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How to Get Out of the Economic Rut

The Share Economy: Conquering Stagflation

by Martin L. Weitzman
Harvard University Press, 167 pp., $15.00

The Second Industrial Divide: Possibilities for Prosperity

by Michael J. Piore, by Charles F. Sabel
Basic Books, 355 pp., $21.95

In 1983 and 1984 the United States was in the midst of a cyclical recovery that was being sold to the public as if it were permanent prosperity. While the selling job was successful, the “stable expansion” promised by the administration looks more and more like a mirage. Almost as President Reagan’s election tide rolled in, a tide of the bad economic news rolled out.

Just after the election Budget Director Stockman opened his books and revealed that the budget deficits were going to be much larger than was previously supposed. The Commerce Department revised real economic growth estimates downward to a 1.9 percent rate in the third quarter. If growth were to take place at such a pace through 1985, the budget deficits would be even larger than the new higher deficits being forecast by Mr. Stockman. With such a growth rate little further decline in unemployment could be expected. While 7 to 7.5 percent unemployment is better than the almost 11 percent of 1982, it is a dismal rate if one remembers that such rates were seen only in the depths of a recession. What used to be our worst unemployment rates are now our best unemployment rates.

Growth slowed in the third quarter of 1984 because American firms were not competitive on world markets. Two thirds of what Americans bought was produced abroad. Foreign sales to the US actually rose at a 5.7 percent rate. If America had been running a balance in its balance of trade, instead of a $130 billion deficit, three million Americans would be working who are not working in 1984. Those three million extra jobs would have brought the US a long way back toward a more reasonable level of unemployment.

While an inflation rate that seems to have stabilized around 4 percent looks good in relation to the recent past, it is also dismal viewed from a somewhat longer perspective. Such rates in the late 1960s produced demands for wage and price controls to end what was then viewed as an intolerable rate of inflation. Such rates are now the best that the economy can achieve right after it has been put through the wringer of almost 11 percent unemployment and four years of no growth from the first of 1979 through the fourth quarter of 1982. Historically, 4 percent is a very high jumping-off point from which to commence the next round of inflation.

Moreover the clouds of just such an inflationary shock are piling up. Funds must be borrowed from abroad to finance America’s trade deficit. At some point the lending stops. No country can forever borrow to finance a deficit in its balance of payments. No one knows when the end will come, but it will come. And when the lending stops, the dollar falls.

Econometricians estimate that the dollar would need to fall about 30 percent to restore balance to America’s balance of trade. But such a fall means that the price of imports measured in dollars would rise approximately 30 percent. Since America imports 12 percent of GNP, simple multiplication reveals that if 12 percent of GNP becomes 30 percent more expensive, then the inflation rate would rise by 3.6 percentage points.

In addition there would be an indirect inflationary effect. Part of today’s relatively low inflation is produced by competitive pressures from abroad. American firms cannot raise prices without losing a share of the market. If imports were to go up in price because of a falling dollar, however, American-made goods competing with imports would also likely go up in price. This indirect inflationary effect of a falling dollar could easily be as large as the direct effect.

In view of the intrinsic instability created by the trade deficit, a rapidly falling dollar could act like the lightning that precedes a thunderstorm; inflation could well return to double-digit rates. What would happen then? The Federal Reserve, we may expect, will return to its habit of fighting inflation by deliberately creating recessions—a recovery in that case becomes a “contraction.”

The lack of competitiveness in international markets produces unemployment and the prospect of an inflationary shock, but it is a symptom of a much more fundamental disease—a very anemic rate of growth in US productivity. This general failure of American industry to increase per capita output has been strangely neglected in recent public discussion. Prominent politicians do not say, and do not seem to know, that during the six years from 1977 through 1983, productivity in American manufacturing grew one-half as fast as that in Germany, one-third as fast as that in France, and less than one-third as fast as that in Japan. Outside of manufacturing, the American performance was even worse.

During the 1984 election the Reagan administration pointed to the rebound of productivity in 1983 as evidence of a new long-term trend. In fact the 1983 results were nothing but the standard cyclical swing: during a recovery, labor costs are spread across more units of output and productivity temporarily grows. Right after the election the Labor Department announced that American productivity was again falling. At the end of the third quarter of 1984 the average American firm was a little less efficient than it had been at the beginning of the quarter. What had been anemic growth was now actual decline.

