It's Worse Than You Think: Halftime Between Two Lost Decades

The recovery feels extraordinarily slow because we face an extraordinary three-part crisis: a financial shock compounded by a global slowdown and a demographic time bomb. Time to think big.

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The global economy is in a synchronized swoon. Brazil's economy practically stalled out in the first quarter, all of China's manufacturing figures indicate much lower growth than last year, Britain remains in recession, Spain's banking system needs a rescue and may collapse, and the U.S. -- which had been the last remaining bright spot in the global economy -- suddenly has started sputtering. The number of jobs created in May was not just half as many as expected; the figures for the previous two months were sharply revised lower as well. And for good measure, GDP growth for the first quarter was revised downward too.

Many observers were surprised or disappointed, because they still do not understand the nature of this recession, which is neither exclusively cyclical, nor exclusively structural, but rather a rare collision of crises -- a financial recession, in the middle of a global slow-down, at the edge of a demographic time bomb.


First, this is not a normal demand-damp cyclical recession. In such a recession, demand has been driven upward by rising population and rising wages, faster than production can keep pace, and the result is inflation. To rein in that inflation, monetary authorities raise interest rates and/or governments reduce spending to reduce demand. The result is a dampening of demand that usually drops unemployment and spending and ends inflation. However, as soon as inflation is under control, interest rates can be lowered and government spending can resume; hiring then usually picks up as does overall demand and the economy again grows. The whole process is a bit like hitting the pause button, then the forward button, for the economy as a whole. In such a cycle, the basic relationship between economic growth and job and wage growth remains unchanged, hence the recession is only cyclical, not structural.

However, the current slump is a different kind of cyclical recession; it is a financial overleveraging recession brought on by an excess of debt rather than just demand. In such recessions, deregulation and unusually easy credit lead to enormous borrowing to invest in 'sure things' -- in this case, private residential housing (in other cases it has been sovereign debt, or property, or new technologies). People view this asset as so safe that they develop all kinds of ways to boost their leverage (e.g. debt to asset ratios) or get out risky loans to purchase those assets. This huge influx of buying power raises the price of the 'safe' asset to unsustainable, unrealistic levels; then when people start to realize that the risky loans will fail and the underlying asset is losing value, you get a collapse of the market and a financial bust. Both borrowers and firms that managed the debt are critically hit.

In the current recession, demand is not being intentionally damped to reduce inflation. Demand collapsed of its own accord as people recognized that they do not, in fact, have the asset wealth they believed they had. Worse, they were left holding large debts that now are much larger than they want given the value of their assets. They then have no choice but to deleverage -- that is, to reduce spending, pay down debts and increase their savings until they return to their desired debt/asset ratio. With this economy-wide collapse of private spending (banks too have to rebuild their debt/asset ratio by recapitalizing and reducing their loan books), deflation and depression follows - unless (as Keynes first showed) government spending moves higher to take the place of the reduced private spending.


Carmen Reinhart and Kenneth Rogoff have clearly pointed out this difference, but their guidance -- that financial crisis-based recessions tend to last 7-10 years and usually involve sovereign debt crises as well -- has often been disregarded. This is why you often hear President Obama being blamed for the recovery being "weak" or "pathetic" compared to the recovery from other recessions. It is of course true that the recovery (or non-recovery as we are likely in this for years to come) has been very weak compared to recoveries from ordinary demand-dampening cyclical recessions. But that is to be expected. This is a different beast. One cannot simply push the "forward" button and restart the economy. The underlying mechanism is broken and has to be repaired by reducing debts, which takes time.

It is true that the solution to a financial-crisis based recession is reduction of debt to acceptable levels. Those calling for an austerity program in response have on their side that they are calling for a reduction in debt, namely government debt. But they have only seen a fraction of the problem. The economy has slowed to a crawl because private firms and households took on too much debt, and have to save and reduce spending and debt. In doing so, they put a lot of people out of work. That in turn raises government spending. Yet at the same time, the recession sharply reduces government revenues, so the result -- a symptom of the underlying crisis -- is much more government debt.

Austerity policies target that symptom. Yet cutting government spending and raising taxes in an economy where both consumers and private firms are seeking to reduce their debts and increase their savings simply redoubles the overall reduction in spending throughout the economy, making the recession even deeper. That is why austerity policies have not pulled any countries out of this economic crisis.


All this would be bad enough. But in addition to this more difficult kind of cyclical crisis, we are experiencing a structural crisis as well, in which the basic relationship between economic growth and employment and wages is changing.

