We’re on the verge of another recession. You will be forgiven if you didn’t know we had recovered from the last one; it sure didn’t feel like it. This next recession is likely to be even more global than the one that began in 2007 because this time, China’s economy is also slowing down. It has to. It has been overheated lately.
I think most people don’t quite understand how we got into this mess, now acquiring the moniker The Great Recession. Since news of bank loans, mortgages and defaults have dominated headlines for the least four years, many may think the fault lies with bankers.
I will propose here a deeper explanation: This economic mess was inevitable given the income distribution patterns that we have seen over the last few decades. The root cause lies in the way modern economies allocate the fruits of economic activity, with structural imbalances that are not sustainable in the long run. And to the extent that we fail to redesign the capitalist model, we’ll never quite get out of the mess.
A trend that is key to understanding the phenomenon is that of stagnating incomes for low and middle-income individuals over the last few decades in developed economies. A number of factors led to this, among them a gradual migration of manufacturing (and lately services) to emerging economies and the adoption of technology, thus lowering the low-skill labour requirements of industry and business — now affecting the middle-skilled too. The pain of stagnating incomes has been mitigated by increasing government social support, and a generally low level of inflation, which in turn was the result of the migration of manufacturing to low-cost countries.
For demographic and political reasons, low-cost countries remained low-cost. India, Bangladesh, Indonesia, the Philippines, continued to have population explosions. China and Vietnam had political systems that were capable of suppressing wage demands. Likewise, despite the gloss of democracy, India, Mexico, Brazil, Indonesia, had social systems that so disempowered the less privileged, they effectively suppressed wage demands too. Income distribution in these countries thus followed the pattern of developed countries, where the elite, with access to education and trade contacts with the wider world, saw accelerating incomes, while the mass of labour had to content themselves with low wages. Even as the latter rose, they didn’t rise as rapidly as the earnings of their richer compatriots.
Thus, globally, we’ve had an era of widening income gaps. The chief beneficiaries of economic activity over the last few decades have been elites. In good times, their earnings and wealth increased dramatically; in bad times, these fell rather less than the incomes of lower classes.
Yet technology all this while was breaking down barriers to information flow. People all over the world were acquiring similar lifestyle aspirations and heavily materialist ones at that. Each stratum of society wanted a lifestyle enjoyed by those better off than themselves.
It is this tension between rising lifestyle aspirations and stagnation of low and middle incomes that lies at the bottom of our present-day crisis. The graph below shows how the gap is bridged:
The red line represents income. If everybody lived within their means, the standard of living line (blue) would coincide with the red line. However, for the lowest income, it was impossible to live within their incomes — these being so low. For the middle-income individuals, they had aspirations.
The lowest-income enjoyed a standard of living higher than their incomes would permit through state subsidies. In Singapore, for example, subsidies come in multiple forms: education, healthcare, cash transfers e.g. Workfare, housing grants, baby bonus. The middle-income mostly bridge the gap between income and standard of living through loans. The average Singaporean, for example, is in debt. He enjoys an apartment or car he has not fully paid for. Others, particularly in the US, have credit-card debt.
At the other extreme, you can only live so well. No matter how fancy your lifestyle, when you have a million dollars flowing in every month, you can’t spend it all, notwithstanding the six butlers, three holiday homes, the Porsche, Ferrari and the stretch limousine.. The result is an accumulation of investible funds.
If you draw a stripped-down diagram of money flows, this is what has been happening:
Let me take you through the above diagram.
Economic activity tends to produce disproportionate rewards for the upper-income. When a business is profitable, employees may see good salaries and bonuses, but by and large, the bulk of the earnings flow to the top managers and the shareholders. Why this distribution is skewed this way is a political and social question, which calls for a separate enquiry.
Referring to “1. Profit” in the diagram above, when customers spend money to purchase an economy’s output of products or services, the spending money comes mostly from low and middle-income consumers (since they are the bulk of the population), with the profits accruing disproportionately to the elite. There is, effectively, a kind of conveyor belt, that moves money from the lower parts of the pyramid to the apex.
What do the rich do with the money they accumulate? One way is to put them into banks and other financial products (“2. Deposits and financial investments”) which includes shares in companies, thus reaping more benefit from economic activity.
Banks, in turn, have to push out loans, and the ready customers are there among the middle-income who aspire to a lifestyle higher than their incomes merit (“3. Loans”).
Either through their banks, brokers or other intermediaries, the elite (including company treasuries, who are effectively proxies for the wealth of shareholders) also invest in government bonds (“4. Govt bonds”). These are effectively loans by private individuals to the government.
Of course, a government also collects taxes (“5a and 5b. Taxes”). However, over the last few decades, there has been a tendency to cut taxes for the upper income. In the US, things have reached an absurd state where, benefitting from lower tax rates for capital gains and other loopholes, the richest stratum pay an effective rate of tax lower than that paid by the middle-class.
Lastly, much money is spent by governments in ways that disproportionately benefit the lower and middle-income groups. This would include subsidies but also salaries for teachers, nurses and soldiers (“6. Govt spending”).
The problem is that this cycle is unsustainable. How can the middle-income continue to borrow indefinitely? How can governments continue to borrow (via issuing bonds) indefinitely? But if they don’t borrow, what will the rich do with their money?
We’re in a crisis because we’ve reached the point where neither consumers or governments (like Greece’s and the US’) can borrow anymore. And that’s why the economic cycle is grinding to a halt with pain all around. And if the government can’t or doesn’t borrow, then either taxes must rise to fully pay for its spending, or government expenditure must be cut — but if so, it will drastically lower living standards for a huge segment of the population. Laid-off teachers and nurses, families cut off from social subsidies, will suddenly have to go hungry.
Politically difficult though it may be, the implication from this analysis is that there is no going back onto that treadmill. Resolving the current crisis will require a whole new economic model, which requires political will and public acquiescence, especially from the elite. This is because it looks as if the key to a solution lies in fairer income distribution, such that people can afford their standards of living without having to borrow, or at least not borrow so much (e.g. pay off your apartment within 10 years rather than 30). Governments have to be able to raise enough taxes to fund its programs without needing to issue bonds (except to smoothen out economic cycles), but for that to happen, either the rich will have to pay a lot more in taxes, or average incomes have to rise considerably so that the middle-class too can afford to pay more taxes.
Whichever way we look at it, income distribution has to be fixed. We cannot have healthy economies when wealth accumulation for the rich and indebtedness for others and governments, keep rising.