No way out of Great Recession without new economic model

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.

29 Responses to “No way out of Great Recession without new economic model”

  1. 1 Simon 23 September 2011 at 13:29

    Can the world fix the huge income disparity?

    I do not think so,look at USA,what did President Obama really do to solve the problems,he was fighting fire and now fighting for second term.

    The USD now grow stronger because the weakness of Euro,and Yan,USA,the country with the biggest debt and is probably going bankrupt is now the safe heaven.

    The rising stars RMB and Indian Rupee are far from a position to take over leaderships.

    The whole world now only practices one system,capatalism,however you call it,like in China.

    The only country not in this system is called North Korea managed by a crazy old man.

    The day of collapse of capatalism is not far off without any visible relacement.


  2. 2 Alan wong 23 September 2011 at 15:39

    When our govt manipulates our CPF savings to their advantage giving meager returns to depositors while rewarding themselves with obscene salaries and bonuses, isn’t that another form of unfair income distribution ?

    There is really no reason for our more ‘uncorrupt’ leaders to perform worse than their Malaysian counterparts when it comes to paying dividends to their Employment Fund contributors especially when our leaders used to boast annualized return of 17% on our investments

  3. 3 Anonymous 23 September 2011 at 15:39

    I think you need to draw a distinction between borrowing to consume and borrowing to invest. For example, a salesman who borrows money to buy a car is able to use that car to be more productive. A government that borrows money to fund education will be able to reap the rewards of a better educated population.

    Borrowing in itself is not wrong. It’s a matter of what you use the money for.

  4. 4 Anonymous 23 September 2011 at 15:56

    As tempting as it looks, you simply cannot get ourselves out of a recession by taxing the rich.

    The developed world had tried taxing the rich before. In the 70’s high income earners in Britain and for a short while, in the US, were taxed at around 50- 70%. Imagine that…

    And what do we find – stagflation.

    • 5 yawningbread 23 September 2011 at 16:15

      The stagflation of the 1970s into the early 80s was in large part due to a similar phenomenon. Starting from 1973, the OPEC countries hiked the price of oil multiple times, reaching peaks not seen today (after adjusting for the historical value of the US Dollar). This resulted in a huge accumulation of money in the hands of OPEC governments. The flip side was a severe reduction in purchasing power of the average consumer in oil-dependent countries. This is similar to the situation today, where money and wealth have steadily flowed into a few people’s hands, reducing the purchasing power of the rest, thus reducing demand as a driver for the economy.

      The sudden loss of demand in oil-dependent countries hobbled their economies, thus stagnation. Governments ran deficits to try to cushion the economic pain, borrowing the money from the OPEC countries. One of the ways to avoid having to pay off all these loans to OPEC countries was to allow inflation to whittle down the value of the borrowings. Thus stagflation.

      This is being mooted today as a solution to the financial crisis — you”ve heard of the US Federal Reserve thinking about printing money. You’ve heard about Greece going into default, leaving the Euro, creating a new currency and devaluing it to regain economic competitiveness. Things aren’t exactly the same as before, but there are several parallels.

      • 6 tk 23 September 2011 at 19:35

        er, alex, the US Fed has already (electronically) printed money – it was called QEI and QEII.

        it hasn’t yet led to hyperinflation because the banks horded all the extra dollars to bolster their balance sheets, instead of lending it straight out again.

        now the Fed is trying to ‘twist’ the yield curve on US debt – again an old strategy – but the solution to a massive steaming pile of debt is not to add yet more excrement on top…

        the only “solution” is to let real, actual capitalism, not some elitist facsimile, do it’s ‘creatively destructive’ work and give all the ‘too big to fail’ banks, insurance companies, investment banks, EU bond holders, EU banks, chinese local government bond holders and hedge funds the massive (i.e. terminal) haircuts they have coming to them, and start all over again.

        oh, and we’ll all be riding bikes too by the time it’s all over😉

      • 7 Fox 23 September 2011 at 21:22

        Taxes are pretty high (~40 to 50 percent) in the Scandinavian countries and they had impressive economic growth in Q4 2010. Taxes are significantly lower in Portugal, Greece and Spain. They don’t seem to be doing too well, to put it mildly.

