Inequality, financialisation and stagnation

Abstract

The failure of exceptional monetary measures pursued in response to the financial crisis in advanced economies to achieve a strong recovery has created a widespread concern that these economies suffer from a chronic demand gap and face the prospect of stagnation. This article reviews and discusses the alternative views on the causes of the slowdown in accumulation and growth and the policies implemented and proposed to deal with it. It is argued that growing inequality, notably the secular decline in the share of wages, and financialisation are the main factors. Neither spending booms driven by financial bubbles, nor exporting unemployment through trade provides sustainable solutions. It is necessary to rebalance capital and labour, restrain finance and assign a greater role to the public sector in aggregate demand management and income and wealth distribution. However, the dominant neoliberal ideology rules out such socially progressive and economically effective solutions. Consequently, stagnation is likely to remain the new normal in the years to come with governments attempting to reignite growth by creating credit and asset bubbles and/or trying to export unemployment through beggar-thy-neighbour macroeconomic, labour market, trade and exchange rate policies, thereby generating financial and economic instability and tensions in international economic relations with significant repercussions for emerging and developing economies.

Great moderation, great recession and stagnation

The global economic crisis that began in the US in 2008 and spilled over first to Europe and then in a third wave to the South has had a far-reaching impact on mainstream economic thinking and expectations about longer term growth prospects. In the US, the beginning of the new millennium was marked by optimism elicited by Great Moderation – almost two decades of tranquillity marked by reduced volatility of business cycle fluctuations, increased macroeconomic stability, low inflation and mild recessions with better monetary policy seen as the driving factor. Europe moved to monetary union without a major hiccup, promising greater stability and faster growth. Led by China, emerging and developing economies started to surge ahead, many recovering from virulent financial crises and growing at rates that would secure rapid convergence towards the levels of advanced economies, and ready to play the role of locomotives for the world economy.

The picture changed dramatically with the onset of the most severe post-war crisis in the North. In the US, the Great Moderation came to be displaced by Great Recession. Severe difficulties faced in securing and sustaining a decent pace of economic recovery despite large bailout operations and unusual monetary measures including zero-bound interest rates and rapid expansion of liquidity and the inability of monetary authorities to exit from these measures even after a decade of their introduction have created serious concerns about the future of the US economy. Using very much the same instruments, the Eurozone has failed to resolve its financial crisis let alone economic and social crises and faced a serious risk of disintegration within a decade of its establishment. Finally, after an initial resilience to the crisis, growth in emerging and developing countries converged downwards towards the severely depressed levels of advanced economies. The vulnerabilities resulting from their deepened global financial integration in the new millennium have become visible even before a significant tightening of international monetary and financial conditions. Their potential growth has been falling even more rapidly and their medium-term prospects are bleaker than advanced economies.

The failure of rapid monetary expansion and historically low interest rates to achieve a strong recovery in spending and growth has bewildered many mainstream economists, triggering a search for ex post facto explanations within the conventional macroeconomic framework. Much of the debate revolved around the secular stagnation thesis first evoked by Larry Summers (2013) in a speech at the International Monetary Fund (IMF), and picked up by many others in the same school of thought.¹

The mainstream story of secular stagnation runs as follows: the combination of increased supply of foreign savings to the US through capital inflows encouraged by the safety of dollar-denominated US assets and vanishing investment opportunities and reduced demand for savings resulting from the slowdown in population growth and innovation has brought the ‘natural rate’ (the full-employment real interest rate) to negative levels, thereby impairing the ability of monetary policy to provide adequate demand stimulus to raise employment and income. As investment stays below the levels needed to secure full employment, potential output and growth decline and the economy remains in stagnation. Overcoming this dilemma requires repeated bubbles, permanent government stimulus and fiscal deficits or penetration of markets abroad.

Marxian and Keynesian views of stagnation

The debate among the mainstream economists about secular stagnation has elicited strong interest among heterodox economists, including both in the Marxian and Keynesian traditions.² A main reason is that it came from the very same people who had entertained considerable optimism about the prospects of modern capitalism under the rubric of Great Moderation (Palley, 2014a; Wray, 2013a). Another is that until they changed heart, secular stagnation remained a heretical idea for the mainstream (Backhouse and Boianovsky, 2015). However, while shifting their view, the mainstream now rarely makes any reference to the history of economic thought, not only to the Marxian analysis of accumulation crisis and stagnation but also the more recent work done by Keynesian economists (e.g. Foster and Magdoff, 2009; Palley, 2012).

