Fix the economy, save democracy

Economic growth
Macroeconomics - Economic growth - Monetary Policy
Politics and Economy

Everyone thinks of changing the world, but no one thinks of changing himself”.

- Lev Tolstòj

COVID-19 will not change the world for the better. Those who dislike capitalism, immigration and pollution hope the virus will end them all at once. Yet, previous crises have shown that change is hard to achieve. Only a decade ago, the 2008 global financial crisis (GFC) led to similar calls - to no avail.

A dangerous status quo. Change is needed. In the absence of bold decisions, rising inequality will foster populism and nationalism, putting democracy at risk (Figure 1), as follows:

First, growth will remain below-potential. The deepest recession in a century will: i) freeze aggregate demand and keep ‘consumer good inflation’ below central bank (CB) targets; and ii) force activity reshoring and shorter supply-chains, inflicting lasting damage to labor productivity and potential output. For years to come, growth and incomes per capita will be lower than in 2019 - across the world. A V-shaped recovery is improbable.

Second, three more crises are likely to unfold. In the fall of 2020, a social crisis will require governments to protect jobs and mitigate the recession’s social costs (e.g. unemployment, mental health and domestic violence). In 2021, heavily-leveraged companies and countries may endure a debt crisis. As a result, a banking crisis might ensue.

Third, CBs have no alternative but to print. To cushion the crisis and finance the recovery, CBs will be the only game in town. Unconventional monetary policy will fund: 1) growing government deficits (i.e. salary, healthcare, and pension liabilities will increasingly be paid with freshly printed money – aka debt monetization); and 2) financial institutions, including insolvent ones (i.e. zombie banks) and established market participants (e.g. systemic investment management firms). Liquidity will be allocated along existing power structures: profit- and rent-seekers will benefit disproportionally more than wage-earners.

Fourth, Statism will rise. Financed by CB liquidity, the role of the State will grow. Economic intervention in ‘national-interest sectors’ (e.g. energy, telecommunications, health-care and pharmaceuticals) will be seen as necessary. State-owned enterprises (SOEs) and stricter regulations will acquire legitimacy – likely leading to an inefficient allocation of resources.

Fifth, numbed by easy money, governments will not reform. Around the world, most governments announced ambitious fiscal plans, up to 10-20 percent of GDP. Yet, shovel-ready projects are rare and execution skills are scarce. As absorption capacity is limited and money is fungible, policy-makers will find it convenient to prioritize recurrent (e.g. salaries and benefits) over capital spending (e.g. fixed asset investments). In the presence of abundant financing, structural reforms – needed to attract long-term capital and spur competitiveness – will be shelved. In labor markets, the dichotomy between the ‘haves’ and the ‘have-nots’ will crystallize.

Sixth, inequality will rise across countries. Each nation’s trajectory will depend on its: i) political leaders’ vision and skills; ii) power structures; and iii) institutions. Policy mistakes will cost exponentially. Inevitably, economic, political, and social outcomes will diverge radically. Organized and innovative countries will come out ahead while slow and bureaucratic ones - characterized by powerful rentiers, little competition, low growth and high debt - will suffer the most.

Seventh, the ‘CB printing press’ will exacerbate the wealth gap. Money will be abundant and free for those who are creditworthy, but unavailable for those who lack the capital to collateralize new debts. “Main Street” will keep suffering from income compression, stagflation risks, and falling investments. “Wall Street” will keep benefitting from speculative leverage and asset inflation[1]. With no “trickle-down”, wealth and opportunity gaps will rise in every nation.

Democracy is at risk. From Athens’ ‘Thirty Tyrants[2] to the rise of Hitler[3], democracy always failed “from inside”. The shift towards authoritarianism was favored by: 1) rapidly changing contexts; 2) inept rulers; and 3) weak institutions. This time is no different: uncertainty, lack of confidence in the future and disrupted education will likely lead to a surge in populist nationalism. Political consensus could veer towards Hobbesian solutions[4].

A radical change of direction is needed. It is time for an act of responsibility. GFC-like inaction should be avoided: short-term challenges must not be allowed to fester, developing into hard-to-resolve problems[5]. Only bold vision, a clear strategy, and leadership will fix the economy and save democracy.

