It’s capitalism, but not as we know it

Economic cycles aren't what they used to be.

Phil Mullan

Topics Politics

Three key distinguishing features characterise the world economy today:

  • The mature industrialised countries of North America, Western Europe and Japan are all having great difficulty in regaining a dynamic of self-sustaining expansion. This is a dampener on world economic growth.
  • The centre of global productive activity is shifting to the east and especially to China. Already the sixth largest economy, China is fast going to get much bigger. It is already having a disproportionate economic impact outside its borders and in the recent past has contributed almost as much to global growth as the USA. This provides the world economy with substantial support.
  • The divergence in economic performance between the west and the east will continue and may widen further. This creates a potential for economic and political instability in the future; but today, and for much longer than many imagine, the resilience and adaptability of the global economy will postpone this prospect from having serious repercussions. Problems will emerge but will be manageable for some time.

Many commentators are aware that there is something odd about the world economy today. This economic cycle has many unusual and perplexing features. It is even difficult to identify what stage we are at on the basis of using the normal four phases of a cycle: (i) recession, stagflation, or contraction phase; (ii) the trough moving to reflation phase; (iii) the expansion or recovery phase; (iv) the boom/overheating/peak phase.

As the Financial Times’ Philip Coggan remarked in November 2004: ‘The picture seems very confusing. The bond markets suggest we are in the reflation phase [because of low interest rates], equity markets recovery [because stock markets remain high and rallied after the US presidential election], and commodities overheating [because of the recent strong prices for many raw materials including, of course, oil]. And we could even be heading for stagflation next year [because the gap between long and short term interest rates is falling – in the jargon ‘the yield curve is flattening’ – and in some cases, like Britain, is negative, normally a harbinger of impending slowdown].’ (1)

Underlying these conflicting signals from the financial markets are many puzzling ‘real economy’ peculiarities. On one hand, with growth of about 4.5 to 5 per cent, 2004 could turn out to be the world economy’s most buoyant year for three decades. But this seems to be at odds with what many recognise as the contained character of the expansion in the mature developed economies. We haven’t seen the traditional post-recession explosive take-off in any of these economies. Cycles historically average about six to 10 years, and the most recent low points in economic activity were seen in late 2001 for the USA, in 2002 for Japan and the UK, and early 2003 for much of mainland western Europe.

Economic growth (real GDP)
Figure 1: Economic growth (real GDP)
(source: IMF database)
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Being about two to three years into the current upturn, we should already have seen these economies at their most potent. Instead, economic progress has at best been respectably moderate. After a slow pick-up during 2002, the mature developed economies did for a time seem to be gaining some synchronised momentum from the middle of 2003. However, before long ‘faltering’ became the more appropriate description.

From earlier in 2004, the advanced economies have slowed to a mainly positive but relatively lacklustre pace, especially for this stage of the cycle. Or to use last year’s favourite economic euphemism, several economies hit ‘soft patches’. As charts from the latest IMF World Economic Outlook reveal, this ‘softness’ is now expected to continue through at least the first half of this year – the ‘patch’ has become something more prolonged. As the invariably astute Lex Column in the Financial Times put it at the end of November 2004: ‘Proof of a strong, self-sustaining recovery does remain patchy.’ (2) As a result, world growth is likely to dip again this year, though it should remain firmly positive at around 3.5 to 4 per cent.

Economic growth comparison
Figure 2: Economic growth comparison
(source: IMF World Economic Outlook, September 2004)
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The latest Economic Outlook from the Organization for Economic Cooperation and Development (OECD) also predicts a slowdown for its 30 members, to a combined economic growth rate of 2.9 per cent in 2005. This is a slower expansion than the 3.4 per cent rate of growth forecast by the OECD in its last twice-yearly report in May 2004, and the 3.6 per cent rate of growth it forecast for 2004. The 2005 forecasts have been cut for all the major economies. The report highlighted that the euro zone’s recovery has yet to become ‘self-sustained’, and that the currency area is ‘plodding along’ (3).

So on one hand, relative buoyancy; on the other, a faltering relative sluggishness. No wonder there’s confusion around. To help their understanding, many have looked to the past for clues. There has been a revival of economic interest in late nineteenth-century business cycles, and in the ‘debt deflationary’ 1930s.

More recently economists have joined the wider social fad to reminisce about the 1970s. The coincidental surge in oil prices and the emergence of a rising economic superpower in the east – Japan then, China today – has prompted economists to recall the stagflationary features of those years. Despite a few illuminating insights, such revival economics is unable to provide full enlightenment about today, because what we are experiencing is something quite different – expressive of the peculiar economic and socio-political circumstances of the past 10 or 15 years.

