The Reckoning

André Côté

The Reckoning – Part 1

Years ago, when I was getting my first taste of comparative public policy as an undergrad, a wise and engaging professor of mine lectured about how states, from time to time, face a “reckoning.” While I could well have missed his point, what I took it to mean was the moment at which a society realizes that the state’s political economy – it’s social, political and economic framework – is no longer working. I found this to be a very profound and powerful idea.

It’s not a stretch to suggest that Western civilization is in the midst its own moment of reckoning. Over the last three years, we’ve seen the post-war liberal-democratic economic model – the source of much triumphalism and hubris in recent times – seemingly come apart at the seams.

The cause of this rupture is generally attributed to the ‘financial crisis.’ The common narrative is that the crash, and the hardship that has followed, were the result of a perfect storm: once-in-a generation housing bubbles in the US and Europe, driven by low interest rates and loose policy; reckless innovation and leveraging in the financial sector; toothless regulators and clueless or complicit ratings agencies; and consumers aided and abetted by feckless mortgage lenders.

The reality is, the financial crisis simply accelerated the economic and fiscal decline that had long been underway. All the warning signs were readily apparent before the crisis: economies increasingly reliant on housing construction, financial services and the public sector (or commodities in some cases) for growth and job creation; governments eroding their balance sheets to pay for entitlements and unaffordable tax cuts; labour markets increasingly creating inequalities by privileging the highly skilled, the unionized and the aged; and, as this recent McKinsey report lucidly shows, a staggering growth in indebtedness – among households, financial and non-financial businesses, and governments alike.

But in the immediate aftermath of the crisis, there was no ‘reckoning’. Even as governments were forced to make truly unprecedented market interventions just to stave off calamity, there was little public debate about how it had come to be that the financial sector was generating over 30% of US corporate profits with only 3% of the workforce; or of what the future held for Europe with youth unemployment shooting above 20%; or of what was prompting consumers to pile on debt to buy houses and groceries. Instead, there was actually some optimism that a speedy recovery was coming.

Only recently has that optimism begun to fade, and the true severity of the problems Western societies face become apparent. In September, the IMF reported that the “global economy is in a dangerous new phase,” as the economic recovery slows, confidence has fallen sharply, and downside risks are growing. This surely proved an understatement. The outlook has worsened since then, as the spiraling European debt crisis increasingly imperils the future of the Eurozone and risks sovereign defaults that would ripple disastrously through the global economy. This uncertainty is heightened by the weakness and fiscal paralysis in the US, crystallized in recent months by the historic downgrading of the credit rating.

Indeed, it is not hyperbole to suggest that we’re on the brink of an economic disaster, the outcomes of which we do not have the analytic capacity to foresee.

And yet, the gravity of the situation has not been fully grasped by Western policymakers and publics. Politicians in Europe have bickered and dithered for two years as the debt crisis has worsened. Flailing European governments, under intense pressure from the bond markets, have only reluctantly laid out austerity plans, generally out of desperation and in return for EU and IMF bailouts. In North America, meanwhile, policymakers have been similarly loath to take action. The US political system has been gridlocked by political polarization, dysfunction and venal brinksmanship. New brands of populist politics have produced electoral success – whether the Tea Party’s small-government credo, or the federal NDP’s campaigning on middle class angst – but have not sought to offer reasonable proposals for reform.

Public attitudes are also conflicted. Polling suggests that Brits and Americans, for example, are extremely pessimistic about the state of the economy (though Canucks are more positive). Incumbent governments have been swept aside in the UK, Ireland, Portugal, and more recently Greece, Italy and Spain (though, again, not in Canada), with Presidential elections looming next year in the US and France. The streets of Europe have also witnessed troubling eruptions of social unrest, violent protest and looting, sparked by longstanding class resentment, intergenerational inequity and government austerity and bailouts. But publics, while aggrieved and eager to punish governments for their profligacy and complacency, don’t seem eager to change their own behaviour or suffer the consequences of government debt reduction.