1. Borrow, but keep interest rates below nominal growth[6]. In the short term, closing the deficit[7] is not a priority: CB financing of government operations – i.e. debt monetization - is unlikely to be inflationary. In the medium term, however, increasing debt/GDP ratios is worthwhile only if debt-financed activities lead to long-term competitiveness, higher investments and sustainable growth.

2. Boost real growth, via regulated free markets. To create opportunities, employment and wealth, economic growth is the priority. In a recessionary business cycle, expansionary fiscal and monetary policies must support: 1) aggregate demand[8]; 2) pro-growth structural reforms[9]; and 3) international trade[10].

3. Improve the welfare state, deepen democracy. Despite its shortcomings, the welfare state remains a valid socio-economic model. Most economies need to improve their service delivery via: i) social safety nets for the distressed; ii) stronger public-health systems; and iii) modern education. To protect democracy, avoid “business as usual”: the expansion of state’s responsibilities must go hand in hand with higher accountability.

4. Save the State from Statism. If governments become more pervasive but remain unable to address citizen’s needs, discontent and alienation will grow. To build a strong, effective State – able to play an active role in enabling innovation - policy-makers need to strengthen the ‘rules of the game’ for the market to function (e.g. breaking monopolies[11] via effective regulation, favoring risk-taking and entrepreneurship) while minimizing the State’s encroachment (i.e. cronyism, bloated bureaucracies, control over private companies). The entrepreneurial spirit and competition are public goods that need protection.

5. Cut unproductive spending[12]. The time is now: the recession is an opportunity to improve the quality of spending – which matters more than its size. For business confidence to rise[13], allocated resources must enhance productivity, spur growth, finance convergence and development, and improve real incomes. To achieve sustainability and defeat decadence and waste, austerity[14] and restraint are needed.

6. As the recovery starts, normalize monetary policy. In the long run, unconventional tools (e.g. zero-interest rates, quantitative easing) do not stimulate economic activity but result in: i) excessive risk taking and asset inflation (i.e.: artificially high prices of equities1, fixed income and real estate); ii) increased bank credit risk; and iii) financial sector fragility. Once the recovery is under way, CBs should increase short‐​term interest rates and shrink the size of their balance sheets.

Bottom line: build better societies. The post-COVID-19 crises will force CBs to print. Easy money will finance: 1) an inefficient enlargement of the State, along existing power structures; 2) zombie banks, able to lend only to the creditworthy; and 3) a bubble in financial markets. The resulting increase in inequalities will threaten democracy. To avoid the inevitable unfolding of a ‘chronicle of a death foretold’ (Figure 1), countries should fix the economy - the prerequisite for saving democracy - and re-shape the State - to offer all citizens: i) equal opportunities; and ii) economic and cultural growth.


[1] Rising prices of financial assets (e.g. in the liquid space: equities, bonds, commodities; in the illiquid space: private equity and real estate). For example, the price-earnings ratio (PE) of the S&P 500 index rose from a pre-GFC three-year-average of 18.9  to 27.3 in June 2020.

[2] During the second Peloponnese War, after the failure of the second Athenian expedition to Sicily (413 BC), in Athens “(...) the crowd broke into a fierce protest against the politicians who had publicly encouraged the expedition, as if the citizens themselves had not been, with their vote, those responsible”. Source: Thucydides, The Peloponnesian War - Book VIII, page 1. The aristocratic coup d’état (411 BC) and hyperinflation ensued. After the definitive surrender (404 BC), Sparta imposed to Athens oligarchic institutions, i.e. a regime known with the name of “government of the Thirty Tyrants”.

[3] Hitler came to power by taking advantage of: i) Germany’s defeat in World War I; ii) hyperinflation; and iii) the economic crisis - attributed to the compensation imposed by the Versailles Treaty on the Weimar Republic, and not to the aftermath of the Great Depression of 1929-1939. On January 30, 1933, without having an absolute majority (in the last free elections of 1932 the Nazis obtained 33 percent of the votes, 196 of the 584 seats available), upon appointment of President von Hindenburg, Hitler became Chancellor - head of a government coalition in which his National Socialist German Workers’ Party (Nationalsozialistische Deutsche Arbeiterpartei) was the first party - and made use of the Constitution to consolidate its power.