A world of two parts

At the heart of answering the conundrum about the world economy today is the interplay between two novel features. This is a tale of two parts: one restraining the global economy, the other sustaining it.

We have shifted into a new type of economic cycle in the mature industrialised countries. It is much flatter than in the past, less volatile. But slow steadiness tends to accompany this greater stability. As the old monetarist warhorse Milton Friedman recently remarked, the present world upturn looks disappointing because the previous recession was so minimal (4).

This drives the odd features of this recovery that are apparent in some if not all the advanced Group of Seven (G7) countries. We have, by historical comparison to most past cycles, below par and faltering growth, expressed in poor job expansion and low personal income gains. This is similar to the also atypical, slow drift 1990s cycle, but in several respects it is even weaker.

On the other hand, profits and cash flow are unusually high for so soon after the cycle trough. Of course it is the norm for the mass of profits to grow as economies expand. But what is odd is that, in the past, the profits peak took some time to be reached and usually marked the beginning of the cycle turning down again. However, almost everywhere today profits, as a share of GDP, are already unusually high and heady for this relatively early stage of the cycle.

In the USA, corporate profits (and proprietors’ income) already exceeded 20 per cent of GDP early last year, higher than their previous peak in the last cycle (that peak was achieved in late 1997, six years into that particular expansion) (5). As the Washington-based Employment Policy Institute said with regard to the USA: ‘this is the most profit-biased recovery since World War II’ – the profit share of corporate income growth has been more than double the average of post-War recoveries (6). In Britain too, profits also appear to have already peaked, though at 22 per cent they do not quite reach the 25 per cent-plus levels of the high points in 1985 and 1997.

This strong profitability mainly reflects the way corporate cost cutting has been elevated to become a near-permanent business strategy. Profits are being made more from watching and controlling costs assiduously than from investing to reap market leadership through stronger, sustained productivity advance. Flows of profits from their overseas activities and from their financial operations are also proving a bigger help for Western businesses today.

This strong profitability across many advanced economies has in turn contributed to unusually high levels of corporate liquidity. Steady positive cash flow has supported company balance-sheet restructuring to reduce debt levels, and many companies are now flush with cash. In Japan, corporate debt is down to levels not seen since the late 1970s, while in the USA, although corporate debt has not fallen by as much as is commonly presumed, companies have built up record levels of liquidity. Their holdings of cash and short-term securities are touching $600billion, a huge increase from the $100billion that was the norm from 1980 through to the mid-1990s (7).

But although many companies are loaded with cash, they are not spending much of it on productivity-enhancing capital investment. Even in the USA, where corporate investment is relatively strong compared to most other developed countries, business fixed investment was expected to grow by only about 10 per cent over the three-year period end-2001 to end-2004. This compares with investment growth of 18 per cent from end-1991 to end-1994, at the similar stage of that recovery, and 30 per cent-plus figures for the two previous recoveries (8).

With the organic, business dynamic for this recovery weak, this puts unusual demands upon the potentially more ephemeral spurs of debt-supported consumption, performed both by households and by government. We will return to explore the implications of this oddly undynamic expansion later in this essay.

The other change, the sustaining one, is the increasing global impact of China. China is already big – accounting for about four per cent of world output at market exchange rates, making it the sixth largest economy in the world (9). At current growth rates, China will soon surpass France and Britain and could overtake Germany by 2010, to take number three spot behind Japan and the USA (10).

But China’s significance for the world economy derives more from its rate of growth – averaging about 8-9 per cent annual growth over the past decade – than from its current absolute size. Because of its dynamism, which is emphasised by contrast to the languid performance of the advanced economies, China punches above its already considerable weight in global impact. Over the past few years, for example, China has accounted for about one sixth of all world growth (rising to one third, using purchasing power parity measures) (11). This makes China disproportionately responsible for world output and demand growth since 2000. This is a big part of the explanation for why 2004 has been the most ‘buoyant’ year for a long time.

One of the ironies of recent economic trends is that while China, and to a lesser extent India and Brazil, have been closing the prosperity gap with the old richer countries, the contrast in performance between the ‘new’ and ‘old’ worlds is widening. There is sustained, dynamic, high growth in the former; and lower, cyclical, though reasonably steady, growth in the latter.

Disaggregating world growth statistics in the chart below shows that, until the early 1990s, developments in the world economy matched quite closely those in the influential G7 advanced economies. Since then, under the influence of China and other fast developing countries, the world’s economic behaviour has become comparatively stronger and a permanent growth gap seems to be opening up between the pace of activity at the world aggregate, reflecting the new areas of expansion, and that across the old G7 economies.

