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Michael Baxter

The real cause of today’s woes

Written by: Michael Baxter on November 19th 2012

Category: Thought for the day

I was bowled over. This weekend I read a report which actually managed to explain what the real cause of today’s economic crisis is. The report went one step further too, and outlined a fix. This is perhaps the most important economic report I have read in a very long time.

I covered an aspect of the report on Friday, but over the weekend I have been reading it in more depth, and the more I read it, the more I like.

The reported was penned by a number of academics including Nobel Laureate Joseph Stieglitz. To read it in full see: Sectoral Imbalances and Long Run Crises

For an easier to follow account, read this piece by Stiglitz in ‘Vanity Fair’: The Book of Jobs

I have never swallowed the idea that today’s crisis was caused by banking excess, by greedy bankers.  Instead, I have felt the banking crisis of 2008, and the problems exposed by it, were symptoms, not causes of the deeper crisis.

There are three theories about what caused the Great Depression. Theory one, advanced  by Keynes, is that this was a crisis of demand: to get the economy moving, governments needed to borrow from companies and individuals who were saving more than was economically optimal, and spend this money. Theory two, advanced by Friedman, says that the Depression was caused by a shrinking money supply, caused primarily by banks being allowed to go bust. Theory three, advanced by Hayek, suggests it was all down to government interference –  for there to have been recovery, the government just needed to do nothing, impose less regulation, and let markets force the necessary adjustments.

The theory that seems to have gained sway is the second one. Before he was chairman of the Fed, Ben Bernanke was just about the leading academic in the world on the link between monetary policy and the Great Depression.

Justification for the banking bail-out and for quantitative easing is based on the monetary explanation.

The Keynesians say it took the spending that came with World War 2, which was a kind of Keynesian stimulus by default, to create the post war boom. They go further, and say that in democracy, the Keynesian stimulus required to end a Great Depression type scenario would not occur in peace time, for the electorate would never countenance it.

The followers of Hayek say the recovery from the Depression was occurring anyway, and that Roosevelt’s meddling with a New Deal, just delayed recovery. Keynesians say that Roosevelt’s new stimulus lacked ambition.

The report that has me so entranced, very much falls into the Keynesian camp. And as an aside, it said that Argentina was not involved in the World War, hence it did not enjoy the massive Keynesian stimulus and structural changes, so its recovery from depression style conditions was much slower.  (I find that idea pretty fascinating in itself, and will revisit that idea at a later date.)

The report says the cause of the Great Depression was innovation in agriculture, leading to lower food prices, leading to job losses and lower incomes in the rural economy. At that time, the rural economy was vital to the overall strength of the US, and – thanks to the fall in farm wages – demand for manufactured goods fell. Consequently, the urban economies which relied on manufacturing also slumped. Furthermore, because of falling asset values in the rural economy, struggling farm labourers could not afford to migrate into the cities, even if jobs were available to them.

Or to put it another way, the Great Depression was caused by the changeover from an economy based on agriculture to one that relied on manufacturing. A factor at play here was the specialisation of the labour force. It was geared towards agriculture, and did not have the expertise to move into manufacturing.

The report said that Word War 2 had two effects. Firstly, it created the demand for a US manufacturing industry, and second it forced labour to migrate from the countryside. The report refers to this second effect as structural changes.

Now forward wind the clock today. The report suggests that over the last decade or two, manufacturing productivity has been increasing much faster than wages. This has meant that demand was struggling to keep up with potential supply. A temporary fix to this problem was the credit bubble, and housing boom, but with the banking crisis of 2008 this temporary fix came to an end.

The report says that QE is not working and the banking bail-out may have been an error, because neither fixed the underlying problem.

In the 1930s, the US was changing from an agricultural dependent economy to one based on manufacturing. Today, suggests the report, the shift is from manufacturing to services. I get that. Innovation surely does mean manufacturers can produce more goods from a smaller workforce.

But countries that try to hang on to manufacturing, may themselves be making a fatal error – make a note of that Germany.

The report concluded that the future of the US economy lies in more jobs going into education and health. I guess that means higher taxes to pay for this. And in the short run, it means massive fiscal stimulus.

Finally, there is the role of the entrepreneur. The report did refer to this, and acknowledged than the banking sector has ceased to be effective in providing funding to budding entrepreneurs. But that’s where my criticism of the report lies. Actually, that’s not fair because the report was focusing on the US.

For the UK all the above makes sense, but I would put more emphasis on encouraging greater entrepreneurial activities via QE funding programmes designed to create more entrepreneurs. And if some of these entrepreneurs are hairdressers that does not matter. We can’t all be hairdressers, but an economy in which advances such as 3D printing means less need for manufacturing jobs, we will either have permanently high unemployment, or more hairdressers, personal trainers, teachers and nurses.

These views and comments are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees

Tags: manufacturing productivity has been increasing much faster than wages, shift from manufacturing to services, specialisation of the labour force, true cause of economic crisis, true cause of economici crisis, was banking crisis a sympton, what caused the Great Depression, World War 2 Keynesian stimulus

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