  5. 8 Pauls 23 September 2011 at 16:17

    This, by the way, is another argument for why it is so important that the compensation levels for political representatives/government officials be temperate.

    As you note, part of the problem with the current economic model is that, in the private sector, “the bulk of the earnings flow to the top managers and the shareholders”. If one wanted to address this issue somehow, then it is surely incumbent on govt officials – if they are truly serious about their moral standing – to set an example for private enterprises. (A democratic govt is supposed to exist not for its own benefit but for the public good after all.) Otherwise, if political/govt officials, as servants of the state, can get away with salaries that are grossly out of proportion to the wages of the average citizen, why should business leaders do otherwise?

    • 9 Heng Wangxing 27 September 2011 at 18:49

      The business world’s salaries do not seem to be influenced by the government leaders’ salaries; rather, it is the other way round. I don’t see how their reduction will be an effective example to the business world to follow suit.

  6. 10 walkie talkie 23 September 2011 at 17:45

    very good article!

  7. 11 walkie talkie 23 September 2011 at 17:47

    if only people will

    earn all they can (i.e. work hard & work smart)

    save all they can (i.e. be relatively contented with their living standard)

    give all they can (i.e. giving to relieve the misery of others)

  8. 12 Anonymous 23 September 2011 at 23:15

    I wonder if this document has any relevance to the discussion at hand? I’ve been trying to go through it on and off for a few months. Tough going, but worth the read I think.

  9. 13 Ally L 24 September 2011 at 00:30

    Dear Alex, you wrote :”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 initial impression I got from reading this in the third paragraph, and I might be wrong, is that this explanation or proposal of yours to explain the Great Recession is original. It is not. Robert Reich, the commerce secretary in Clinton’s administration, in his book called “After Shock’ published in 2010 had claimed that income gaps were at the highest right before the Depression and the Great Recession and that this was the main cause of the Great Contraction (I prefer this term coined by Kenneth Rogoff of Harvard because he had argued the implications of calling this the Great Recession has resulted in wrong prescriptions for the economy).

    Joseph E Stiglitz, the Nobel Prize winner in economics had made similar claims years ago. And of course, the most revered John Kenneth Galbraith, since 40 years ago, had written extensively (for example, The Great Society and The Affluent Society) on the widening income gap even before globalisation and technological innovations became a buzzwords. The widening income gap has always been a main argument of liberals in the U.S for progressive taxation and this call has been getting louder in recent days.

    So I’m asking you to please give credit to these and others who have made extensive academic research on this area or at least attribute the cause to theories ‘proposed’ by others because you don’t own this explanation. Thank you.

    • 14 yawningbread 24 September 2011 at 14:38

      I am aware that Robert Reich has done work on the widening income gap, but I am not aware of the book you cited, or that he had linked his previous work to the current malaise. If I happen to voice the same views then it’s a coincidence.

  10. 15 Simon 24 September 2011 at 11:04

    Dear Alex,

    It is fairly obvious that Germany government is the only capable party holding up the Euro and thus prevent it from collapse.

    This is mainly because of its own calculation,the troubles of second tiers countries like Greece and Spain resulted in lower Euro exchange rate which helps in Germany’s export(no.2 in the world currently).

    The voters in Germany seem to be moving in the opposite direction,judging from results of recent polls.

    How long Germany government can hold up the collapsing Euro is a question mark,and I really appreciate comments from your readers on this point.
    Thank you.


    • 16 Anonymous 26 September 2011 at 19:41

      My perception is that Euroskepticism, the idea that centralising power in the hands of people operating out of a country that has itself no government for more than 1 year liao, is alive but hardly well.