Diverging growth trends
Figure 3: Diverging economic growth trends
(source: IMF WEO database, real GDP PPP rates)
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As well as becoming much more important in itself, China also exemplifies the greater role of internationalisation for the mature economies. This shift is commonly recognised as ‘economic globalisation’, meaning the emergence of a more closely integrated world economy. But its underlying driver is the way that the mature G7 economies are more dependent than ever on economic activity outside their own borders – to do with trade or capital flows and profits earned abroad. In Western countries the proportion of profits generated overseas has grown substantially since the 1960s. Today Japan’s reliance on Chinese export markets to fuel its domestic expansion, and the USA’s reliance on China financing its current account deficit with capital flows, represent two of the most important underpinning international relationships.

The end of the old economic cycle

The rest of this essay will focus on the peculiarities of the economic cycle in the advanced economies, and the consequences of it flattening. While abnormal features are most evident among the ‘Anglo-Saxon’ bloc of developed countries – principally the USA, Britain, Australia and New Zealand – given the increasing convergence of all the industrialised countries to regulated market structures, signs of such peculiarities are also apparent in Japan and continental Europe. This pervasiveness reinforces the conclusion that something more significant is changing in economic forces, rather than merely expressing some aberrant, momentary, ‘softness’.

The relative anaemia within the mature industrialised nations is especially striking with respect to the USA. The USA has gained the reputation, albeit grudgingly granted in some cases, as being the most dynamic of all the advanced economies over the past decade. But despite the more upbeat commentary that often still surrounds the USA, even its expansion is unspectacular for this stage of a ‘normal’ post-recession recovery.

While recent growth has been in what seems like a fairly healthy 3-4 per cent range, this is well below what you would normally expect three years after a recession. For example, in 1977-78 the USA was growing at 5-6 per cent, and in 1984 at 7 per cent (see chart below). The present cycle is shaping up to be similar to the lethargy of the first half of the 1990s, when US economic growth rarely exceeded four percent.

The flattening of the US cycle is also evident. The high points are lower, and the low points higher. The latest growth peak in 1997-2000 (which encouraged all those breathless homages to the New Economy) was below any other growth peak in living memory. On the other hand, the trough in 2001 was also the most shallow. So the level of variation, the amplitude of the cycle, the distance between highs and lows, has diminished.

US real GDP growth
Figure 4: US real GDP growth
(source: BEA)
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The shift in tempo comes across even more clearly if we compare the first three years of the past four sustained recoveries in America. Post-trough surges of around five per cent in the earlier two have been replaced by a more leisurely three per cent average in the most recent pair. The take-off just isn’t happening in the old way.

US post-trough growth
Figure 5: US post-trough growth
(source: Bureau of Economic Analysis)
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US job creation has also been much slower than normal. Traditionally private employment levels fall during recessions as company closures lead to people being laid off, with employment rising again as the economy recovers (see chart).

Total private employment
Figure 6: Total private employment, USA
(source: Economagic)
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Such an employment increase took much longer to appear in the1990s recovery, leading to the epithet of ‘jobless recovery’. This time new jobs have again been slow to appear, leading to a reprise of the same discussion, but with the difference that the labour market has been even weaker.

Between 1960 and 1982, employment levels expanded immediately after the economic trough. In the post-1991 recovery it took just over a year before employment showed net gains. However since the 2001 trough, employment continued to fall for almost two years.

US payroll employment
Figure 7: US payroll employment
(Reproduced from the OECD’s Economic Outlook, December 2003)
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Focusing only on US private sector employment – without the benefit of additional government jobs – and thereby providing a more direct measure of the state of the market economy, the record is stark. Three years after the economic trough the level is still over one million below the pre-recession peak, which was hit in December 2000.

As the Employment Policy Institute pointed out in November 2004 this qualifies as the weakest overall job recovery since the US government began collecting monthly jobs data, which was in 1939 at the end of the Great Depression:

‘Since the recession began 43 months ago in March 2001, 490,000 jobs have disappeared from the US economy, representing a 0.4 per cent contraction. … To put this performance in historical perspective, in every previous episode of recession and job decline since 1939, the number of jobs had fully recovered to above the pre-recession peak within at least 31 months of the start of the recession (the average, excluding the 1991 recovery, has been a full recovery of jobs by the 20th month). …
Jobs in the private sector [have fared worse and] have dropped by 1,261,000 since March 2001, representing a 1.1 per cent contraction.

‘However, having no job losses, or gains, is a very low standard by which to judge a recovery – with history as a guide, one would have hoped that the economy would have recovered the jobs lost months ago.’ (12)

Change in private sector employment
Figure 8: Change in private sector employment
(source: Economic Policy Institute)
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Not just jobs but wages too have been unusually slow to pick up in this expansion. Personal income growth is one of the classic characteristics of a recovery following the rigours and hardship of recession. This missing, or diluted, ingredient is as much a feature of ‘stakeholder and worker friendly’ countries like Japan, as it is of ‘shareholder capitalism’ America and Britain.

