Wednesday, November 5, 2008

A Long-Term Trend Toward The Depletion of Fiscal-Macroeconomic Slack in the World Economy?

By Nader Elhefnawy

Slack can be defined as that "human and material buffering capacity" enabling social and technological systems "to absorb unpredicted, and often unpredictable, shocks."1 Besides providing a cushion, it is also what enables systems, be they an ecology, a corporation or a country, to seize new opportunities, fulfill new roles and grow.

Archaeologist Joseph Tainter has argued that industrial societies are in the process of depleting their slack through diminishing marginal returns on investment in complexity.2 Such a position may seem counterintuitive, since complexity is a way of adapting systems in problem-solving ways, and one which typically succeeds. Nonetheless, adaptation is conducted with imperfect information and decision-making processes, and adaptive capabilities are not infinite; they can be overwhelmed, and the cost of having coped successfully with the last challenge may be not having the resources to face the next crisis.3 Solutions that may apparently be appropriate to dealing with a given problem commonly have "maladaptive" effects.

Compelling and widely applicable as Tainter's theory is, it nonetheless remains to be proven that there is increasing investment in complexity; and that it is having these effects. To consider only the first half of the problem, there are literally dozens of yardsticks for measuring complexity in fields of human activity, from linguistics to physics.4 However, their common denominator is information content, specifically the amount of information necessary to model or operate a given system.5

From that standpoint, there can be little doubt that the complexity of human civilization is steadily increasing. The world’s expanding population and material output; the growing volume and evolving structure of trade and investment; the rising flows of long-distance travel and communication; the enlarged share of capital, income and labor devoted to information processing provides ample statistical support to such intuitions.6

It is a less simple matter to demonstrate that investment in these areas is actually producing the diminishing marginal returns Tainter wrote about; and that this is leading to the depletion of slack-particularly at the global level. Arguably, however, the performance of the advanced economies, and the world economy as a whole, can demonstrate the former, with a falling rate of economic growth classifying as a fall in such returns.

Measuring the depletion (or accumulation) of societal slack is more difficult, since even at the level of individual countries or the global economy as a whole, there seem to be at least four different kinds of societal slack. The first is fiscal-macroeconomic, namely the economic (and especially, financial and monetary) resources societies can call on in time of need to achieve a given end. The second is industrial-technological, or the flexibility inhering in existing infrastructure and other physical assets to do the same.7 The third, human resources slack, is the reserve of labor and skills that can be deployed for such purposes. The fourth is political-cultural, or in other words, the collective willingness of societies to act in the ways described above.

One can only go so far in distinguishing between them, some overlap being inevitable, but this article will concentrate on discussing the first kind of slack, which seems to be the most susceptible to measurement. In exploring this, it will concentrate on the pattern of savings and debt, and the state of public finances (particularly central government finances), these being good indicators of the slack existing in an economy, and especially government resources. Falling savings, mounting debt and tighter finances (relative to the size of the economy) all indicate fewer unused resources (perhaps absolutely, but certainly relatively, and it is the relative rise or fall of this kind of slack with which this article is concerned) which can be called on in time of need, and can therefore be interpreted as a reduction of slack.

The global data apart, the focus will be on the major advanced states because they arguably represent the furthest development of observed economic trends; because they account for the larger part of the world's total economic output; and because they have been the most thoroughly studied to date. After its survey of the data relevant to these areas, the article will then move on to assessing the data for its implications, and possible explanations for this case of affairs.

Falling Economic Growth
Measured in constant 2000 dollars, the U.S. economy grew at a rate of 4.2 percent a year from 1950-1973, then 2 percent a year from 1974-1995 according to Bureau of Economic Analysis data (Table 1.1). According to the same time series, growth picked up again after that, rising to 3.2 percent a year in the 1995-2000 period, but falling back down to an average of 2.3 percent a year for 2000-2008 after adjustment for inflation.