Capitalism has worked for as long as it has because, contrary to Karl Marx's predictions, overall economic growth brought strong employment and rising wages to workers. Marx predicted that as economies grew, more and more of the rewards would go to owners of capital, while workers faced reduced employment and stagnant or falling wages. There have been periods like this, to be sure, such as during the Robber Baron age, the Gilded Age, and the recent 1990-2010 period. In these periods, the rich managed to beat down workers and retain the bulk of the gains from new technologies and productivity increases (think railroads, electricity and chemical industries, communications/ computing). And such periods ended in busts that brought predictions of the 'end of capitalism.'

But capitalism did not end, because of two major adaptations. First, the organizing and political clout of workers grew and allowed them to fight back through progressive legislation. The Progressive Era and the New Deal in the U.S., and labor governments in Europe, broke up the trusts, reined in the runaway wealth of the elite with progressive income and estate taxes, and empowered workers to bargain to gain a larger share of the benefits of their productivity increases. In the short run, the wealth and power of the elites was diminished (which is why they fought these changes tooth and nail and predicted the end of America, democracy, and everything else would result). But in the long run, these changes put the masses back on the side of sustaining capitalism, and kept it going.

The second major adaptation lay in education. As capitalism went through rounds of creative destruction and changed the composition of the capital structure, the numbers and kinds of workers needed changed as well. In particular, advancing capitalism required more workers with specialized skills, first machinists and engineers, then creative designers and software engineers, and who knows what next? In a structural crisis, employers rid themselves of employees who had the skills appropriate to earlier stages of economic development, but who are no longer increasing their productivity, and replace them with workers that have new skills that lead to faster rises in productivity. During such junctures, economic growth does NOT simply lead directly to more jobs and higher wages. Economic growth may go in hand with fewer jobs and declining wages for workers who have the older skill set that is no longer in demand. Claudia Goldin and Lawrence Katz have called this the "race between education and technology." When technology leaps ahead, it can be bad for labor trained and experienced in older technologies. It often takes a decade or even more, but eventually the workforce adapts its skills and education to what is needed, employment returns to higher levels, and economic growth again is linked to more jobs and higher wages.

For the last twenty years, the world has been experiencing a leap in technology through computing that has created a structural crisis. Workers with skills in demand in the older mass-manufacturing industrial era have been let go or forced to find lower-paying jobs, while smaller numbers of computer engineers and designers can set up projects executed by robots or lower wage overseas workers. The result is that economic growth and productivity gains in the U.S. no longer lead directly to more jobs and higher wages. Instead, wages have been pretty much flat for most workers for over two decades.


We have seen this kind of structural crisis before, but we now have three other elements that I fear are unprecedented. The first is global aging. In all of the world's largest economies -- even China and Brazil -- population aging has set in. This has several effects that dampen growth: the labor force shrinks; it grows top-heavy in older, higher-wage workers with lower productivity growth; and more money is spent on pensions and health care leaving less for investment and educating and training the young. Global aging really started to matter in 2010, right in the midst of our cyclical recession, as the baby-boomers in Europe and the U.S. born from 1945 onwards started to hit retirement age (65), and as the one-child policy in China, started in 1980, finally began to stem the growth of young workers there.

The second is that China -- the world's second largest economy -- is in the middle of radically shifting its growth model. When it was smaller relative to the global economy, China could grow rapidly by ramping up its exports. But as China grew larger and larger, it could not keep growing by raising its exports to richer countries. At some point, more of China's growth was going to have to come from demand by its own consumers. But that has not happened yet; rather the Chinese growth model has relied on keeping its consumers relatively poor and investing productivity gains in infrastructure and production to boost exports. Today, the cyclical crisis has caused a collapse in China's export markets, well before it is in a position to shift to domestic demand-driven growth. Reflecting the first cyclical crisis, observers have commented that "China will be the first nation to grow old before it grows rich." But that is only the half of it; China will also suffer the end of growth of its export markets before its domestic markets can take up the slack.

In order for China's domestic consumers to pick up the slack, several things must happen. First, China's industries need to churn out products that appeal to local tastes and incomes, rather than products oriented to export markets. Second, China's workers need to have both higher wages (which will hurt China's competitiveness in the short run) and public health care and pensions that relieve them of the burden of saving as much as they can for the unknown future. One cannot simply create these conditions at the wave of a wand; it is more like turning a battleship around when it has been under full steam in the opposite direction. So adjustments to deal with this structural crisis will take time as well.