For example in Japan, despite over two years of steady economic growth, wages have been falling. Many Japan experts admit this is a ‘puzzling phenomenon’ (13). In Germany the picture is similar, with the Economist Intelligence Unit anticipating that wage growth will be very low for the next few years (14). So in many parts of the advanced world we seem to be having a ‘wageless recovery’ as well as a jobless one.

The recurrence of some features from the past decade highlights the fact that post-trough torpor is more a feature of the world since the late 1980s, than something very contemporary. This points to a secular qualitative shift in the economy, rather than simply being the consequence of present-day and possibly transient factors.

A new stability

The most immediate feature of the lacklustre domestic dynamic in the older economies is that the real economy seems more stable. Many have welcomed this: some because they support the environmentalist ethos of ‘sustainable development’ and see slow, stable growth as a good thing in itself; others because they hope that greater stability could remove some of the uncertainties and waste that have characterised the traditional economic cycle. UK chancellor Gordon Brown, in particular, but others in western governments too, have basked in the elimination of the boom-bust cycle in the real economy. This more marked stability is genuine, and is a sober retort to the faddish but unsubstantiated idea that business operates in unusually uncertain, rapidly changing and turbulent times.

Enhanced economic stability is illustrated by the fall in the volatility of growth and inflation in most developed countries. Economic growth does not rise as far in good times, nor fall as low in bad times. With less variability in the rate of economic growth, the level of inflation has also become more subdued. The outcome of a study in 2004, written by economists Bill Martin and Bob Rowthorn for the investment bank UBS, challenges the notion of more turbulence. It shows that economic volatility in Britain, the USA, and most other Western countries has been at lower levels than at any time since the industrial revolution. One of their charts clearly illustrates this historic shift in the UK since the 1990s (15).

Declining economic volatility
Figure 9: Decline in economic volatility
(source: USB Global AM)
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Greater stability sounds like a positive development for an economy. The textbook understanding is that it should be good for business, by removing the uncertainties that can stand in the way of investment decisions. However this is not what has been happening, and investment has been unusually languid. The big snag is that the reason for the stability that we have been seeing is not the stability of underlying economic strength, but is mainly a symptom of the way that the market’s dynamic is being held back (16).

Market economies generally move in cycles, from troughs to peaks. This is not a natural phenomenon, but is to do with the interconnections for market societies between recessions and periods of expansion. Profitability problems tend to build up during periods of expanding production – taking the form of the overproduction of capital and other imbalances, the legacies of older and generally less productive capital equipment.

For capitalism, recessions are the warning signs that these problems are building up to become a constraint on continued economic expansion. In bringing an abrupt temporary slump in economic activity, recessions remind us that the market system has intrinsic defects as a long-term driver of productive development. But recessions also help to cleanse the system, forcing the destruction of these inherited problems and clearing the way for a new bout of profitable expansion. Investment stagnates, economic activity and trade contract, weaker firms are forced out of business with their assets written off or bought on the cheap, unemployment rises, and debts are wiped out. Without these periodic purifications, the old problems would tend to persist and hold the market economy back.

Those odd recent economic features that we have seen mainly flow from having tamer recessions. The market system has been a constraint on the sustained expansion of wealth, but through a different mechanism than normal. The clearouts have not been happening in the traditional way – neither the recessions at the start of the 1990s, nor the recent one, played their destructive, purifying role to any great extent. In the early 2000s some countries, including Britain, missed out completely on contraction, and even the USA avoided recession in the conventional technical sense of experiencing two successive quarters of negative growth: US GDP fell a little in each of the third quarter of 2000 and the first and third quarters of 2001, but rose in the intervening quarters. Of course some aspects of the traditional cycle persist. Hence the cycle is softened and tempered rather than eliminated, but what stands out is how muted and subdued it has become.

A new constraint

So the unusually mild contraction at the start of the 2000s, following on from the flatter 1990s cycle, establishes the framework for today’s lacklustre expansion. In particular there is a heavy legacy of unpurged imbalances and constraints hanging over from the past. At base level these represent restraints on productive investment. At a company and industry level, without the forced clearout of obsolescent capital the ‘deadweight of the old’ becomes a barrier to new higher quality investment. But what is more apparent on the surface is how these imbalances manifest themselves at the financial level.

For example, in any economic cycle increases in credit levels and borrowing come into play especially in the later stages to lubricate real economic activity. Recessions traditionally force debt levels down to remove the burden of debt repayments and to clear the way for renewed credit expansion when it is needed again in the next cycle. But this time some debt levels have continued to rise through the slowdown, especially for governments and households. These imbalances have grown rather than been whittled down. High and increasing levels of personal debt, most evident in the USA, Britain, Canada, Australia and Holland, has prompted much official anxiety about low savings rates and whether people are over-borrowed – a concern more often expressed in the late rather than early stages of recovery.

