Traditionally economists have tended to ignore distributional issues. These issues were considered to rest on value judgements, and to therefore be outside the purview of orthodox neo-classical economics. To the extent that distribution did enter the economist’s model, it was often presumed that there was a trade-off between equity and efficiency. However, it is argued here that the economic stagnation experienced over the last decade or more, is reason to reconsider the present economic strategy, which assumes that economic growth is largely driven by supply-side factors. Instead, the stagnation seems to be mainly a result of inadequate demand, and the economic strategy for the future should therefore focus equally on how best to sustain the growth of aggregate demand and how that has been impacted by increasing inequality.
The dominant economic strategy in OECD economies, and especially the English-speaking members, has been built around the presumption that economic growth is determined by the three PPPs – population, productivity and participation. The role of macroeconomic policy, or demand management, is essentially limited under this model to smoothing fluctuations in economic activity around the growth in potential output. In other words, under the prevailing economic strategy, economic growth is considered essentially to be a supply-side phenomenon, and the rate of increase in demand cannot alter the rate of economic growth in the long run.
This so-called ‘neo-classical’ growth model did not, however, emerge by accident, nor because of some ideological crusade by neo-liberals. Rather this growth model was a response to the experience of stagflation, which ran from the 1970s to the 1980s. The distinguishing feature of this period was that both unemployment and inflation were high at the same time; indeed, at its peak in Australia both inflation and unemployment were running above 10%, while economic growth stagnated. But this conjunction of high inflation and unemployment defied orthodox Keynesian norms which presumed that there was a trade-off between unemployment and inflation (as embodied in the Phillips curve). So the adoption of an economic strategy based on the neo-classical growth model was essentially in response to the perceived failure of the previous Keynesian model which focussed on maintaining strong demand growth.
Accordingly, the reform agenda that flowed from the focus on the supply-side led to a focus on improving the flexibility of markets and strengthening competition. These reforms were critical to achieving a less inflation-prone economy and increasing productivity, which was typically considered to be the most significant of the three PPPs. In addition, because of a mistrust of governments’ willingness to take the tough actions needed to restrain inflation, this strategy assigned the principal responsibility for maintaining price stability to an independent central bank; fiscal policy, at least notionally, was assigned to a more minor role.
These reforms have proven to be successful. Without them it is doubtful that Australia could have gone 27 years without a recession, and despite major disturbances in Asia in 1997 and in the developed countries in 2008.
But what I want to emphasise here is that this strategy was primarily a reaction to the perceived nature of the economic problems of the time. Furthermore, this approach to defining the appropriate economic strategy is not new. Indeed, it is quite natural that the economic strategy adopted will always be directed to resolving the principal problems of the time and have regard to the institutional framework that the economy is operating within. Thus, the adoption of Keynesian policies was a direct response to the Great Depression. That depression was characterised as an excess of savings over investment leading to a shortage of demand, and the distinguishing feature of Keynesian policies was that governments should run budget deficits (ie dis-save) if there was an excess of private savings, in order to ensure sufficient aggregate demand to maintain full-employment. Equally the present economic strategy reflects the period of stagflation whereby inflexible and uncompetitive markets allowed inflation to be used as the safety valve to the excessive and incompatible claims being made by different interest groups.
But now that the problems have changed, so should the economic strategy change.
What Economic Strategy is now needed
Interestingly, today’s economic circumstances bear many resemblances with those of the Great Depression. Although our present circumstances are not as severe as during the 1930’s, this is probably largely because this time governments have adopted much more sensible policies to support aggregate demand in response to the Global Financial Crisis.
Nevertheless, over the last decade the OECD countries have experienced economic stagnation, with the average annual rate of growth for the OECD since the GFC representing only 1½%, compared to a previous ‘norm’ of around 3%. In the last year there has been some sign that economic growth in the US and Australia could be returning to past rates, but as I argued in my recent post on “The US Economic Outlook”, slower growth over the medium to longer term is likely in the US (and probably also to some extent in Australia). Significantly, most of the other OECD countries are still stuck in economic stagnation, and the latest OECD forecasts in September have been revised downwards relative to the May forecasts.
The fundamental reason for the economic stagnation of the last decade has been inadequate demand growth, mainly because of increasing inequality and low wage growth. But if demand growth is the principal problem, then that is what economic strategy must focus on, and more specifically the reform agenda should focus on how to improve wage growth, especially for low and middle-income earners, and thus aggregate demand.
In the next article, to be posted tomorrow, I will discuss what that means for the future economic reform agenda, where the starting point must be how to reverse the increase in inequality that is the key reason for inadequate demand growth.
Michael Keating is a Visiting Fellow at the ANU. Previously he was the Head of the Departments of Employment & Industrial Relations, Finance, and Prime Minister & Cabinet.