Secular Stagnation?

Secular stagnation, the wage share, and asset bubbles Annamaria Simonazzi1 (Provisional)

1. Introduction: secular stagnation? Slow growth has been usually attributed to supply factors: a decline in productivity which is explained in turn by disincentive effects of welfare systems no longer attuned to the changed environment (globalization, technical change), excessive protection and regulation resulting in a too slow adjustment of labour and wages and a rate of innovation out of step with the rate of technical progress. By calling the supply-side story into question, Summer’s suggestion that “our economy is constrained by lack of demand rather than lack of supply” (Summers, 2014a) stunned the economic profession. In such a situation, increasing capacity to produce will not translate into increased output unless there is more demand for goods and services, and “training programs, reform of social insurance, [greater flexibility] may affect which workers get jobs, but they will not affect how many get jobs. Indeed measures that raised supply could have the perverse effect of magnifying deflationary pressures”. Summers advocates more government spending and employment, to take advantage of the current period of economic slack to renew and build out our infrastructure. Thus, the crisis has returned legitimacy to old discredited explanations based on demand, or lack thereof. Summer’s argument is based on the idea that the short-term real interest rate that is consistent with full employment has fallen to negative values. With the failure of monetary policy to enforce equality between investment and full employment savings in a “liquidity trap”, we may be stuck in a long-run equilibrium with underemployment and we are doomed to economic stagnation. The reasons of the fall of the “natural” or “Wicksellian” real interest rate lie in its standard determinants: (i) the savings-supply schedule, (ii) the investment-demand schedule, with the shift in the curves being explained mostly by demography and IT respectively. Low interest rates, in turn, may foster financial instability: “It may be impossible for an economy to achieve full employment, satisfactory growth and financial stability simultaneously simply through the operation of conventional monetary policy”. Bubbles are an alternative way for society to deal with excess saving when fiscal policy does not take up the challenge: the recent growth is thus “fragranced with hints of new financial bubbles” (Teulings and Baldwin 2014). Among the reasons affecting the propensity to spend and leading to the lack of demand, changes in income distribution, though mentioned, are not given by Summers their full weight. Indeed, the huge increase in inequality over the last three decades has refocused attention on income distribution as a factor affecting demand and growth. Measures to reduce income concentration at the top, so as to sustain effective demand in the rest of the population have been advocated by many unorthodox economists in the past and are now coming from the most unexpected quarters: the IMF (Ostry et al. 2014) now maintains that “lower net inequality is robustly correlated with faster and more durable growth”, and the Central bankers of the richest countries reunited in Jackson Hole have rushed in support of employment and wages2. “From her position as the world’s single most powerful economic voice, the chair of the US Federal Reserve, Janet Yellen, is forcing the financial

11 Dipartimento di Economia e Diritto, Sapienza University of Rome. 2 Appelbaum B. Central bankers' new gospel: Spur jobs, wages and inflation. http://www.nytimes.com/2014/08/25/business/central-bankers-new-gospel-spur-jobs-wages-and- inflation.html?wpisrc=nl-wonkbk&wpmm=1&_r=0; Apparently, even the austere President of the Deutsche Bundesbank, Jens Weidmann, has welcomed higher German wages, though strictly limited to some sectors (Frankfurter Allgemeine Zeitung July 30th, 2014). http://uk.reuters.com/article/2014/07/30/uk-germany-wages- weidmann-idUKKBN0FZ03U20140730 1 markets to rethink assumptions that have dominated economic thinking for nearly 40 years. Essentially, Yellen is arguing that fast-rising wages, viewed for decades as an inflationary red flag and a reason to hike rates, should instead be welcomed, at least for now”. Yellen’s new stance, that echoes that by another former Fed Chairman (1932-48), Marriner Eccles3, has forced Wall Street to re-focus as well. Judging from the articles in the financial press4, finance has become obsessed with a simple, easy-to-understand measure of American household health: wages. The paper argues that, with increasingly unequal distribution in income and wealth and fiscal policy proscribed, advanced economies are bound to stagnate. Monetary policy, conducted within a financially de-regulated setting, is more likely to produce bubbles rather than steady growth. Bubbles thus become the only way in which economies can grow. It is generally maintained that they can produce only short-run, temporary effects on demand, and negative, long-lasting effects on growth through speculative investment ending in waste, deleveraging and balance sheet recession. The paper investigates whether, and in which conditions, booms might activate a process of transformation and growth, and which policies may prevent or mitigate the disruptive effects of deleveraging. In order not to be misunderstood, it is not argued that bubbles are the best way to growth; the aim is simply to compare the disruption following the bursting of a bubble with the wasteland produced by austerity and secular stagnation. Section 2 reviews the literature on the relation between income distribution, demand and growth. It argues that financial deregulation has given rise two ways to exorcise the negative effects of a declining labour share on growth: exports and debt, which are creating cumulative disequilibria, possibly culminating in bubbles. Sections 3 and 4 analyse the need for bubbles and their impact on demand, in the short and in the long-term. The last section briefly compares the experience of three Eurozone countries – Germany, Italy and Spain – which have followed different patterns of growth.

