by Peter Brain
The end-result has been the creation of divisions between segments of society so deep that compromise cannot be reached on what policies are necessary to achieve more acceptable economic outcomes — hence political dysfunction. The United States provides a prime example; the United Kingdom, another.
The 2016 United States presidential election
The election of an American president who repudiates important elements in the Washington Consensus was not a surprise to anybody with a rudimentary knowledge of United States income-distribution statistics. The real surprise was why it had taken so long for the political tensions arising from increased inequality to have electoral effects.
The key to Trump’s election was the changed voting pattern of non-college-educated white voters. While the share of this demographic in the total electorate fell from 83 per cent in 1960 to 34 per cent in 2016, it is still a strong voting bloc. When 67 per cent of this bloc voted for the Republican candidate, up from 61 per cent in 2012, they delivered the electoral-college votes of three previously Democrat-majority states (Pennsylvania, Michigan, and Wisconsin) to the Republican candidate.1 This made the difference between winning and losing in a close-fought election. The winning margin across the three states was small — less than 1 per cent — indicating the importance of the shift in the white, less-than-college-educated vote. Over the last three decades, these three ‘rust belt’ states have lost substantial industrial capacity as the combined result of technological change and increased imports, especially imports from China and Mexico. The result of the 2016 US election seems to reflect the rejection of globalisation, particularly of unfettered imports and immigration, by middle-income citizens.
The increase in income inequality that took place during the Washington Consensus era helps to explain the current political dysfunctionality of the United States. During the post-war period from 1950 to 1979, the top 1 per cent of households ranked by income received 10 per cent of household income (including capital gains, and before taxes and transfers), and households in the top 0.1 per cent received a little over 3 per cent. By 2012, the respective income shares were 21 per cent and a little over 10 per cent. Wealth has always been more concentrated than income, and by 2012 the richest 1 per cent of households held 42 per cent of all wealth, and the top 0.1 per cent held 22 per cent. More graphically, during the Washington Consensus era from 1980 to 2012, markets awarded the whole of the increase in the national income to the richest 10 per cent of households. Even among these top incomes, the rewards went mainly to the rich. The highest-income 1 per cent of households claimed 70 per cent of the increase in national income, and the top 0.1 per cent cornered 43 per cent.2
The diversion of income to the rich explains why, in the 37 years between 1979 and the beginning of 2016, median inflation-adjusted weekly earnings derived from full-time employment for those aged 16 and over rose by a total of just 3 per cent — an increase too small to be noticeable. In an associated change, the share of gross domestic income represented by employees’ earnings fell from 47.7 per cent in 1980 to 42.9 per cent in 2015.3 Taken together, these statistics mean that all the gains from the growth in American productivity over those 37 years accrued either to wealth owners or to salary-package employees in the top decile of income earners, such as senior management and finance-sector workers. The last time the United States experienced inequalities of this order was during the 1920s, in the lead-up to the Great Depression.
Radical changes would be needed to restructure the American economy to spread income increases across nearly all social groups, as happened in the golden era from 1945 to 1974. The changes would have to include increases in both taxes and the minimum wage, a rapid expansion of government services directed at low-income and medium-income households, and the adoption of an aggressive infrastructure-investment program and complementary education initiatives to raise the productivity of American workers so that they can compete with those located overseas. Restructuring would also require a reversion to balanced budgets, relying on the balanced-budget multiplier to generate full employment. To avoid excessive reliance on taxes and social-welfare transfers, the share of pre-tax income accruing to the top 1 per cent of households would have to drop from 80 per cent or more to just over 20 per cent.
These radical changes would sacrifice the small-government, tax-cutting element of the Washington Consensus while retaining its free-trade elements. However, such changes are contrary to the perceived interests of the small coterie of billionaires who are major donors to American media, academia, and political parties — especially to the Republicans.4 It comes as no surprise, therefore, that Trump is committed to the small-government side of the Consensus (at least as far as it provides tax cuts for the rich), and has instead appealed to middle-income voters by resiling from the free-trade aspects. A move to raise tariffs and restrict immigration is attractive to an electorate that blames its poor employment prospects on competition from immigrants and imports. This move is of concern to the executives and shareholders of American globalised companies, whose prosperity is built on their capacity to move production to low-cost countries and to evade taxes via tax havens, but is acceptable to those of the American rich whose fortunes derive from domestic sources such as oil or real estate.
It is salutary to remember that the last time the United States experienced high inequality, during The Roaring Twenties, major negative shocks to the political system from the Depression and the Second World War were required to trigger the institutional changes on which the golden era of post-war prosperity was founded. In particular, the war allowed massive government intervention in the labour market to engineer a substantial redistribution of income from high-paid to low-paid employees without inflationary consequences. The war also justified large increases in tax rates.
