The Failure of the Free Market and Democracy: And What to Do About It

Introduction

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.

John Maynard Keynes, General Theory

Western democracies are under threat economically and politically. Citizens are increasingly disaffected with politicians and institutions that have become dysfunctional and incapable of catering to their basic needs. Real income growth has petered out, public services are stretched, infrastructure is crumbling, well-paying jobs are disappearing. More broadly, the environment is being degraded while inequality is reaching record proportions way beyond most people’s sense of justice. Violence is on the rise, in the streets and in political discourse. The social contract between the state and the governed is under threat, as the lopsided and weak recovery since the Great Financial Crisis (GFC) over a decade ago feeds a pervasive sense that something is very amiss. Perhaps most corrosive of all is the realisation that today’s young adults stand to be worse off than their parents – unheard of in modern times. There is a gradual loss of optimism for the future. In spite of the marvels of modern technology, the signs are that Western civilisation peaked a generation ago and we are now on an inevitable decline towards its fall.

These are the symptoms of a deep malaise, and piecemeal palliative measures that do not attack the roots of the problem look increasingly like the equivalent of prescribing painkillers for a life-threatening illness. Tinkering with the tax system, hiking the minimum wage or banning plastic bags will not cut it; the forces that are corroding Western society are multiple, interconnected, and have been undermining its foundations for decades. These are the same destructive forces that triggered the GFC of 2008. They are still at work today. We need a root-and-branch diagnosis of how they came about, how they operate and how to stop and reverse them. This book aims to provide that diagnosis and to offer solutions.

Many of my themes are not new. Globalisation, rising inequality, the substitution of machines for human labour, dysfunctional politics and the rise of China have each been written and talked about elsewhere. What has been missing, however, is a coherent explanation of how all these phenomena are interlinked, mutually reinforcing, why they originated together and have led us into crisis.

The challenge to Western society posed by these issues has been aided and abetted by a minor revolution in politics and economics. The post-war consensus on how to run our societies was declared a failure, taken out to the woodshed and shot. In its place, a Darwinian, lightly regulated free-market regime has become the default, the ultimate efficient economic machine and arbiter of social outcomes, banishing politics from its workings. After the inflation of the 1970s, the academic and political pendulum swung firmly against government intervention in the economy and regulation of business practices. In came the era of President Reagan in the US and Margaret Thatcher in the UK, their free-market ideology reinforced and validated by the fall of the Berlin Wall in 1989, the demise of the Soviet Union and the opening up of China to international trade.

The principles of the free market and unfettered international trade were adopted unquestioningly as the optimum way to organise economies. In spite of major changes in society, economic principles set out by Adam Smith and David Ricardo two centuries ago have been used to guide the new dominant political, economic and academic ideology in the West. It is an ideology based on the premise that governments should confine themselves to providing a secure legal framework in which markets can operate seamlessly, and abstain from steering the economy; markets themselves produce the best outcomes in terms of the allocation of resources and the distribution of rewards, and they should be deregulated in order to operate freely.

The deregulation of markets, including that for labour, coincided with the opening-up of a massive supply of cheap labour in countries such as China and those of the former Soviet Union. This has resulted in a visible transfer of income and wealth from most Western workers to the winners in this process: workers in emerging markets and the corporate sector. Globalisation and technological change have boosted the corporations’ share of profits in the economy and exacerbated inequalities of income and wealth within countries. Those at the top of the corporate pyramid have reaped the benefits from international trade, the substitution of machines for human labour and lower tax rates, forgetting on the way to compensate those left behind.

This new framework also set in process a powerful debt dynamic. The finance industry was let off the leash as Western households borrowed to increase their living standards in the face of stagnant incomes. This was encouraged by aggressively expansionary banks and ever cheaper credit, courtesy of falling interest rates. Governments and central banks sat watching on the sidelines, unwilling to interfere. Not only was it politically unwise to restrain the rapidly growing mountain of debt, which after all was being created by willing participants in the market, but corporate interests, including the finance industry, began to corrupt the political system in their favour. Campaign finance contributions, lobbying, regulatory capture, or simply the generation of outsize profits that could yield much-needed tax receipts, made governments and political parties reluctant to kill the golden goose. Ironically, economics was re-joined with politics, but through the back door, undermining the very principles and workings of democracy.

