Wednesday, August 13, 2014

Books reviewed: Twenty-first century capitalism

DOMINANT FINANCE AND STAGNANT ECONOMIES by Sunanda Sen; 2014


CAPITAL IN THE TWENTY-FIRST CENTURY by Thomas Piketty; 2014

Reviewed by Aseem Shrivastava

THE globalized world is a case of a long and bushy tail wagging a virtually strangulated dog, the tail wrapping and gnarling itself around the latter, restricting any possibility of free movement, while itself indulging in an extravagant dance. The tail represents the increasingly bloated financial sector, while the dog is the ‘real’ economy, including the massive working population. More accurately, picture a pack of such dogs (and puppies) – led by a pack leader. Imagine that in each case their growth is led by the long, twisting tails, inextricably tied together. The dogs gyrate helplessly each time the tail get excited or depressed.

It is evident from the outcomes where the centre of gravity of economic policy lies today. The real economy dances to the tune that global finance sets. Two excellent new volumes ask fundamental questions about the insane manner in which a hyper-financialized capitalism is working today. In doing so, they raise serious doubts about the stability – and claims to ‘common utility’ – of the system. I review each of the books in turn, before drawing some salient conclusions.

Sunanda Sen’s volume marks the dedicated work of a lifetime. It is an impressive collection of 17 interconnected essays on global finance written over almost half a century. The book offers a theoretically rich tour through the history of global finance since just before the breakdown of the Bretton-Woods system in 1971, examining the key patterns in its evolution. The remorseless deregulation of finance – after the dollar was made inconvertible into gold in 1971, allowing currencies to float against each other – is the core narrative. Stagnant economies are its consequence, the cumulative result of policies promoted by international institutions and national governments, both shaped profoundly by the interests of global finance. The returns in the real economy are low and slow in comparison with financial markets, prompting businesses everywhere to shift their portfolios towards the latter. Real industrial investment and employment have suffered as a result. Also important here is the impact (in countries like India) on public welfare spending of tight fiscal standards put in place to ease the concerns of foreign investors.

Systemic risk and crises are inevitable in a deregulated, financialized capitalism. Sen provides, in separate essays, persuasive interpretations of India’s 1991 balance of payments crisis which set off the reforms, the 1997 Asian financial crisis, and the Great Crash of 2007-08. What is common to each of the three accounts is the (ir)responsibility of footloose finance, and the acquiescence of state policies.

In relation to advanced economies, Sen offers a withering critique of the famed ‘efficient markets hypothesis’ which has been the abiding justification for deregulation since the 1970s. In a world in which the beneficiaries of risk taking in capital markets are rarely the same as the carriers of the risk, and in which the future is not a mere ‘statistical shadow of the past’, there can be no grounds for such a belief.

Instead, seeing how we have come to dwell in a world of radical uncertainty, Sen justly leans on the post-Keynesian economist Hyman Minsky’s financial instability hypothesis. She closely examines the stages of the credit cycle, arguing that a financial boom can only be sustained under conditions of a deceleration in the real economy as long as Ponzi schemes – which continue to be funded by deregulated banks in the wake of a ‘euphoric economy’ – remain unexposed. Excessive financialization means that banks and financial institutions, unconstrained by orthodox regulations, can liberally ‘originate and distribute’ credit by repackaging assets. This happened most prominently in the run-up to the Great Crash of 2007-08, abetted strongly by the high leverage ratios made possible by the dismantling of protective banking legislation like the Glass-Steagull Act. Shifting of risks to counterparties generated huge profits. The inevitable followed when reality hit home.

The second half of the book is even more absorbing and is devoted exclusively to the problems being faced by emerging economies in Asia – especially China and India – as a consequence of being integrated into a world run by global finance. Most significant among the problems is the infamous ‘trilemma’ that confronts vulnerable open economies in an uncertain world. This consists of the fact that such economies have the impossible task of keeping their exchange rates stable, while keeping the capital account open (as per today’s internationally imposed norms for free capital mobility), and also being in a position to freely use monetary policy to target domestic inflation, growth and other policy goals using instruments like interest rates and bond sales.

