28 July 2021

The retreat from free market economics leaves the West exposed to the next crisis

By Nikola Kedhi

Secular stagnation, reliance on massive government spending and dependency on quantitative easing appear to be the norm in Western societies, as of late. A mixture of bad policies and short-sightedness have brought some of the most advanced economies into a crossroads with no easy choice.

The rolling crises of recent years have seen governments extend their reach further than in any other peace-time period. The extension of government power often means promises of trillion-dollar borrowing packages, often directed towards zombie companies, unproductive sectors, and political cronies. Once these stimulus programs end unsuccessfully exactly because of erroneous government interventions, it is politicians who present themselves as the saviours while vowing to continue doing the same.

The clearest example is the European Union, which has been following this path at least since 2009. Based on the EU’s own estimates, between 2014 and 2019, the Juncker Plan doled out €439 billion on investment projects. The return on that huge outlay? A +0.9 % uptick in the bloc’s GDP and just 1.1 million extra jobs. The same poor results were evident even in the 2009 Employment and Growth Plan. Logic would suggest that the 2021 recovery plan is heading the same way. Why would anyone expect otherwise from packages that shovel borrowed money towards unproductive programmes, rather than letting the private sector work its magic?

The consequence of this EU economic centralisation and massive government interventions has been mediocre growth, high unemployment, and a decrease in global competitiveness. The pandemic did not create an economic crisis in Europe, but it has exposed the Old Continent’s ongoing decline. Eurozone unemployment rate was 7.9% in May. while tax burdens in EU countries are higher than the US and productivity is much lower. Despite the endless stimulus packages, Eurozone industrial production fell by 1% in May.

It’s not just Europe though. In the last year the US has waved through the largest fiscal and monetary stimulus in its history, with only a weak recovery to show for it so far. According to the Congressional Budget Office, the estimate for average real growth in GDP from 2020 to 2030 is 1.7%, while the unemployment rate is forecast to average 4.8%. As the Spanish economist Daniel Lacalle points out “a $20 trillion fiscal and monetary boost is expected to deliver just a $4 trillion real GDP recovery followed by a rapid return to the historical trend of GDP growth. This will likely lead to new record levels of debt, weaker productivity growth and slower job recovery”.

The UK, however, is an interesting case, because it is showing a stronger recovery than its peers in the Eurozone. A recent Deloitte UK report shows that the institution forecasts a “stronger growth in 2021 than previously projected, in light of strong economic data in March and April and steady progress in easing restrictions, rolling out vaccinations and a low rate of new Covid-19 infections”. GDP is expected to grow 7.5% in 2021, compared to 3.7% in Germany and 6.4% in the US.

All is not rosy, however. With the furlough scheme unwinding, unemployment is expected to hit 6.1% by the end of the year, before falling to an average of 5.4% in 2022 – still well above pre-pandemic levels. Just as importantly, government debt has soared to £2 trillion, close to 100% of GDP and a level not seen since the 1960s.

But despite strong growth projections and rising inflation, the British government is planning to hike taxes in the next couple of years, which can only dampen the UK’s growth prospects. Rather than putting their faith in the private sector, freeing up businesses to create jobs and help pay off those massive debts, both Britain and America both seem to be drifting to European-style fiscal policies – in spite of the clear evidence that those policies are worse than ineffectual. Indeed, the slowdown in the US started precisely when the federal government turned on the spending taps, and created the expectation of further interventions.

The upshot of all this is that when another economic crisis lands, the West will be in poor shape to withstand its impact. Even Boris Johnson’s Conservative government is adopting borrow-and-spend policies that are more at home on the political left – and that was the case long before anyone had even heard of Covid.

The immediate risk is that inflation in both the US and UK will end up leading to stagflation. In the US, consumer prices in June were up 5.4% year-on-year, the highest rate since 2008. In the UK the figure was a more modest 2.5%, the fastest rate since August 2018. The UK may have been through years of very low inflation, but the former Bank of England governor, Mark Carney recently warned that “the balance of risks is headed toward the prospect of inflation being above target for longer than the makeup of the past undershoots”.

What’s really concerning is that although some elements of increased inflation are undoubtedly transitory, there are also signings suggesting higher prices are here to stay. In the US, one of the drivers is the enormous deficit spending that is cheapening the value of the dollar and making goods more expensive as a result. That spending is financed by new debt issued by the Treasury and purchased by the Federal Reserve with the new money printed. Precisely because in recent months, due to the pandemic, money supply has grown faster than demand, inflation is rising now compared to the lower levels of the previous years.

That matters because it means the fiscal and monetary toolbox is now empty.  When the next crisis hits there will be next to no room to lower interest rates, increase government spending or rely on the private sector, as Western countries are stuck in a state of perpetual unproductive spending and monetary easing. Debt in nearly all advanced economies is reaching record levels, which can only be absorbed through inflation or higher taxes – in the best case scenario. If inflation persists, central banks in the Eurozone, in the UK and in the US will be forced to raise rates, increasing the cost of interest payments on their huge debt pile.

The answer to all this – a return to fiscal consolidation and free market policies – might not be politically convenient, but it’s no less necessary for that. Without a full-throated embrace of the principles that made the West great in the first place, its economic decline will only continue. And that bodes well for no one.

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Nikola Kedhi is a Senior Consultant at Deloitte, but writes in a personal capacity.

Columns are the author's own opinion and do not necessarily reflect the views of CapX.