According to free-market textbooks, the GFC of 2008 was, by definition, an event that should not have happened. But this was a crisis so deep that the market had to appeal for help to those very institutions that had been so derided as irrelevant: governments and central banks. Without their unprecedented and massive bail-outs of banks and large corporations, the market system would not have been able to right itself and would have collapsed.

In spite of this dramatic refutation of market efficiency and wisdom, free market ideology still limps on today, zombie-like, as the commercial and political elites are reluctant to give it up. It has become so deeply entrenched in our thinking, repeated as a mantra so many times over three decades, that pundits and those in power cannot face up to their mistakes, particularly in the absence of any obviously viable alternative to sell to their disappointed citizens. Worse, the entrenched interests of the winners have made it all but impossible for politicians to steer an independent course. This is especially true in the case of the dominant player in the global economy, the US. From its position of power, America sets the example and the rules of engagement. In an open, globalised world, it is very difficult for other countries to resist and behave differently.

For all the elegance of foundational economic theories, the truth is that politics and economics can never be separated. To attempt to do so is itself a political act and, as we have seen, a path to economic and social disaster. Politics is always about money somewhere along the line, just as economics is always in need of political choices. There is no economic proof of the best decisions for society, not only because economics isn’t a hard science like physics, but because there is no proof that one way of slicing the economic pie is superior to another. At best, economists can describe, for example, the trade-off between growth and tax rates or profits and wages, but where to land within these and other trade-offs is inescapably a political decision. In the absence of a world government, there is simply no mechanism for resolving some of these choices when it comes to the allocation of resources for the production of goods and services globally. To simply rely on the market and the goodwill of the winners towards the losers has demonstrably failed.

Put another way, contrary to the orthodoxy of the last few decades, which tried to kick the politics out of economics, we urgently – and explicitly – need to re-join the two.

To achieve this, we must recognise how our predicament has been caused by the malign and mutually reinforcing interaction between our political processes and economic and technological developments since the 1980s. Solutions which try to fix individual symptoms in isolation will not work. For example, pumping money into the system to alleviate job redundancies caused by technological change will not work without a wholesale redesign of our attitude to work, taxation, leisure and what are considered socially useful occupations – and the repositioning of international trade on a more level playing field. We can no longer rely on private companies to make decisions about where in the world to produce for short-term gain irrespective of the long-term consequences for all stakeholders.

The solutions proposed in this book follow from this diagnosis. They include measures that can be taken quickly to stop the rot, while others involve a more radical, long-term overhaul of our political institutions.

At one level, we need simply to change incentives and reduce, if not eliminate, conflicts of interest. Governments still have enormous powers to curb corporate greed through taxation and re-regulation. They can raise corporate taxes; disincentivise corporations from transferring production abroad or diverting profits to lower tax jurisdictions; reinvest in society through training, socially useful jobs, public services and legislating for a living wage. Laws can be enacted to reduce conflicts of interest between shareholders and the executive class, including making top compensation packages transparent and legally accountable to shareholders. Banks can be nudged back to being boring financial utilities, safekeeping savings and lending for investment within conservative limits and for small margins.

At the government level, a major upgrade to our antiquated political institutions is now possible and desirable. We can and should cut out conflicts of interest between private capital, elected representatives and citizens. As a first step, all special and private interests should be banned from politics, whether through campaign finance or lobbying. This is not, however, sufficient to guarantee long-term investments in public infrastructure, education and health, the benefits of which will be reaped by future generations. Politicians simply cannot be incentivised that far into the future and are too weak to resist the temptation to bribe the electorate with its own money and short-term policies the bill for which will be presented after they have moved on.