While there is little dispute about the deceleration of accumulation and growth in advanced economies, its causes and the appropriate policy response are highly contentious. There are important differences in these respects both within and across the mainstream, Marxian and Keynesian analyses of stagnation.³ In the Marxian analysis, stagnation is the outcome of inherent contradictions in the accumulation process in a capitalist economy. Profits constitute both the motive and source of capitalist accumulation. Permanent unemployment and underemployment (reserve army of labour) are needed to suppress the claims of labour over capital. This produces a pattern of accumulation which leads to declines in profits which, in turn, hinder accumulation and growth. This perspective has subsequently been elucidated by several economists such as Paul Baran, Paul Sweezy, Michael Kalecki and Joseph Steindl by incorporating the role of monopoly capital, underconsumption and financialisation in the accumulation crisis and stagnation.⁴ The mainstream fails to allow for such influences or offer a plausible theoretical or a historical explanation of structural changes deemed responsible for the shift of the balance between savings and investment and the relation of secular stagnation ‘to the contemporary expansion of finance’ (Magdoff and Foster, 2014: 2).

In Keynesian thinking, stagnation is seen not as an inevitable consequence of internal contradictions of capitalist accumulation process, but as the outcome of neoliberal policies pursued since the 1970s (Palley, 2014a). The mainstream hypothesis of secular stagnation is criticised, among other things, for its neglect of the role of these policies in slowing investment and growth, notably those encouraging financial bubbles and financialisation as a remedy to stagnation. This criticism also comes from more conservative circles, notably the BIS (Bank for International Settlements) economists.⁵

While focussing on inadequate demand, a main tenet of the Keynesian economics, the secular stagnation and savings glut hypotheses are criticised by Keynesian economists because they do not conform to the Keynesian theory of income and interest rates (see, for example, Hein, 2015; Keen, 2014, 2015; Palley, 2016; Wray, 2013). These hypotheses are formulated in terms of the pre-Keynesian Flows of Funds theory where money, finance and debt have effectively no macroeconomic role to play in determining the equilibrium level of income and the real interest rate. The theory fails to differentiate between savings and financing and ignores that, in a modern monetary economy, loans do not come from preexisting stocks of deposits, and investments do not come from preexisting stocks of savings. Credit mechanisms delink investment from preexisting savings and modern banking delinks credits from preexisting deposits. Indeed, it is credits that generate deposits and it is investment that generates savings.⁶ Excess of savings over investment implies excess supply of goods or services. This sets off a process of adjustment through changes in the level and functional distribution of income rather than the interest rate. Since savings adjust to investment, an ‘investment dearth would be matched by a savings dearth’ (Wray, 2013: 4). Investment is governed by demand and profit expectations and made and financed independently of savings. These expectations have indeed played a greater role in the behaviour of investment during the global financial crisis than financial conditions (Banerjee et al., 2015). In a modern economy, the interest rate is a monetary phenomenon and there is no such thing as a stable ‘natural’ rate of interest that is compatible with full employment: ‘Contrary to ZLB [zero lower bound] economics, not only does a laissez-faire monetary economy lack a mechanism for delivering the natural rate of interest, it may also lack such an interest rate’.⁷

Financialisation, globalisation and wage suppression

The main contention regarding stagnation relates to its causes. In this respect, there is considerable agreement among heterodox economists, both in Marxian and Keynesian traditions, on the role of two interdependent factors. First, the growing income and wealth inequality, particularly the relative decline in the purchasing power of labour over the goods and services they produce. Second, financialisation – that is, the significant increase in the size, scope and influence of finance in the economy. Declining share of wages in GDP (gross domestic product) and increasing concentration of wealth and asset income in the hands of a very small minority lead to underconsumption and a structural demand gap – a phenomenon that the mainstream describes as excess savings. Thus, these trends in income and wealth distribution imply that inequality is not only a social problem but has increasingly become a macroeconomic problem. Financialisation plays a major role in the concentration of income and wealth. The financial boom-bust cycles generated to reignite growth exacerbate the stagnation problem by redistributing to the top and widening the structural demand gap, and by creating waste and distortions on the supply side and reducing potential growth.

