An acid test for liberal democracies

Has the fat lady sung for “extreme” capitalism, or is the recent policy response by Western governments to the current financial and economic crisis proof that the system works?

It is a question that may dominate political debate for many years, as the simplistic Left again rises to tell everyone that recent policy trends were a mistake.

Already Phillip Adams, on Late Night Live (November 12, 2008), again trumpeted the ideas of John Maynard Keynes; although that brilliant Brit did not have all of the answers to help competing nations avoid rocky roads ahead.

Yes, the 1944 Bretton Woods Agreement (influenced partly by Keynes) did promote a world order which gave all member governments an “explicit right” to control all capital movements to aid industry development, employment, and the welfare state.

But such a world order did not last because the economic fortunes of all Western nations have long been tied to the fortunes of the international economy. Even the mighty US, which provided much stability from the late 1940s until 1971 with many countries effectively tying their currency values to a US currency fixed to the value of gold, also needed to remain competitive.

Substantial policy reform has since taken place in all Western nations in order to adapt to increasing competition from developing nations - in regards to manufacturing - without jeopardising general support for freer trade. This has included floating exchange rates, financial deregulation, more flexible industrial relations systems, and taxation reform that favoured corporations and the wealthy.

The promotion of freer trade was hardly the wrong policy approach. After all, a free exchange of trade, capital and ideas are critical to a progressive world, notwithstanding justified concern today about income disparity both within and between nations as well as environmental degradation.

Furthermore, a greater acceptance of trade deficits and debt by certain Western nations (including the US and Australia) aided economic growth both internationally and in Australia, given the world’s greater demand for raw materials.

But now the good times for Western societies are over, as the illusion of recent economic stability has been exposed by a flawed reliance on such high levels of debt. Given the current economic crisis, and the reality that higher levels of national debt cannot be sustained forever, the promotion of freer trade is likely to be severely tested in coming decades.

As John Browne noted on the Euro Pacific Capital online site (November. 19, 2008), the US financial industry should never have been allowed “to hide the risk by using ‘off-balance-sheet’ accounting and fictitious capital asset classification”, as seen by Fannie Mae leveraging “its mortgage investments by some one hundred times its ‘true’ capital, while disclosing only some fifty times in its accounts”.

It is a view shared by the billionaire financier and philanthropist George Soros, who notes that the current crisis caused by “the ever-increasing use of credit and debt leverage, combined with the (false) conviction that markets are self-correcting, took more than 25 years to grow” (The Huffington Post, November 17, 2008).

But what solutions will emerge?

Though Western governments have already adopted measures costing many hundreds of billions of dollars in order to ensure the viability of financial systems, protect savings, and aid consumption, they will indeed have to make their economies more productive in the longer term.

This is easier said than done: Western societies are unlikely to allow their governments to obliterate public social welfare expectations or reduce wages dramatically to make their economies more competitive.

Indeed, the mobile nature of production and capital across national boundaries may cause further social upheaval in Western nations as each society decides just which issues should be assisted or targeted most in these difficult times.

With old and new policy demands requiring greater resources, such as the environment and health with its ever-improving technology, many Western governments in recent decades have already increased public debt levels or privatised public assets in order to maintain such high levels of social welfare expenditure.

So while I have long argued that Western societies should remain supportive of freer trade, promote democracy, efficiency and transparency, and distribute resources in a most productive and efficient way to meet the policy issues of the day, this belief may be wishful thinking.

If Western governments cannot convince their societies of the need for dramatic reform, and rising developing nations do not conform to Western expectations, then much greater economic conflict may be on its way.

The time has indeed come when the competitiveness of the international economy will test the ability of the influential liberal democracies to uphold any willingness to balance national and international aspirations, through institutions committed to freer trade. Though most nations will be affected by global wealth shrinking considerably from a peak of $US109 trillion in 2007, how prepared are Western nations to give further ground to developing nations - with China, Brazil, Russia and India representing about 13 per cent of world GDP in 2007 in nominal terms?

The idea that freer trade would provide a win-win situation for all participating nations has always been nonsense, notwithstanding the concept’s greater potential to promote wealth and efficiency amongst nations.

In the longer term, there is no way that Western nations with their high levels of wages and social welfare spending can ever compete in industry terms with authoritarian governments who are less constrained by various interest groups or pubic opinion.

Compare the current policy response by the US and China.

China’s government announced a $US600 billion stimulus package during November primarily to assist infrastructure spending and to a lesser extent social welfare, despite China’s economy being one-fifth the size of the US. This will further enhance China’s wealth creation once the current crisis subsides.

In contrast, the US has focused on stabilising the financial system and aiding consumption. First, the US Congress agreed in October to a $US700 billion Troubled Asset Relief Program. Second, a stimulus package of $172 billion gave 87 per cent of the amount to consumers on the basis that consumption accounted for 72 per cent of US GDP with just 13 per cent going to producers. Third, on November 26, $US600 billion was provided to support mortgage-backed assets in order to boost the housing market, with another $US200 billion program to ease commercial lending on debts to aid student, business, and car loans.

