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The Road From Slump to Boom
From: Columbia University
| By:
Edmund S. Phelps |
EDITOR'S INTRODUCTION |
The strengthening of the American economy, characterized by dramatically increased investment and employment rates  since 1996, should be seen as a structural boom mainly springing from America's capitalist marketplace, argues Edmund S. Phelps (right), McVickar Professor of Political Economy at Columbia University. American business investors provided crucial supplies of risk capital to fund selected new economic ventures, their facilities and staffs. In this article, Phelps explains why this classic investment boom is characteristic of the capitalist structure, most pronounced in the US, and why such a boom is not seen in Western Continental European economies operating with the corporatist model. |
 o one doubts that the American boom has deep significance for economic policy. Yet a misperception of its mechanism prevents many from looking in the right place for the lessons to draw. |
In Europe, most commentators view the boom with the lens of Keynesian economics--the monetary theory of unemployment. They lay the rise in employment to a rise in output stemming from a rise in effective demand--in the flow of money chasing goods. They lay the rise in effective demand to consumption and investment spending induced by the rise in share prices.
This monetary interpretation is implausible, though. Past studies never found effective demand to be very sensitive to share prices--witness the toothless 1987 crash. Besides, if effective demand were the main agent of the boom, the inflation rate would be rising steeply by now. Europeans reply that the US escapes rising inflation through a limitless ability to import and borrow abroad. But that overlooks a similar non-inflationary boom in Australia, Britain, Canada, Holland and Sweden, and also in tiny Denmark, Finland, and Iceland. In these boom economies, effective demand rose only as an effect of what was really a structural boom--a drop in the natural unemployment rate, temporary or permanent.
What forces brought about this structural boom? And why first in those nations, not others? A clue is that the forces became powerful with the suddenness of a tornado, even if their gestation took years. The boom hit the US in 1996, when unemployment rates in every education group started a steep four-year descent. It struck the others with equal suddenness. So the boom isn't a result of slow-moving demographic changes in the labor force. |
The critical clue is the broad surge of business investment in the boom economies. Expenditure on new plants and equipment has climbed steeply, and there has been heavy investing in new customers and new employees. Non-monetary models of unemployment show most such investing to have structural impacts that pull up both employment and compensation per employee. A shift of output toward construction creates more jobs than it destroys and pulls up wages, since construction is so labor-intensive. A shift of emphasis from current profits to accumulating new customers leads to lower markups, which raises labor demand. A shift from producing now to recruiting and breaking in new employees creates more of them and prompts a pay raise in order to keep them. Hence a rise in compensation as a share of aggregate output is a sign of a broad investment surge. Real exchange rate appreciations are also circumstantial evidence. |
The impetus for all this investing is a rise in the productivity and hence the profits expected from business assets. Faster growth of productivity since mid-decade in some boom economies has surely raised expectations of the trend growth rate. In my analysis, however, both investment and share prices in the boom economies exceed what can be rationalized by past experience. Much investment aims to prepare for a future leap of productivity and the profit bonanza not ruined by the preparatory investment. These hopes are conveyed to analysts and on to their clients. |
No doubt these expectations are mostly inspired by visions of a "new economy" built on information and communication technologies. Yet the boom's typical industrial composition does not explain why it came to some OECD (Organization for Economic Cooperation and Development) economies and, so far, hardly at all to Continental Western Europe. |
A commonplace answer blames Europe's welfare state. It saddles the economy with fiscal burdens and handouts, which blunt employee incentives and raise production costs, and with rigid regulation of the labor market, which scares employers from risking creation of new jobs. These hypotheses help to explain why the Continent has chronically high unemployment in times of normal productivity growth. But they do not suggest why, from 1995 to the present,
the unemployment rate in Germany and Italy actually rose and the rate in France fell only modestly--in contrast to the big strides in the boom economies. Nor do they suggest why productivity and investment have failed to surge on most of the Continent in contrast to the boom economies. After all, some booming economies also have high taxes, big entitlements and wide job protections. And Europe's productivity and investment easily kept pace with the US in the '80s. |
What, then, is the reason the boom has stayed off the Continent? Why has productivity not accelerated and investment not surged there? The answer, I think, is that when the boom was gathering force, the core of the typical Continental economy was still organized on the corporatist model--a tripartite system of established firms, large unions and an interventionist government all bent on preserving their interests. In this model, business investment is controlled through bureaucratic red tape and a closed system of big banks--banks taking guidance from the state and loath to finance and mentor risky new entrants in new industries without state guarantees. |
In the US and the other boom economies, entrepreneurs could launch new economy ventures since they had the right institutions: capital and product markets open to start-ups and capable of supplying needed risk capital. Notably, these economies had available a far more developed stock market. That was crucial to venture capitalists, since they would eventually need to sell their shares in any start-up they financed through an initial public offering on the stock market. Also, a liquid market for shares was crucial to the rise of stock options to focus managers on earnings growth. Data on the size of national stock markets 12 years ago are uncanny predictors of the gainers and losers in the '90s. In America, Australia, Sweden and Canada, 1988 stock market capitalization stood around 50 as a percentage of GDP; in Britain, about 80; in Holland, 40. In Germany and Italy, it was only 20; in France and Spain, about 25. Higher education was also a good predictor, but it too is cultivated by the entrepreneurial economy. |
If that is the boom's lesson, the Continental nations have a choice. They can preserve their corporatism, holding down new entry and catching up slowly by copying proven innovations in the boom economies--but without having a boom. Or they can join the boom--but only by casting off corporatism for a vital capitalism. |
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