In both Marxian and Keynesian traditions, wages are the most important component of both the cost of production and effective demand. A generalised and sustained decline in wages tends to generate two counteracting influences on profits. On the one hand, it would increase profitability by reducing the cost of production. On the other hand, it would limit the extent of the market and create the classical Marxian problem of realisation of profits by leading to underconsumption. This demand gap cannot permanently be filled by investment since that would ultimately lead to overcapacity. If investment is raised beyond a certain point, demand constraint would start to bite and profitability would fall, and this would in turn deter investment. This implies that there is no inconsistency but causality between falling share of wages and vanishing investment opportunities.

Sluggish wages also reduce inflationary pressures and allow and encourage central banks to pursue expansionary monetary policy. This is all the more so because, with unrelenting fiscal orthodoxy, monetary policy has become the only instrument left for achieving the objective of full employment. In the US, for instance, over the past three cycles, the Federal Reserve has been quite restrained in raising policy rates at times of expansion while cutting them drastically during contractions, creating a downwards bias in interest rates (Palley, 2016). Thus, the ‘coincidence of a declining wage share and declining real interest rates is not . . . accidental’ (Goodhart and Erfurth, 2014).

This process creates destabilising interfaces between debt and interest rates. Lower wages and reduced inflationary pressures lead to lower interest rates which, together with financial deregulation, encourage rapid accumulation of debt. This, in turn, makes it difficult for central banks to raise policy interest rates without causing disruptions in financial markets, thereby making low interest rates self-reinforcing. Indeed, in major advanced economies, the downwards bias in real interest rates has been associated with a strong upwards bias in debt as a proportion of GDP since the mid-1980s, suggesting that aggressive monetary policies made possible by sluggish wages and low inflation have created a debt trap (Borio and Disyatat, 2014).

In most advanced economies, the tendency for wages to lag behind productivity growth started in the 1970s and early 1980s and continued with full force in the new millennium. According to International Labour Organisation (ILO)/Organisation for Economic Cooperation and Development (OECD) (2015), in 10 advanced economies for which data are available, between 2000 and 2013 labour productivity rose by 17% while real wage index rose by some 6%. Consequently, in sharp contrast with a long-standing belief that income shares stay relatively stable in the course of economic growth, there has been a secular downwards trend in the share of wages in GDP (Figure 1).⁸ It is more pronounced in the US and Japan than other major advanced economies. According to estimates by the ILO, between 1970 and 2014 the labour share declined by around 10 percentage points in the US and Japan and around 6 to 7 percentage points in Germany and the UK.

Figure 1. Wage share in major advanced economies.

Source: Goodhart and Erfurth (2014).

GDP = gross domestic product.

Evidence from emerging and developing economies is more nuanced, but there is a pronounced downwards trend in the share of wages in Asian countries (ILO, 2015; Lim, 2014). A notable example is China where the share of wages in GDP has shown a downwards trend since the early 1990s with its growing integration into the global economic system (Akyüz, 2012; chapter 2). The wage share in China is also much lower than that in major advanced economies, about 50% compared with 60% or more in the latter. However, the downwards trend in China appears to have been reversed since 2011 as a result of efforts to establish a strong domestic consumer market (Huang and Lardy, 2016).

Some studies undertaken in the OECD, IMF and the European Commission suggest that technological changes are the main reason for the decline in the share of labour in income. However, this is highly contentious since the measurement of this effect is fraught with difficulties (Goodhart and Erfurth, 2014). Indeed, closer examination reveals that many of these findings are not robust (Stockhammer, 2009). Rather, policies promoting financialisation and globalisation and affecting the bargaining power of labour appear to have played a much greater role in the downwards trend in the share of wages in advanced economies (Dünhaupt, 2013; Furceri and Loungani, 2015; Hein, 2013; ILO, 2011; Palley, 2007; Soons, 2016; Stockhammer, 2009, 2012).

There is a close relation between the increased size, scope and influence of finance and growing inequality, notably in the US. On various measures, the US financial sector expanded rapidly from the late 1970s and the early 1980s relative to the rest of the economy, strongly helped by deregulation, more or less the same time as inequality started rising.⁹ A financialisation index combining various measures including the financial sector’s total financial assets as a percent of GDP, the shares of the financial sector in total corporate profits, total employment and employee compensation shows a 3.5-fold increase between the early 1980s and 2015. This index is highly correlated with the increase in the shares of the top 10%, the top 1% and the top 0.1% in total income (Soons, 2016).