Nothing is more important than restoring growth in American productivity, yet nothing is being done to do so. Nothing could help more to restore productivity growth than the elimination of frequent and persistent recessions; but nothing is being done to change the structural characteristics of the economy so as to get America off its up-and-down roller coaster. Why?

Some answers are to be found in Martin Weitzman’s The Share Economy and Piore and Sabel’s The Second Industrial Divide. The Reagan administration and most of the economics profession believe that social institutions and structural arrangements for productive work either don’t matter much or take care of themselves. “Get the government out of the economy and off the backs of the people.” Underlying this political slogan is the belief that competition forces the best possible institutional arrangements to the fore. “If it wasn’t efficient it wouldn’t exist.” “If it does exist, it must be efficient.” “If there was a better way to do it, that better way would automatically drive the inferior way now in use out of existence.” Therefore, societies don’t have to make deliberate social changes in the ways in which they organize themselves. Instead of trying to improve the ways that society is organized so that it works better, as President Roosevelt did during the Great Depression. Americans have merely to stand aside and “let free enterprise do its thing.”

The public will reject this argument when they see that it isn’t working. What has to be seen to be believed will, I think, soon be visible, however painfully. When recovery turns to recession, we may expect that people will want to know why a system that is supposed to work according to automatic assumptions is not working, and how that system might be changed. Then the views of Weitzman and of Piore and Sabel may get serious attention.

They all share some unfashionable premises that can be stated bluntly. Social organization matters. The most efficient forms of social organization do not automatically come forward. Societies can consciously organize themselves efficiently or inefficiently. The societies that win economically are the ones that pay attention to improving their social organization. Efficient social organization will usually beat inefficient social organization; efficent organization may often be found in Japan while inefficient organization prevails in the United States.

Weitzman examines the structural changes in social organization that he believes would be necessary to run the American economy at continuing full employment without inflation. Piore and Sabel examine shifts in modes of social organization that would be necessary to run firms more efficiently. Weitzman’s thesis should logically come first. He starts with a simple sociological observation that derives from an underlying economic reality. In capitalistic economies, corporations that sell goods or services often send presents to their customers at Christmas time; in socialist economies the customers give presents to sellers. Why? In socialist economies the problem is production. There is a scarcity of goods at current prices and buyers need to ingratiate themselves with (one might say “bribe”) sellers. In capitalistic economies the problem is sales. Since there is a surplus of goods at current prices, sellers need to ingratiate themselves with (bribe?) buyers.

The reasons for this can be stated simply. Modern advanced capitalism is marked by imperfectly competitive firms. Most firms are sufficiently large that they cannot sell all that they can produce at current prices; they must lower prices (or spend more on selling) if they are to sell more of what they produce. This means that the extra revenue (what economists call marginal revenue) from an additional unit of sales is less than the price previously received (what economists call average revenue). But if society wants firms to expand their production to full employment levels, then production costs must also fall as sales expand. If production costs do not fall as output expands, firms will not expand production since to do so would be to lose money. The falling revenue per unit of extra sales does not cover the cost incurred in producing more output.

Since labor costs typically account for 70 percent of total production costs, labor costs must fall if total production costs are to fall. In the textbook world of classical supply and demand they do so. Full employment is guaranteed by falling wages. If unemployment breaks out, unemployed workers will bid for current jobs by offering to work for less than those employed and so they drive wage rates down for those employed. With lower wage costs employers will expand production. With production expanding unemployed workers will be reabsorbed into employment. In a perfectly competitive economy in which every market worked as it is supposed to, unemployment would not exist and if it were to occur for some unknown reason it would be quickly absorbed by the expanding demand flowing from falling wages and lower production costs.

The unfortunate reality is that unemployment does exist and wages do not fall so as to reduce production costs. Despite unemployment rates ranging from 25 percent in 1933 to 17 percent in 1939 real wages rose during the Great Depression for the lucky ones who remained employed. Between 1979 and 1982 average labor compensation rose 30 percent despite an unemployment rate that almost reached 11 percent. Wages should have been falling to reduce unemployment, but they weren’t. Perhaps if the US had been willing to let the Great Depression run for more than ten years and were willing to let the recent recession run for more than four years, wage rates might have started to fall—but that remains in question. In neither case were there any signs that the wage structure was about to crack. Within any reasonable period of time, wages do not fall to the level required to produce full employment.

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