Imbalances have also continued at the international level, most sharply expressed in the USA’s burgeoning national indebtedness and growing current account deficit – the gap on all trade and investment income between the USA and the rest of the world. These international financial imbalances are also primarily symptoms of underlying problems in the realm of real production. Recessions normally bring a current account back into balance, through cutting back on imports as the domestic economy slows. This is the first time for at least 100 years where the USA has begun its recovery with a current account deficit. The deficit is now at a record of more than $600 billion, and is approaching six per cent of GDP.

The deficit is fuelled by the way that the US economy’s dependence on debt-fuelled personal and government spending to sustain people in jobs and maintain a sense of continued prosperity has not let up during or after the slowdown. American industry is incapable of meeting this buoyed-up domestic demand, so the USA is in effect living beyond its means.

US current balance as share of GDP
Figure 10: US current balance as share of GDP
(source: BEA/IMF)
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As America isn’t making enough to finance its consumption and investment, including the government budget deficit, the US economy must be financed by capital inflows – either through foreign direct investment (FDI) or equity investment into the USA, or by America borrowing money from abroad, selling bonds or other IOUs to foreigners.

There are now anxieties that the foreign appetite for investing in US assets is waning. Already the quality of inflows has deteriorated – away from buying long-term assets into liquid financial assets, which are more vulnerable to selling and which could generate a destabilising run on financial assets and the dollar. In fact the USA has had net FDI outflows since 2002, so has had to rely increasingly on borrowing from foreigners to finance its payments shortfall.

As a result of concerns about the sustainability of the deficit, the dollar has fallen substantially since 2001 and could well fall further. While attention is focused on these immediate exchange rate issues and the way they can make life more difficult for many of America’s trading partners, the problem is deeper.

There is always the potential for international economic imbalances to develop in the world market, expressing different levels and rates of productivity change. Today, at root, the west-east performance differential underlies global imbalances, but these have been exacerbated by the forces manifest in the flatter economic cycle in the old economies. This is why financial measures, such as changing relative currency prices, may ameliorate the problem temporarily but can’t solve the underlying structural deficiency in production and indigenous wealth creation within the US economy. Due to this deficiency the USA has moved from being the world’s largest creditor nation for much of the past century until the mid-1980s to being its largest debtor. That is, it now owes more to the rest of the world than any other country, and this debt to others keeps growing year after year to finance its current account deficits. This relationship will remain a constraint overshadowing the whole global economy.

New times – new possibilities

Why has the cycle flattened since the late 1980s? This is due to the interplay between new possibilities for market survival and new restraints on economic development.

No capitalist ever welcomed being one of the losers in a period of destructive recession, even if this was the necessary price for the system’s overall advance. Notwithstanding the pressures of market competition, capitalists would always try to be one of the survivors rather than one of the victims. Governments are also keen to prove themselves as effective economic managers – priding themselves on fostering stability and taking steps where they can to avoid the ‘boom-bust’ scenario. What has changed is that new or modified routes for economic and business survival have emerged both at the level of the individual firm, and in the macro-economic arena, which have made it possible to curb the destructive aspects of the cycle.

Underpinning these developments has been a greater room for manoeuvre in addressing economic tensions and difficulties, made possible by a political climate marked by the absence of social contestation and conflict. Political shifts have extinguished for today the sort of social crises pitting one part of society against another that used to be such a dominant feature of capitalism. Capitalist society is no longer polarised between left and right. Politics is no longer driven by opposing ideologies. Class is not the salient and dominating divider it once was.

In the workplace, too, conflict is much diminished. Industrial action is only the faintest echo of the first couple of hundred years of capitalism. Strikes are not just less frequent but lack the element of class struggle of earlier times. Parties today compete not over alternative visions of the future, but over which can be the better social and economic managers.

The absence of sharp political and social conflict has made it easier to withstand and work through economic challenges in a less destructive way than in the past. Without the circumstances requiring them to focus on issues of social conflict and protect their class interests above all else, business and political leaders have had the freedom to make more use of and extend the available coping measures. This has tempered the harsh winds of competition, and made it possible to mitigate destructive recessions.

These measures include the possibilities opened up by the global reorganisation of industrial activity. We’ve already noted the greater resort to internationalisation, and the support China brings to global stability. In addition, Western economies have become much more financialised, with the development of a wide range of new financial instruments to bolster the economy. There has been more extensive state support for the private sector, including through fiscal and public procurement policies. Instead of the mythical story of the state disengaging from economic intervention, state economic intervention has become more pervasive. The more adept use of monetary policy and state-backed liquidity has also contributed to sustaining economic activity.