Given the current dysfunctionality of American politics, it is almost impossible to see how changes of this magnitude can occur unless they are precipitated by external shocks of the same magnitude as the Second World War. The American electorate is ideologically conditioned by partisan media and an untamed blogosphere to abhor big government and taxes. It is bedevilled by the centuries-old unresolved issues of race. It is additionally polarised by differences in socio-economic status between electorates and states. The scope for change is limited by the enforcement of party discipline, which ensures that elected representatives do not diverge from the values of their ‘base’. All this is already apparent and will continue to intensify political tensions, increasing the likelihood that the United States will adopt policies that damage not only its own interests but those of its trading and military partners. We consider these risks from an Australian point of view after the following update on that other bastion of neo-liberal policy, the United Kingdom.
The United Kingdom Brexit vote
In 2016, the United Kingdom also produced political changes that will have long-term adverse economic consequences and that, as in the United States, can be directly linked to the increase in inequality over the three decades of neo-liberal policies, exacerbated by relatively poor economic performance over the last decade. This was the outcome of the so-called Brexit plebiscite as to whether or not the United Kingdom should remain in the European Union.
As in the United States, the proponents of Brexit argued that the re-establishment of national control over immigration and trade would re-invigorate domestic industry while reserving jobs for the native-born. Again, as in the United States, these policy objectives were particularly attractive to lower socio-economic groups. In local government areas (LGAs) with median wages around £300 a week, the average percentage vote for Brexit was 60 per cent. It averaged 50 per cent in LGAs with median weekly wages around £450, and 25 to 30 per cent in LGAs with median weekly incomes approaching £900, such as the City of London.5 The greater the fall in real wages or the lower the rate of wages growth since 1997, the higher was the vote for Brexit. This vote was clearly the revenge of the
losers from the United Kingdom’s sustained commitment to Washington Consensus policies, despite the most likely outcome being that Brexit will result in an additional decline in their absolute economic circumstances, if not in their relative position.
The decision of the government to abide by the plebiscite and in 2017 to trigger notice of withdrawal from the European Union will inflict considerable damage on the British economy. With various general elections due in 2017 and 2018, continental European governments have strong incentives to generate income for their voters by transferring as much as they can of local demand currently satisfied by British exports to local producers. They will be keen to attract industrial capacity that would otherwise have been located in the United Kingdom. The transfer of a significant proportion of the City of London’s financial services activities to EU cities will also be rigorously pursued, if only to enhance internal support for the European Union and to demonstrate the costs of leaving.
Theresa May, the new British prime minister, installed after the Brexit vote signalled the end of the Washington Consensus policies introduced by Thatcher. Government interventions, if only moderate, were promised to promote equality of opportunity. For Britain, this shift is far too late. Given the negative headwinds from Brexit, a low currency with price increases squeezing real incomes, and an already high current-account deficit, there will simply be too few resources available to finance the necessary interventions in such fields as education, housing, and employment development. If a hard Brexit does eventually occur by the 2020s, the United Kingdom economy is likely to stagnate, and political divisions will intensify, with a return to the political dysfunctionality of the 1960s and 1970s, and perhaps the 1930s. Thatcherism will have come full circle.
Despite historic ties, the United Kingdom is no longer important for Australian trade and investment, either directly or indirectly via its influence on world trade. Brexit is unlikely to affect Australia’s economic prospects; indeed, the effect could be mildly positive if it hastens necessary fiscal reforms within the EU. It is otherwise with the United States — not so much because of high levels of mutual trade and investment, but because American policies still have strong effects on world trade. It also matters that Australia is a military ally of the United States, while the United States is a rival of Australia’s chief trade partner (China), and that swathes of the Australian political, media, and academic elite are under strong American influence. We therefore return to the risks posed for Australia by the incoming Republican administration.
American risks for Australia
In Chapter 6, we concluded that Australia has a breathing space of a few years before our indicators of vulnerability to economic catastrophe turn to Code Red. We expect that the advent of the American Republican administration will shorten this breathing space. We leave to one side the risks that would arise were Australian politicians to speed the process by copying the Republicans’ policies; we concentrate instead on the effects of the policies’ implementation on Australia, allowing that the policies implemented are likely to fall well short of those espoused in the election platform.
From an overseas point of view, a first concern with American policy is whether it will accelerate or retard the rate of income growth in the United States, and therefore the level of imports it takes from the rest of the world. This is important to Australia, not so much because of direct Australian exports to the United States, but because of the importance of the American market to China, Japan, and other important Australian trading partners. Our assessment is mildly positive as to American income growth, but this growth is likely to generate increases in world interest rates that will definitely not benefit Australia.
The Republicans ardently desire re-election in 2020, and calculate that economic growth of at least 4 per cent in each of 2019 and 2020 would maximise their chances. They face a major constraint in that they do not have the numbers in Congress to pass economic-stimulus measures that will add to the deficit ten years hence. Given this constraint, it is likely that they will resort to temporary tax cuts and expenditure increases.