2. Income distribution, demand and growth 2.1 The dual nature of wages. Demand-led growth theory has a long tradition5. In this approach, the dynamic of demand affects the level of output in the short and in the long run, through its influence on the creation of productive capacity (Vianello, 1985). A lower creation of productive capacity prevents insufficient demand from resulting in a sizeble and persistent under-utilisation of capacity, thus covering up the tracks of the lost production (Garegnani 1992). In Summer’s (partial) rediscovery of this tradition: “Perhaps Say’s dubious law has a more legitimate corollary – “Lack of Demand creates Lack of Supply” (Summers 2014b, p. 37) (figure 1). In the European context of the Stability Pact, by reducing the rate of growth of potential output, insufficient demand can impact on fiscal sustainability, as far as the reduction in potential output reduces the output gap, and hence the structural deficit (Boitani and Landi, 2014).

3 “As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth – not of existing wealth, but of wealth as it is currently produced – to provide men with buying power equal to the amount of goods and services offered by the nation’s economic machinery. Instead of achieving that kind of distribution, a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations. But by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.” (Eccles 1951). 4 M. Phillips, Janet Yellen’s Fed is more revolutionary than Ben Bernanke’s ever was. http://qz.com/247113/janet- yellen-is-a-more-revolutionary-fed-leader-than-bernanke-ever-was/ 5 Keynes (1936) is obviously the leading figure here. 2

Income distribution is regarded as a fundamental determinant of final demand, and, through final demand, of the inducement to invest. Given the Kaleckian assumption that the marginal propensity to save is higher for capital income than for wage income, consumption is expected to increase when the wage share rises6. However, wages have a dual function: they are a cost of production as well as a source of demand. A higher real wage increases consumption but may also reduce investment, in so far as a lower profit share weakens the incentive to invest7. Thus, any exogenous variation in the real wage has contradictory effects on the level of aggregate demand. Bhaduri and Marglin (1990) distinguished between a wage-led demand regime, when an increase in the wage share leads to an increase in aggregate demand in the short run, and a profit led demand regime in the opposite case8. Most empirical studies find that domestic demand regimes tend to be wage-led, i.e. the effect of a pro-capital redistribution of income on demand is negative because consumption is much more sensitive to an increase in the profit share than is investment (Stockhammer 2011). However, in an open economy, external demand can provide a vent for surplus, absorbing the excess savings that would arise when the purchasing power of wages is faltering. Indebtedness can provide yet another support to consumption when the wage share falls.

Figure 1 Actual and potential GDP in the Eurozone.

Source: Summers (2014b).

6 In the models of Kalecki (1971) and Steindl (1952) an increase in the wage share unambiguously leads to an increase in effective demand. 7 By depressing profits, high wages may discourage investment and accumulation, or may force capitalists to rationalize, speed up technological progress and labour saving technologies, in turn affecting the level of employment, wage earners’ bargaining power, and distribution (Barba and Pivetti 2012). However, high wages and labor market institutions may also have positive effects on economic growth if good labor relations improve the propensity of workers to contribute to the production process. Productivity is defined wage-led if an increase in wages encourages productivity enhancing capital investment resulting in an acceleration of the growth of productivity (Lavoie and Stockhammer 2012, p. 15). 8 A wage-led investment regime defines a more long-run concept: it implies that an increase in the wage share will lead in addition to a wage-led demand also an increase in investment expenditures. Over the long run it implies an increase in the rate of accumulation of the capital stock. 3

2.2 Exorcisms Export-led growth. In an open economy, the effect of distribution on demand must take account of net exports. Looking at wages only as cost, and assuming away the possibility of an equilibrium at less than full employment, mainstream models recognize only the positive effects that follow a decrease in wages: the improved competitiveness will increase net exports while the higher profit share will sustain investment. When considering also the role played by wages on consumption, however, the result is no longer obvious. The total effect of a pro-capital redistribution of income depends on the effects on consumption, the sensitivity of investment to profits and the sensitivity of net exports to unit labor costs. If the total effect of the increase in the profit share on aggregate demand is negative, the demand regime is called wage-led. Conversely, if the effect of distribution on net exports is high enough to offset the effects on domestic demand the demand regime is called profit-led. A number of studies have attempted to estimate the effects of a redistribution of income on all three components of private demand. They conclude that, in most of the large economies such as the US, Japan, the Euro area in aggregate as well as individual large European countries - Germany, France, Italy, the effects due to net exports are not large enough to change the nature of the demand regime from wage to profit-led, since foreign trade forms only a small part of aggregate demand (Onaran and Galanis 2012). Different, systemic effects result if all countries follow the same distributional strategy. A simultaneous wage cut is likely to leave all countries with only the negative domestic demand effects, with their combined GDP contracting. While beggar thy neighbor policies cancel out the competitiveness advantages in each country, and are therefore counter-productive9, an across the board increase in money wages, though leaving competitiveness unaffected, can sustain a wage-led growth (provided that firms still feel sufficient competitive pressures to compel them to cut their mark-ups in response to the wage increases). Debt-led growth. Finance and credit can play a double role: they can affect income distribution directly, while neutralizing their effects on demand by granting credit. During the last 3 decades finance staged an astonishing expansion of profits in a rapidly expanding financial services industry, simultaneously supplementing the reduced incomes with debt. Changes in consumers’ access to credit and in consumers’ borrowing behaviour, especially regarding what consumers think is appropriate to borrow, fuelled the type of herd behavior and irrational exuberance that is usually attributed to stock markets. The different impact that the change in distribution exerted on final demand and accumulation in the Anglo-Saxon world compared with most of continental Europe – at least until the inception of the euro – is largely explained by the debt and wealth effects created by the financially-driven high-tech and construction bubbles. According to Barba and Pivetti (2012), “the overall effect on investment of the financial sector enlargement, in size and scope, was negative: it contributed to bring about a change in income distribution unfavourable to the expansion of demand, while providing only a temporary disconnection of demand from the distributive change”. Eurozone: two symbiotic growth models. Stock and property markets bubbles are initiated and sustained by bubbles in the supply of credit, reinforced by the liberalization of capital flows. In debtor countries booming sectors attract capital inflows thereby financing their current account deficits. Export-led countries run current account surpluses and net capital outflows. Thus, international financial deregulation has given rise to two symbiotic growth models: a debt-led growth model (with foreign capital inflows) and an export-led model (with capital outflows) (Lavoie and Stockhammer 2012).