[4] When political consensus favors Hobbesian solutions, crises are not opportunities. Jean Monnet’s famous wish “Europe will be forged in crises, and will be the sum of the solutions adopted for those crises” should not be taken for granted.

[5] For example, the insolvency of viable companies can lead to long-term unemployment and greater inequality. The unemployed must not become unemployable.

[6] When nominal GDP growth is higher than the average cost of debt, the debt/GDP ratio decreases over time.

[7] In 2019, Olivier Blanchard’s presidential address to the American Economic Association argued that the economics profession over-estimated the cost to society of government debt. In the short term, in absence of inflation, unorthodox measures such as price controls and debt monetization are acceptable. Yet, the long-term viability of the three major world reserve currencies as ‘store of value’ should be preserved.

[8] Wage-earners need to be protected over profit- and rent- seekers. So far, only a few countries provided cash-deprived households and businesses with ‘insurance-like payments’.

[9] Reforms able to alleviate binding constraints on growth. For example, policy-makers could:  1) promote growth with counter-cyclical fiscal policies – while preserving macro stability; 2) increase spending in infrastructure and education via public-private-partnerships (PPP); 3) reduce taxes, especially on labor, to encourage job creation; 4) promote the restructuring of the banking system and reform insolvency procedures; 5) reform the judicial system and simplify settlement practices; 6) address rent seeking and élite capture and promote meritocracy; 7) improve the efficiency of the public administration; and 8) align wages with productivity and make the formal labor market more flexible.

[10]  “When goods don’t cross borders, armies will”, Frédéric Bastiat, a French economist buried in Rome’s church St. Louis of the French, seems to have said in the first half of the 1800s. Governments must commit to globalization and to: 1) maintain an open economy and the competitive pressures that ensue; 2) (de)regulate product markets; and 3) stimulate productivity growth by removing protective barriers to entry, particularly in the service sector.

[11]Resist the powerful influence of organized private interests interested in building and protecting monopoly positions and impede the efficient function of free market, and thereby reduce the overall level of economic opportunity in society”. Source: Rajan, Raghuram, and Luigi Zingales. Saving Capitalism from the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity. New York, Crown Business, 2003.

[12] E.g.: 1) subsidies to rent-extracting, politically-backed monopolies (e.g. regulatory capture); 2) local governments with no fiscal discipline; 3) unnecessary banks’ bail outs (i.e. moral hazard); and 4) nepotism-driven benefits (e.g. early retirees). During a recession, the short-run adverse impacts on growth recovery and jobs prospects are marginal. A fiscal consolidation of 1 percent of GDP typically reduces GDP by about 0.5 percent within two years, and raises the unemployment rate by about 0.3 percentage point. Domestic demand—consumption and investment—falls by about 1 percent. Source: IMF, Rebalancing GrowthWEO, April 2010. IMF, “From stimulus to consolidation: revenue and expenditure policies in advanced and emerging economies”. Washington DC, April 2010. Ball, Laurence, Daniel Leigh, and Prakash Loungani, 2011. ‘Painful medicine’. Finance & Development September 2011.

[13] In prolonged recessions, ‘expenditure-based’ (i.e. cutting spending) deficit reductions are to be preferred to ‘tax-based’ ones (i.e. raising taxes).  If uncertain about future fiscal policy, taxation, and regulation, firms stop investing or hiring. In the past, after ‘deficit reductions driven by spending cuts’ private-sector capital accumulation rose, with firms investing more in productive activities—for example, buying machinery and opening new plants. Source: Alberto Alesina, Carlo Favero, and Francesco Giavazzi, Austerity: When It Works and When It Doesn’t. Princeton University Press, 2019. Downloadable data appendix.

[14] Austerity is not used here in its technical meaning of ‘reduction of government deficits or debt via spending cuts and tax increases’. In this context, it is used in its broader, moral meaning: “Austerity means rigor, efficiency, seriousness; it means justice”. [...] “For us, austerity is the means to combat [...] waste and misuse. […] Indeed, it can be observed that often, in decadent societies, injustice and the squandering of public resources have gone together, as much as justice and parsimony go together in rising societies”. Source: Final speech by Enrico Berlinguer - secretary of the Italian Communist Party (PCI) at the intellectuals’ conference at the Eliseo, Rome, January 1977.


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