Thursday, April 24, 2008

Why is economic growth interrupted by periods of stagnation?

In his book, "The moral consequences of economic growth", Benjamin Friedman argues persuasively that economic growth has important spill-over benefits – movement towards more openness, tolerance, mobility, fairness and democracy. Arguably, these consequences are all consistent with development of institutions – rules of the game – that would encourage further economic growth. So why has economic growth been interrupted by periods of economic stagnation?

Friedman doesn’t address this question in his book. It might be unreasonable to expected him to do so - the book is highly ambitious as it stands. As I read the accounts of stagnation during the 1970s and 1980s, however, I could not help thinking that this stagnation was at least in part a consequence of the way governments had responded to the preceding period of economic growth during the 1950s and 1960s.

I found myself thinking that the book could have been better if the author had spent more time discussing the ideas of Joseph Schumpeter – in particular, Kondratieff cycles. Building on these ideas, and those of Mancur Olson, Wolfgang Kasper has suggested that contradictions and obstacles tend to build up in fast-growing economies after a generation of accelerated growth (“Building Prosperity”, The Centre for Independent Studies, 2000, pp 6-11). These obstacles can include bottlenecks in supply of raw materials and labour (a decrease in elasticity of supply) and increased use of market power to squeeze profits. If monetary policy is used to expand demand, the result is little real growth and much inflation. As growth stalls, the prevalent social mood shifts from can-do optimism to defence of existing positions. Politicians increasingly side with established interest groups against emerging competitors.

According to this Kondratieff – Schumpeter – Kasper cycle theory, downturns eventually become periods of rejuvenation in which past economic difficulties trigger economic reforms that make institutions more market-friendly. Periods of accelerated growth are triggered by low and stable real interest rates, secure supplies of raw materials at relatively low prices and a low degree of industrial relations conflict. This enables investors to plan ahead and anticipate strong profitability.

I think it is important to make the point that there is nothing inevitable about these long cycles. It is possible for a country to remain stuck in a downturn, or even to go into secular decline, while the rest of the world returns to prosperity. It is possible for a country to avoid the worst consequences of a period of stagnation in the world economy if it maintains a set of institutions that enable it to adjust quickly to the changed environment. It may also be possible for the world economy to grow indefinitely if leading economies can avoid the contradictions and obstacles that would otherwise lead to recession.

Finally, I think it is also important to note that in some countries the contradictions that lead to prolonged recession may have more to do with attitudes encouraged by governments and central banks than with specific government interventions (eg regulations or taxes). For example, the lax responses of central banks to inflationary pressures in the 1960s conditioned people to expect that increases in inflation (such as those resulting from oil price shocks) would tend to persist. Thus the economic stagnation experienced in the 1970s may be attributed, in part, to contradiction between the expectations of the public that increases in inflation would persist and the lower inflation outcomes that restrictive monetary policies were intended to produce. (See: Athanasios Orphanides and John Williams, ‘Imperfect knowledge, inflation expectations and monetary policy, 2002.)

During the 1960s it was commonly believed that governments could sustain economic growth at close to full employment – all that was required was political will and the judicious use of monetary and fiscal policies. These unrealistic expectations were shown to be unsustainable when it became necessary for economies to adjust to increases in energy prices in the early 1970s and early 1980s. Let us hope that faith in governments never again returns to the levels experienced in many countries during the 1960s.

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