8/2/13 – Back to Political Economy

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Aug 2, 2013 9:44:32 AM

and tagged Europe, Politics and the Economy

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One of my major themes last year was the return of political economy. This is the discipline that Smith and Ricardo, among others, invented, and it was called that because they understood very clearly the relationship between politics and what we now call economics. The notion of considering them independently would have seemed nonsensical.

Partly, this arose from the environment of the times. Given the fractured nature of the polities in Europe and around the world, and the wide diversity of laws and governmental systems, the impact of politics on the prosperity of countries was unavoidable. This study has recently been resurrected, in the modern form of the effect of institutions on growth, but at the time it was not a special field; it was and had to be part of the core.

In recent decades, the two fields came to be considered as separate. Economics was one discipline, dealing with the economy, while politics dealt with government. This was possible only because of a wide consensus that had evolved about the most efficient economic structure (capitalism, in a variety of forms) and the most efficient governmental structure (democracy, in a variety of forms), as well as the arm’s-length relationship between them.

That consensus is breaking down around the world, for a variety of reasons—to be discussed in another post—but the most interesting breakdown, for me, is right here in the United States. Much of what is currently being reported as partisan political bickering actually reflects, in my opinion, a breakdown in the consensus on the right forms of the economy, the government, and the relation between them.

This isn’t a particularly useful point. Taking the next step, though, does provide some insight.

The next step is to connect the consensus breakdown with the emerging economic gap in the U.S. Often described as the gap between the haves and the have-nots, it’s much better described as the gap between the educated and the uneducated. The advantages of education have grown enormously over the past couple of decades. The higher the education level, the higher the wages, the lower the unemployment . . . and the advantages continue.

To the less educated, capitalism, with its increasing returns to scale, has less and less appeal. In an age of prosperity, when everyone was getting more, the appeal was clear. In the U.S. in the 1950s, for example, manufacturing workers could live well. The increasing returns to scale were shared across the income structure, making capitalism visibly work for the average person.

Thanks to the good times, democracy also was seen to work. LBJ created the Great Society, a mass benefit program that benefited the average person. Social security fit the same mold. Again, visible benefits justified the governmental structure.

As the gap between different segments of the population expands, the benefits of the existing consensus are eroding, potentially damaging support for democratic capitalism in a large part of the population. This is not unprecedented; the same happened in the 1930s. I’m not comparing our situation now to then, but the notion that difficult times can erode a social consensus is well supported.

In another context, we can see that same agreement breaking down in two very different places. The European experiment was based on, and justified by, shared prosperity. Hard times are now calling it into question. Capitalism, never very popular there, is also being challenged. Again, we can point to examples in European history of difficult times causing social chaos.

China’s governmental legitimacy is very clearly based on economic growth. Although there may be a popular consensus supporting it, the government is very careful never to test whether that’s actually true. It will be interesting to see how slower growth affects the current economic and political structures.

Here in the U.S., we do things differently. Attacking capitalism has never been a vote-winner, so rather than restricting the private sector, we expand government. Same song, different tune.

Both parties have actually been doing this for decades, starting in the 1980s. Whenever the economy turned down, the deficit ticked up, as federal spending picked up the slack. Again, in good times, this was affordable, and the economic consensus could be supported.

As for politics, both parties have been using increasingly sophisticated tools to manage elections. Gerrymandering is the most egregious example of this, but as long as times were good, the parties could agree on enough to keep everyone happy. Managing the political consensus was also possible.

Which brings us to the present. Despite what I’ve been saying about the economy’s recovery, we’re not going to have enough growth to continue to pay for everything everyone wants. With an aging citizenry, slower population growth, much more competitive world markets, and much higher commodity prices, we’re not going back to the 1950s.

The booms and busts of the past 20 years—accompanied by the increasing political polarization—have been an institutional attempt to figure out how to maintain the political consensus in the face of the different and more competitive economic world we find ourselves in.

Much of the commentary around politics these days decries the polarization, suggesting that, if only politicians could agree, we could solve our economic problems. This implicitly assumes the politics/economics divide I mention above, much as most economic commentary assumes that politics is a separate field.

A more useful approach, I think, is to realize the causality is wrong. Political problems aren’t causing economic problems; rather, the slowing of growth—the economic problems, if you will—is causing the political problems. What this means is that our political woes won’t go away until strong growth resumes. In other words, we’ll be stuck with them for some time.

In the U.S., this suggests that the debt ceiling and budget fights this fall will be just as bad as last time. What it suggests for China and Europe is potentially much more serious.

It also suggests that I’ll be focusing much more on politics over the next couple of months. Sorry about that.

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