From the November 2012 issue of Research Magazine • Subscribe!

October 24, 2012

No Quick Fix

The economy has changed, but our thinking about it has not.

No matter who ends up on top in this year’s closely fought presidential election—billed by both Republicans and Democrats as the most important in a generation—don’t get too excited about the winner’s ability to “fix” the economy. The economy’s problems are deep and long-term.

Fundamentally, the economy has evolved while the socioeconomic model—our set of assumptions and institutional arrangements—has stayed in place. The model eventually will be replaced, but the change will be radical and painful and there is no consensus what the new model will be. Certainly, neither major presidential candidate has seemed to have an answer.

All advanced industrial nations developed the so-called welfare state around the middle of the 20th century. It is a system in which the state redistributes incomes via a progressive taxation system from its wealthier citizens to poorer, while providing free or affordable education and a safety net for the old, sick or underprivileged. In the U.S. it was established by Franklin Roosevelt as a way out of the Great Depression, but in the post-World War II decades it also helped maintain workplace peace and a considerable degree of political consensus.

In Western Europe, the welfare state was built as a way to maintain social peace after the disastrous experience of two bloody wars, revolutions and repressive dictatorships. But it also helped bring an unprecedented and broad-based prosperity to European citizens.

Such a system worked generally well as long as industrial economies were labor-intensive and the bulk of production concentrated in the highly developed countries of Western Europe and North America. The enclosed economic system provided full employment with high wages, which in turn translated into steady consumer demand and healthy profits for businesses. The government was able to pay for a generous safety net without going into debt. On the contrary, governments were able to pay down or grow out of the debt they incurred during World War II. In the case of the U.S., national debt as a share of GDP went from 120% at the start of the 1950s to 30% by 1980. Government regulations and unionization, meanwhile, ensured stability by discouraging too much competition and slowing technological progress. 

The system, in its U.S. and European variants, eventually became stagnant and inefficient, and then began breaking down rather quickly. Production facilities were set up in new locations, as first East Asians and then others learned to manufacture the same goods cheaper and, in many cases, better. Established companies started to move production offshore in order to save costs in a more competitive environment. New technologies increased competition, but also made it easier to move production around the globe and replace labor-intensive processes with machines and robots. Intensified competition swept aside much government regulation and all but eliminated industrial unions, at least in more dynamic economies such as the U.S. 

New Economy

The economy looks very different now than it did only 20 years ago. Full employment has broken down. The jobless rate in the U.S. is now at the level of the early 1980s, but today’s unemployment, the structure of the labor market and the composition of the labor force have changed substantially. Many more women have joined the labor force today, by both choice and necessity, as few households outside the upper middle class can afford live on one income and have wives stay at home.

Underemployment is nearly twice as high as the headline unemployment rate, at over 15%, and it seems like a permanent feature of the labor market. So is having multiple jobs none of which alone can provide a living wage or offers fringe benefits. Over the past five years, there has been the phenomenon of college graduates being stuck in low-paying, low-skilled service jobs, possibly creating a permanent underclass. 

At the other end of the income spectrum, it has been noted that most of the gains in incomes over the past 30 years have gone to the highest 20% of US households, with the top 5% benefiting disproportionately. 

All these trends have been exacerbated in the 2008-09 global economic downturn and the subsequent anemic recovery, a period in which lower-income households lost further ground as far as incomes are concerned, and the top quintile, once again, moved further ahead. The labor force participation rate has plummeted from over 67% of the population during the boom of the late 1990s to just 63.5% in August 2012.

Some manufacturing is now returning to U.S. shores in the process known as insourcing. Foreign companies are also alert to opportunities in the U.S. South Korea’s Hyundai recently relocated car production to its plants in Alabama, while Germany’s Siemens closed its gas turbine operations in Canada and moved production to North Carolina, to cite just two recent examples. But insourcing brings back far fewer jobs than before, and at lower pay. Even if the U.S. once again becomes a net exporter of manufactured goods in the near future, the development of robotics technology suggests that job creation will not keep pace with the growth of the labor force. Moreover, only low wages will be able to compete with automation.

Same Old Model

The changes in the economy have not been matched by an updating of the socioeconomic model. Policies and institutions still assume a large middle class able to find adequate employment and buy ample consumer goods. As before, the government relies on taxation to redistribute incomes and to sustain the incomes of the poorer social classes. 

The problem is that the tax burden is now falling more and more heavily on a shrinking tax base. Lower income households find it progressively harder to pay even lower taxes; a smaller percentage of citizens with higher incomes are footing the lion’s share of the tax bill while using fewer and fewer government services. The lower-income classes grow, swelling the ranks of people who want to lay a claim on government largesse and who either can’t find jobs or can’t get a living wage. 

While getting less in taxes, the government is actually forced to provide more and more aggregate demand to sustain the economy. Thus, it finds itself footing a larger and larger share of the national bill with shrinking resources, pleasing no one. Public spending is growing, undermining overall economic efficiency. Upper income households and corporations balk at paying even more taxes and as a result public sector deficits are reaching dangerous levels. In the U.S., trillion-dollar deficits have become structural, and eliminating them would result in an 8-10% economic contraction, which would be classified as a new Depression. 

This situation is unsustainable. Western Europe has come to the end of the road, with the euro-zone crisis devastating the economies of the biggest debtors and plunging the entire region into an open-ended recession. The U.S., meanwhile, is accumulating debt at the pace of $1 trillion per year, and can’t continue to do so for long before becoming a giant Greece or Portugal. Social peace, too, is starting to break down on the fringes of the crisis-riven euro-zone and discontent with the political system is running high everywhere, even in relatively prosperous northern European countries and the U.S., where ideological polarization and the bitter tone of the political debate are almost without precedent in the history of the Republic. 

The socioeconomic model is in need of some fundamental change. It has to adapt to an economy that has moved far ahead of a system designed for the mid-20th century. The problem is that no one really knows what the new model should look like and how it will address an economy way out of balance—an economy in which goods can be made cheaply and efficiently with less and less labor, while consumer demand depends on a labor force that finds it harder and harder to get gainful employment.

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