Build For the Future (Part III)

This is part three of a three-part series on the need for the western economies to embark on fundamental reforms.

Restoring the growth path of the western economies requires hard work and fundamental change. Part I of this series recommended investments in education and capital stock, later retirement and higher workforce participation of women. Part II covered immigration policy, the efficiency of government and of raw materials, and cooperation on a global basis.

Most of these changes will not be welcome by the broader public, as they require adaptation and change – from short-term to longer-term orientation and from consumption to production.

Innovation could play a significant role. The more inventive we are in supporting future economic development, the less we need to go for cuts in our existing lifestyle. Part III of this series examines what innovation could look like, what root causes need to be address and the rationale for acting – now!

8. Launch the next Kondratiev wave

In the 1920s, the Russian economist Nikolai Kondratiev identified a pattern of economic growth consisting of successive “long waves” of economic development. Periods of rapid growth are interspersed by periods of slower growth and financial crisis before a new cycle of growth begins again. Later, the Austrian economist Joseph Schumpeter showed how these long waves were associated with major advances in basic innovation— for example, the steam engine, electricity and the automobile.

The developed world needs to prove Professor Gordon wrong!

According to Robert Gordon of Northwestern University, the space for truly fundamental innovations that result in step-change improvements in living standards is getting smaller and smaller. As he puts it, the invention of running water and indoor toilets was orders-of-magnitude more important than the invention of the iPad, Twitter and Facebook.

The developed world needs to prove Robert Gordon wrong. By investing in a growing and highly productive workforce and by making it easier for engineers and technologists to innovate and for entrepreneurs to start new businesses, the developed economies need to unleash a new Kondratiev wave of global economic development.

Stop protecting traditional industries

Many government policies in the developed world are designed to protect traditional industries, whether through subsidies or favorable regulation. This practice not only makes the inevitable decline of these industries more expensive to the economy and society as a whole. It also leads to a loss of future technologies and future industries.

As hard it will be to lose income and jobs in traditional sectors, efforts to postpone the inevitable always fail. Removing hurdles implies more active anti-trust policies as the high levels of profitability many industries enjoy today could be a sign for a lack of competition.

Encourage risk taking

Innovation tends to appeal to the young. Some of the most innovative companies — Apple, Google, Facebook, and Microsoft — were all founded by university students in their early 20s. Therefore, it is important for societies to encourage risk taking at a younger age and to make entrepreneurship more attractive and rewarding than working in other functions in the economy.

Increase social acceptance of new innovations

In many developed countries, especially in Europe, the public has grown skeptical of innovation and new technologies. The classic example is biotechnology and its application in food production and in some parts of health care research.

Resistance to new innovations is largely a function of the average age of a country’s population. The older the average age, the more the population seems inclined to protect the status quo and be wary of the new. Leaders in these societies will have to persuade citizens that only increased innovation can help deal with the costs of demographic change if overall levels of wealth are to be preserved.

Increasing GDP per capita will only be possible through innovation and new industries. Failing to achieve this will lead to a drop in living standards. For the West to have a higher GDP per capita than in the developing world is only possible – and justified – if the productivity and the innovativeness is higher than in other parts of the world.

9. Addressing the root causes

Globalization has brought the promise of economic prosperity to billions of people around the world. But it has also contributed to tougher international competition. And it has led to the creation of new inequalities of wealth and income in the developed world.

The growth in the global labor force continues to put pressure on labor costs in developed economies. At the same time, globalization is also leading to increasing inequalities in income and wealth within countries. Some groups (for example, investors) benefit more from increased globalization than others (for example, manufacturing workers).

Income statistics highlight this development: Between 1979 and 2007, the average U.S. household income grew by 62%. Over the same period, the income of the top 1% of the income distribution grew by an extraordinary 275%. The income of the rest of the top 20% grew by a slightly above-average 65%, while the income of the remaining U.S. households grew by less than 40%. The incomes of the lowest quintile grew by only 18%.

Inequality increases the risk of social unrest and of declining support for capitalism and a free society. As former University of Chicago economist and former IMF chief economist Raghuram Rajan (now head of India’s central bank) points out, “a capitalist system that does not enjoy popular support loses any vestige of either democracy or free enterprise.”