For example, fiscal policies – to do with what government taxes and spends – and monetary policies – to do with the level of official interest rates – have rarely been this easy and expansionary, with large government spending deficits and doggedly low interest rates. From 2000 to 2004, policy eased in all the G7 economies and by a record amount in the USA. There, short-term interest rates have been at 40-year lows, while the fiscal loosening – the state spending much more than it taxes – by over six per cent of GDP since 2000 is the largest since the Second World War. The most telling aspect is not just how low interest rates went, but that they have been kept low so long into the recovery.

Change in structural fiscal balance
Figure 11: Change in structural fiscal balance
(source: IMF World Economic Outlook, September 2004)
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Similarly, the most significant feature of government budget deficits is not their quantitative level but the way they have continued and expanded during the post-trough expansion, when deficits would normally contract. Budget deficits in most of the G7 countries have become even bigger since 2002.

All these measures of exogenous support come at a price. Some are like addictive drugs. There is the dilemma between withdrawal and going ‘cold turkey’, or of suffering the growing side-effects. One side effect of prolonged loose official policies is that greater and permanent dependency can produce near immunity. It is difficult to cut them back, but also room for further official support becomes restricted.

For example, with interest rates only recently starting to rise again, and tentatively (or, in the words of US Federal Reserve chairman Alan Greenspan, at a ‘measured’ pace), there is very limited scope for cutting them again if circumstances required it to offset another slowdown. Yet the mature economies look like slowing into next year, when they could do with a bit more monetary stimulus. Hence those ‘flattening yield curves’, as short-term interest rates have to rise because they have been low for so long, while long-term interest rates fall as the financial markets react to the sense that a slowdown is underway. But given that short-term rates are still so low, even a dramatic official gesture to reduce them could not go very far, and hence could not assist by much.

Similarly it is also difficult for governments to countenance even bigger budget deficits to compensate for renewed slowdown. Borrowing gets more difficult and its cost – in the interest rate on government bonds – would be likely to rise. Even if treasuries did temporarily boost spending, the amount of extra stimulus delivered would be minimal, and offset by the negative effect of higher interest rates.

Another price, and a potentially more disruptive one, is in prolonging and exacerbating those imbalances that have accompanied this expansion. For example, all the additional debt and liquidity flowing around the economy is tending to push up the price of financial assets, including bond and equity markets, leading to a series of financial bubbles. While the ability to raise prices remains subdued in both consumer and capital goods markets – a big difference from the stagflationary 1970s – credit and liquidity are flowing into other areas that have almost become financial asset surrogates, such as housing, property and raw materials. While demand has helped to drive their prices up, this is not demand driven by a strong domestic economy but has more the character of an outlet for some of that sponsoring liquidity. Hence the fears expressed about more bubbles bursting.

But the dangers from all these imbalances should not be exaggerated. The greater ease with which Western capitalism has been able to resort to external, non-spontaneous supports has also reinforced the system’s contemporary resilience and flexibility. These measures do have both stabilising and destabilising tendencies, but in today’s climate the former dominate.

Problems and disturbances have arisen and will continue to arise, especially emanating from the financial sphere – the downside of the more extensive financialisation. But the flexibility of the economy limits much damage. There are no finite limits to many coping mechanisms. When one causes a problem, they turn to others to ease any pain. We’ve seen this already in the wake of a series of country debt crises and defaults (such as Mexico, Argentina, Russia), the East Asian regional financial crisis 1997-98, and bubble deflations, such as that which struck Western stock markets in 2000-1. All of these financial difficulties generated enormous anxiety at the time about their negative economic repercussions. But as testimony to enhanced resilience, they caused little global dislocation away from their immediate locus.

In similar fashion, today’s fears about the immediate potential turmoil arising from the consequences of the US external deficit are exaggerated. Asian, especially Japanese and Chinese, government purchases of US government stock since 2001 have been key to financing the USA’s expanding twin deficits, and defer a bigger dollar fall. In 2003 Japan, China and the rest of Asia financed more than two-thirds of the current account deficit. While escalating pressures will bring about some modifications – a few Asian governments are already diversifying away from holding so many dollars – it is unlikely that the plug will be pulled on the USA any time soon. Everyone has too much to lose.

China will continue to export Asia’s manufactured goods to the USA and then use at least some of the proceeds to recycle dollars back to help fund the US deficits. This allows the USA to keep buying those imports, and therefore underpins the global supportive role being played by American consumption. While the international media speculate on how long US-east Asian relationship can endure, the much more important consideration is what this rebalancing of global wealth production from West to East will eventually mean for international political power relations.

