Political Malaise in the West

“The West in political crisis has echoes of 1930s” writes Stella Dawson for Reuters, here.

Excerpt:

“The global financial crisis that began four years ago has morphed into a political crisis for United States and Europe.  

… The shifting international economic order toward developing countries is nothing new. But it has been happening at a faster pace than expected, accelerated by what analysts have begun describing as Western democracy in crisis.

They see a government credibility problem in the United States and European Union, stemming from a perception that the political elite is too closely tied to the financial elite in the West, and their collusion caused the financial chaos of 2007 and 2008 and its messy aftermath, leaving the average citizen burdened with higher public debt, higher taxes, unemployment and austerity programs.”

My comment:

Quite true. But the problem predates the 2000s. It comes, in my opinion, from the globalization process of the last few decades. Not that globalization per se is a bad thing. On the contrary, it helped develop trade and specialization, thus increasing productivity everywhere. And anyway it is an inevitable consequence of the greater ease of transportation and communication (the information revolution).

But the increased mobility of factors (labor and capital) tends to reduce the fiscal power of territorial states through an increased competition between national governments. Thus a structural cut in public spending, a “downsizing” of states, was required, on top of the general downsizing trend affecting all hierarchical organizations, including commercial firms (see my co-authored paper on “the shrinking hand” on my website, to be presented next week at the American Economic Association meetings in Chicago).

Faced with these growing constraints most western states tried to cut their expenditures but did not succeed, not trying hard enough given the demands of their various electoral clienteles confronted with several financial and economic shocks. That’s why most governments came to rely more and more on debt to replace tax finance.

This changing financial structure of governments has produced two effects: first, politicians have come to rely more on the finance business and banks, which are channeling funds from capital markets to the governments treasuries. Hence the increasing collusion between demanders (governments) and suppliers (banks) of funds. And second, the new “capital structure” of governments, with less taxes and more debt, gives more importance to capital markets (the so-called “bond vigilantes”) and less to voters and taxpayers, hence the regression of democracy.

He who pays the piper calls the tune.

What is needed now, and urgently, is an across the board decline in public spending and in taxes on labor to stimulate supply at the same time. But this requires first a return to growth and a reduction of the bloated public debts (a public deleveraging). That’s why monetary policy and exchange rates are so important at this point. One has to remember that the first countries to exit the gold standard and devalue their currencies in the 1930s were those that returned to growth earlier than the laggards. Many analysts decried the “currency wars” then, but they were in fact currencies in search of new equilibrium prices.

However, as shown by several studies, a currency depreciation requires a cut in public expenditures to produce its positive effects. And there are no serious structural programs of government reform capable of stimulating supply (rather than just contracting demand, which is self-defeating) in view on either side of the Atlantic (except maybe the payroll tax reduction in the US, but it is temporary). 

Hence the low ratings of politicians in opinion polls and their generally low credibility.  Let’s hope nevertheless for some realistic fundamental reform proposals – at last – in 2012. Just the reverse of the New Deal is needed: a fall in the “churning”, inefficient from a redistributive point of view, public spending that taxes middle class income in order to ... subsidize middle classes, and a major cut of the taxes on labor (in order to raise wages,) instead of an increase in transfers and taxes (that reduce earned real wages). Also required is a shrinking of administrative and political hierarchies instead of an expansion of already excessive administrative employment, in order to reduce the overhead cost of government … Let’s call this a “second new deal”.