Instability, a challenge for economic theory and policy

Instability, a challenge for economic theory and policy

Faced with the conjunction of the financial, health and ecological crises, economic thought is in disarray. A deep-rooted idea remains that these crises are mere digressions, from which we should be able to return at the previous state. However, there are grounds for believing the hypothesis that our economic model is undergoing a profound transformation. Without taking things that far, it appears to observers that the health crisis is accelerating changes that were already underway, rendering a return to a pre-crisis state unlikely (Christophe Morel,  La crise sanitaire a pris la forme d’une “destruction créatrice” schumpetérienne ; Isabelle Job-Bazille, Quelles séquelles pour une crise inédite ?) . Some businesses will disappear, others will develop. Some economic activities will decline, others will grow. This creative destruction process will necessarily cause imbalances and nothing guarantees that they will be easy to resolve. Economists have no lack of references that they can use to understand this reality, so long as they are willing to draw on lessons from the observations and analyses of events made after significant turning points in the past, which counter numerous misconceptions.

Belief in a digression, or the fantasy of a return to the past

The health crisis led governments to take the exceptional step of halting economic activity and introducing support measures to maintain the income of employees placed on furlough and prevent businesses from failing. Although not always openly stated, the aim was to be in a position to return to previous levels of economic activity in the short- or longer-term.

A return to normal, promoted by freezing the effects on income, is intended to be reinforced by the stimulus packages voted and implemented, including, among others, measures to accelerate the digital transition and the ecological transition. The prevailing idea, which is at the heart of econometric models, is that there is a long-run equilibrium towards which an economy will automatically converge.

This return to normal would be in line with the excess savings expected to fuel a rebound in consumption within a relatively short time under the influence of largely unchanged preferences. It would be made possible by the creation of debts underwritten by central banks, which would abandon their conventional policies for a while. These debts would contain the negative effects of the shutdown and then prompt a quick rebound. There would be a direct and unique link between finance and the real economy. This generously distributed cash, initially frozen in savings accounts, would then flow naturally into consumption and investment.

If we follow this approach, which is too exclusively macroeconomic, we fail to take into account the distribution (which in addition is highly unequal) of savings which, when they are released, will naturally affect the final structure of demand, meaning that some goods and services will be in high demand while others are not. This approach also fails to consider the precautionary savings triggered by the uncertainty felt by those households that expect to be more than averagely affected by job destructions in the near future. It skips over the short-turn capacity constraints that would be experienced in the event of a fairly sharp and unequally spread rebound in demand, both due to a lack of labour and due to the constraints on investment caused by excessive businesses’ levels of debt. More generally, it omits the change that would be seen in the type of sectors and geographical areas that capture wealth.

A temporary freeze in activity and the belief in a mechanical return to the status quo lead us to ignore the impact of short-term imbalances on medium- and long-term development. The selection mechanisms have been altered so radically that it is practically impossible to identify the consequences, in the relatively short-term, of the debt carried by businesses. No one can really say what is coming in the way of business failures and job losses. Inflation risk, which some people fear, is only addressed in terms of monetary financing of budget deficits without any real attempt to analyse the sequences of future events caused by the imbalances on the markets for goods and labour. No mention is made of the wide range of situations and behaviours.

The vision of the post-crisis world set out by those intending to seize the opportunity offered by the crisis to accelerate the ecological transition gives the illusion of convergence with no significant clashes towards a new equilibrium. It assumes the benefits of new technologies and new behaviours without giving any consideration to how these would be discovered or achieved. The desired reshoring of business and the expected regression in global trade resemble a kind of backwards step, which would apparently be achieved without any costs or casualties.

The hypothesis of large-scale structural change

In reality, the world was not economically stable before the health crisis. Structural transformations were already under way, so it is fair to assume that they will be accelerated by the experience gained in managing this crisis and the constraints it has caused (Philippe Dessertine, Le grand basculement).  

