The inequality of nations
MILAN — The eighteenth-century British economist Adam Smith has long been revered as the founder of modern economics, a thinker who, in his great works “The Wealth of Nations” and “The Theory of Moral Sentiments”, discerned critical aspects of how market economies function. But the insights that earned Smith his exalted reputation are not nearly as unassailable as they once seemed.
Perhaps the best known of Smith’s insights is that, in the context of well-functioning and well-regulated markets, individuals acting according to their own self-interest produce a good overall result. “Good,” in this context, means what economists today call “Pareto-optimal”, a state of resource allocation in which no one can be made better off without making someone else worse off.
Smith’s proposition is problematic, because it relies on the untenable assumption that there are no significant market failures, no externalities (effects like, say, pollution that are not reflected in market prices), no major informational gaps or asymmetries and no actors with enough power to tilt outcomes in their favor. Moreover, it utterly disregards distributional outcomes, which Pareto efficiency does not cover.
Another of Smith’s key insights is that an increasing division of labour can enhance productivity and income growth, with each worker or company specialising in one isolated area of overall production. This is essentially the logic of globalisation: the expansion and integration of markets enables companies and countries to capitalise on comparative advantages and economies of scale, thereby dramatically increasing overall efficiency and productivity.
Again, however, Smith is touting a market economy’s capacity to create wealth, without regard for the distribution of that wealth. In fact, increased specialisation within larger markets has potentially major distributional effects, with some actors suffering huge losses. And the refrain that the gains are large enough to compensate the losers lacks credibility, because there is no practical way to make that happen.
Markets are mechanisms of social choice, in which dollars effectively equal votes; those with more purchasing power thus have more influence over market outcomes. Governments are also social choice mechanisms, but voting power is, or is supposed to be, distributed equally, regardless of wealth. Political equality should act as a counterweight to the weighted “voting” power in the market.
To this end, governments must perform at least three key functions. First, they must use regulation to mitigate market failures caused by externalities, information gaps or asymmetries, or monopolies. Second, they must invest in tangible and intangible assets, for which the private return falls short of the social benefit. And, third, they must counter unacceptable distributional outcomes.
But governments around the world are failing to fulfill these responsibilities, not least because, in some representative democracies, purchasing power has encroached on politics. The most striking example is the United States, where electability is strongly correlated with either prior wealth or fundraising ability. This creates a strong incentive for politicians to align their policies with the interests of those with market power.
To be sure, the Internet has gone some way towards countering this trend. Some politicians, including Democratic presidential candidates like Bernie Sanders and Elizabeth Warren, rely on small individual donations to avoid becoming beholden to large donors. But the interests of the economically powerful remain significantly overrepresented in US politics, and this has diminished government’s effectiveness in mitigating market outcomes. The resulting failures, including rising inequality, have fuelled popular frustration, causing many to reject establishment voices in favour of spoilers like President Donald Trump. The result is deepening political and social dysfunction.
One might argue that similar social and political trends can also be seen in developed countries, Italy and the United Kingdom for example, that have fairly stringent restrictions on the role of money in elections. But those rules do not stop powerful insiders from wielding disproportionate influence over political outcomes through their exclusive networks. Joining the “in” group requires connections, contributions, and loyalty. Once it is secured, however, the rewards can be substantial, as some members become political leaders, working in the interests of the rest.
Some believe that, in a representative democracy, certain groups will always end up with disproportionate influence. Others would argue that more direct democracy, with voters deciding on major policies through referenda, as they do in Switzerland, can go some way towards mitigating this dynamic. But while such an approach may be worthy of consideration, in many areas, such as competition policy, effective decision-making demands relevant expertise. And government would still be responsible for implementation.
These challenges have helped to spur interest in a very different model. In a “state capitalist” system like China’s, a relatively autocratic government acts as a robust counterweight to the market system.
In theory, such a system enables leaders, unencumbered by the demands of democratic elections, to advance the broad public interest. But with few checks on their activities, including from media, which the government tightly controls, there is no guarantee that they will. This lack of accountability can also lend itself to corruption, yet another mechanism for turning government away from the public interest.
China’s governance model is regarded as dangerous by much of the West, where the absence of public accountability is viewed as a fatal flaw. But many developing countries are considering it as an alternative to liberal democracy, which has plenty of flaws of its own.
For the world’s existing representative democracies, addressing those flaws must be a top priority, with countries limiting, to the maximal extent possible, the narrowing of the interests the government represents. This will not be easy. But at a time when market outcomes are increasingly failing to pass virtually any test of distributional equity, it is essential.
Michael Spence, a Nobel laureate in economics, is professor of Economics at New York University’s Stern School of Business and senior fellow at the Hoover Institution. He was the chairman of the independent Commission on Growth and Development, an international body that from 2006-2010 analysed opportunities for global economic growth, and is the author of “The Next Convergence – The Future of Economic Growth in a Multispeed World”. Project Syndicate, 2019.