The Occupy movement, while now ebbing, really captured the zeitgeist of our current moment. The camp cities were born out of latent frustration and resentment about the status quo, loosely tied to the motifs of rising inequality, middle class anxiety, and the culpability and greed of the financier class. The movement garnered significant public support and recognition, and unlikely kudos from elite opinion-shapers. It has also inspired an ethos of communitarianism, social justice and democracy. Tellingly though, the Occupy Movement’s chief failing was its inability to convey a coherent message, outline objectives for reform, or harness the public support to spur political action.

This seems emblematic of the public mood: uneasy, angry and ever more aware that something is going terribly wrong; but uncertain of the hard choices their societies face, and reluctant to tolerate a political discussion of the sacrifices they’ll require. The ‘reckoning’ is beginning, acceptance will follow.

The Reckoning – Part 2

It’s hard to learn uncomfortable truths about yourself. But as many who’ve recovered from addiction and dependency can attest to, the first step on the road to recovery is acceptance.

If Western society is indeed ready to admit that it is facing a moment of ‘reckoning’, requiring a fundamental rethink of the 20th century political economy, then policymakers and publics need to come to terms with three difficult truths.

The first difficult truth: the global economy is sick and the healing process will be long and painful.

What the 2008 crisis and its aftermath has revealed is how dysfunctional the global economic model has become. Many of the symptoms are plainly obvious, such as dramatic global trade and current account imbalances, increasingly volatile and speculative financial markets, and asset bubbles driven by low interest rate policies and lax regulation.  Author Michael Lewis has made a great living traveling the Western world, from Dublin to Sacramento, chronicling the folly of these unhealthy financial practices. The core, systemic problem, however, has essentially been this: the global economy has in large measure been sustained by the growth of export-driven emerging markets through the financing of Western consumption. This, clearly, wasn’t sustainable.

There are a couple of important conclusions to draw. The first is that a significant and wrenching restructuring must occur as developed countries acclimatize to a world in which they can no longer live beyond their means. This process will slow growth in the years ahead, as developed world consumptive capacity declines, currencies depreciate, and trade imbalances gradually narrow. This will consequently be challenging for emerging economies as their capacity to grow as low-cost manufacturers will be diminished by deteriorating terms of trade and declining demand for their products. China has been signaling that the growth of domestic consumer markets is critical to replacing Western demand and sustaining growth.

The second conclusion is that a variety of other factors will likely only make this realignment more difficult in the years ahead. Recent IMF research suggests that sustained fiscal consolidation, or deficit cutting, will reduce growth and increase unemployment, particularly long-term unemployment. Access to capital for investment will likely remain difficult for firms, as sovereign debt uncertainty persists and banking reforms take effect. Aging populations will shrink labour forces and shift resources from investment in productive things to the consumption of services like healthcare. If all this weren’t enough, questions persist about whether China, a driver of global growth, could face destabilizing asset and credit crises of its own.

Suffice it to say, the restructuring will be a long process and growth will remain slow.

The second difficult truth: governments will no longer be able to fund the level of services citizens are used to.

While it needn’t be belabored, Western public finances are utterly shambolic (here’s an interactive way to learn about it). While severely aggravated by the economic crisis, this should again be understood as a longer term phenomenon – driven by slowing economic growth, increasingly unsustainable health, pension and social service expenditures, and an anti-tax orthodoxy that has eroded the revenue base.

The consequences of this are clear: reducing public deficits and debt will require dramatic reductions in public service levels, or large tax increases, or both. The challenge will again be heightened by an increasingly grim set of forward-looking circumstances. Weak economies will restrain revenue growth and increase social assistance and unemployment costs. Rising interest on debt payments will eat up larger shares of expenditures, even with persistently low interest rates. Growth in health spending will also likely continue to crowd out other public priorities.

What type of pain will the era of fiscal austerity inflict? The UK’s 2010 emergency Budget provided an early example, coupling welfare reductions and draconian departmental budget cuts of 25% with increases to the value-added and capital gains taxes, and the imposition of a bank levy.  Most other major economies in Europe have since announced plans that include some combination of spending cuts, asset sales, public sector pay cuts, benefit and pension reductions, and tax or levy hikes. Particularly severe measures, imposed in likely defaulter nations such as Greece, Ireland and Spain, will perversely further constraining their future growth potential.