We must also recognise the need to replace our anachronistic institutions with a model of direct democracy that is now technologically possible. Simply put, a well-educated citizenry can vote with their phones or TV remotes. To be successful, this presupposes the education and involvement of citizens in the issues of the day, not to mention a considerable investment in resources devoted to education and training, the key to our future. We need smart citizens to make smart decisions.

Politics on the ground is already chipping away at the political dead wood. Traditional loyalties are disintegrating as conventional parties, prisoners of the current outmoded system, run out of ideas and the ability to deliver. Grass-roots movements attest to the death of tribal politics in which the troops are led by a small group of full-time professional politicians. There seem to be no bounds to how far people will go to break the stale political status quo. This is a first step. No doubt future elections in the US and Europe will debate these issues as the pendulum swings back from the certainties of the last thirty years. We must hope for tangible progress, and that the forces of inertia will not hijack or hold back the yearning for real change. The cost of failure does not bear thinking about.

We need not be resigned to our fate unless we choose to remain timid in our ambition and passive in our response. The time for action is now.

PART ONE

The Twin Challenges of Globalisation and Technology

1

Globalisation and its perversions

Globalisation presumes sustained economic growth. Otherwise, the process loses its economic benefits and political support.

Paul Samuelson

Globalisation is a process of interaction and integration among the people, companies, and governments of different nations, a process driven by international trade and investment and aided by information technology … Governments also have negotiated dramatic reductions in barriers to commerce and have established international agreements to promote trade in goods, services, and investment. Taking advantage of new opportunities in foreign markets, corporations have built foreign factories and established production and marketing arrangements with foreign partners. A defining feature of globalisation, therefore, is an international industrial and financial business structure.

Levin Institute of International Relations

THE FOUNDATIONS OF ECONOMIC GLOBALISATION

What does globalisation mean in concrete terms? One of its high priests, the International Monetary Fund (IMF), opined in its 2008 Overview that people had ‘become more globalised’, noting,

•  The value of trade (goods and services) as a percentage of world GDP increased from 42.1 per cent in 1980 to 62.1 per cent in 2007.

•  Foreign direct investment increased from 6.5 per cent of world GDP in 1980 to 31.8 per cent in 2006.

•  The stock of international claims (primarily bank loans), as a percentage of world GDP, increased from roughly 10 per cent in 1980 to 48 per cent in 2006.¹

The central premise of economic globalisation is, according to the IMF, ‘that global markets promote efficiency through competition and the division of labour – the specialisation that allows people and economies to focus on what they do best. Trade enhances national competitiveness by driving workers and economies to focus their efforts where they have a competitive advantage.’ These theoretical underpinnings of globalisation are not new; as far back as 1817 David Ricardo published his theory of comparative advantage to explain why countries engage in international trade.² Notice however that the IMF speaks of competitive advantage without specifying whether this advantage is absolute or comparative. But as Ricardo shows, this is a crucial distinction.

Ricardo was trying to improve on his friend Adam Smith’s theory of absolute advantage,³ which, in turn, was a better (if imperfect) justification for international trade than mercantilism, the policy of growing an economy through exporting more goods and services than you import. Smith argued that mercantilism could not benefit all countries at the same time because one nation’s exports are another nation’s imports. Instead, he advocated that countries should specialise according to their absolute advantage, determined by a simple comparison of labour costs. Clearly, though, some nations might have no absolute advantage in anything, meaning that, while some will gain from international trade with absolute advantage, the gains may not be mutually beneficial.

In other words, concentrating production in countries with absolute advantages in everything is really just another form of mercantilism: the higher-cost countries will have to import all they consume, while the low-cost countries, enjoying an absolute advantage, will accumulate reserves – unless their currency rises, in which case their purchasing power will have risen at the expense of the absolutely expensive country that had to import goods and services.