9 Onaran and Galanis (2012) find that a 1% simultaneous decline in the wage share in G20 leads to a decline in the global GDP by 0.36%. 4

Since the adoption of the euro, the member states have followed different growth strategies: most countries in the periphery have adopted a debt-led growth, the core an export-led growth. If the export-led country is characterized by a wage-led demand regime, as it is maintained to be in the case of Germany (Stockhammer et al. 2011), wage moderation requires ever stronger export stimulus to support growth. This entails increasing deficits in those countries which are on a debt- led growth. This precarious “equilibrium” can continue only until the core countries are willing to supply liquidity to the debtor countries. As soon as this fails debtor countries must adjust, since it is unlikely that surplus countries will change their strategy to act as “locomotive”. In the case of Germany, in fact, given wage moderation, domestically-originated growth is limited. Germany acts rather as a transmitter of global trade impulses, from the United States and Asia to Europe. German supply chains are set in motion by demand that predominantly originates outside Europe (Bornhorst and Mody 2012). Simulations of demand-induced GDP reductions triggered by austerity policies in the Eurozone suggest that, with the exception of Germany and Austria, the most important determinant of the fall in income has been the domestic component of final demand. Similarly, Garbellini et al (2014) find that peripheral Eurozone countries have generally been more sensitive to domestic demand reductions, while core-eurozone countries have been more vulnerable to (and inflicting more damage to) their trade partners10. These results help to better assess the “way out” represented by internal devaluation. For those who look at wages only as cost, an internal devaluation can succeed in converting the debt-led growth countries into export-led performers. This, it is argued, requires the implementation of structural reforms, in the labour market (freedom of firing for newly hired employees, downward wage adjustment, lower unemployment duration, weakening of collective bargaining institutions, decentralized bargaining and wage differentiation across workers and sectors) and in the product market in order to speed up the reallocation of resources to more productive sectors. However, the euro area is still a rather closed economy with a high intra-EU trade. Wage moderation in the Euro area as a whole is likely to have only moderate effects on foreign trade but it will have large detrimental effects on domestic demand11. Thus, when all Eurozone countries pursue ‘beggar thy neighbor’ policies, the international competitiveness effects are likely to be only minor, and the negative domestic effects dominate the outcome.

3. Are bubbles essential for growth? “Prior to 2003, the [US] economy was in the throes of the 2001 downturn, and prior to that it was being driven by the internet and stock market bubbles of the late 1990s. So it has been close to 20 years since the American economy grew at a healthy pace supported by sustainable finance.” (Summers 2014b, p.31)12. Since the early 1980s dramatic changes in income distribution have occurred, with a substantial decline in the wage share across the world. Globalization may have contributed to weaken the wage-led demand regimes of the relatively closed economies in the post-war era: imports and exports have grown relative to GDP, imported inputs have increased their share in domestic demand