The experience of remote working is expected to herald a profound transformation in the organisation of work and businesses, which in turn will cause a transformation in urban infrastructure and transport. These transformations will be even more significant in that they will contribute to a new scientific and technological revolution made manifest in new abilities to capture, process and use very large databases (big data). Under this viewpoint, the digital revolution becomes far more important than the energy revolution, the producers of data supplant the producers of energy from both old and new sources, and places of value creation change drastically. There could follow in certain cases a return to producing close to markets, and a regression of movements of goods and people, which would incidentally reduce the toll by the environment. The movement–concentration–hyper-consumerism triumvirate that prevents sustainable development would be challenged. This would require the emergence of relative equality of incomes and assets and the rebirth of a genuine middle class which would make change socially acceptable and a source of value.

This kind of great shift does not call into question the principle of the industrial world organised to maximise the utilisation rate of funds of services (equipment, human resources and stocks), and synchronise the successive stages of production of goods and services (Georgescu-Roegen, The Entropy Law and the Economic Process). Geographical concentration is no longer a condition for achieving this. Large units are no longer relevant. This decentralisation has the ability to reduce transport distances (for raw materials and products) without affecting production efficiency. These are however very large-scale structural changes. They will necessitate new communities and new collective intelligence. The contours of businesses will need to be redefined. The places where value is captured, such as in share price movement data, are already shifting markedly in favour of digital players. In these conditions, it is difficult to imagine that we will not see instability. Consequently, any idea of a return to “normality” is illusory.

Without looking so far into the future…

Current transformations, which affect technologies and preferences, remain difficult to understand and forecast. And they will not happen overnight. There is nothing to guarantee that a stable state will even be reached in the future. It is, however, clear that we are going to see an acceleration in the restructuration of the productive base under the combined effects of the health and ecological crises. New technological and behavioural data will accelerate the process of creative destruction. The lasting effects of shifts in demand are already being seen in some sectors, such as the aviation and automotive industries, which are not facing only the consequences of the energy transition. And of course, effects will also be seen both upstream and downstream of these sectors. It is not possible to imagine the return to a long period of equilibrium that would cancel out the losses suffered. If business activities are reshored, they will not return in an identical format, but with the use of robots. They will not create “old” jobs capable of reducing structural unemployment. Rather than reshoring and shorter value chains, it is preferable to talk about the restructuration of value chains, and a change in the nature of global trade.

The current transformations will affect markets first and foremost. Excess demand will appear in some sectors, and excess supply in others. Labour shortages and surpluses could accentuate due to the diversity of the labour supply and curbs on professional mobility due to a lack of time and finance for training. The risk of even more acute polarisation of qualifications and salaries in the job market is clear given the lack of qualified labour and the flow of the most affected workers towards less qualified roles.  This can only be negative for global growth due to the effect on income distribution and the structure of demand which may be characterised by heightened demand for luxury goods and financial assets to the detriment of the strong demand for wage goods seen in the presence of a large middle class.

Inflationary pressure can already be seen on raw materials markets (iron, copper, wood, aluminium, wheat, soy and oil) and semi-finished goods markets (semiconductors and computer chips) which will, to a greater or lesser extent depending on the industry, affect companies’ production costs, margins and prices. Such tensions are a result of the structural transformations in progress, including those caused by the ecological transition. To produce an equivalent quantity of power, wind and solar generation facilities require considerably more steel and concrete than a fuel-fired or nuclear power station. The electrification of objects, beginning with cars, and the consequent need for batteries to store power, will inevitably cause the demand for the materials used to make them, and the prices of these, to skyrocket.

Very high levels of investment are required, including for ecological reasons. Like any transition, the transformation that is under way will push up the cost of building new capacity and potentially cause a relative fall in gross production leading, temporarily or not, to an increase in the unemployment rate and a fall in productivity gains (the Ricardo machinery effect described by J.R Hicks). Countering this will require, at the very least, a monetary policy and a financial organisation that guarantee businesses the loans they need to invest in productive assets  (Amendola et Gaffard, 1998).

