For almost all of human history economies were stagnant. From 0 AD to 1820, the growth rate in the western world averaged an exiguous 6% per century. Progress came marginally faster from the middle of the 19th century onward, but the 20th century is the one that stands out in terms of both strong GDP growth and rapidly rising living standards. Over several decades of this sanguine experience, economists, governments, and peoples came to believe that the new pattern of stronger GDP growth and inflation was permanent; and this unarticulated assumption informed the various social contracts that evolved in the OECD economies. Unfortunately, this implicit belief in constant inflationary growth is incorrect. The 20th century was in fact an aberration and the global economy is now reverting toward the earlier pattern of slow growth and disinflation. The profound political, geopolitical, and social implications entailed by this are not yet fully recognized.
Until well after the Industrial Revolution the addition of new peoples and countries to the global economy meant that the aggregate supply of goods and services generally grew faster than aggregate demand, so deflation and depression were more frequent and serious problems than inflation. The distribution of income and wealth during that long period was inequitable since most of the benefits of growth went to capital and not to overly abundant labor. Poor people accepted this inequality as the natural order of things, so it was usually not a source of great political instability. Things changed in the latter half of the 19th century, however, when faster industrialization increased the need for labor, improvements in transportation opened up new outlets for goods around the world, and the consequent accretions to demand and employment engendered a small but politically conscious middle class in some parts of Europe and the United States. This political awakening put more pressure on governments to address the needs of the middle and lower classes.
Those trends accelerated dramatically in the 20th century. Particularly after the Great Depression, aggregate demand in the Western world and globally surged, growth rates rose, labor markets tightened, and inflation became policy makers’ perennial concern. The various welfare states arose from this milieu. Having made enormous contributions to their countries during the World Wars, the citizens of Western countries believed they deserved more governmental support and governments were inclined by both the legacy of the wars and fear of international communism to acquiesce. The result, broadly speaking, was the evolution of a new social contract according to which people expected ever higher living standards and more generous social security benefits in exchange for giving their rulers freedom to reduce barriers to trade, finance, and immigration while also entering into more extensive security arrangements. The Western political order was thus founded on widespread but largely unarticulated expectations of sustained inflationary growth.
The critical question about the 20th century is why did aggregate demand rise so sharply and remain so high relative to aggregate supply given that the human experience until then had been much the opposite. Until the very recent demurrals by Janet Yellen, Larry Summers and a few others, economists and central bankers claimed that their professions had devised better fiscal and monetary tools and that superior macroeconomic management explained most of the miracle. That widely shared view, however, is wrong.
The wellsprings of 20th century prosperity lie in three sequential developments, the first of which was the combined destruction of World War One, the Great Depression, and World War Two. Those events laid waste to an immense volume of plant and equipment and shrank the advanced economies’ workforces. Reconstruction after 1945 required decades of elevated investment rates and put a premium on now-scarce labor, which explains the sharp upturn in demand, wages, and inflationary pressure. Second, the inception of the baby boom generation provided further impetus, lifting the rate of household formation and ensuring that demand would continue vigorous even longer. The resulting sense of confidence among lower- and middle-class voters gave governments the leeway to de-emphasize national sovereignty and expand international cooperation.
The third consecutive source of demand was credit. Just as the reconstruction boom—and hence wage growth—was decelerating in the late 1970s, financial deregulation and innovation gained speed and brought a multitude of new ways to borrow and spend. Whether one looks at household, government, or total national debt, the trend lines are remarkably linear from roughly 1982 through the early part of the present century. Greater household leverage and more government largesse meant that for most people in the OECD countries living standards continued their upward trajectory through the early 2000s. But since financial deregulation and innovation went farthest in the United States, American consumption expanded much faster than elsewhere and became the most important single driver of world trade and GDP growth. Thus the basis of the Western social contract and the Western-led world order gradually shifted from reconstruction and the baby-boomer phenomenon in the early post-war era to US consumer spending towards the end of the century.
Although this fact has not yet entered the popular consciousness, the Great Recession of 2007-2009 marked the end of the 20th century pattern of high inflationary growth. The implosion of the subprime market caused the US financial system to freeze, which interrupted the flow of credit to corporations and households and thereby precipitated a sharp decline in consumption and aggregate demand. This shock spread abroad directly through a collapse in the American appetite for foreign goods and services and, indirectly, through damage to foreign banks and the ensuing effect on economic actors in other countries. For the first time in decades the engines of world GDP growth went sharply into reverse.
Policy makers reacted with urgent efforts to prevent a depression. The policies they adopted achieved that very important objective but failed to return the world economy to the robust inflationary growth that almost everyone had come to accept as the normal state for advanced economies and the world more generally. Substituting government spending around the world for moribund American consumption, for instance, was ultimately unsustainable. Meanwhile lower household net worth and stricter lending criteria meant that many US households could no longer use leverage to finance more spending even at interest rates near zero. Quantitative easing—a bastardized version of Milton Friedman’s “helicopter money”—was helpful in the short run but over the longer-term it mainly pushed up asset prices and enriched the wealthy relative to the poor and the middle class.
This was profoundly important. The wellsprings of aggregate demand during the inflationary period had been post-war reconstruction, the baby boom, and then a debt-fueled increase in middle-class borrowing and spending in the United States. The Great Recession killed the American consumer without providing any substantial replacement for the demand he represented. Viewed objectively and without presumptions about what was “normal,” the world now looked more like the 19th century than the booming 20th.
The proposition that the world economy has shifted down to a significantly lower growth trajectory finds substantiation in global data since 2009 and in the inability of central banks to achieve their target levels of inflation, something that in Congressional testimony last week Janet Yellen described as a “mystery.” The proximate cause of this “mysterious” deceleration is in fact the aforementioned financial constraints on working and middle-class households in the United States, but there are several other disinflationary dynamics at work as well.