10 Germany, Austria and Belgium ‘exported’ more than 75% of the drop in domestic final demand while the drop in final demand from PIIGS contributed to around 50% of their own GDP reduction, and was more than offset by the expansion of BRIC countries (Garbellini et al. 2014) . 11 This argument is based on the (wrong) assumption that competition is mostly based on prices and unit costs. Relaxing this assumption (see Simonazzi et al 2013) will only reinforce the argument. 12 The idea that the current system can only grow through bubbles had already been put forward in 2010 by Andrea Ginzburg, in his abstract for a paper, “Bricks & Chips. Real and financial interactions in a global setting”, which has unfortunately never been written. 5 and exports, investment may have become more sensitive to profitability and delocalization and outsourcing, or the threat of it, may have affected employment and wage bargaining13. The concentration of income and wealth at the very top greatly increased the demand for complex financial products, putting pressure on financial institutions to supply profitable securities. The investment banks generated huge fee and commission revenues by obliging. “Neoliberal economic principles allowed the regulators to believe that the surging growth of complex financial instruments must be to the social benefit” (Wade 2010). The combination of pull and push forces has made the financial system prone to generate bubbles, followed by crashes. Given the national and systemic changes in the advanced economies - an increasingly unequal income distribution, the labour-saving and skill-biased features of technical change and globalization, the de-regulation of finance – and the related market approach in economic theory and policy, only two ‘engines’ were left: export-led and debt-led growth. In these conditions, growth can easily degenerate into a bubble. “Boom-bust cycles driven by stock markets, property markets or capital flows have been a key feature of neoliberalism as practiced in the real world, as exemplified by the Latin American crises of the 1980s and of the mid 1990s (the Peso crisis), the EMS (European Monetary System) crisis (1992/93), the South East Asia crisis (1997/98), the dot.com bubble burst 2000/01 and the Great Recession of 2008/09” (Lavoie and Stockhammer 2012, p. 22). Thus, mainstream and post-Keynesian analyses converge. In Summers’ words, “macroeconomic policy as currently structured and operated may have difficulty maintaining a posture of full employment and production at potential … and if these goals are attained there is likely to be a price paid in terms of financial stability.” In short, secular stagnation may force policymakers to choose between sluggish growth and bubbles. Bubbles are an alternative way for society to deal with excess saving when fiscal policy does not take up the challenge. Though eschewing income distribution as the main cause, the effects of different policies on distribution are acknowledged. “Policymakers in an economy with excess saving face a major dilemma. Either they set monetary policy to allow the interest rate to fall until the point at which rational bubbles emerge to absorb the excess saving, or they avoid the interest rate from falling that far by using fiscal policy for the absorption of the saving. There are profound differences in the distributional impacts of the two. Using monetary policy favours the current owners of bubbly assets, predominantly the richer elderly; using fiscal policy allows for a broader spreading of the benefits. But trying to avoid this dilemma by picking neither of the two will lead to a failure of the capital market to clear and hence to a long, dragged-out Keynesian recession, as shown by Japan’s experience since 1990.” (Teulings and Baldwin 2014).

4. Bubbles, busts and growth Bubbles create discontinuities, disproportions, disequilibria; busts inevitably trigger intense processes of restructuring and deleveraging. After the bubble bursts, economy and society are no longer the same. Whether the change involves creative destruction or plain destruction depends on a host of factors, such as the sectors involved, their impact on the rest of the economy and society through multiplier/propagation effects, the policies implemented in the bubble and in its aftermath to overcome the recessionary consequences of de-leveraging (such as measures to reduce the disruptive effects of debt deflation, bankruptcies laws, macroeconomic policies). The effects on the overall economy differ also with domestic and international conditions.

13 According to Stockhammer et al. (2011), globalization has affected how changes in the income distribution influence aggregate demand, but these effects have been and still are rather modest. The changes have not been sufficient to undermine the wage-led demand regime in Germany. 6

There are two main channels through which the bursting of a bubble negatively affects demand and growth: deleveraging and increase in inequality. De-leveraging. “When a debt-financed bubble bursts, asset prices collapse while liabilities remain, leaving millions of private sector balance sheets underwater. In order to regain their financial health and credit ratings, households and businesses are forced to repair their balance sheets by increasing savings or paying down debt. [...] people with negative equity are not interested in increasing borrowing at any interest rate. Nor will there be many willing lenders for those with impaired balance sheets, especially when the lenders themselves have balance sheet problems. [...] This act of deleveraging reduces aggregate demand and throws the economy into a very special type of recession”. This is the balance-sheet recession described by Koo (2011). We are in the world of Fisher, Keynes, Minsky: there is little that monetary policy can do to restart demand, apart from trying hard to avoid that the debt default mechanism spreads to the whole economy by providing liquidity to the segments more under pressure. This calls for fiscal policy to absorb the excess saving after a bubble has burst and the private sector has to deleverage14. Increasing inequality. Bubbles entail rapid accumulation and destruction of wealth. The housing and stock markets give and they also take away, though they give to some and take away from others. In the US, the one-percenters saw their incomes slide 36.3% during the 2007-2009 recession compared with a fall by 11.6% in incomes of the 99-percenters, but as the US emerged from recession, about 95% of the income gains from 2009 to 2012 accrued to the top 1% of American families (Saez 2013). The highest earners were only temporarily set back by the most recent downturn, continuing the trend which had been unfolding for more than 30 years. Conversely, the burst of the construction bubbles in Japan and in Sweden did not lead to comparable increase in inequality (Koo 2011), but the implementation of austerity policies in the euro-zone has transformed the deleveraging first into a balance sheet recession (spreading from the private to the public sector) and then into a tragedy. Finally, in a bubble, speculative investments may end up in projects whose profitability depends on the expectation that their prices would continue to rise. Much of this capital may turn out to be scarcely productive when the bubble bursts – empty buildings, unessential infrastructure and excess capacity in manufacturing – and will take a long time to dispose of. In conclusion, when the bubble bursts, processes of de-leveraging, excessive capacity, and polarization of wealth between winners and losers make the prospect of a rapid recovery less and less likely, and can turn to the worse if monetary and fiscal policies do not take up the challenge. While the literature has focused on the disruptive effects of bubbles, and especially of the possibly devastating effects of debt deflation, the effects of the changes on the economy and society brought about by the frenzy activity in the boom period have been generally overlooked, or condemned as waste. However, the bubble is a time of profound structural transformation, and could represent an opportunity for change and innovation in an otherwise stagnating economy. We may have multiplier and propagation effects deriving from consumption linkages (Hirschman 1977); demand- led growth can activate the supply-side factors of growth, from labour productivity to labour

