More public investment, not less, could lift advanced economies out of their malaise | Larry Elliott

The past 15 years have been the most difficult for Western economies since the 1920s and 1930s. Public anger has grown as living standards have been reduced by a prolonged period of low growth. American politics is uglier than it has ever been, while far-right parties have become powerful political forces in Germany, Italy, Austria, Finland, France and Sweden.

The new era of anger is a far cry from the six decades between 1948 and 2008. Sure, there were recessions – often deep – during that period, but growth resumed and living standards rebounded. Certainly, there were protests – sometimes prolonged as during the protests against the Vietnam War – but the young people who marched eventually gained a stake in the system.

The capitalist system was expected to be efficient and, for most people, it was. When the global financial system went pear-shaped in 2008, people worked fewer hours than in 1948. Additionally, they lived longer, took more vacations, and were able to purchase consumer goods that were previously the prerogative of the rich.

Looking back, there were warning signs that things were starting to go wrong. Western economies grew faster in the first half of the 1948-2008 period than in the second half. The fruits of productivity improvements were increasingly captured by the better-off. The environmental costs of continued expansion have only gradually begun to attract political attention.

In his book The End of Times, Peter Turchin says that historically there have been five leading indicators of impending political instability: stagnation or decline in real worker wages; a growing gap between rich and poor; overproduction of young graduates with advanced degrees; declining public confidence; and the explosion of public confidence.

“In the United States, all of these factors started to take a worrying turn in the 1970s,” says Turchin. “The data points to 2020, where the confluence of these trends is expected to trigger a rise in political instability. And here we are.”

For 15 years, central banks and finance ministries – advised by multilateral institutions such as the International Monetary Fund – have been searching for a way to bring back the good times. They cut interest rates to zero, they printed money, they paid the salaries of workers made unemployed during the Covid pandemic; they subsidized consumers’ energy bills when gas prices soared after Russia invaded Ukraine. But while no one can say that policymakers have stood idly by, this approach has proven problematic on three counts.

First, and most obvious, it didn’t work. Growth and investment rates have not returned to their 1948-2008 average. The Eurozone looks set to enter recession this winter, while the UK will, at best, move sideways. Among the major Western industrial nations of the G7, the outlier is the United States, and even there a slowdown looms. Additionally, young people are leaving college with student debt and – unless they have financial support from their parents – with little chance of buying their own home. Add to this the stagnation of living standards and it is not difficult to understand why graduates remain radicalized well into their 30s and 40s.

The second problem is that central banks and finance ministries are increasingly worried about deviating from economic orthodoxy for so long, and even more so after the surge in inflation starting in 2021. So they raised interest rates, took money from their economies by selling bonds rather than buying them, and – with the exception of the United States – took steps to reduce budget deficits.

Even economists who opposed austerity in the wake of the 2008 global financial crisis have raised eyebrows at the fact that the United States is running a budget deficit of 7 to 8 percent of national output (GDP) despite a strong growth and low unemployment.

Paul Krugman, writing in the New York Times (paywall) said: “The fact is that the economics of deficit reduction are simple. This can be done either by reducing social benefits or by increasing taxes. Given that U.S. social spending is low relative to other countries, taxes are the most plausible route. But I don’t see any plausible policy path to raising taxes that would significantly reduce the deficit.

“Serious deficit reduction, a bad idea ten years ago, is a good idea today. But I don’t see any way to achieve this.

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Krugman’s payline illustrates the third problem: going back to 2008 means much higher interest rate levels, government spending controls, tax increases, and voter acceptance that governments cannot solve all problems.

That’s a lot to swallow, and policymakers need to be careful, especially when it comes to cuts in public spending. A study of 200 regional, national and European elections in eight countries – Austria, Finland, France, Germany, Italy, Portugal, Spain and Sweden – between 1980 and 2015 revealed a strong bond between austerity and support for extreme parties.

“Our results show that budgetary consolidations are associated with significant political costs: a 1% reduction in regional public spending leads to an increase in the vote share of extreme parties by around 3 percentage points,” the study says.

Last week, the National Institute of Economic and Social Research (NIESR) has suggested a way out of the low growth trap for the UK, although its message is applicable to other struggling economies. The think tank called on Chancellor Jeremy Hunt to increase public investment from 2% to 3% of GDP over the next five years, saying spending on digitalisation, decarbonisation and transport infrastructure would attract investment private and would revive the economy. Over time, higher levels of growth would translate into higher tax revenues and stronger public finances.

This makes perfect sense, especially since the alternative would be another decade that leads nowhere.

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