Politicians should have addressed the changing global landscape by investing in education, capital stock and innovation. But this would have been a painful and not very popular approach. So they opted for providing cheap credit in the United States and social welfare in Europe.

Ever rising real estate prices allowed consumers to take on credit to fund the shortfall between income and ever-rising costs for living, especially for schooling and health care. The central banks, notably the Fed under the leadership of Alan Greenspan, were acting more as a political vehicle than as the bank of the banks, backstopping financial crises and providing capital against solid collateral.

Going forward, we have to get back to solid central banking, an income and wealth distribution which is perceived as fair and a society which not only thinks about itself, but also about the following generations. Implementing a debt restructuring and implementing the measures outlined above form a solid foundation. Mechanism for income redistribution will have to play a part as well – and, no, I am not a socialist!

10. Act now

Debt continues to grow faster than income. Unfunded liabilities grow with every new retired person and the workforce starts to stagnate or shrink. There is never a good day to act on these things if you are a politician. After all, you can always hope the problems don’t show up during your tenure and that your successor will have to deal with the mess.

Our problem is that every day we wait, the problem only grows bigger and bigger. It would have been much better to deal with the problem 50 years ago. That would have required not making promises that no one can keep – and accepting that consumption requires income, which has to be earned in the market via competition.

Standard-of-living increases cannot be sustainably generated out of cheap credit and more social welfare. We passed the days of pain-free solutions many years ago.

No one knows how long the developed world can continue the current path without causing major social and economic breakdowns. As long as it does, however, economic uncertainty will remain high.

One indicator of growing uncertainty is an index developed by economists Scott Baker and Nicholas Bloom at Stanford and Steven Davis at the University of Chicago. (Scott Baker, Nick Bloom, and Steven J. Davis, “Measuring Economic Policy Uncertainty,” Working Paper, June 4, 2012.)

Their “economic policy uncertainty index” shows not only that overall levels of uncertainty have risen since the financial crisis. This uncertainty is also increasingly driven by political disputes over economic issues rather than, say, by military conflicts such as the First Gulf War or 9/11. To the degree that politicians and other leaders fail to address the structural challenges described in this paper, the odds of economic paralysis goes up.

What will happen?

Implementing the ten steps discussed in this series is absolutely necessary to get the Western world back on track. Everything depends on a fast and decisive solution to the debt crisis. Politicians alone will never be able to embrace this agenda on their own.

It is just as Luxembourg’s former prime minister Jean-Claude Junker was quoted to have said recently, “We all know what to do, we just don’t know how to get re-elected after we have done it.”

Therefore, they will need the active support of the broader public. Depending on how the leaders of the developed world respond, there are four potential scenarios for the future.

Option 1: Rome

If neither the developed world’s debt problems nor its longer-term structural issues are addressed, the developed countries will face a secular crisis with increasing social unrest and risks to democracy and the free market economy. Call this scenario “Rome.”

Option 2: Stagnation

If the developed world addresses its long-term structural issues, but does not solve the immediate debt problem, then that debt will be a permanent drag on economic growth resulting in reduced GDP per capita. This is a scenario of long-term economic “Stagnation.”

Option 3: Missed Opportunity

If the developed world is able to eliminate the debt overhang in the near future, but does not address its long-term structural issues, then it will have missed an important opportunity. The result of this “Missed Opportunity” scenario will also be sluggish recovery, increased social tensions, and reduced GDP per capita.

Option 4: Return to Growth

Finally, if the developed world can both resolve the debt crisis quickly and undergo a thorough structural adjustment, it will be able to return to a path of sustainable growth and social stability. Needless to say, the whole purpose of this series is to encourage the developed world to embrace this “Return to Growth” path.

It is up to us to make these changes happen. The program I have outlined above is not popular, but it is less painful than the alternative of not acting.

We have to help leaders to act. Of course, our politicians, almost regardless of which country one is concerned about, still believe in their little games and don’t work on the truly relevant challenges our societies face.

The challenges are too important to leave to politicians alone. It is time for a new social movement. This time to rebuild our societies!