14 See also Krugman (2014) who argues that temporary fiscal stimulus to support demand while the private sector gets back to spending normally may not be enough “if negative natural rates are persistent” and quotes Koo in contending that governments may have to provide stimulus for years to offset the drag of prolonged private-sector balance-sheet repair: “Any premature withdrawal of fiscal stimulus would unleash the deflationary forces as unborrowed savings are allowed to become a leakage in the economy’s income stream. Indeed, the US in 1937, Japan in 1997 and the UK and Eurozone in 2010 all experienced serious double-dip recessions when their governments pursued fiscal consolidation while their private sectors were still in the process of repairing balance sheets.” (Koo 2014, p. 135). 7 supply; it may foster innovation via dynamic economies of scale and demand-pull innovation15, and through the stimulus transmitted to producers of inputs and capital goods by the interaction between demand and supply; fiscal linkages can sustain investment in social infrastructure; last, but not least, it can favour social innovation and social progress,. Whether the end result on the productive capacity, the economy and society is creative destruction or plain destruction will depend on the policies accompanying the boom and the bust.

5. Three euro-zone patterns: smoulder, fatigue, bubble It has been argued in section 2 that the Eurozone countries have followed two symbiotic models: debt-led and export-led growth. As usual, reality fits uncomfortably in the straitjacket of models. Germany certainly followed an export-led model, but smothered growth through a deeply depressed domestic demand (fig. 2 and 3). Partly dictated by very different macroeconomic conditions, Italy too followed a path of domestic demand restraint, with exports as the only dynamic component. In terms of growth, the German “success model” is not very different from the Italian “decline story”: between 1995 and 2007 Germany’s rate of growth was barely 0.1 percentage points higher than Italy’s, the laggard of the Eurozone (table 1 and fig. 2). On the bubble side, also Spain and Ireland trod different paths, though both ended up in a spectacular construction bubble and a sea of private (turned public) indebtedness. In the following, I will briefly compare the evolution of Germany, Italy and Spain to assess the relative costs of bubbles and stagnation.

Figure 2. Real GDP 1992-2011 (1992=100)16

169

159

149 Germany 139 Greece 129 Spain Italy 119 Portugal 109

Source: Ameco Notes: 2005 prices.

15 The evidence of the derived demand-driven influence regarding the European Union (EU) over the period 1995- 2007 is strong and positive, but varies between three EU innovation systems, EU core, East and South (Antonelli and Gehringer 2013). 16 In 2007 Ireland GDP was 274 (1992 = 100). By comparison, Spain’s GDP at its peak in 2008 was 162.4. 8

Figure 3 Decomposition of GDP growth Panel a: 1998-2007

Panel b: 2007-2012

Source: Employment and social situation in Europe, 2013 Report, 2014, pp. 293, 303

Table 1 Pre-crisis growth in selected OECD countries 1995-2007 (% per year)

Real GDP Employment GDP/worker Eurozone 2.3 1.3 1.0 USA 3.2 1.2 2.0 France 2.2 1.1 1.1 Germany 1.6 0.4 1.2 UK 3.3 1.0 2.3 Greece 3.9 1.3 2.6 Ireland 7.2 4.3 2.9 Italy 1.5 1.2 0.3 Portugal 2.4 1.0 1.4 Spain 3.7 3.6 0.1 Source: The Conference Board Total Economy Database

5.1 Germany: “sick man of Europe” or “imaginary invalid”?

In the 1990s Germany has been hit by two almost simultaneous “shocks”: the opening of the Eastern markets and the creation of the monetary union. By opening new opportunities for the German industry, the “new frontier” affected both the German and the Southern periphery’s options and policies (Soros 2011), besides, of course, the Eastern countries’ ones.

The Eastern Eldorado. The fall of the Berlin Wall in 1989 entailed dramatic costs of reunification and huge opportunities of access to neighboring East European countries. The bubble triggered by reunification was soon smothered by the Bundesbank, but the gigantic industrial policy continued all through the decade: between 1991 and 2003 net transfers totaled about 900b. euros (half of one year GDP). The shift of production to Eastern Europe had started quite early, largely as outward processing trade, and accelerated after the unification, with the increasing commercial integration with the Visegrad countries (Poland, Slovakia, Czech Republic, and Hungary). Between 1995 and 2007 the share of imported inputs in the tradable manufacturing increased by 8 percentage points, with the greatest increase occurring between 1995-2000. Although Germany continued to maintain its traditional exports to Europe, where it was able to fend off competition from Asian sources, its imports of intermediate goods were increasingly tilted towards goods produced by Visegrad countries and China (Figure 4). While German exports stayed largely insulated from Asian and lower-wage European competition due to Germany’s specialization, much of advanced Europe— including the periphery—faced the new reality of global low-wage competition, also when selling to Germany (Bornhorst and Mody 2012, p. 14). In 2011 China became Germany’s second most important import partner after the Netherlands, overtaking France.