Ricardo’s refinement of this argument was to introduce the idea of comparative advantage. He argued that, for mutually beneficial international trade, a nation should concentrate resources only on industries where it had a comparative advantage, that is, on those industries in which it had the greatest competitive edge. He even went as far as to suggest that national industries which were, in fact, profitable and internationally competitive should be jettisoned in favour of the most competitive industries, the assumption being that subsequent economic growth would more than offset any economic disadvantage from closing these down.

Ricardo attempted to prove his theory that international trade is beneficial by using a simple numerical example relating to the trade between England and Portugal in wine and cloth. In an address to the International Economic Association in 1969, Paul Samuelson famously called the numbers used in this example the ‘four magic numbers’.

Comparative difference in cost

A country is said to have a comparative advantage in the production of a good (or service) if its cost of production relative to another good is lower than is the case in other countries. This may arise because of natural advantages – for example, Portugal’s climate is conducive to the production of wine – or because of long accumulated know-how and technical expertise. A country should be left to specialise in the production of commodities where it has a comparative advantage. For Ricardo, the essence of mutually beneficial international trade is not the absolute difference in production cost between countries, but the comparative difference in costs between two goods in two countries.

Ricardo’s theory of comparative advantage

All other things being equal, a country tends to specialise in and export those commodities in the production of which it has maximum comparative cost advantage or minimum comparative disadvantage. Similarly, the country’s imports will be of goods having relatively less comparative cost advantage or greater disadvantage.

Ricardo explained his theory with the help of the following (theoretical) assumptions.

1. There are two countries and two commodities.

2. There is perfect competition both in commodity and factor (labour) markets.

3. The cost of production is expressed in terms of labour – i.e. the value of a commodity is measured in terms of labour hours/days required to produce it. Commodities are also exchanged on the basis of the labour content of each good.

4. Labour is the only factor of production other than natural resources.

5. Labour is homogeneous – i.e. identical in efficiency in a particular country.

6. Labour is perfectly mobile within a country but perfectly immobile between countries.

7. There is free trade – i.e. the movement of goods between countries is not hindered by any restrictions.

8. Production is subject to constant returns to scale.

9. There is no technological change.

10. Trade between two countries takes place on barter system.

11. Full employment exists in both countries.

12. There is no transport cost.

Here’s how the four magic numbers play out.

The four magic numbers

On the basis of the above assumptions, Ricardo explained his comparative cost difference theory by taking the example of England and Portugal as two countries and wine and cloth as two commodities. The principle of comparative advantage is expressed in labour hours by the following table.

Portugal requires fewer hours of labour for both wine and cloth production. From this it could be argued that there is no need for trade as Portugal produces both commodities at a lower cost. Ricardo, however, tried to prove that Portugal stands to gain by specialising in the commodity, in this case the production of wine, where its comparative advantage is larger. Similarly, England should specialise in the production of cloth, because its comparative disadvantage is lesser than in wine.

Comparative cost benefits both participants

To prove the Ricardian contention that comparative cost-based trade benefits both participants, though one of them has a clear absolute cost advantage in both commodities, we need to work out the domestic exchange ratio.

Let us assume these two countries enter into trade at an international exchange rate (terms of trade) of 1:1. At this rate, England specialising in cloth and exporting one unit of cloth gets one unit of wine. At home it would be required to give 1.2 units of cloth for one unit of wine, which is worse. England thus gains 0.2 of cloth, so wine is cheaper from Portugal by 0.2 unit of cloth. Similarly, Portugal gets one unit of cloth from England for its one unit of wine traded as against 0.89 of cloth at home, thus gaining extra cloth of 0.11. Here both England and Portugal gain from the trade, as England gives 0.2 less of cloth to get one unit of wine and Portugal gets 0.11 more of cloth for one unit of wine.

In this example Portugal specialises in wine, where it has a comparative advantage, leaving cloth for production in England in which the latter has a comparative advantage. On this basis, comparative cost theory states that each country should produce and export those goods in which they enjoy most cost advantage and import those goods where they suffer most cost disadvantage.