Adjusting the data for population growth makes little difference. The rate of per-capita growth for the 1950-1973 period was 2.6-2.7 percent a year, fell to 1 percent in the years 1973-1995, went up to nearly 2 percent for the remainder of the decade, and then for 2000-2007 fell back to 1.3 percent a year (Table 1.2).

This trend has been paralleled in other advanced economies, the rate of per-capita growth across the Organization for Economic Cooperation and Development (OECD) falling by more than half between the 1960s and 1990s (Table 2.1), according to OECD statistics. World Bank data generally supports this view, and indicates a similar drop in the performance of the advanced and developing economies during this period (Tables 2.2 and 2.3).

World Bank data is less informative about global trends, but they would point to a drop in world GDP expansion, substantiated by the data compiled by the World Trade Organization (WTO) (Table 3.1), showing a slowing in world GDP expansion fell-from 5.4 percent a year in the 1960s, to 4.0 percent in the 1970s, 3.2 percent in the 1980s and only 2.3 percent in the 1990s. The drop in the rate of per capita growth is sharper still, falling from roughly 3.3 percent a year in the 1960s to 1 percent in the 1990s (Table 3.2).

The global picture after 2000 (or even starting in the late 1990s) is more ambiguous. According to the WTO, the years 2000-2006 have seen a 2.8 percent a year rate of growth, with per-capita improvement even more pronounced, this occurring at the rate of 1.5 percent a year (Table 3.3). Additionally, figures reporting twice that rate for the latter years of that period, continuing to the present, are fairly common.8

This upward swing in the global economy does not seem to be driven by developments in the advanced countries, but by developing nations, and the fact only adds to those ambiguities, even beyond their playing "catch-up." Much of their economic expansion may simply reflect the surging prices of primary commodities, and in particular oil and metals, since 2002.9 The rapid growth of Russia since the turn of the century, certainly, owes much to these factors.

Additionally, Purchasing Power Parity (PPP) figures significantly in these growth rates, and it has recently been found that this was greatly overstated in the cases of China and India, the economies of which together comprise 15-20 percent of global GDP, and have been growing at rates well above the average during this period, so that their situations alone substantially impact the picture.10 I have yet to encounter time series that have been clearly adjusted to take into account these very substantial revisions. Nonetheless, even before these revelations, Alan Freeman authored a noted study which showed that, when PPP is eliminated from the picture and the current dollar figures are adjusted for inflation, the world's per capita GDP did not grow at all between 1980 and 2002, and actually shrank slightly between 1988 and the end of that period.11

In other words, economic growth may barely be keeping pace with the rate of population increase. The argument seems even more plausible when the deficiencies of Gross Domestic Product as a unit of measure are considered, highlighted in the common likening of GDP to "a calculating machine that adds but cannot subtract." In its estimation, no distinction is drawn between costs and benefits, or sustainable and unsustainable activities, as with the well-known example of the cancer patient who becames an "economic hero" by running up a high medical bill.

In the parlance of economists, it tends to externalize ecological and social costs, damage to long-term productivity included. Unsurprisingly, some have sought to ameliorate those deficiencies, with one notable result being the Genuine Progress Indicator (GPI), which accounts for a wide range of the aspects so often overlooked, including the consumption of capital stock (like the depreciation of infrastructure), environmental damage and resource depletion (what some term the loss of "natural" capital), unemployment, and debt.12 The precise data reported by the inventors of GPI has varied considerably over time, with the 2006 report seeing a substantial revision in the instrument's methodology.13 However, it has been consistent in indicating the cessation of growth in GPI in the 1970s even as U.S. GDP has continued to expand, with the 2006 report showing virtually no per-capita increase in American prosperity between 1978 and 2005.14

Savings and Debt
Just as economic growth offers a rough picture of return on investment, savings and debt can offer a rough picture of an economy's slack. A high savings rate indicates an abundance of unused resources which can be drawn on in the event of need or opportunity, and a low level of debt indicates the same thing, while the reverse is also true. Not surprisingly, the ups and downs of both typically tie in with economic performance, periods of stagnation or contraction lowering the former.15