      The general public is much aware that it is largely the banking lobby that is resisting the need to take a haircut in their risky overseas loans, persistently preaching the bugbear of a bank run. Angie says the currency must be saved at all costs. Her LibDem kakis tried to fish themselves out of their miserable polls by denouncing the common currency, to no avail. The German constitutional court does not want to decide if Euro-bailout funds should be allowed on the national budget, taichi-ing the decision to the Bundestag. Who stands to gain from all this?

      The end result of Germany holding up a Greek loan default is that the banks get their loans protected.


  11. 17 Fong 24 September 2011 at 11:26

    Brilliantly insightful. Thanks for sharing.

  12. 18 Anonymous 24 September 2011 at 13:40

    Elizabeth Warren, a distinguished law professor now running for Senator in Massachusetts, gave a lecture entitled “The Coming Collapse of the Middle Class” in 2007. Although a lttle dated and set in the United States, there are lots of similarities with Singapore in present times. Pretty gloomy picture if you’re not one of the super rich elites.

    Worth viewing:

  13. 19 Simon 24 September 2011 at 15:18

    The irony is, Singpore richest people are getting wealthier, including our top civil servants. Imagine, 11 per cent of our citizens are millionaires. There is a mad rush with investing in more properties to grow the wealth even faster. The same is taking place in the upper income, middle income and even the lower income. We are all sucked in involuntarily because of the rising property market and the need to have a roof over our heads. If everyone is so preoccupied with putting so much money aside in getting a HDB flat, condominium or landed property – what monies are left after paying off morgages, buying a car, living expenses, income tax and other expenses. There is hardly any money left for a proper retirement or health care.

    The government borrows heavily from our C.P.F. to invest, at the same time paying pittance (not like before) in terms of interest on the reserve funds. Its headlong rush to increase immigrant population growth to achieve GDP expansion by whatever means only helped fuel inflation – making it tough going for the lower income groups and the poor. Even the so call middle income group are feeling the pinch. In a sense, the government has not done enough to level out the distribution of wealth and create enough jobs to help those who needed it most – the retrenched workers. Those 45 years and above are facing the most difficulties.
    It is true that some of our citizens don’t deserve any help because they are choosy over jobs offered. But, by and large the government does not have a “Singaporeans first” policy for job placement. This is a very big loop hole which employers are exploiting (to keep cost down) and which the government are deliberately turning a blind eye to.

    We have often heard the expression that Singaporeans are assets rich but cash strapped (or, poor). Any elected government is expected to ensure that its citizens are well looked after, not in the sense of “welfare” as in most western countries. If our government continue to stay on the present course – which is already looking unsustainable, the bubble will burst. When there is a subsequent glut on properties lets see whether having cash on hand is better than sitting on our expensive property. This is where the government has failed in its housing, immigration and job creation policies. The coming stagnation of the world economy is already taking place as we speak. It will be a very painful experience for all concerned.

  14. 20 Hopeful 24 September 2011 at 16:26

    One main premise of how economies are run is that of permanent growth or permagrowth.

    That is how the astronomical salaries of CEOs, executives, some political leaders are justified…… because profits will be 100% x number of years later and 1000% y number of years later.

    The model is also how the normal folks (non-CEO, non-executive, non-political leaders are lulled into taking 30 year mortgages.

  15. 21 Hopeful 24 September 2011 at 16:30

    A blog talking about permagrowth, how it is not possible/sustainable.

  16. 22 Robox 25 September 2011 at 00:48

    Alex, it has taken me some time to digest the information in this article because I had never heard this argument being made before. But it is increasingly making sense to me.

    But only if you can help me plug this one gap in my understanding.

    If most people’s lifestyle aspirations exceed their ability to afford it, and they are borrowing from banks to finance those lifestyles, wouldn’t it be the overly liberal lending practices of the banks – and not really the economic model they are operating under though there is a link between the two – that is the ultimate culprit in this problem?