Faced with the inevitability of structural transformations and the demand for viability, it becomes essential to develop new qualifications and new adequately paid jobs. And this is not only about the labour supply, and initial, general, professional and ongoing training. It is also about the demand for work implied by the development of new economic activities and new investments. This very clearly raises the issue of the need for a financial system and corporate governance model that would channel available financial resources into the projects with the potential to generate the most long-term growth.

Have economists lost their frame of reference?

It is unreasonable to expect economic theory written to describe periods of calm to provide an understanding of the root causes of instability and the conditions for market economy resilience. In reality it is preferable to consider lessons drawn from the observation of past turning points. We will look here at two episodes.

The 1970s provide us with one lesson, as we can identify this decade as a period of large-scale structural change. The simultaneous rise in inflation and in the unemployment rate called into question strictly macroeconomic Keynesian policy, which is predicated on the idea of a managed trade-off between the two. The accepted explanation pointed to a budget deficit which disrupted the natural state of long-term equilibrium. This re-established the principle of a separation between the (monetary) causes of inflation and the (real) causes of unemployment. The actual explanation for stagflation is however different. It centres on the consequences of the restructuration of the productive base set in motion by the very sharp rise in the prices of all raw materials before the oil price shock even took place. The simultaneous increase in inflation rate and unemployment rate was quite simply a consequence of the disarticulation of the productive base demonstrated by the increased dispersion of excess (sectoral) supply and demand, in a context where, due to a lack of sufficient information, prices adjusted more strongly upwards than downwards (and volumes and therefore jobs more strongly downwards than upwards), Tobin J. (1972) Fitoussi J-P (1973). In the sectors in expansion, faced with surplus demand for labour, businesses increased wages (and prices) rather than jobs because of the tight labour supply and capacity constraints. In the sectors in decline, faced with surplus supply of labour, businesses cut jobs rather than wages to keep the trust of the staff that they continued to recruit. Downward price rigidity is a response to downward wage rigidity. This behavioural asymmetry constrains the unemployment rate and the inflation rate which can increase simultaneously under the effect of increased variance of the distribution of excess demand (positive and negative).

The period of reconstruction in Europe during the post-war years provides a second lesson. At the time, the general situation was excess demand for labour and surplus demand for goods. Reconstruction necessitated investments in order to make up a capacity shortfall. On the supply side, purchasing power in the form of wages had to be distributed in the absence of immediately available supply, because a certain amount of time was needed for investments to be made and give rise to operational production capacity. In the short-term therefore, inflationary pressure and a foreign trade deficit were inevitable, necessary and also self-limiting (Hicks J.R (1947) &  J.R. Hicks (1982). But it was vital for them to be accepted, and for companies to be able to forecast reliably and have access to the required liquidities. That is how the Marshall Plan came into being. 

While they do not provide ready-made solutions, these lessons give us an insight into the nature of the difficulties and problems that could arise in the short- or longer-term. It is inevitable that imbalances will appear on the various markets (raw materials, semi-finished and finished goods, and labour) and that one will lead to another. Inflation, unemployment and debt are unavoidable because they are linked to structural transformations. It will only be possible to contain them by using both economic policy and company strategy approaches to deal with the wide range of situations and behaviours and reconcile the long-term with the short-term. On the macroeconomic policy front, the cyclical support to economic activity must not mask the importance of public investment that triggers the private investment which will in turn guarantee future growth and make it possible to restore the government debt ratio. This has certain consequences on the way governments make choices. On the business front, to develop firms need to be able to forecast reliably in the long-term and to have access to patient capital and labour relations which will enable workers to learn new skills. This has consequences on their modes of governance. The challenge for governments and businesses is to deal with the short-term difficulties and in doing so look to the long-term (Amendola M. J-L Gaffard et F. Saraceno, 2020).

Jean-Luc GaffardJean-Luc Gaffard, Emeritus Professor and GREDEG Member (CNRS - University Côte d’Azur), Associated Researcher OFCE-SciencesPo, Emeritus Professor, SKEMA Business School

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