In line with the slowing of global economic growth since 1973, the indications are that this is exactly what happened. Net savings rates have fallen across the world since the 1960s; in the case of the American private sector, from 11 percent of national income in the 1960-1979 period to 3.9 percent, with household savings dropping into the red.16 Since the 1990s, this has even been the case in high-saving Asia (China excepted).17 It is also worth noting that while the drop in savings has been less pronounced in Europe and Japan than in the U.S., the drop in gross capital formation since the 1980s is somewhat sharper in those regions.18

Debt, too, has substantially increased during this time frame. Public debt, particularly central government debt, has got most of the attention, and this does undeniably show an increase. The proportion of gross debt to GDP more than doubled between 1974 and 2007 in the G-7 countries, from 39.3 to 79.1 percent of Gross Domestic Product.19 Of course, gross debt may appear to overstate the problem, since governments may well amass high levels of debt while also expanding their assets, but this has generally not been the case. In this age of privatization, government assets have tended to shrink. Britain, for instance sold off government assets and used income from the sales to reduce itsdebt in the 1980s. With only so many assets to sell off, however, the improvements were temporary and Britain's debt burden has since been climbing back up. For the Group of Seven countries overall, the growth of net debt-gross debt minus government assets-was generally even faster after the 1970s (Table 5.1). In any event, the rate at which both gross and net debt grew during the first half of this decade was not much below that of the 1974-1996 period as a whole (Table 5.2).

Private debt has not received nearly so much attention in recent decades, and comprehensive data collection and analysis regarding that issue is (unfortunately) much more limited. However, the indications are that this too has markedly increased. In the United States alone outstanding public and private bond market debt rose from $4.5 trillion in 1985 to $22.1 trillion in 2003, from roughly 100 to over 200 percent of GDP.20

Mortgage and corporate debt have continued to rise rapidly since then, mortgage debt coming to nearly $13 trillion in October 2008, and corporate debt to another $7 trillion according to one report.21 According to the Federal Reserve, consumer debt came to another $2.5 trillion at that time.22 The result is that the total debt appears several times larger than the central government debt level so often cited.23

Public Finances
While not readily separable from the broader picture of national savings and debt, public finances (which entail dimensions not covered above) merit special attention. Government, more than other public or private institutions, is uniquely positioned to command societal slack in the event of exogenous shocks, or the appearance of new opportunities (as well as a bearer of the final responsibility for dealing with such exigencies). Its ability to mobilize fiscal-macroeconomic slack, which might be roughly established by considering their taxation and spending alongside their debt profile, is a way of measuring how much slack exists in a modern nation-state.

A budget surplus, for instance, can represent slack in that the state which has it possesses at least some of the means for coping with an emergency ready to hand. That is to say, for a state with relatively low levels of taxation and deficit spending, a tax raise or additional borrowing would not represent an intolerable burden, as they have more slack on which to draw (all other things being equal). By contrast, a state where these are high, or rising (particularly if this is during "normal" times) is likely to be "living beyond its means." It also has more difficulty increasing any of these to take advantage of an opportunity, or cope with an emergency, while also suggesting that public goods are becoming more expensive.

The connection of public finances with more general economic performance, given government susceptibility to revenue shortfalls or surpluses, enlarged or diminished expenses in areas like unemployment relief, and rising or falling pressure to cut taxes, also help to make it a useful indicator of the level of strain on the whole system.

In keeping with "Wagner's law" that the government's share of the economy generally tends to rise, the state seems to have "grown everywhere."24 Before World War I, tax-to-GDP ratios were at ten percent or below. Since then they have risen to 25 to 50 percent in the advanced nations, with central government revenues among the Group of Seven advanced industrial nations rising from 31.4 percent of GDP in 1970 to 38.7 percent in 2000, a level at which they have remained ever since.25

Christopher Hood raised a number of counterarguments to the thesis that states are pushing the limits on taxation, two of which are relevant to this discussion. (The third will be discussed later in this piece.) The first is that assuming economic growth, tax-to-GDP ratios (assuming, of course, the validity of GDP as a valid indicator of productivity) can always rise to capture increasing above-subsistence income.26 However, subsistence should not be thought of as a fixed figure, and the cost of subsistence arguably rises as a society develops. Even food provision or basic sanitation is a different matter for a densely populated industrial country than a smaller, more dispersed agrarian population.