Globalisation has also played an important role in shifting the balance between labour and capital. China’s and India’s integration into the global economic system and the collapse of the Soviet Union have added to economically active persons competing in world trade by almost 1.5 billion workers, doubling the global labour force. It is argued that as the new entrants brought little useful capital with them, the global capital-labour ratio has fallen by more than 50% (Freeman, 2010). This works against labour not only because labour productivity and pay tend to increase with the capital-labour ratio, but also because it shifts the balance of power towards capital as too many workers chase too few jobs or too little capital to employ them. The emergence of cheaper offshore locations has also raised the bargaining power of corporations, making capital a lot more mobile than labour.

While technology and globalisation tend to have similar effects on countries, the extent of inequality differs significantly in different advanced economies. In terms of the Gini coefficient, the US and the UK come at the top of the list of major OECD countries. This is partly because financialisation has gone much further in the Anglo-American world than in major economies in continental Europe. On the contrary, while all major advanced economies have adopted policies that weakened the bargaining power of labour, there are still important differences in the erosion of labour markets institutions such as declines in union density and collective bargaining coverage as well as in employment protection and minimum wage legislation, with the US and the UK again coming at the top of the list of countries in terms of market orientation (Freeman, 2008; ILO, 2015; Jaumotte and Buitron, 2015). These differences in financial and labour market policies and institutions and tax treatment of earned and unearned income and wealth explain much of the intercountry variations in income and wealth distribution.

Financial bubbles: The problem or the solution?

So far, there have been two main responses to the structural demand gap. First, create spending booms driven by debt and asset market bubbles, as in the US during the subprime expansion and in China in the aftermath of the Great Recession. This may provide a partial and temporary solution to underconsumption, but it extends and deepens financialisation, aggravates the structural demand gap and lowers potential output. Second, rely on foreign markets to fill the demand gap and export unemployment through macroeconomic, exchange rate or incomes policies as done by China and Japan before the global crisis and Germany throughout the new millennium. This is no more sustainable than financial bubbles, particularly for large economies which account for an important part of the world trade.

Financial bubbles do not always raise aggregate demand sufficiently to reduce unemployment. When wages are sluggish and demand and profit expectations are subdued, liquidity expansion and low interest rates cannot be expected to generate a significant amount of new investment in productive capacity for goods and services. But they may encourage borrowing for consumption and/or investment with prospects of large capital gains such as property. Generally, credit booms tend to have greater impact on spending than stock market booms because capital gains generated by the latter are reaped mainly by the rich. Indeed, the contribution of the dot-com bubble to growth in spending was limited in large part because the bubble was in the stock market, benefitting mainly high-income classes with lower spending propensities (Wray, 2013). This is also true for the stock market bubble created by historically low interest rates and rapid expansion of liquidity since 2008.

Credit bubbles are more effective when they involve lending to low- and middle-income classes with higher propensities to spend. But this also would heighten financial fragility, rendering much of the debt so accumulated unpayable. This was seen during the subprime bubble-bust cycle when much of the borrowing was for the purchase of property. Similarly, consumption bubbles supported by credit card or auto lending can be effective in reducing unemployment, but they also end up with widespread default. In the US, rising household debt and spending was the main factor driving growth until the Great Recession. Credit expansion since the crisis has not had much impact on consumer spending or corporate investment because increased risk aversion made the banks unwilling to lend to households and small businesses while big businesses have mainly borrowed to finance mergers and acquisitions and stock buybacks, pushing the stock market to record highs.

A related issue is whether inequality leads to excessive credit expansion and financial crises. This may be the case in certain circumstances. On the one hand, as declining and sluggish wages make it difficult for the less wealthy to maintain or increase their living standards, they can create an urge to borrow beyond their means, particularly in modern consumer societies. On the other hand, financial deregulation may ease their access to credits and implicit government guarantees create incentives for banks to lend to subprime borrowers. Thus, rising inequality can lead the less wealthy households to increase their leverage, increasing financial fragility and susceptibility to crises. It is indeed shown that the two major crises in the US, the Great Depression starting in 1929 and the Great Recession starting in 2007, were both preceded by a sharp increase in inequality and a similarly sharp increase in household debt leverage (Kumhof and Rancière, 2010). It is also argued that in the run-up to the subprime crisis, growing inequality in the US created political pressure to foster easy credit to assuage the less wealthy and reduce consumption inequality despite rising income inequality (Rajan, 2010).¹⁰