LONDON – If indications of disappointing economic growth in the eurozone are confirmed, the European Central Bank will loosen monetary policy further in September. Last week, outgoing ECB President Mario Draghi signaled a further likely cut in the ECB’s rate on commercial banks’ overnight deposits with the central bank, which is already -0.4%. In addition, the ECB is discussing a new program of asset purchases.
Economic stimulus is clearly needed. Annual inflation is well below the ECB’s target of “close to, but below 2%,” and financial markets expect it to remain so for years. What’s more, the eurozone has grown more slowly than the US economy since the 2008 global financial crisis. Growth has flagged since peaking in the third quarter of 2017, and slowed again in the second quarter of this year.
It is also clear that national governments in the eurozone are reluctant to provide a coordinated fiscal stimulus, despite the urgings of the ECB and many economists. Willingly or not, the ECB remains the only game in town.
The question is whether monetary policy alone can help to improve real growth and the inflation outlook in the eurozone. Monetary policy can be a powerful tool. The key to President Franklin D. Roosevelt’s successful effort to revive the US economy in the 1930s was not deficit spending, but rather the large monetary stimulus resulting from America leaving the gold standard before continental European countries did. Today, the ECB needs to engineer something similar with different tools.
In principle, taking the ECB deposit rate further into negative territory should remove the restriction on future expected short-term interest rates turning negative, and therefore flatten the forward yield curve. A rate cut should also put downward pressure on the euro’s exchange rate, potentially making eurozone exporters more competitive.
But such a move would be controversial, in particular because it would dent the profitability of banks that cannot pass on negative ECB deposit rates to their customers. Such policies have heterogeneous effects across banks, and mitigating action, although feasible, requires complex engineering.
According to an analysis by the ECB’s staff, “strong” eurozone banks are able to pass on negative rates to their corporate clients; “weak” banks cannot.
The ECB is therefore considering ways to mitigate this – in particular by granting very favorable conditions on the special loans that it will offer under the TLTRO III program, which are likely to be taken by the “weak” banks. In addition, a tiering system is being considered in which reserves below a certain threshold would not be subject to negative rates. But this is likely to benefit the strongest banks of stronger core eurozone countries such as Germany, France, and the Netherlands, which together hold about one-third of total deposits at the ECB.
Beyond these technical considerations, policymakers must grapple with two root causes of excess demand for central-bank reserves among strong eurozone banks. One is very high demand for safe assets in general – and banks in core eurozone countries have little incentive to hold their own governments’ debt when the interest rate is below the ECB deposit rate. Another cause is the segmentation of the eurozone’s interbank market, which, if the ECB implemented tiering, would prevent strong banks from benefiting from arbitrage opportunities by lending to weak banks at a rate above -0.4%. Both causes are the result of the eurozone’s dysfunctional banking system, in which demand for safe assets involves both a “home bias” and a strong demand for core countries’ sovereign debt.
In these circumstances, the ECB will not find it easy to implement a policy that would remove the constraint of the zero lower bound on interest rates, while ensuring that the policy’s distributional effects on banks and EU member states are neutral. Doing so will involve many instruments and complex design, far from the simple one-tool-for-one-target framework that was best practice before the financial crisis.
Moreover, negative rates become less effective over time and, if protracted, may have undesirable effects – for example, by inducing savers to de-risk, thereby potentially generating asset-price bubbles and increasing financial disintermediation. The positive stimulus from the depreciation of the euro’s exchange rate could offset these effects, but only if other central banks – and in particular the US Federal Reserve – do not ease at the same time. And on July 31, the Fed announced a widely expected quarter-percentage-point cut in its benchmark interest rate, while further future cuts cannot be excluded.
But the main problem is that neither negative rates nor quantitative easing can by themselves address the pervasive risk aversion holding back the eurozone economy. The ECB is trying to discourage demand for safe assets by making them more expensive to hold, but it cannot address the causes of the increase in such demand. This is a global trend driven by several factors, including demographic changes, widespread uncertainty linked to technological transformation, and political risks such as trade wars and nationalism. But in the eurozone they are exacerbated by the lack of reform of the single currency.
More than ten years after the financial crisis, the eurozone’s financial markets are still fragmented, and the supply of safe assets is limited by the conservative fiscal policy of northern European countries, particularly Germany. Eurozone policymakers must, therefore, find the political will to design a comprehensive package of financial and fiscal measures aimed at injecting new energy into the European project. Such a combined approach is essential to address the deep-rooted risk aversion sapping growth across the eurozone.
In the 1930s, America’s key stimulus was monetary rather than fiscal, but a vital ingredient of success was a comprehensive set of reforms coupled with a strong message capable of unifying the country. Today, Europe needs a twenty-first-century version of that policy.