The Global Recycling problem

December 8th, 2009 · No Comments

At the heart of the world-economic problems lies an imbalance between the world supply and demand for goods and services. The funny thing is, it’s actually surprisingly easy to amend….

We have seen three powerful structural trends emerging in the last couple of decades:
∙    globalization
∙    a structural rise in productivity growth
∙    the emergence of China (and India).

These trends have been related and reinforcing themselves. The ICT revolution that started in the 1950s didn’t gain sufficient economic momentum until the mid 1990s. By then, it was sufficiently cheap and sufficiently powerful, and more importantly, organizations started to find out how to best take advantage of it.

This produced a structural rise in the growth of labour productivity, the single most important motor of wealth production. Normally, as in the so called ‘Golden Years,’ the 1950-1970 post WOII era of stable economic growth, the benefits of this increase in labour productivity would have been shared.

During the Golden Years, an increase in labour productivity allowed real wages to rise without pushing up wage cost so profits stayed more or less stable (as a % of GDP) and the residue benefits helped to finance increased public spending (there were quite notable differences here between countries).

The implicit social contract underlying these arrangements were largely national in character, but they grosso-modo worked. Until, for reasons still hotly debated, the productivity growth started to decline.

This happened in the early 1970s, and the remarkable thing is that it happened in most rich economies at roughly the same time. With unemployment low almost everywhere, and the decelerating trend in productivity not noticed until much later, wage bargainers were in no mood do make concessions to the rise in real wages.

However, if labour productivity rises by just 1% but labour bargains for, say, a 3% rise, the results were no surprise (by far the best theoretically coherent approach can be found in the competing claims approach of this really excellent textbook)

Labour cost rose, firms facing little competition (mostly domestic services) mostly increased prices in order to maintain profit margins, firms exposed to international competition could not do that and saw margins erode.

Add to that the commodity boom and monetary uncertainties of the early 1970s (the collapse of the Bretton Woods system and the inexperience and wide differences in preference of policy makers with running flexible exchange rates), and you have a full blown crisis with monetary chaos, profit squeeze, inflation and rising unemployment.

Needless to say that the Keynesian reaction to what was essentially a supply shock worsened, rather than improved things, as Milton Friedman and Phelps had set out at the end of the 1960s already (work for which they shared the Nobel prize).

It took Paul Volcker and Margaret Thatcher to slay inflation for good. But the postwar order had been upset, and would not return even with the return of productivity growth.

Labour’s wage bargaining position has been dramatically reduced as a result of the decline of the traditionally unionized mass production industry and the heterogenization and individualization of the labour market, result of a shift towards services and knowledge intensive work.

Information and communication technologies reinforced these trends. More often than not they are tools increasing the productivity for knowledge workers and thereby widening the differences in productivity and pay in the labour market.

Perhaps more important still has been the globalization of the economy, driven by the ICT revolution,  trade liberalization, economies in transport (the advent of the container, for instance), the fall of the Berlin wall, the capitalist experiment in China and the reforms of the (previously stifled) Indian economy in the early 1990s.

This tremendously increased the supply of cheap, often well-educated labour in the world economy. The threat of outsourcing, the mobility of capital, and the emergence of new competitors at the world stage ensured that when labour productivity started to rise again, labour in the rich countries would bear only little of its fruits.

And that is where the problems began. Incomes of many employees, especially in the US, didn’t keep up with productivity growth and inflation. Instead, profits increased, leading to a stockmarket boom.

To maintain consumption, people started to borrow more, enabled by financial deregulation and rising house prices. But this model wasn’t sustainable, and it came crashing down in most spectacular fashion.

However, the root forces are still in place. Wages are still lagging productivity growth and inflation, as they’re now not only under pressure from cheap labour abroad and technological developments, high unemployment is another damper on wage growth.

This leads to a global underconsumption problem. It’s actually not unlike the ‘recycling problem’ in the 1970s, when global income was redistributed from oil consuming to oil producing countries. The problem then was that the oil producing countries couldn’t spend all their newfound wealth, hence world demand fell.

Today, global income is redistributed from rich countries largely to big developing countries like China and India. But just as the oil exporters in the 1970s, these countries have higher saving rates compared to the rich countries, hence a potential global demand shortfall.

Two things are masking this, at least for now. First is the unprecedented government (and central bank) action to revive spending, both in the rich world as well as in those big developing economies. Second, in China especially there is an unprecedented credit and investment boom.

But this boom itself is unsustainable. Sooner or later China has to rely less on exports and investment in new plant, and start consuming more, to compensate for it’s deflationary effect it has on wages and interest rates in the rest of the world.

That is, global reflation in the real economy cannot happen without a Chinese increase in domestic consumption and, more especially, a rise in its currency to let that increase in domestic consumption spill over to the rest of the world.

Tags: Credit Crisis · Economy · Public Policy · The World according to Economics