Even as the dollar falls further, the strong probability is that this will also be coped with without much global disruption. In fact, by boosting the competitive position of US exporters, as well as the dollar earnings of US multinationals, the dollar’s depreciation more ranks as another financial prop to the American economy than as a serious source of crisis. Although European and some Asian companies will be adversely affected for the opposite currency reasons, there will be indirect compensations for their economies, because with today’s global set-up anything that sustains US external demand is a plus for the others.

New times – new restraints

While all these features and trends have helped to sustain at least a modicum of economic activity and thereby stave off destructive bouts of recession, other, sometimes parallel, forces have become significant new restraints on innovation and on the seizing of productive opportunities. Many of these have been noted elsewhere in their own terms, but their combined impact has yet to be fully appreciated by most. The sluggishness of the expansion is being buttressed by several mutually reinforcing trends that have become both symptoms and determinants of the slow drift economy.

There is some implicit recognition that things are working differently today because of the ubiquitous sense of business uncertainty. In several recent speeches, US Federal Reserve chairman Alan Greenspan has summed up the modern mindset in stressing that uncertainty is not just an important and pervasive feature of the policy-making environment, but has become the ‘defining characteristic’ of the modern economic landscape (17).

This perspective is a paradox since there are strong grounds for establishing that the traditional, primary sources of business risk have been diminishing in recent years – a by-product of the new economic phase of tempered stability. Nevertheless, the presumption that the world has become a riskier and more uncertain place is strongly held, driven by a sense of greater vulnerability and defensiveness in business. This has its own auto-restrictive effects. Business leaders anxious in the face of uncertainty tend to be more conservative when approaching future development.

Alongside extensive state economic intervention is the spread of state regulation of economic affairs. As a general rule the state-market relationship is less direct than 20 years ago but is now more pervasive. Sometimes this represents directly economic regulations emanating from national government or from the European Union (EU) – often in Britain it is the mix of the two that creates the most difficulties – and sometimes it is the spread of social, safety or risk management regulation. Either way this is creating bigger burdens for business in cost, distraction, compliance requirements, and, ironically, the creation of genuine uncertainty. It becomes another disincentive to act and implement change if some future regulation may become a barrier – hence biotechnology companies’ desire both for more intelligent regulation and for some regulatory stability.

Such state regulation is only one part of a broader trend representing the enhanced formalisation of business matters. Distinctions have become more blurred between (i) state laws, regulations and standards, (ii) voluntary corporate codes, and (iii) company-specific rules and procedures. The overall impact is that market and business relations are much more codified and rule-driven than in the past. The formal is tending to drive out the informal, which used to be such a permeating and lubricating feature of economic relationships. This formalisation ranges from the spread of internal process controls to extensive risk management procedures, to much more prescriptive forms of corporate governance, codifying how company executives and managers should operate and their relationships with investors.

There is growing acknowledgment that this spread of regulation, using the word in the broad sense, has tended to reinforce the pre-existing defensiveness and caution in business, and that it risks stifling innovation (18). This broadening culture of corporate caution is detrimental to long-term strategic thinking and genuine productive innovation. The economist Roger Bootle was strikingly perceptive in his latest book in drawing together four developing threats to innovation and continued economic advance: increased litigiousness; increased regulation; the growth of political correctness; the rise of environmentalism (19).

‘The New Economy’ – of restraint not revolution

All today’s economic peculiarities highlight that we are in a different economic context. Many of the imbalances normally cleared out by recessions have not gone away, while the usual driver of the first few years of a recovery – corporate expansion and all that goes with it – has been unusually torpid. And as the mature advanced economies have at the same time become more dependent on stimulants external to domestic production, new barriers to innovation and development have also emerged.

The shift to the slow drift economy therefore renders anachronistic the classic four phase periodisations discussed by Philip Coggan. But to assess that the cycle has changed, even to the extent of losing many of its cyclical drivers and dynamics, has nothing to do with that New Economy ‘the business cycle is dead’ mentality, which was so fashionable at the end of the 1990s.

The shift is not the result of the supposed ‘revolutionary dynamism’ of the new Information Economy, which was said to have changed the rules of business and eliminated cyclical downturns. Rather it is symptom of the weakness of economic dynamism. This is a continuation of earlier trends. Since 1973 there has been a downshift in productivity growth evident in all the advanced economies, which has not been reversed (20). But the current situation is also a development and evolution from this period.

The new economy reflects the transition to a type of market system that relies much more on muddling through than on its historic intrinsic dynamic. This means that the advanced economies are overall more sluggish, while the world economy becomes more stable.