While the US hasn’t yet taken these difficult steps, the degree to which largely non-discretionary spending on health, pensions, interest on debt and the military dominate Budget allocations demonstrates how daunting fiscal reform will be. This fiscal architecture is similar across the Western world.

The third difficult truth: the middle class ‘social compact’ needs a rethink.

In the mid to late 20th century, a system of welfare state capitalism emerged as the core of the Western political economy. The model has been based upon striking a balance between the inherent risks, rewards and inequities of free markets, with the assurance of high employment, rising standards of living, and the government provision of education, health and other services to ensure equality of opportunity for all and social supports for the unlucky. This liberal-democratic ‘social compact’ was predicated on the idea that though some would take a disproportionately large slice of the pie, most would benefit from the growing size of the pie.

The data today shows that this arrangement has been eroding since the 1970s. In Canada, though the Canadian economy has grown significantly over the last 30 years, the real median income has barely budged – rising from $45,800 in 1976 to $48,300 in 2009, or just 5.5%. The trend has been similar in the US. In Europe, this wage stagnation has been coupled with an epidemic of youth underemployment, spurred on by rigid labour markets and protected cadres of entitled older workers.

The figures are stunning. Yet, the impact on middle class standards of living has been muted. The reason for this, as labour economist Robert Reich demonstrated brilliantly in The New York Times, is that household incomes have been supported by two somewhat surprising factors.

The first was the entry of women into the workforce en masse during the 1970s and ‘80s. Unquestionably a landmark progressive advance in gender equity for our societies, it also quietly served a critical economic purpose: boosting incomes for households that increasingly couldn’t get by with a single breadwinner. More recently though, households have become dependent on a second form of income supplement:  debt. In Canada, household debt to after-tax-income levels have spiked from 80% in 1970 to nearly 150% today. Canadians are by no means unique, as savings rates have fallen across the developed world.

Even the promise of post-secondary education, sold to recent generations as the ticket to prosperity, is proving somewhat of a chimera. In a recent article, former Obama budget chief Peter Orszag argued persuasively that college degrees in the US don’t provide the return on investment they used to: they are more expensive than in the past, less likely to guarantee a high wage, and less of leg up in times of high unemployment. Prospects are even bleaker for European graduates. Among other factors, this has been driven by the growing capacity to outsource or digitize work done by some segments of the white collar workforce, causing poorer job prospects and downward pressure on wages.

All of these trends paint a gloomy picture for the 21st century worker. What is called for, suggest the MIT academics that co-authored an influential recent study on stagnant wages in the US, is a fundamental rethink of the linkages between workers’ wages and productivity growth in our economies. They urge the creation of “a new Social Compact, not in the mirror image or with the same institutions of the original Compact, but with policies, institutions and organizational practices suited to the current economy and workforce.”

The critical insight is that these three ‘difficult truths’ – the painful processes of economic restructuring, fiscal retrenchment, and renewal of the middle class social compact – represent thorny, integrated and long-term challenges. They will require policymakers to have the courage and foresight to make difficult choices in the public interest. And that electorates shed their aversion to change, and their intolerance for personal sacrifice. This will be profoundly difficult.

But the darkest hour is before the dawn. These challenging circumstances will compel public debate on some foundational questions that have been off the table in recent years, outside the boundaries of acceptable political discourse.

How can public expectations for services be aligned with a reasonable tolerance for tax? What sacrifices are required, and by which groups of citizens, to ensure a sustainable welfare state? What types of jobs do people want, and what policies can reorient the economy to create them? What role should the financial sector play in the economy? And what levels of income inequality and intergenerational disparity are tolerable?

These questions are daunting. Yet, they get to the heart of the core promises of Western liberal-democracy, such as fair and competitive economies, representative politics, social justice and equality of opportunity. What this reckoning provides is much needed reflection that must be embraced.

André Côté is an alumnus from the Class of ’09 at the School of Public Policy and Governance, University of Toronto. The views expressed are his alone.

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