Figure 4

Source: Bornhorst and Mody (2012)

In the same decade of the ‘90s flexible working practices developed and spread. In the early to mid- 90s opting out and “opening clauses” (that is deviations from industry-wide standards) “allowed for an unprecedented increase in the decentralization (localization) of the process that sets wages, hours, and other aspects of working conditions, from the industry- and region-wide level to the level of the single firm or even the single worker, which in particular helped to bring down wages at the lower end of the wage distribution” (Dustmann et al 2014, p. 176)17. In addition, East Germany was

17 “Real wages at the 15th percentile fell dramatically from the mid-90s onwards. From the early 2000s onwards, median real wages started to fall, and only wages at the top of the distribution continued to rise” (Dustmann et al 10 able to decouple itself from West German wage-setting mechanisms and unit labour costs declined rapidly in relative terms.

Why was this possible after the mid-90s but not before? The threat to move industry east compelled work councils and unions to make concessions. This intrinsic flexibility became only evident under the difficult economic circumstances and the extreme duress in which Germany found itself in the decade after reunification, because of the macroeconomic policies of the government, obsessed by the cost of reunification. The process following reunification has been seen uniquely as a (transfer) cost, rather than an injection of demand – to be financed by increased taxation on the west (Lehndorff 2014).

When, by the end of the ‘90s, globalization and liberalization raised worries about the survival of the “German model”, and Germany came to be referred as the sick man of Europe (Streek 1997; Sinn 2003), the German industry was well ahead on its new path. The Hartz reforms were implemented starting in 2003, hence nearly a decade after the process of wage decentralization and the improvement in competitiveness had begun in Germany. The scale of the reforms is modest enough that they seem unlikely to have triggered the dramatic increase in competitiveness or the enormous drop in German unemployment, or to have led Germany’s labor market through the deep recession in 2008–2009; nor can they account for the wage restraint witnessed since the mid 1990s. It is restructuring by Germany’s private sector, using traditional German institutions based on employer-worker cooperation, and not government labor market and welfare state reforms that are to be credited for the German quick recovery after the recent crisis (Lehndorff 2014). Work-time accounts provided internal flexibility for core workers, with lesser need to resort to temporary workers. Moreover, in the previous boom firms held back in hiring, piling up time accounts so that in the ensuing downturn they simply let the account deplete, with the help of public subsidies (Bornhorst and Mody 2012, p. 19; Lenhdorff 2014). Indeed, discretionary stimulus is pragmatically used in Germany, even if it is often downplayed in public discourse.

If the Hartz reforms cannot be credited for the remarkable rebound of the German economy in the crisis, they can be blamed for the equally remarkable increase in inequality and in the share of working poors. By relying on exports while suffocating domestic demand – the fixed investment share has been constantly decreasing since unification and, even in the deep of the crisis, it has been smaller than the Italian and French shares – the German economy produced spectacular surpluses, but its model is one of structural under-employment. The virtuous response of working hours to the cycle, ensured by work-time accounts and internal flexibility in manufacturing, should not conceal the structural segmentation of the labour market: in 2013, 26 per cent of total employment and 45.1 per cent of women, worked part-time (often with a mini-job), compared with 21.6 per cent and 36.3 per cent respectively for the Eurozone. While the total number of people in employment has increased, the total number of hours worked has diminished (Weinkopf 2013) (figure 5).

2014, p. 170). The 15th percentile declined dramatically in all disaggregation: non-tradable sector; tradable manufacturing (since 2004); tradable services. 11

Figure 5 Total employment 1992-2014 (200 = 100).

135

125

115 Germany Ireland 105 Greece Spain 95 Italy 85 Portugal

Source: Ameco.

5.2 Italy

Since the second half of the 1990s growth in Italy fell well below the EU average. The currency crisis of September 1992 and the ensuing severe recession marked a watershed between two different economic policy scenarios. With the decision to enter the Economic and Monetary Union (EMU), the European Monetary System (EMS) first and the EMU afterwards provided the legitimacy of an external constraint for unpopular policy measures aimed at coping with structural disequilibria. Major supply-side reforms were implemented in the aftermath of the 1992 crisis in the fields of labour market and industrial relations, privatisation and corporate governance, administrative decentralisation, pensions and social protection. They shared the common principle of letting the market work, but while the pars destruens was fully or partly implemented, the pars construens was constantly delayed, due partly to budget and external constraints.

The extremely low rate of growth had given support to the hypothesis of a long-run economic decline. According to this view, firms’ size and industrial specialisation resulted in a lack of product and process innovation leading, in turn, to a loss of competitiveness, as evidenced – inter alia – by the decline in Italy’s export share. Labour reforms and the deregulation of the labour and product markets were deemed necessary to resume growth.