In reality, however, things didn’t work out as Ricardo had predicted. Economist Joan Robinson⁴ has pointed out that, following the opening of free trade with England, Portugal endured centuries of economic underdevelopment: ‘the imposition of free trade on Portugal killed off a promising textile industry and left her with a slow-growing export market for wine, while for England, exports of cotton cloth led to accumulation, mechanisation and the whole spiralling growth of the Industrial Revolution’.

Robinson also argues that Ricardo’s required conditions – such as full employment and a lack of trade deficits and surpluses – were not relevant to the real world. Nor did his theory take into account that some countries may be at different levels of development, raising the prospect of unequal exchange, which might hamper a country’s development, as in the case of Portugal.

While it is true that specialisation and trade according to relative cost of production can benefit all parties, the conditions under which it actually will, requires preconditions that do not currently exist in the real world. The idea that countries manage who produces what within their borders in coordination with each other is particularly flawed, given that the decision unit in capitalist economies is the company, an institution designed to support its own shareholders rather than coordinate economic policy and planning more widely. Ricardo’s theory of comparative advantage implicitly assumes the existence of industry and trade policy at a national level. It does not presume that business decisions are or should be made independently by entrepreneurs on the basis of viability or profit.

RICARDO, COMPETITIVE ADVANTAGE AND TRADE POLICY TODAY

Despite its obvious flaws, Ricardo’s model – morphed into the more general concept of competitive advantage – has had a significant influence on the laissez-faire international trade policy that has dominated the last fifty years.

World trade increased strongly from 1960 to 2015,⁵ as many countries dismantled or reduced their barriers to trade through bilateral agreements and later under the auspices of the World Trade Organization (WTO). Governments were sold on the idea that global trade benefits everyone, and that the obvious benefits to consumers of being able to buy cheaper goods made in low-cost countries would raise standards of living. Rarely was it acknowledged that, in order to consume such cheap imports, consumers also need to be producers who sell enough to pay for their goods.

According to the IMF,

Global markets also offer greater opportunity for people to tap into more diversified and larger markets around the world. It means that they can have access to more capital, technology, cheaper imports, and larger export markets. But markets do not necessarily ensure that the benefits of increased efficiency are shared by all. Countries must be prepared to embrace the policies needed, and, in the case of the poorest countries, may need the support of the international community as they do so.

In fact, developing countries have done remarkably well from the explosion in international trade, but they were not the ones in need of help. Rather, more traditional economies have often borne the brunt, including the US. Consider, for example, the case of the dramatic decline in decently paid manufacturing jobs there. In a speech in Cleveland, Ohio in 2015, the chair of the US Federal Reserve Board, Janet Yellen, bemoaned the loss of manufacturing jobs: ‘Unfortunately, the number of US manufacturing jobs has been generally decreasing since its peak in the late 1970s …This painful trend reflects a number of long-term challenges faced by domestic manufacturers, including the relative costs of labour and investment in producing domestically versus abroad.’⁶

The loss of jobs is an inconvenient truth for the argument that globalisation delivers win-win benefits, with American manufacturing in rude health while its citizens also benefit from cheaper imports. In fact, data published by Susan Houseman and her colleagues in 2011 shows that once you take out computers, the picture is much more complex.⁷ The big increases in manufacturing output recorded in the US, even as employment plummeted, were partly due to statisticians adjusting upwards the output for quality improvements such as computing power in the technology sector. If you strip this out, manufacturing output in the US has been stagnant. However, this point has gone largely unnoticed and the assumption remains that the increases reflected healthy productivity growth.