While India has been easing its capital account since 1993, China had wisely desisted from financial liberalization till 2005. However, it too is now moving in the direction of full capital account convertibility, with all the attendant risks that follow. With rapid deregulation and financialization, both China and India have been facing high volatility in markets for financial assets, real estate, currencies and commodities. An example is the impact felt on the rupee in the summer of 2013, when the US Federal Reserve was briefly tapering off its policy of quantitative easing, prompting funds to recede from emerging markets.

National sovereignty over economic policy under such trying conditions can be little other than an illusion, since both monetary and fiscal policy options are severely constrained by free capital mobility which increases the possibility of financial vicissitudes impacting the real economy. For instance, should governments under such conditions use the sale of bonds to ‘sterilize’ a large influx of capital (and thereby control inflation), let interest charges accumulate, putting pressure on the government budget, which then has less room for development spending? Similarly, if capital starts exiting the country in a moment of panic, the central bank must once again, using its foreign currency reserves, intervene in exchange markets to restore the value of the domestic currency, stabilize the external account, but in the process lose control of the interest rate. Such problems are endemic to today’s integrated economies and threaten them with pathological consequences.

One elementary difference between India and China does not appear in the text. While Chinese reserves are their own, earned the hard way through exports over decades, Indian reserves are not. India has been running a trade deficit since the mid-1970s, while the Chinese have been running a trade surplus since then! So India’s deficits are being routinely financed by speculative, volatile portfolio investments which are temporarily parked in Indian assets. They are thus susceptible to withdrawal in a moment of crisis, exposing the economy in a way far more dangerous than what could happen in China. One may also recall that while the Chinese economy is five times larger than India’s, its reserves are about 10-12 times greater, offering it a cushion India does not have.

It is rare enough for a mainstream economist to devote his career to the study of inequality. It is rarer still to find one who not only includes within his ambit of concerns inequalities of income, but also of wealth, and does so by examining closely the evidence on top incomes and wealth. Normally, given the low status accorded in the profession to studies of distribution, inequality is considered to be an interest of social scientists concerned particularly about the condition of the poor. (What could this possibly have to do with the way the rich live?)

It is to the rare credit of Thomas Piketty that he has done just this. Drawing on an enormous and unique database (‘World Top Incomes Database’, available at http://www.parisschoolofeconomics.eu/en/expertise-dissemination/wtid-world-top-incomes-database/), which he has helped to build, in addition to accessing data on tax returns and inheritances, he offers a commanding view of inequalities of wealth and income across space and time. His book, almost 700 pages, has serious theoretical problems, but is empirically meticulous and rich. It includes data from the OECD nations, China, India and some other parts of the developing world. (As an important digression, it is worth noting that some income tax data ‘sources have deteriorated since the advent of the information age… A case in point is India, which ceased publishing detailed income tax data in the early 2000s, even though such data had been published without interruption since 1922. As a result, it is harder to study the evolution of top incomes in India since 2000 than over the course of the twentieth century.’ Is a truly rigorous social science really possible when so much relevant information is consciously hidden by authorities, that too in the information age?!)

Piketty is the rightful successor to Simon Kuznets, who received a Nobel Prize for his pioneering research on national incomes and inequality in the 1950s and 1960s. One of Kuznets’ salient contributions is the famed, bell-shaped Kuznets curve, showing that income inequality tends to first rise and then fall with the growth in per capita income.
Piketty takes issue with this virtually universally accepted, and seemingly innocent, conclusion which has been the basis of trickle-down economics around the world since the Thatcher-Reagan era. Kuznets’ data-set is all too limited (the USA, 1913-48). Piketty marshals data from the western world on inequality over longer periods (income inequalities 1910-2010 and wealth inequalities 1810-2010). It turns out that the Kuznets curve begins to reverse itself after the 1970s, even in the US, which sees ‘vertiginous growth’ in the incomes of the top 10%, just like in the previous Gilded age before World War I 

Piketty provides similar graphs for the distribution of wealth as well. Despite being universally taken as an article of faith by policy-makers today, the Kuznets claim turns out to be an aberration, prompted by the three exceptional events of the period – the two World Wars (which prompted high taxation) and the Great Depression (which engaged the state in economic activity on an unprecedented scale) – rather than a generalized stylized fact.
What is the explanation for the secular increase in the inequalities of income and wealth? According to Piketty it stems from the deceptively elementary fact that the rate of return on capital, ‘r’ (even in times of low growth, such as the 19th century) always exceeds the rate of growth, ‘g’ of the economy. It means that capital always tends to extract a growing share of the GDP.