While providing a partial and temporary solution to demand deficiency, financial bubbles can make the problem even more chronic. They create supply-side distortions, impeding productivity and slowing growth. During booms, cheap credit diverts resources to low-productivity sectors such as construction and real estate services at the expense of more productive ones such as manufacturing. The financial sector also crowds out real economic activity and more productive sectors (Cecchetti and Kharroubi, 2015). Viable companies are held down by zombie companies sustained by artificially favourable financial conditions. Misallocations created by the booms are exposed during the ensuing crises when the economy would have to make a shift back to viable sectors and companies, but this is impeded by credit crunch and deflation. Examining the link between credit booms, productivity growth, labour reallocations and financial crises, Borio et al. (2015) conclude that labour misallocations that occur during a boom have a much larger effect on subsequent productivity if a crisis follows – when economic conditions become more hostile, misallocations beget misallocations. It is estimated that the cumulative hysteresis effect of lost productivity over a decade-long boom-bust cycle amounts to several percent of GDP.

Second, boom-bust cycles aggravate the underconsumption problem by increasing inequality. Booms favour asset holders, while crises tend to reinforce the long-term trend in inequality. In the US, the crisis has impoverished the poor, particularly those subject to foreclosures, while policy interventions have benefitted the rich, and growing inequality has been a major factor holding back the recovery (Stiglitz, 2013). In the recovery period 2009–2014, the top 1% captured 58% of total growth as their income grew by 27% against 4.3% growth of the income of the remaining 99% (Saez, 2015). In every year from 2008 onwards, real hourly wages stayed behind hourly labour productivity and the share of wages fell both during the contraction and subsequent recovery (Dufour and Orhangazi, 2016). According to a recent study on income distribution since the onset of the global crisis, the real incomes of about two-thirds of households in 25 advanced economies were flat or fell between 2005 and 2014 and this proportion was over 80% in the US. It is noted that while long-term factors such as demographic trends played a role, the recession and slow recovery after the 2008 global financial crisis were significant contributors to the lack of income advancement (Dobbs et al., 2016).

Exporting unemployment

Relying on exports to overcome underconsumption is a common practice among major economies. Until the Great Recession, China, Germany and Japan all relied on foreign markets in different degrees to fill the demand gap, with GDP growing faster than domestic demand thanks to growth in exports (Table 1). During 2004–2007, exports accounted for about one-third of Chinese GDP growth thanks to their phenomenal expansion.¹¹ In Japan and Germany, export growth was more moderate but their contribution to GDP growth was greater because domestic demand was sluggish. The Chinese export push was accompanied by a much stronger growth in domestic demand than in Japan and Germany, creating an expanding market for exporters of both commodities and manufactured parts and components.

Table 1. GDP, domestic demand and current account in main surplus countries (annual percent change unless otherwise indicated).

Source: South Centre estimates based on IMF WEO database; IMF Article IV Consultation Reports with the People’s Republic of China.

GDP: gross domestic product; CA: current account; IMF: International Monetary Fund.

a 2005–2007 average.

In all three countries, in the period until the global crisis, the shares of wages and private consumption in GDP declined. However, in China, the decline in the wage share was associated with a strong growth in real wages because of relatively rapid growth in productivity. Germany was engaged in ‘competitive disinflation’ – internal devaluation of the real effective exchange rate of the euro by cutting productivity-adjusted real wages and prices to improve competitiveness, particularly vis-à-vis other Eurozone countries, increasingly relying on exports for growth (Akyüz, 2012: chapter 2; Palley, 2013). Wage suppression rather than productivity growth played a central role in improved German competitiveness. For instance, the Eurostat Labour Productivity data show that, between 2000 and 2007, real labour productivity per hour worked and per person employed grew much faster in Greece and Ireland than in Germany. In Japan too, the gap between productivity and wage growth widened during that period as competition from low-cost emerging and developing economies intensified.

Growth in China fell sharply with the onset of the global crisis and the collapse of exports to main markets in advanced economies. This in effect gave an opportunity to design a stimulus package so as to address the underconsumption problem. However, rather than boosting household incomes and private consumption, China chose to create a debt-driven boom in investment in infrastructure, property and industry, pushing its investment ratio towards 50% of GDP and credit growth well ahead of GDP. It thus unbalanced domestic investment and consumption while rebalancing external and domestic sources of demand, creating excess capacity in several sectors and a large stock of debt in public enterprises and local governments. The ratio of debt to GDP reached 250% of GDP in 2015.