Hood's second counterargument is that the maximum tax level previously attained ought not to be confused with the limits of a state's capability. In an emergency a government could always increase taxes and possibly extract more revenue for a time. Still, higher taxes do not always mean a government will successfully raise more money, as the problems of subsistence and evasion demonstrate. A considerable body of economic theory also discusses the tendency of governments to maximize their revenue, a particularly well-known example of which is Mancur Olson's "stationary bandit" model of government. There is thus reason to believe that actual tax levels bear some relationship to the limits of such taxation, at least over the long run.

Additionally, tax levels do not always return to pre-crisis levels after a crisis ends, so that peacetime tax levels can reflect a not irrelevant previous "crisis maximum," as the case of the U.S. before, during and after World War II demonstrates. At the beginning of World War II, the tax ratio in the U.S. was less than seven percent of GDP. During the war it went up to twenty percent, in large part assisted by an expansion of the income tax (both in the elevation of the rates paid by the highest earners, and its extension to the middle class). After the war it fell from this high, but only to about fourteen percent-twice as high as it was before the war. Since then they continued to increase until they were back at 1944 levels by the late 1990s.27

Moreover, there is no escaping the question of public tolerance for taxation, which always generates a measure of resistance and evasion, greater when seen as excessive or illegitimate, and which can take legal (like the more intensive exploitation of loopholes, "investment strikes," and capital flight) as well as illegal forms. Processing costs, and enforcement costs, too, must be taken into account on the credits side of the balance sheet, and these go up in exactly that situation.28 As the furor over the 1988 British poll tax demonstrated, the reaction to even relatively small increases can be prohibitive, and the failure of many of the major economies to raise taxes despite considerable pressure to do so in recent years (in the U.S. because of the multi-trillion dollar costs of the War on Terror, in Japan because of exploding government debt in the 1990s and 2000s, in France and Germany because of the discipline required by the European Union's Stability and Growth Pact) is indicative of their approaching the political (though not necessarily economic) limits on their ability to raise revenue.

As might be expected given rising government debt, spending rose at an even swifter pace than taxation in the post-war era, from 32.1 percent of GDP in the G-7 nations in 1970 to a peak of 42.2 percent in 1993.29 Despite post-Cold War military draw-downs; the scaling back of welfare states; major reductions in public spending on infrastructure and research and development; and the savings that privatizing and decentralizing government services were supposed to generate; only very limited reductions were achieved.30 The lowest point they attained after this was 38.7 percent of GDP in 2000 (in part because GDP had been growing somewhat more rapidly in the late 1990s in the advanced Western nations), but since 2002 the figure has not dropped below the 40 percent level.

The same trend is evident in the swelling of central government budget deficits, from an average of 1.2 percent of GDP in the early 1970s to 4 percent in the 1980s (Table 4.1), pushing the level the IMF has identified as the maximum safe one. In the early 1990s, the average deficit ran at an even higher 4.3 percent, but dropped with the boom in the later part of the decade, many countries actually running surpluses at this time, high-spending Japan the notable exception (Table 4.2). With the waning of that boom, however, deficit spending returned to the levels of the early '90s, the average deficit for the years 2002-2005 coming to 4.2 percent of Gross Domestic Product (Table 4.2).31

In short, it seems to be all they can do to hold down the growth of deficit spending. And this is all without considering the likely understatement of those deficits, government accounts long being notoriously deceptive. In the case of the U.S., it was noted that the official $248 billion Federal deficit of 2006 would actually come to $1.3 trillion were "corporate-style accounting" used.32


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