How will the global economy recover from the Covid-19 shock? Most observers wish for a rapid and sustained recovery and expansion. However, this wish is unlikely to be granted.
Prior to the pandemic, the global economy had ‘preconditions’ implying that it was already on an unsustainable path. While stocks of debt and greenhouse gases were rising continuously, towards ever more dangerous levels, the stocks of trust and political good will needed to achieve sustainable policy solutions were falling equally alarmingly. Growing economic and social disparities contributed materially to rising political tensions.
Moreover, the public policies used to cushion the economic impact of the pandemic have in many respects aggravated the ‘preconditions’ problem. Paring back stimulus has become ever more necessary, but ever more likely to trigger future problems. The crisis has also affected poorer members of society disproportionately. To get off this bad path will require a ‘total reset’ rather than the incremental changes desired by those who wish to ‘build back better’.
Fostering a sustainable recovery, in spite of such preconditions, requires answering five questions. First, what public policies have led us to the current unsustainable state of affairs – what I call ‘policy preconditions’ – and should be avoided in the future? Second, what future shocks threaten sustainable growth? Third, what would a more sustainable global economy look like? Fourth, what policies are required to get ‘there from here’? Fifth, how do we – to use John Kenneth Galbraith’s phrase – choose between the ‘unpalatable’ and the ‘disastrous’?
My analysis emphasises the importance of monetary and fiscal policies in both shaping the recent path, and conditioning the future. However, interactions over time between the global economic system and the surrounding political and environmental framework are also crucially important. These interactions imply the need for policies with a much longer-term focus than hitherto. As well, it requires global political leaders able to rise to the challenge of choosing the ‘unpalatable’ over the ‘disastrous’.
1: What ‘policy preconditions’ threaten sustainable growth?
Monetary policy has been the preferred countercyclical policy instrument since the 1980s. Each actual or anticipated slowdown was met with monetary easing. This was observed in 1987 (stock market crash), in the early 1990s (recession), later in the 1990s (long-term capital markets failure), 2000 (dot-com bubble burst and stock market crash), 2008 (North Atlantic credit bubble) and again in the response to the Covid-19 crisis. Against a backdrop of global disinflation, reflecting technological advances but especially the opening up of previously closed economies, interest rates never rose as much in recoveries as they fell in downturns. Thus, interest rates, both nominal and real, have ratcheted down towards zero in recent decades.
The growing reliance on monetary policy reflected the belief that fiscal policy could, in practice, never be used in a ‘timely, targeted and temporary way’. In contrast, it was believed that monetary easing would always be effective in stimulating aggregated demand, and that it would have no meaningful unintended side effects. Unfortunately, both of these views about monetary policy are wrong. The longer run effects of policy changes matter enormously.
The effectiveness of monetary policy depends on future spending being brought forward, often accompanied by an increase in debt to finance spending. This works, but only for a limited time since the debt build-up restrains future spending. The ‘headwinds’ of debt have been steadily increasing in size and scope. At the end of 2019, the Institute for International Finance estimated that the ratio of global debt to global GDP had risen to 322 % ($255tn), 40 percentage points higher than at the onset of the 2008 financial crisis. Moreover, private sector borrowers in emerging markets made a significant contribution to this increase. Since the pandemic, sharp increases in corporate sector debt have been accompanied by sharp declines in GDP almost everywhere. This implies an even greater vulnerability to corporate debt overhang problems. In many countries, rising inequality implies that household debt is also increasingly burdensome as the poor become increasingly exposed.
As for other side effects, the business models of many financial institutions have been threatened by low intermediation margins. Pension funds and insurance companies, having the longest liabilities, have suffered the most, but even banks have raised concerns. Further, the ‘search for yield’ has exposed many institutions to losses should bets go bad. Mispriced markets (where prices could fall sharply) and malfunctioning markets (where liquidity suddenly dries up) also threaten the stability of the financial sector. These factors can also help explain resource misallocations, not least the growing number of ‘zombie companies’, with resulting effects on the level and perhaps even the rate of growth of potential. Finally, if low rates raise the prices of assets belonging mainly to the rich, this can become socially disruptive and politically destabilising.
If expansionary monetary policy seems increasingly unsustainable, so too is fiscal policy. Discretionary fiscal expansion and automatic stabilisers have interacted in successive downturns to constantly swell the ratio of public debt to GDP. Similar to monetary policy, the tightening in subsequent upturns has never been symmetrical. Public debt ratios have thus ratcheted up in recent decades to levels not previously seen outside of war time. Adding in off-balance sheet obligations and contingencies, governments in all advanced countries, even prior to the pandemic, could satisfy intertemporal balance sheet constraints only with significant tax increases. Record increases in deficits in the post-pandemic period have clearly made this problem worse.
The structure of both sovereign expenditures and taxes has been less than ideal. The proportion of government expenditures directed to investments with a longer run payoff (infrastructure, education, research and development) has been falling steadily. At the same time, transfers to support consumption have been rising. On the tax side, deductions that subsidise debt accumulation and the use of fossil fuels have also contributed to an unsustainable rate of growth for both debt and greenhouse gases. More generally, government policies have encouraged, or at least tolerated, excessive concentration in some industries and an excessive focus on near-term profits in others.
2: What future shocks threaten sustainable growth?