Chinese policy response to fallouts from the global crisis has made the economy financially highly fragile since an important part of this debt can become unpayable with a sharp slowdown in economic activity. Although China gradually turned its attention to rebalancing consumption and investment, the progress made so far is quite modest, with the share of private consumption rising from around 35% of GDP in 2009 to 37% in 2014, compared with 47% at the turn of the century. The jury is still out on whether and how fast the domestic rebalancing can be done and a large and vibrant domestic consumer market can be created without facing financial turmoil and/or a sharp slowdown of growth. If progress remains slow, a significant slowdown in growth can lead to a temptation to generate a renewed investment bubble, aggravating the imbalances and fragility.

After the global financial crisis, Germany replaced China as a major surplus country with its exports almost rising constantly relative to imports, also helped by the weakening euro. In almost every year since the crisis, growth of domestic demand in Germany continued to remain below that of GDP (Table 1). The contribution of the public sector to aggregate demand remained below the levels seen before the crisis while stagnant real wages resulted in a decline in private consumption as a percent of GDP. As a result, between the mid-2000s and 2016, the German surplus rose from some 5% of GDP to more than 8% while China’s current account surplus dropped from a peak of 10% to 2% to 3%. Before the onset of the Eurozone crisis, the region’s current account with the rest of the world was in balance and an important part of German surplus was with other Eurozone countries, notably the periphery countries with large current account deficits. Since the crisis, the German surplus increased while the region as a whole moved to a surplus with the rest of the world, by 3% of its combined GDP, as crisis-hit periphery countries were forced to make a swift payments adjustment, mainly through cuts in imports and growth (Atoyan et al., 2013).

For major underconsumption economies in the North and China, export surpluses cannot provide a sustainable solution because of the problem of fallacy of composition. Emerging and developing economies outside China cannot provide an adequate outlet for them collectively without compromising their own industrialisation and development. Without China, the share of emerging and developing economies in world income (at market exchange rates) is no more than 20% and their share in world trade is even less while the underconsumption economies account for more than half of world income and trade. This implies that they would need to run trade deficits in the order of several percentage points of their GDP for each percentage point trade surplus needed to avoid stagnation in the underconsumption economies. However, they cannot rely on inherently unstable international capital inflows to finance and sustain such deficits. On the contrary, they need to reduce their dependence on capital inflows in order to mitigate their vulnerability to boom-bust cycles generated by policies in major reserve-currency economies, notably the US.

Solution or dissolution?

Neither financial bubbles nor export surpluses constitute sustainable solutions to underconsumption in major advanced economies. Nor is it possible, when demand and profit expectations are depressed, to stimulate productive private investment through interest rate adjustments. The solution is to be found in rebalancing labour and capital and reversing the secular decline of the share of wages in income and to reignite a wage-led growth.¹² Evidence suggests that in all major advanced economies, the US, Germany, Japan, France and the UK, a higher share of wages in GDP would lead to faster growth. Although, at the national level, increases in the wage share can lower growth in some major emerging economies such as China, wage competition can lower growth everywhere. Thus, the global economy in aggregate is wage-led; that is, a simultaneous increase in the wage share in all major economies would lift global growth (Onaran and Galanis, 2012).

How this can be best done naturally varies from country to country but should include significant increases in minimum wages, reform of union legislation to widen the coverage of collective bargaining and increase union density so as to strengthen the bargaining power of labour.¹³ There may also be need to restrict management remuneration (e.g. bonuses) which are found to contribute strongly to growing wage inequality (Lemieux et al., 2009).

There is a growing agreement that increased public spending has an important role to play in closing the deflationary gap. Since the gap is structural, the additional public spending needed should be permanent. That means bigger government. It may be possible for the public sector to constantly add to debt without running into the sustainability problem provided that it is used to finance productive investment, particularly in areas that help improve the overall productivity of the economy such as human and physical infrastructure. When interest rates are at historical lows, additional revenues needed to service such debt may not be prohibitive.