    • 23 yawningbread 25 September 2011 at 12:16

      Basically, it takes two to clap. Indeed, banks were aggressive in lending too, and to compound it, resold the risks to other consumers via investment banks (think Lehman Bros bonds); so they could be aggressive without bearing risks. But one can be aggressive in offering loans without consumers taking up those loans, just as a company can be aggressive about selling a product without customers being tempted. What I wanted to highlight in the article is that beside the banks’ culpability, there was also an economic climate that encouraged ordinary people to borrow.

      • 24 middle-class 25 September 2011 at 18:20

        Agreed. I’m a middle class citizen and it is truly getting very difficult to maintain the same lifestyle as it was 5-6 years back. I have to reduce it by at least 30-35%. I’m a normal civil servant and my pay isn’t exactly fantastic to boot, plus with kids in tow. The sentiments now is to be as frugal as possible since my pay isn’t going to increase substantially, and with inflation causing basic necessities to get more and more expensive at a quicker rate. I dread the day that I might be ‘forced’ to borrow to sustain this already reduced quality of living.

  17. 25 Alfred Bartom 25 September 2011 at 13:30

    When analysis addresses the inherently inflationary and debt generating fractional reserve financial system (a sanctioned ponzi scheme) underlying the operations of central banks throughout the Western world broadly, and how this inevitably leads to widening income gaps, lose of purchasing power of paper currencies, and typically high spending on military industries and increased warfare – well, that’s the root of the economic woes that seem to show up with increased frequency. It’s an unstable system ever requiring intervention to address one failure after another. I think we well understand the symptoms and how the effects play out to the detriment of society; less well understood – actually public education doesn’t address this issue at all – is the origin and mechanism of the recurring recessions and loss of purchasing power. It’s no mystery, but what to do about it?

  18. 26 hopeful, not? 26 September 2011 at 13:32

    There is a westernised, global culture of the “super-star” and the need to pay super salaries to these “super-stars”.

    There are superstar footballers (e.g. the many in Man U, contributing to a essentially bankrupt football club), there are also superstar CEOs. superstar architects, so on and so forth.

    In a company where there are superstar CEOs and senior executives, the salaries/wages of the rank and file will be less. After all, the money to pay everybody comes from the same pool. Simple math.

    And when politicians base their own pay on these superstar CEOs, it encourages new policies to be set that favours the inflation of superstar CEOs. This is terrible.

    I believe this “superstar” culture is a factor behind 2008 and coming recessions.

    • 27 Alfred Bartom 26 September 2011 at 16:59

      Interesting social comment. Especially considering certain “superstars” in banking and finance, in the US at least, are not being prosecuted for fraud and other criminal acts tied to the housing and mortgage markets. Many Wall St fortunes have come from simply looting or otherwise “milking” an institution. Prof Bill Black has written comprehensively on such control fraud from financial, political, as well as social perspectives, and on the moral decay that comes from not prosecuting it.

      On another note, does anyone else think politicians claiming major credit for economic performance seriously begs a question – is discredit equally assigned for poor or recessionary economic performance, including forgoing bonuses or other pay incentives, perhaps even to the point of a bonus clawback scheme? Now that would be a different world, wouldn’t it?

  19. 28 Gazebo 27 September 2011 at 05:30

    This is a fantastic paper which should be more publicized. The authors leveraged a unique natural experiment in New Jersey, where tax on top earners was raised substantially in 2004. The authors found that there is little to no migration out of the state, while revenues were raised substantially.

    The Singaporean government should read this, and think harder about the proper policies it should be implementing. People and talents are stickier than they like to think. Instead of implementing short sighted and arguably futile policies such as lower taxes to “attract talents”, we should be focusing on creating truly “sticky” citizenry.

  20. 29 Paradox 5 October 2011 at 12:57

    Pardon me but who is Alex?

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