So what happened to all those jobs? Globalists argue that automation has been the root cause, with robot-driven productivity both pushing growth and taking traditional manufacturing jobs. And, according to Houseman et al., automation did happen in manufacturing; we look at its effects in more detail in Chapter 2. However, the extent of its impact, especially in the US, is questionable, as reported by Quartz.com in 2018: ‘Consider the shuttering of some 78,000 manufacturing plants between 2000 and 2014, a 22 per cent drop. This is odd given that robots, like humans, have to work somewhere. Then there’s the fact that there simply aren’t that many robots in US factories, compared with other advanced economies.’⁸

Remarkably, while Germany installed more robots per worker than the US, a study by German academics found that only 274,000 manufacturing jobs were lost in Germany between 1994 and 2014 because of robots, this in a sector that still makes up around a quarter of the economy.⁹ Germany lost only 19 per cent of its manufacturing jobs between 1996 and 2012, compared to a third lost by the US. Korea, France and Italy also lost fewer such jobs even though they used more robots per hours worked. Conversely, low-robot-intensive economies such as the UK and Australia saw faster declines in their manufacturing sectors.¹⁰

When we consider, for example, that the US production of motor vehicles dropped from around 13 million in 1999 to 11 million in 2017, it’s difficult to identify a boom in manufacturing output or productivity growth attributable to robots. And if booming robot-led productivity growth wasn’t displacing factory workers, then, according to Houseman et al., ‘the sweeping scale of job losses in manufacturing necessarily stemmed from something else entirely’. Instead, a good part of the job losses in sectors such as autos is attributable to the rising share of imports.

In other words, contrary to the globalists’ thesis, the role of trade in displacing workers is a bigger contributing factor than its defenders are willing to admit.

THE RISE OF CHINA

Of particular importance is China’s emergence as a major exporter, which US leaders had encouraged. This has been evidenced in a wealth of research. A study by economists David Autor, David Dorn and Gordon Hanson found that the parts of the US hit hard by Chinese import competition saw manufacturing job loss, falling wages and the shrinking of their workforces.¹¹ It also found that compensating employment gains in other industries never materialised. The authors drew on detailed studies of the local impact of trade with China to estimate conservatively that at least a quarter of the collapse in manufacturing jobs in the US between 2000 and 2014 was caused by trade with China. These conclusions were mirrored in a second paper, which estimated that competition from Chinese imports cost the US as many as 2.4 million jobs between 1999 and 2011.¹²

The US National Bureau of Economic Research published a report in 2012 on the decline in manufacturing due to the integration of China into the trading system. They summarised their findings as follows:

According to the Bureau of Labor Statistics, US manufacturing employment fell from 19.6 million in 1979 to 13.7 million in 2007 … This paper finds a relationship between the sharp decline in US manufacturing employment that occurs after 2001 and US conferral of permanent normal trade relations on China in October 2000. This change in policy is notable for eliminating uncertainty about potential increases in tariffs rather than changing the actual level of tariffs … these employment declines are associated with relative increases in US imports from China, the number of US firms importing from China, the number of Chinese firms exporting to the United States, and the number of US–China importer-exporter pairs … Second, we show that elimination of uncertainty is associated with suppressed job creation as well as exaggerated job destruction. The relative importance of the former indicates that analyses of the effect of international trade on domestic employment that focus solely on job destruction may be inadequate … estimates of employment loss persist even when controlling for industry attributes which might be linked to trends in technical change, particularly industry capital and skill intensity.¹³

In 2017 an Economic Policy Institute report concluded that, since China entered the WTO in 2001, its trade surplus with the US had grown from $83 billion to $367 billion in 2015. That is to say, the US went from rough self-sufficiency up until the 1980s, to outsourcing a lot of its production to low-cost China, at the inevitable cost to American jobs and wages.¹⁴ US manufacturing employment dropped 18 per cent between March 2001 and March 2007.

Figure 1.1: Manufacturing employment, percentage change 1990–2014

Why did China have such a big impact on US manufacturing employment sparked by granting China Permanent Normal Trade Relations (PNTR) in 2000 and China’s accession to the WTO in 2001 – set in motion by Bill Clinton? Because when China joined the WTO, it became a fully protected member of the globalised trading community, reducing the risk that the US might retaliate against