However, debt-financed public spending encounters two problems. First, public debt is generally regressive since ownership of government bonds is heavily concentrated (Hager, 2013). Second, if public spending is successful in raising economic activity, employment and prices, it could eventually lead to substantially higher interest rates and create debt-servicing difficulties. For instance, in early 2016, US rates for 10-year treasuries were around 2% and interest payments accounted for 6% of all federal outlays. But projections by the Congressional Budget Office show that they could account for more than 13% of all federal outlays in 2026 when interest rates are projected to rise to 4.1% (Wessel, 2016). Thus, assessments of public debt sustainability based on historically low interest rates prevailing in conditions of deflation may contain a significant margin of error.

There are ways of financing permanently higher public spending without running into higher levels of debt. One way is to combine progressive taxation with increased public spending. Under conditions of deflation and highly skewed distribution of income and wealth, the so-called balanced-budget multiplier tends to be quite high, particularly if public spending is financed with additional taxes on top income classes and/or with capital levy. This is particularly true for the US and the UK where income and wealth inequality are much greater than other major OECD countries and taxation is much less progressive. It has been estimated that, in such cases, the top tax rate on the top 1% income earners could be raised to over 80% without impairing growth and that the potential tax revenue at stake is very large (Piketty et al., 2011).

Progressive taxes would not only provide financing for additional demand, but also help correct market-generated inequalities particularly if combined with transfers to lower income groups. Since the balance in the market place between labour and capital cannot be restored overnight, greater attention would need to be given to redistribution through the budget.

Perhaps even a more effective way is deficit monetisation – central bank financing of additional public spending. When monetary policy fails to stimulate private spending but supports mainly speculative activities, as has been the case in recent years, a way out would be to make the money available directly to those who are willing to spend but cannot do so because of tight budget constraints and debt overhang. Milton Friedman long suggested dropping money from helicopters to increase spending and avert deflation. Naturally, the public sector comes at the top of the list for helicopter drop. This was seen by Bernanke (2002) before becoming the chairman of the US Federal Reserve, as a way of reversing deflation.

Deficit monetisation is significantly different from quantitative easing (QE) operations. First, QE is an exchange of assets, newly printed dollars for bonds held by the public through the banking system. By contrast, here the base money and reserves increase as a result of additional spending on goods and services either directly by the government or indirectly by the private sector through budgetary transfers and tax cuts, not because of asset substitution. Second, the US Federal Reserve’s purchase of treasuries in QE operations do not provide the government non-debt creating, interest-free resources unless such debt is monetised indefinitely. In other words, deficit monetisation requires permanent QE – an irreversible increase in the nominal stock of fiat money (Buiter, 2014).

The kind of cooperation needed for deficit monetisation between the monetary and fiscal authorities is in principle feasible in most other advanced economies suffering from deflationary gap. However, in the Eurozone, direct financing of government deficit is explicitly prohibited by the Lisbon Treaty. Unless the relevant provisions of this treaty are reformed, deficit monetisation in the Eurozone would have to go through the market – governments would have to issue debt to finance deficits and the ECB (European Central Bank) would have to buy sovereign bonds from secondary markets but with a commitment to hold them indefinitely. Purchases of sovereign bonds in the secondary markets are already made with the QE programme that started in January 2015.

Under deflationary conditions, ‘money-financed’ spending or tax cuts need be no riskier for financial stability than the ultra-easy monetary policy, since the money thus created would not find its way directly into asset markets. Nor would it endanger monetary instability. If a permanent increase in money supply resulting from deficit financing turns out to be inflationary, it can be sterilised by using bank reserve requirements rather than selling government bonds. The claim that monetisation of fiscal deficits is inherently more inflationary than monetary expansion to support private spending has no sound theoretical basis and the main challenge is how to ‘design institutional constraints and rules that would guard against the misuse of this powerful medicine’.¹⁴

There thus exists an array of policy measures that can overcome the chronic deflationary gap in major economies by reversing the secular decline in the wage share, using redistributive policies through progressive taxes and transfers or raising government spending to permanently higher levels without commensurate increases in public debt. However, under the dominant neoliberal ideology, it would be far-fetched to expect governments to take effective measures to rebalance capital and labour or to put finance in the reverse gear. Nor is it possible to expect a fundamental restructuring and redesign of taxes, public spending and financing of budget deficits so as to enable the public sector to play an effective role in aggregate demand management and more equitable distribution of income and wealth. Consequently, stagnation is likely to remain the new normal in the years to come with governments attempting to reignite growth by creating financial bubbles and/or trying to export unemployment through beggar-thy-neighbour macroeconomic, labour market and exchange rate policies, thereby generating financial and economic instability and tensions in international economic relations.