The Financial Times’ Lex Column noted that: ‘A period of more sluggish expansion may simply be the price to pay for the shallowness of the last recession.’ (21) But the longer-term price could be much greater. Weak expansions and weak recessions reinforce each other, with the tendency for output growth to settle at a lower average rate. Hence the way the trend line points down in the earlier chart ‘US real GDP growth, 1960-2003’. This tendency eventually undermines the possibility of continued social progress.

At any juncture in the new subdued form of cycle, there is a relatively little waste and destruction taking place. In the abstract this seems good for economic health, but it generates a new and different problem with market economies. In the previous ‘normal’ conditions, markets tended over the long term to bigger crises, but now the tendency is towards prolonged atrophy. The market is not getting to strain at its limits. Capitalism in effect gets clogged up without those occasional bouts of severe destruction – what Joseph Schumpeter, the prominent conservative economist from the first half of the twentieth century, poignantly called waves of ‘creative destruction’.

It is unlikely that even the more mature economies will lapse into long periods of absolute stasis or depression. There are many avenues of sustenance to turn to in order to obtain at least temporary vitality. But over the medium term and longer, we can anticipate a huge waste of productive possibilities due to a more anaemic pace of economic growth. The real underlying problem of the ‘new economy’ is this long-term drag on genuine and sustained wealth creation and thereby on social progress.

This is even more of a problem for those of us who have wanted to see faster and more sustained development and progress than the old capitalism could deliver. Contradicting the prejudices of the anti-growth lobby, capitalism is not today aggressively rampaging around the globe causing havoc and destruction in its greedy pursuit of material wealth and profit. On the contrary, its representatives are strikingly defensive and apologetic.

The harm to society will not be all that evident in the short-term, but will be felt further ahead. The possibilities for further economic development are being increasingly constrained, thereby limiting our material capabilities to address old, new and future problems. This poses new challenges for those who aspire to a more dynamic and innovative society than capitalism – new or old – has been able to offer.

Phil Mullan is the author of The Imaginary Time Bomb: Why an Ageing Population Is Not a Social Problem, IB Tauris, 2000 (buy this book from Amazon (UK) or Amazon (USA))

(1) ‘Is this a time to laugh or a time to weep?’, Philip Coggan, Financial Times, 20 November 2004 (italicised notes added)

(2) Financial Times, 29 November 2004

(3) Wall Street Journal, 30 November 2004

(4) ‘My wish for the second term’, Samuel Brittan, Financial Times, 5 November 2004

(5) Corporate profits section of the Bureau of Economic Analysis website

(6) Economic snapshot, Economic Policy Institute, 3 December 2003

(7) Economist, 4 September 2004

(8) Source: International Monetary Fund World Economic Outlook and US Bureau of Economic Analysis

(9) In terms of Purchasing Power Parities (PPP) China is already the second largest economy, with 13 per cent of world GDP. PPPs take account of the differences in the prices of the same goods and services between countries. A pound or a dollar in China, when converted at market exchange rates, buys a lot more than one does in the West. PPP corrects for this, by valuing goods and services on a like-for-like basis, and so can give a better comparison of the size of economies and of real living standards between countries. But to assess a country’s global impact, market exchange rate measures are a better guide, because international trade and capital flows – unlike the bulk of GDP – are actually transacted at market exchange rates.

(10) See ‘Dreaming With BRICs: The Path to 2050’, Goldman Sachs, October 2003

(11) ‘The dragon and the eagle’, Economist, 2 October 2004

(12) Job Watch, Employment Policy Institute, 5 November 2004

(13) ‘A wageless recovery: Japan’s economic growth has failed to boost workers’ pay’, David Pilling, Financial Times, 10 November 2004

(14) Germany economy: A welcome agreement, Economist Intelligence Unit, 5 November 2004

(15) ‘Will stability last?’, Bill Martin and Bob Rowthorn, UBS Global Asset Management, March 2004

(16) Of course, today many people – and not just ardent environmentalists – would not see this as a problem. On the contrary, for them stable and slower growth sounds like manna from heaven. This is not a view I share. See The dismal quackery of eco-economics, by Daniel Ben-Ami

(17) See, for example, Remarks by Chairman Alan Greenspan at the Meetings of the American Economic Association, Alan Greenspan, Federal Reserve Board, 3 January 2004

(18) See The Timid Corporation: Why Business is Terrified of Taking Risk, Benjamin Hunt, John Wiley and Sons, 2003; The Risk Management of Everything, Michael Power, Demos, 2004

(19) Money for Nothing: Real Wealth, Financial Fantasies, and the Economy of the Future, Roger Bootle, Nicholas Brealey Publishing, 2003, p172-173

(20) See, for example, Dynamic Forces in Capitalist Development, Angus Maddison, Oxford University Press, 1991

(21) Financial Times, 23 November 2004

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