An ever increasing reliance upon debt by the US simply to aid consumption will have enormous consequences ahead in the form of inflationary pressures alone, as suggested by Peter Schiff (Euro Pacific Capital, November 21, 2008). Schiff argued that the US government can hardly afford new loans to fund its ailing industry sectors with new money “either printed or borrowed from abroad”.

Addressing debt in the future may mean harsh decisions with disastrous consequences for many Americans, in the form of much less social welfare assistance if taxation levels are not increased.

Some might argue that the different circumstances faced by the US and China reflects the need of any nation committed to freer trade to accept the reality that all economies must remain competitive and productive rather than relying more and more on debt.

I agree.

However, if one believes that Western societies are the most progressive societies, the current level of economic competition between Western and developing nations is unfair, although many Western nations still retain most of the highest levels of per capita wealth and income.

While it would be a positive development if the Chinese government diverted wealth to its poorer population, its transition towards a Western-style democracy is likely to be a very slow process and one which cannot be guaranteed.

It is good to remember the acceptance of voting rights and decent working conditions in many Western nations only emerged after a long period of struggle over many decades during the late 19th and early 20th centuries.

It remains to be seen how generous China’s middle and upper classes will be. With the 2008 Global Wealth Report noting that China now has 391,000 households worth at least $US1 million in assets, the fifth highest number in the world, its level of inequality remains obscene given a World Bank estimate in December 2007 that 300 million Chinese were still living on just one dollar a day.

And China, a nation with an estimated 5 per cent of its population being Communist Party officials as of 2006, has a very high level of corruption which hardly enhances its prospects of becoming an effective pluralist society. The Transparency International 2007 survey ranked China 72nd of 180 countries with a score of just 3.5 on a scale of 0 to 10: similar to India, Mexico, Brazil and Saudi Arabia although higher than Russia with 2.3, and well behind New Zealand, Denmark, and Finland with a score of 9.4 and the US with 7.2.

While the West’s promotion of liberalism has allowed Japan and Korea to rise and to develop western democratic practices, and it does rightfully give the opportunity for any nation to improve its economic plight, how can the West deal with a booming China? At best, China may evolve into a gigantic version of Singapore, which Freedom House noted is only “partly-free”, although Singapore was judged one of the least corrupt nations in 2007 with a score of 9.3.

Clearly China, due to its ability to organise and utilise a large pool of cheap labour, has much more room to manoeuvre in economic terms than any Western nation. China has $US2 trillion of foreign exchange reserves, although about half is in US Treasuries or mortgage-backed securities and agency bonds now directly or indirectly back by the US government. It produced a national fiscal surplus for the first half of 2008 of about $US179 billion (4.2 per cent of China’s GDP), and it has a national debt of just 18 per cent of GDP well below the 60 per cent rate of many developed nations.

So are we going to accept Peter Schiff’s argument that we should emulate the economic example set by China, Brazil, Russia, and India due to their wealth creation ability in contrast to the West’s greater reliance upon debt and consumer spending?

Yes, the present international system can remain viable, at least from a Western perspective, but not if such authoritarian governments increasingly influence policy trends in the world.

Quite simply, it remains to be seen how far Western societies can maintain existing levels of wealth even if they were to become smaller imitations of the more competitive US model in economic terms. As Schiff suggests (Euro Pacific Capital, November 21, 2008), for the US to compete:

Spending must be replaced with savings, and consumption with production. The service sector must shrink and manufacturing must expand to fill the void. The dollar must fall, wages in America must be brought down to a competitive level, and hopefully government spending and burdensome regulation can be reduced.

But how likely are the US and other Western societies to simply obliterate their way of life just to compete effectively against developing nations? With public-private infrastructure partnerships now also threatened by the current financial crisis, where is the money going to come from to meet a variety of economic, social and environmental policy needs?

Of course, Western leaders need to adopt a sophisticated policy approach that gives adequate attention to international economic, security and environmental needs. This is especially true today given the Pew Research Centre’s 2005 annual survey which found that 26 of 33 countries polled now have a less favourable view of the United States than they did in 2002 with even 50 per cent of Brits wanting the EU to become as powerful as the US.

Once it becomes clear that Western economies cannot compete against nations like China and India, there will be just two general policy options. One: Western nations will increase taxation levels and protectionist measures, which will have an adverse effect on developing nations and may initially reduce the consumption possibilities of Western consumers as they face higher costs for many products. Two: there will be severe cutbacks to social welfare programs and wages in Western societies as any reliance upon services and debt cannot mask the need to become much more competitive if a commitment to freer trade remains.

Western nations are likely to adopt measures that will seek to maintain their influence in the world, at least if a decent national social welfare system is deemed to be necessary by such societies.

Once economic confidence is restored, this may even mean a much greater promotion of renewable energy industries in an attempt to aid wealth and employment creation, and to maintain a competitive advantage over other nations.

We live in a world where nations must adopt appropriate reform to remain competitive within the ongoing struggle for resources, but the struggle over the influence of certain ideas will long remain just as important.

There are indeed no easy policy options for Western governments as they face their toughest peacetime threat since the Great Depression.

It remains to be seen just how far Western societies will allow any reform to boost their productive capacity at the expense of hard won working conditions or extensive social welfare systems.

As the development of Western societies represents the ultimate expression of liberalism, and the wealthy liberal democracies remain most influential, it is freer trade which now faces a greater test.