The ‘policy preconditions’ of debt, associated financial instability, rising inequality and resource misallocations could, in themselves, culminate in a deflationary spiral that would make the real burden of debt ever harder to bear. Unfortunately, we must also take into account other threats to sustained growth.
The future behaviour of the Covid-19 virus is itself a huge source of uncertainty. Basic epidemiological models suggest that infections will not cease, absent a vaccine, until ‘herd immunity’ is reached. This implies recurrent outbreaks and lockdowns that will constrain both demand and supply for an extended period.
Moreover, it is already clear that sectoral demand for goods and services will change massively. Relative prices, not least real estate, could change significantly while frictional unemployment will rise with lower paid workers being most affected. Given the fragile state of the underlying economic conditions, both developments could easily get out of hand.
Prospective supply side developments also merit attention. The demographic dividend that drove real growth and disinflation in recent decades is now going into reverse. The skilled work force in both the advanced market economies and Asia is now declining absolutely.
Whether this negative supply shock will be matched by an equal decline in aggregate demand is a source of much debate. On balance, however, the outlook would seem more inflationary. The impact of digitalisation is also debatable. Some point to prospective, large increases in productivity. However, others fear further increases in corporate concentration and a further hollowing out of middle-class jobs in the advanced market economies in particular. This could exacerbate social and political problems arising from widening income inequality in many countries, as well as increased indebtedness as the poor borrow to ‘keep up with the Jones’’.
Both the slowdown in international trade and global warming are unambiguously negative for future living standards. The former implies fewer productivity gains from the extension of global value-added chains. The latter will inflict huge damage from extreme weather events and the need to divert scarce resources to adapt the landscape to lower those costs. The costs of mitigating climate change are separate and will be treated below.
We must consider uncertainties about political outcomes. Surveys indicate that trust in both national political institutions and international engagements has been declining for many years. There is a growing body of academic literature that links financial crises, like the one that began in 2007, and growing inequality, to the erosion of support for governing parties in democratic countries.
Polarisation in favour of parties with nationalist agendas commonly follows, as we have seen in many advanced countries in recent years. Evidently, ideological barriers, like those now affecting Chinese-American relations, further reduce the likelihood of the multilateral cooperation required to deal with global threats to sustained growth.
3: What would a sustainable economy look like?
Continuing down the current path raises the likelihood of worsening economic crises that could threaten both the capitalist and democratic models. Given this dire prospect, alternative paths are worth considering. The first question is where we want the path to lead us. What would be the characteristics of a sustainable economic model?
The first requirement is for a paradigm shift in our analytical framework. The global economy would be recognised as a complex, adaptive system like many others in nature and society. Thinking in terms of systems, not silos as is currently the case, holds the key to a more sustainable world. Increasing sustainability includes building in more resilience, even at the cost of near-term efficiency and profits. Moreover, in spite of best efforts at structural change, all such systems break down regularly. Policy-makers would try to prepare ex ante for such outcomes, even those arising from unexpected sources. Finally, it would be recognised that the economic system is nested within interacting social, political and environmental systems. The sustainable development goals, developed by the United Nations, and the adoption of SDG criteria in evaluating investments, indicate a growing recognition of this reality.
A sustainable economic system requires a sustainable policy framework. The public sector, both finance ministries and central banks, would also conduct their policies more symmetrically over time to prevent ratcheting effects, particularly with respect to debt stocks. This would imply both more ‘leaning against the wind’ of credit upswings and more willingness to accept small economic downturns. Similarly, public sector safety nets would be more limited, to prevent moral hazard, and to protect taxpayers. There would be more disincentives to leverage and more incentives for risk-sharing across the private sector.
A sustainable system of capitalist production would adjust production costs and prices to reflect environmental and other externalities. Since complex systems like the environment have ‘tipping points’ beyond which uncontrollable processes are set in motion, the urgency of this requirement (e.g. imposing carbon taxes) should not be underestimated. Moreover, a sustainable system would be focused more on the interests of stakeholders rather than only shareholders. A greater focus by companies on sustainable profits over time, rather than meeting near-term expectations, would also work in the same direction. With the exception of a few countries, economies would operate with higher levels of investment to GDP than has been observed in recent decades. Finally, antitrust legislation would be vigorously enforced to ensure the widespread distribution of economic benefits.
A sustainable, democratic political system requires more attention to distribution and social inclusion. Altered behaviour by private companies can help, but most governments would have to give this objective higher priority. Efforts to ensure equality of opportunity for younger people of different means would play a crucial role in such a world. Governments would also limit corporate influence in the drafting of legislation. Nothing threatens political legitimacy more than a popular belief that ‘the system is rigged’ against the interests of ordinary citizens.
Improved institutional structures are needed to ensure sustainability within and across the various systems that contribute to the global economy. Many problems are global, yet our global institutions are either lacking (we do not have an ‘international monetary system’) or are increasingly ineffective (vetoes at the United Nations), as nation states refuse to cede sovereignty. Moreover, urbanisation implies subnational poles of influence that are best placed to respond to local problems. Perhaps the best solution would be a ‘barbell approach’. We need a globally shared ‘vision’ of how best to ensure sustainability, allied with ‘execution’ in a flexible and decentralised way by a variety of actors. This is essentially how the Paris climate agreement is meant to work. It also guides some of the thinking by the European Commission, approved by European leaders in July, on an ambitious new framework for European post-Covid-19 recovery.