Over a period of time, there is a snowball effect. Not only do growing inequalities of wealth lead to greater inequalities of income, the rates of return on concentrated capital tend to be greater (than on evenly shared gains) for a whole host of reasons, not the least of them being the political consequences of greater inequality, which favour policies in the interest of corporate oligarchies, reinforcing prevailing patterns of inequality.

There are, of course, many serious conceptual problems and limitations in Piketty’s analysis to do, for instance, with the very concept of capital, which he fails to see as a process and a set of social, political and legal relationships. But to get into such questions would take us beyond the scope of this review.

Also, given its focus, and mode of analysis, perhaps the volume ought to have been more modestly titled ‘Inequality in the Twenty-first Century’. Yet, it is laudable enough that an integration of distribution and growth has been attempted from a neo-classical perspective. Normally they are treated in an utterly flawed, sequential manner. Those who still advocate trickle-down economics – even in developing countries – should ponder over some observations based on the two volumes under review:

1. Large developing countries like India and China are not obliged to comply with the international norm of free capital mobility. Financial liberalization has been at the root of problems around the world in the last three decades. As Sen argues, there are definite public policy choices which have led us to the stagnation in real economies. It is possible to reverse this if priorities are radically changed and financialization is brought to an end.

2. If r > g is indeed the ‘central contradiction of capitalism’, as Piketty claims from his data, then income and wealth will increasingly be concentrated in the future at the top of the social scale. There is nothing within the innate workings of a market economy to distribute the gains of growth fairly. Further growth under free-market principles will go on making the rich wealthier.

3. What if Piketty is right? ‘For Kuznets it was enough to be patient, and before long growth would benefit everyone.’ What if it doesn’t? What if the poor are actually harmed by it? What should countries like India do under such conditions?

4. Piketty does not address the question of effective demand, something that concerned even Henry Ford. The experience of the last three decades shows that as the share of capital in GDP increases, and is mostly saved (and reinvested mostly in financial assets, as Sen argues), the growth in consumption lags behind the potential growth in output. Why should new investment in the real economy continue under such conditions? The salve of consumer debt has been tried, and we know that it led to the great financial crises that began in 2007-08. Stagnation in the real economy, as Sen reveals, is the likely outcome.

5. To save capitalism from capitalists, Piketty argues for an activist ‘social state’, including in developing countries (India, for instance, cannot ‘modernize’ and ‘develop’ while keeping taxes below 15% of GDP; in the US the IRS collects over 30%, while EU nations collect over 40% of GDP in taxes). He suggests much more progressive taxation.

6. Higher marginal income tax rates and higher capital gains and inheritance taxes have little effect on the entrepreneurial incentive to innovate and invest. If this was not true, no major technological change would have been possible during 1940-80 in western countries when, for instance, marginal tax rates ranged between 60 and 90%. Many of the technologies we use now, including the computer, come from that period. It is almost equally possible to argue that the period since 1980, when tax rates have been at all-time lows, has hardly generated the same stream of innovations that came prior to that date.

7. One of Piketty’s proposals to address the socially and politically ‘terrifying’ inequalities of today’s world is a ‘global tax on capital’, without which a rapid decline of democracy and a ‘drift towards oligarchy’ is all but certain. If such a tax is seen to be ‘utopian’ or ‘unrealistic’, one must remember what the default is: when the rate of return on capital becomes far greater than the rate of growth, ‘the past tends to devour the future.’

8. Last, perhaps most critically, neither of the two authors addresses the ecological implications of the inegalitarian financialization of the economy, just what one would expect from economists. The implications of this neglect are serious. Consider just one: as inequalities of wealth and income rise rapidly, the rich can increasingly insulate themselves in the short-run, in unsustainable ‘green bubbles’ like air-conditioned homes, workplaces and malls, and thereby escape for a while (and only in some areas) the ecological consequences of policies that favour them. The poor, on the other hand, are pushed to receding margins of existence, and are led to destroy any relationship they hitherto had with their natural surroundings. In both cases, the consequences for our environment and us are devastating in the end. Economists, more than others, ought to remember that resources – including breathable air – are more than ever dangerously scarce!

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