This interpretation, which enjoyed increasing popularity to become the consensus view, had come up for reconsideration in the very years preceding the crisis. Firm-level evidence from Italian manufacturing confirmed that low-tech businesses, which arguably benefited most from devaluations, had been restructuring more since the adoption of the euro. Restructuring entailed a shift of business focus from production to upstream and downstream activities, such as product design, advertising, marketing and distribution, and a corresponding reduction in the share of blue- collar workers. The process of change had been led by medium-sized firms, firmly rooted in district

12 economies (Coltorti 2007), and had been accompanied by outsourcing (Breda and Cappariello 2010). The new challenges posed by globalisation, the diffusion of information and communication technologies (ICT) and the adoption of the euro were inducing the most dynamic among Italian firms to rethink their organisation and their degree of vertical specialisation. The conclusion was that, since the adoption of the euro, a reallocation of activity had occurred within rather than across sectors, supporting the productivity growth in those sectors that once relied more on competitive devaluations to regain price competitiveness (Bugamelli et al. 2009). While this evidence cut the nexus which had linked the data on ‘frozen specialisation’ with the hypothesis of a lack of innovation and restructuring, it also made evident that the crisis struck Italian medium-sized firms just as they were crossing the ford.

This rejuvenation process had three main weaknesses.

1. Restructuring had not been supported by an adequate expansion of the domestic market. The labour market reforms of the late 1980s and 1990s resulted in an increasing share of precarious, badly paid jobs, and stagnating real wages. Two major consequences followed. On the one hand, the stagnation in consumption accounted for the limited expansion of the productive capacity: innovative firms focussed more on the efficient exploitation of existing capacity than on the expansion of new capacity, making for a productive base too small to absorb the entire labour force at fair wages. On the other hand, the creation of an ample reservoir of cheap labour allowed the survival of marginal firms.

2.Widening of the north-south divide: since the mid-1990s the gap in per capita income started to increase again. In 1992 the Cassa per il Mezzogiorno was dissolved, ending the experience of active policy of industrialisation. However, the Southern industry was too fragile to stand the harsh competition of a monetary union unaided: it is more dependent on domestic demand, while the incompleteness of its value chains makes it dependent on external inputs, so that the leak of imports from the Centre-North weakens the correlation between demand and production18; finally a much higher share of firms in the southern value chains are in a weaker contractual position than their northern counterparts. Since the inception of the common currency the gap between the South and the Centre-north of Italy widened again (and got worse in the crisis).

3. Micro-led restructuring, without a macro framework: the process of restructuring has occurred in a void of national coordination and guidance and the crisis has accelerated the trend, inducing even more fragmentation.

Aggregate demand had no explicative role in the interpretation of the slow growth of the Italian economy: the effects of the macroeconomic policies undertaken in this period on income distribution and domestic demand were simply negated. Thus, the long, painful period of cutbacks that started in the 1990s had no corresponding results in terms of improved public finances. When, in 2007, Spain made il sorpasso of the Italian economy in terms of GDP per capita, an event much

18 Bronzini et al. (2013) have estimated the degree of completeness of the value chains, showing that the linkages (measured in terms of additional workers) activated in the South are seldom greater than half the number observed in the Centre-North. 13 hailed by the Spanish government and mass media19, the Italian economy and society was worn-out by two decades of restructuring fatigue.

5.3 Spain.

Halfway through the past decade, the Spanish economy appeared to be extremely successful in many aspects: it was experiencing a decade of sustained growth in production, output and employment, unemployment was going down, women were entering the labour market. The engine of this growth was construction, mostly the residential sector but also public works. Property development, construction and tourism have represented the focus of growth ever since the Franco era, with the conspicuous absence of manufacturing. According to López and Rodríguez (2011) Spain was integrated into the wider European economy on the basis of partial de-industrialisation and persisting structural weaknesses: labour intensive industries, low productivity increases, and little has changed over time. The phase of spectacular economic growth from 1994 to 2007 masked these problems and, to some extent, aggravated them. While financial inflows and European economic integration initially fostered manufacturing investment, they soon fuelled an unsustainable property boom. Taking loans from abroad to transform them into loans for property developers and individual buyers, the financial sector played a crucial role in the buildup of household indebtedness, growing eventually into a bubble. The explosion of mortgages taken out by households throughout the country has its counterpart in Spain’s mounting external debt (Banyuls and Recio 2014).

The way in which, when the bubble burst, deleverage has been implemented within the Maastricht framework, as well as its consequences on indebtedness, are well known. Less attention has been devoted to the analysis of how the bubble has changed the Spanish economy. The impact of the construction and real estate industry on the overall economic activity is unquestionable: the enormous building activity boosted employment (fig. 5) and tax revenues. Bielsa and Duarte (2011) have estimated the direct and indirect effects on the overall economy: each direct job generated in the construction–real estate block is matched by almost one other job in dependent sectors, underlining the strong dependence of the Spanish economy on the construction and real estate sectors. As the authors point out, this is a lower bound estimate, since they did not account for the income multiplier effects generated throughout the economy by the huge creation of (direct and indirect) employment. Although the direct import content of construction may be assumed to be rather low (it is not considered in Bielsa and Duarte’s analysis), it is not so for the import content of the input-producing industries (including investment goods) and of the consumption and investment goods activated by the higher employment and income: in the boom years Spain recorded increasing current account deficits, financed by huge inflows of short-term capital. The aggregate indicators signaled a persistently low rate of growth of productivity. However, as observed by Haltiwanger (2013, p. 206), “rapid growth in a sector is often accompanied by a wave of entry, and the entrants tend to be extremely dispersed in terms of productivity and growth rates… [so that]for a time one may observe a greater dispersion of productivity among firms and possibly a leftward shift in the size distribution even as the sector grows”. Thus, it is not possible to rule out a process of up- grading and innovation in the construction industry and in those sectors producing inputs and