The most salient of these is the aging of the OECD nations. The high rate of household formation and the birth of the baby boom generation after World War Two contributed greatly to aggregate demand for several decades, but first in Japan and then in Europe and the United States those people transitioned from the high-spending stage of life to the more parsimonious years of retirement. The middle-aged and elderly contribute to disinflation through weak consumption and by expanding the supply of credit, which in turn suppresses inflation both domestically and around the world. Population growth in the emerging markets will doubtless counteract some of this negative momentum. But because of the old one-child policy China, the greatest of the developing economies and a significant source of world demand growth over the last two decades, will soon experience a demographic squeeze even more acute than that which has long afflicted Japan.
As some Silicon Valley luminaries have lately observed, technological change may also aggravate the problem of low wages and insufficient aggregate demand. When demand chronically exceeds supply, as was true during the long 20th century boom, innovation expands the availability of goods and services at a given price level and hence enables faster GDP growth. But when an economy needs more demand and inflation, increasing low-cost supply makes things worse. To put the point bluntly, most of today’s technological progress is aimed at replacing labor with more efficient machines and software. There is consequently good reason to believe that the stagnation in wages that began in the 1980s will persist, and perhaps intensify, for years and perhaps decades to come.
Prospects for the world economy today are not very bright. There will be no post-war reconstruction, no baby boom generation in the rich countries, no massive expansion in debt-fueled American consumption. Global growth will therefore probably continue at an average rate one or two percentage points lower than in the 1990s and early 2000s, inflation remain minimal, and lower- and middle-class incomes stagnate. This is not a bad outlook relative to most of human history, but it is significantly worse than the 20th century taught people to expect.
The social contract throughout the OECD and particularly in the United States has been irrevocably broken. The implicit deal was that people would enjoy a realistic possibility of upward mobility, middle-class incomes and living standards would steadily rise, each generation would do better than the previous one, and the distribution of income and wealth would worsen only marginally if at all. Japan succumbed first to demographically-induced decline and paid the price in a younger generation that is largely disengaged from national and international affairs. The rest of the advanced economies were spared until the 2007-2009 crisis. But that seemed a unique event, and once it had passed most people, political leaders, and central bankers in Europe and the United States thought their economies would soon resume the inflationary growth of the late 1990s and early 2000s. The fact that something fundamental had changed dawned on the various countries only over the course of years and is not even now fully appreciated. Even a partial realization, however, has been enough to leave electorates disgruntled and restive. Especially among working-class people the sense of betrayal is in many countries palpable.
The political implications of this are readily apparent. Across most of the OECD much of the lower and middle classes have lost faith in their governments and are looking more critically at the dominant political parties and the policies they have long espoused, including trade liberalization, international security cooperation, and reasonably free immigration. As people look for the causes of their troubles, scrutiny of foreigners has grown more common and nationalistic sentiment has strengthened. The disenchantment has registered in different ways and different degrees from country to country. In the United Kingdom popular discomfort with globalization contributed to the Brexit decision; and in the United States anger at the traditional political elite contributed to Bernie Sanders’ popularity and then to Donald Trump’s election. In France and Germany the disillusionment has bolstered the influence of right-wing parties, a trend even more noticeable in the recent Austrian elections. Japan too has gradually moved towards the political right, with both major parties now supporting constitutional revision and looking more skeptically on the country’s neighbors. China is a unique case since it is at an earlier stage of development and still growing speedily, but Beijing is acutely aware of its impending economic slowdown and hopes to rally public support by taking advantage of the West’s domestic dramas to assert greater political influence regional and globally.
Geopolitically, the more introspective and nationalistic orientations of the OECD economies make international cooperation more difficult. Trade anxieties led the United States to withdraw from the Trans-Pacific Partnership and have throughout the wealthy world vitiated interest in other trade negotiations—an ironic outcome given that it will exacerbate the economic slowdown and disinflation. Meanwhile atypically weak policy coordination between Washington, Tokyo and Seoul has facilitated the acceleration of Pyongyang’s nuclear and missile programs and maverick tendencies in the United States are undermining the united front against Iran. Nationalistic confusion in the West is likewise benefitting Russia and contributing to a more rapid rise in China’s stature.
Yet most political analysts and strategists are still laboring under the delusion that the old social contract, or something close to it, remains viable. Even the more prescient economists and monetary authorities—people like Yellen and Summers—have not publicly reached the conclusion that slower GDP growth, flat wages, and low inflation are “the new normal” and that subdued interest rates will drive asset appreciation and hence expand the wealth gap for decades to come. The Western countries are consequently ill prepared to deal with the intensification of class-based anger that will ensue when people realize that their recent setbacks are effectively permanent. It therefore appears inevitable that the OECD countries will undergo still more social and political dislocations, and that the foundations of the middle-class state—and with it the post-1945 commitment to collective security, free trade and human mobility—will suffer further erosion. That is good news for at least some of the West’s adversaries around the world.
The Western-dominated world order was founded on a massive surge in aggregate demand, wages, and inflation that stretched from the 1940s through the early 2000s. Without the resulting popular confidence, governments would not have been as free to pursue trade liberalization, collective security, and other types of international cooperation. That historically anomalous surge in growth, however, came to an end when the American consumer retrenched a decade ago. The question is whether the various post-World War Two social contracts can be sustained in the circumstances that obtain today and that will continue for at least another couple of decades. If not, then governments must devise new compacts with their citizens that preserve as much of the old order as possible and yet comport with the uninspiring new reality. If political leaders fail to start that discussion soon, the gap between expectation and experience will fuel still more discontent and do considerably more damage to Western polities and their international institutions.