The third structural crisis is in Europe, which is garnering the headlines today. When Europe adopted the Euro as a single currency, it created a unified monetary zone, in which the currency values were unified across the region. However, Europe did NOT create a unified political/fiscal zone, despite some half-hearted moves in that direction with the European Parliament, European Commission, and European Central Bank. As long as the economy was stable, this did not matter. But in an economic crisis that was not just a simple demand-dampening recession (where you just hit the 'forward' button in national banks and the ECB), Europe did not have the political and fiscal mechanisms to rescue failing banks or sovereign debtors. Europe entered such a crisis in 2008, and for the last four years has been stumbling through the lack of institutions to deal with it, until banking and sovereign debt problems have become critical. Europe is now facing a choice between ending the Euro or moving toward creating unified political/fiscal institutions; either one is a structural change with unknown repercussions. The uncertainty is driving markets mad.

This is why we are stuck in a stubborn, long-term recession. We are facing the most difficult kind of cyclical crisis -- a financial crisis leading to many years of deleveraging and reduced private spending in Europe and the U.S. We also have a structural crisis of employment in the U.S. and Europe as we adapt to discarding of old-skill workers and creating a new labor force suited to the high automation high-computer-tech economy. And we have additional structural crises in China as it changes its economic growth model from export-driven to internal demand-driven, and in Europe as it deals with the disjuncture between its political and economic institutions.


This is such a perfect storm that even otherwise strong economies, such as Brazil and India, cannot move against the headwinds. Instead their own weaknesses (excess federalism and debt in Brazil, poor infrastructure and weak parties in India) are exposed. The multiple crises in the Middle East arising from the Arab revolts are a further drag on growth.

So we cannot expect any sudden return to normalcy. The best we can hope for is to muddle-through for perhaps a decade, as the various structural crises are resolved in the midst of a long period of deleveraging. There is also a risk that we may see more shocks as severe as in 2008 with sovereign debt crises and political clashes. In the worst case, if policy blunders or sudden drops in confidence in banks or sovereign debt occur in the midst of political deadlock, we could get a true global depression.

Yet I do expect capitalism to survive and adapt, as it has done before. I expect a new round of progressive legislation to improve the position of workers, coming after 2014; I expect a new round of education (perhaps internet driven) and emphasis on personal and craft skills to reshape labor markets in advanced economies; I expect an adaptation to population aging that involves greater integration of global labor markets and rich/poor country labor exchanges; and I expect China will shift to greater democracy, better conditions for its workers, and a healthy internal market. Europe is harder to predict, as we are too close to the peak of the crisis; but one way or another Europe will go on. We should also get some technical breakthroughs in medical care, clean energy, lighting, pharmaceuticals, and other areas now under intensive research. And currently small but fast-growing economies in Africa and southeast Asia should continue to grow and make greater contributions to the global economy.

Sadly, Marx was right about one aspect of capitalism - it is prone to periodic crises. Even rational actors tend to over-borrow if they are unduly optimistic about asset values and risk; the adjustment of labor forces to new technology is not a smooth and frictionless process; and the political institutions that provide the vital legal and contractual framework for capitalism to function can sometimes get clogged by political clashes and deadlock, or turn out to be wrongly designed to cope with the kind and scale of economic problems that emerge from growth. It seems that every sixty or seventy years, these cyclical and structural problems come together to create a truly major crisis. Yet where Marx was badly mistaken is in failing to appreciate the great resilience of capitalism. Rational actors do eventually adjust their debts and assets; new deals between labor and capital are developed while labor forces gain education and adapt to new opportunities; and political systems (so far) have managed to overcome conflicts and hammer out new institutional frameworks to set the stage for renewed growth. None of this is easy or painless, however - quite the reverse. Economic crises of the kind we are in are costly tragedies, and it takes dedication, sacrifice, and hard work on the part of business elites, labor organizations, political leaders, and ordinary consumers and voters to make it through. Historically, the gumption has been found, and in the Progressive Era, the New Deal, and the Bretton Woods accords, the U.S. and other leading nations created new national and global frameworks for renewed growth.

So we are headed down and out for the next few years. Nonetheless, capitalism will survive, and spread, likely emerging stronger than ever, as it has done in previous crises. But it is time to face up the magnitude of the current crisis. This is not a "normal" recession that will quickly pass, or from which the economy will just bounce back on its own. We need address its root causes, both cyclical and structural, find ways to fairly share the costs that must be paid, and forge agreements on the new institutions and frameworks we need to move forward.