How the crisis may puncture the GDP cult

Short-term economic growth has been Europe's guiding star since World War Two. It's time for a new horizon, before our lack of imagination leads us into ever deeper crisis.
Eivind Hoff
19 December 2011

Polaris, or the North Star, is a reliable guide to measure one’s latitude in the northern hemisphere. But if you want to go east or west, you need other guiding stars. Similarly, short-term economic growth has served as an attractive guiding star for public policies since the Second World War. But the current crisis requires Europe to move in new directions to meet the challenges of rising debt and inequalities. We need new guiding stars.

We want to learn from history, but we can be sure that history never repeats itself.  After the First World War, the gold standard was the guiding star for economic policies of most governments, serving as a guarantee against inflationary spirals. It was surely better to follow this target that had worked so well in the golden age before the World War, rather than risk inflation spinning out of control like in Germany in the early 1920s?

With hindsight, it is clear that this clever prudency amplified the impact of the 1929 stock exchange crack: The gold standard made it impossible to reduce interest rates. Credit tightened and banks collapsed. Governments gradually realized that the gold-standard was not the right guiding star to follow in order to address the new problems. A new indicator was created in 1934 to guide US policy-makers out of the mess: Gross Domestic Product. By measuring gross economic output, the government got a better idea of how it could stimulate the economy without heating it up too much and trigger inflation.

After the collapse of Lehman Brothers in 2008, everyone knew that the mistakes of the early 1930s had to be avoided. Governments built up huge debts from fiscal stimulus and central banks vastly expanded their balance sheets by pouring cheap money into the banking system.

But this was the equivalent of administering a painkiller to treat a disease: The fundamental cause of the crisis was an economic model based on permanently swelling debt-to-income ratios. The average debt-to-income ratio of EU households in 1995 was 52% according to Eurostat figures. By 2010 it had more than doubled to reach 106%. That may be bearable as long as interest rates decrease or GDP growth accelerates. But both developments had to come to an end, particularly in an ageing Europe. So the problem is essentially how to orderly dismantle a giant Ponzi scheme fuelled by exuberant confidence in everyone else’s optimism. This was epitomised by asset bubbles but was characteristic of the entire economic model, as shown by the flood of consumer credit. A government’s attempts to whip GDP growth quickly back into life won’t succeed in such circumstances. Because once exposed as a Ponzi scheme, most people won’t put their money into it – even if some other fool (government, with tax-payers’ money) does.

The result now will be economic recession for most of Europe. What is the problem with that? Servicing public debt will take a larger share of income, and unemployment will increase. It means welfare policies will be squeezed from both sides: Reduced supply of welfare from government and increased demand for it from citizens. That in turn means greater income inequalities. The magnitude of this squeeze is beyond living memory of Europeans: Greece’s debt to foreigners equals more than 100% of GDP.  The debt Germany was ordered to pay in war reparations after the First World War (which triggered the hyperinflation of the 1920s) was 83% of its GDP at the time (at a modest 2.5% interest rate). Does German memory stop in the early 1920s, forgetting what triggered the hyperinflation in the first place?

Governments will of course try to pay down debts and re-launch economic growth by making tax regimes smarter and more progressive by shifting taxes from labour to capital income and pollution. But with free trade and globalised capital markets, there are limits to the possibilities for individual countries to do so without industry and capital leaking abroad.

That is why many nations will face a choice between economic growth and social cohesion in the years to come. Post-Second World War globalisation was accepted by Europeans because it came along with a fair sharing of increased standards of living for all. When the social contract of secure jobs and steady income increase for all came to an end in the 1970s, cheap credit came to the rescue of the middle classes. But today, the globalised world no longer offers an answer to how fairness can be achieved. Even within the EU, solidarity between poor and rich countries is tenuous.

In this situation, it is not given that people will want to stick to the overall economic efficiencies provided by the single currency and free trade. A standard psychological experiment, the “ultimatum game” demonstrates that people prefer to forego income if that leads to a much higher income increase for others. In other words, equality has a value in itself to humans. Chimpanzees, on the other hand, are perfectly economically rational in the ultimatum game. It points towards heartening conclusions about what distinguishes us from our closest relatives.

People are not starving on the streets of Europe. Behind all the talk about jobs and taxes, the crisis is fundamentally about equality and fairness. Thanks to the combined gains in living standards achieved by welfare states and globalization, Europeans may have reached a stage where they prefer to forego further economic growth if that is required in order to make societies more equal. Not only may this change of mindset be the best way to find a new guiding star to navigate out of the maelstrom we find ourselves in. It could also be the most effective way to break with unsustainable consumerism.

Simon Kuznets, the man behind the GDP concept, said already in 1934: “The welfare of a nation (…) can scarcely be inferred from a measure of national income.” The implications of the debt crisis across Europe force us to admit he was right. But what are the alternative metrics that should instead guide governments? A new guiding star needs to measure something attractive. The surge of research on well-being and happiness has prepared the terrain well, and it is already being taken on board by governments, for instance through the National Well-Being Index in the UK, or the French follow-up to the Stiglitz-Sen-Fitoussi commission. The research on well-being point to meaningful freedoms – to choose one’s own way in life – and equality – necessary to create a sense of justice and trust in society – as key metrics that should guide public policies.

The first European navigators who ventured into the southern hemisphere were bewildered by the disappearance of the North Star under the horizon. But they soon found new guiding stars. Likewise, the ever more unattractive trade-offs required to squeeze short-term GDP growth out of society will make it easier to find our new guiding stars for a better society.

Eivind Hoff is head of The Bellona Foundation's Brussels advocacy office. He has worked for the WWF European Policy Office, and was a member of the national board of the youth movement of Friends of the Earth Norway. Eivind has also worked for the EFTA Secretariat in Brussels and for the Norwegian Ministry of Trade and Industry. 

This piece was written in the author's personal capacity.

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