19 Ana Carbajosa ans Serafí del Arco, “España supera por primera vez a Italia en riqueza por habitante”, El País, December 18, 2007). Quoted in Munoz de Bustillo and Antòn (2014). 14 machinery, if not for the economy at large. Just to give an example, in 2012 Spain became the world leader in the production of ceramic tiles (overtaking Italy) and Spanish producers of machinery for the tiles industry are now competing with Italian (and Portuguese) firms for the control of the markets of the main producers of ceramic tiles: China, Turkey, Mexico, Brazil, besides Spain itself (Vesentini 2014). Last but not least, the long period of sustained growth led to a deep transformation of the Spanish society, marked by the opposition between a neoliberal economic policy orientation20 and a strong demand for social-democratic policies, which led to the expansion of social services. One striking indicator is the enormous increase in female employment: on the eve of the crisis the female employment rate was 55 per cent, up from 40 per cent in 2000 and 30 per cent in 1990. This data compares with 59 per cent in the EU27, and 47 and 49 per cent respectively in Italy and Greece (2008). The balance between a neoliberal economic orientation and progressive social policies was made possible by international financial inflows, that sustained the boom, while hiding the piling up of structural problems. However, their prompt availability also undermined the quest for alternative development patterns. The development model remained focused on construction, mobilised a reserve workforce employed in very precarious conditions, wasted the opportunity provided by buoyant tax revenues to address the structural problems of the Spanish economy, and delayed the need to tackle the chronic current account deficit through policies aimed at favouring import substitution, enlarging and diversifying the productive basis. When the crisis and the fiscal consolidation arrived, unemployment rates soared, and the social rights that had survived the conservative mandate, could no longer be defended. Fiscal austerity and cuts in social services, education, R&D, local development policies, essential to pursue innovation and rejuvenation of industry, doom the same possibility of a new model, reinforcing the old production model based on low wages and precarious employment. Yet - in spite of austerity, deleveraging and balance sheet recession; of the increase in youth and total unemployment and the fall in employment, which in 2014 reverted back to the level recorded in 2002; of the forced cuts in wages; of the huge flow of outmigration, of foreigners and natives alike – in 2014 total employment was still higher than the level recorded at the beginning of the boom, and GDP growth was still higher than the EU15 average (figure 6)21.

20 The Socialist Party, ruling from 1982 to 1986 and from 2004 to 2011, reflected this contradiction from within.. Although the 1986-2004 conservative mandates introduced important regressive elements, they took place in a context that forced part of the acquired social rights to be preserved (Banyuls and Recio 2014). 21 The same is true for Ireland. 15

Figure 6. Real GDP and employment growth in the EU and Spain (1992-2012)

180 EU(15) 158.8 160 Spain 140 134.8 120 117.2

100

Employment in 1992 = 100= 1992in Employment 60

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Source: Munoz de Bustillo and Antòn (2014).

6. Conclusion: vice versus virtue?

Over the last decades, a steeply declining wage share has aggravated the shortage of demand relative to full employment output, and a finance dominated accumulation regime has heightened financial instability. As argued by Summers, in these conditions, it may be impossible for an economy to achieve full employment, satisfactory growth and financial stability simultaneously simply through the operation of conventional monetary policy”. And nonetheless, in the Eurozone fiscal policy has been severely restricted and monetary policy has been insulated from national governments, the exact opposite of what should have been done. Koo (2014) contends that “handling a balance sheet recession requires centralised political power22 … Japan struggled for 20 years to find a workable solution. The fragmented decision-making process in Europe might cause even more difficulty in finding a way out”.

In the euro era, Germany and Germany-inspired rules smothered growth, its own and that of the entire area. Italy trailed behind Germany, encumbered by a huge public debt and its lack of resolve. For the rest of the peripheral countries debt-led growth might have represented a “rational” response to an irrational construction. Waste and ruin have been made worse by bad policy.

22 See also Goodhart (1998) on the metallist interpretation of money (as opposed to the Chartalist view) underlying the OCA approach and the construction of the EMU. 16

This paper did not want to argue that debt-led growth is a good thing. Bubbles can be extremely costly. Fiscal and monetary policy are needed, and must work together, to prevent bubbles when possible, and to assuage the costs of their bursting. Its ambition was a more limited one, that is, to point out that, if vice is no panacea, virtue has not much to be recommended either. We can abhor the “waste” of resources and the destruction of wealth produced by bubbles only if we are willing (or used) to disregard the waste of capacity and resources, human and otherwise, caused by widespread, extended “lapses” from full employment.

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