An important element in the Republican platform was its proposed cuts to income-tax rates, especially to taxes imposed on high incomes. Though these tax cuts will be partially offset by the withdrawal of deductions and the closing of tax loopholes, it has been estimated that the net impact of the proposed changes will be to give a tax cut of 14 per cent of average taxable income to the top 0.1 per cent of income recipients (an average of US$1.1 million each), compared to an average cut of US$110 or 0.8 per cent to people in the lowest income quintile6 — a skewed distribution of benefits that has implications for the effectiveness of the policy as a stimulus to demand.
The draft tax changes presented to Congress in April 2017 broadly followed the election platform, and included a reduction in the corporate tax rate to 15 per cent. Depending on the accompanying changes in deductions, the cost of this was estimated at between US$300 billion and $700 billion a year. Given the political difficulty of eliminating deductions, a realistic cost would be towards the upper end of this range, enough to double the federal government deficit unless expenditure is cut to match.7
There are likely to be savings from cuts to the so-called Obamacare and other social-welfare programs, though these could be offset by increased incarceration costs — the United States has the very expensive habit of using its prison system to provide income support of last resort for many of its poorest citizens. Increased expenditure is also promised on infrastructure, but this is likely to be limited to tax credits to encourage private investment in transport facilities. By their nature, these will target investments that can be financed from user charges, and neglect those with benefits that cannot be so captured — a process that will further increase the inequality of distribution of real income.
In sharp contrast to the promises of cutbacks in social benefits, the fiscal promises include a rapid build-up in defence expenditures, including an upward revision of the current target of a 308-ship navy in the late 2020s to one with 350 ships. This raises an old spectre — that of a national leader seeking to unite his country against a foreign enemy. Even if the build-up is purely defensive, it well-nigh guarantees that the tax cuts will outrun the expenditure cuts, so that the fiscal deficit will increase.
Aside from the proposed increase in defence expenditure, the fiscal policy proposals of the Republican administration will generate very little economic stimulus relative to the size of the likely budget deficit — whether this is financed by adding to government debt held by the public or by adding to the excess reserves in the banking system (as will happen if the budget deficit is funded by the Federal Reserve Bank). The GDP-multiplier benefit accruing from the increased incomes of high-income households is small, because these households have high levels of savings. In response to the windfall of a large increase in their after-tax income, they will no doubt apply even higher marginal-savings ratios. These are the ratios that matter when tax cuts are intended as an economic stimulus.
The company tax cuts will likewise have weak stimulatory effects. In times of high business confidence, corporate tax cuts can be relied on to result in increased purchases of equipment, buildings, and new technologies. But these are not such times. Instead, in the context of relatively weak economic fundamentals, including low expectations of future long-run demand growth, and given that the corporate sector is already flush with funds, the extra corporate cash flows from tax reductions will either be paid out to shareholders — thus adding to the incomes of high-wealth households — or will be spent on investments undertaken largely for financial-engineering reasons (which will include investments under the infrastructure-policy initiative). Such investments may be profitable for the investor, but will not raise total output very much.
Given that they are likely to raise — indeed double — the budget deficit, the Republican policies continue and intensify the Democrats’ rece
nt policy of injecting monetary stimulus into the American economy. This policy has produced much smaller increments to growth than would have been possible with well-designed fiscal-expansion initiatives at a similar budgetary cost, and the Republican version is likely to be even less effective. Even so, the resulting short-term increase in the American economic growth rate will give a temporary stimulus to world trade and to the Australian economy. However, as the United States’ public-sector borrowing requirement rises towards 6 or even 8 per cent of GDP, both financial market volatility and interest rates can be expected to increase above the levels assumed in Chapter 6. This represents a serious risk to the Australian economy, given its current vulnerability.
The other side of Mr Trump’s platform, that involving trade restrictions, is a departure from the Washington Consensus, and the big-business base of the Republican Party will be reluctant to support it. However, the administration will find it difficult to backtrack on it, given its contribution to its electoral success, particularly in the so-called rust-belt states, and the limited benefits these states will receive from the fiscal policy changes. To backtrack would risk loss of control of Congress in the 2018 mid-term elections. This makes it highly likely that, even if it stops short of generating a general trade war, the Republican administration will implement wide-ranging managed-trade initiatives, such as anti-dumping rules and the erection of other short-term trade barriers to assist specific industries, and will try to transfer demand for imports, particularly imports from China, to manufacturers in the rust-belt states. The Republicans are unlikely to be deterred if China and other countries disadvantaged by their policies retaliate against American exports, since these come mainly from the so-called knowledge-industry states on the north-east and west coasts — states that are Democratic Party strongholds.
Even within the new-found Republican strongholds, the new trade-barrier policies are likely to be ineffective if hastily implemented, shorn of long-term support programs. Channelling demand to rust-belt states, where capacity has been permanently closed, will do little to raise output or employment there. If businesses believe that the additional demand is permanent, they will begin to construct new capacity, but it will not necessarily be located in the rust-belt states. Again, even if spare capacity exists in the newly protected industries, production will only increase if the necessary skilled labour is still around and able to work. There is no suggestion that the diversion of demand will be accompanied by the large-scale training programs required to reskill the long-term unemployed and underemployed.
