Crisis and Inequality. Mattias Vermeiren

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Box 1.3 Supply-side versus demand-side macroeconomics

      What are the main sources of economic growth and economic crisis? This question determines the ultimate dividing line between different schools of (political) economic thought. Classical and neoclassical economists emphasize the role of the supply side of the economy, which refers to those factors that underpin the efficiency of the production process of firms – for example, taxation, product and labour market regulation, and the availability of (human) capital. A key assumption of supply-side economics is that entrepreneurship in the private business sector is the ultimate driver of economic growth and capital accumulation: only when private firms and individuals are willing to take risks and invest capital are jobs created and income (profits and wages) generated. From a supply-side perspective, the key to economic growth is profitability: firms will only invest in new factories, machines and production facilities when it is profitable to do so.

      Demand-side economists, on the other hand, emphasize the importance of sufficient aggregate demand in the economy: firms will only invest and produce goods and services when they believe their goods and services will effectively be sold. These economists also recognize the importance of private investment spending, but they add that firms will only undertake new investments and raise output if there is adequate demand. In macroeconomics, the following sources of aggregate demand (and therefore economic growth) are identified:

      Y (GDP) = C + I + (G – T) + (X – M),

      where C refers to household consumption (i.e. purchases of consumer goods and services), I to private investment (i.e. purchases of capital goods), (G – T) to the government balance (i.e. government spending minus tax revenues) and (X – M) to the trade balance (i.e. exports minus imports).

A key reason for continuing disagreement between supply-side and demand-side economists is the contradictory role of wages as an important – if not the most important – source of both aggregate household consumption and firms’ production costs. From a supply-side perspective, governments should get rid of ‘distortionary’ regulations of the labour market, like minimum wage laws, that lead to excessive labour costs for firms and diminish their incentives to invest and employ people by hurting their profits. From a demand-side perspective, these labour market regulations are needed to empower workers and boost their wages, which is necessary to support aggregate consumption in the economy. A similar argument exists with regard to taxation: while supply-side economists tend to be in favour of cutting taxes on firms to make investment more profitable, demand-side economists point to the redistributional role of tax revenues and the fact that they enable transfers to poor households with a high MPC.

      Any capitalist economy faces a potential contradiction between the need for firms to contain production costs and make profits and the need to support the consumption capacity of lower- and middle-income households. This contradiction lies at the heart of Marxist theory that capitalism is inherently prone to economic crisis and instability due to the recurring problem of ‘underconsumption’ and ‘overproduction’.²⁹ As Marx wrote, ‘the ultimate reason for all real crises always remains the poverty and restricted consumption of the masses as opposed to the drive of capitalist production to develop the productive forces’.³⁰ Marx noted that there is a fundamental contradiction in the capitalist system between the competitive need for capital owners to extract as much surplus value as possible from the working classes and the need to find enough buyers for their goods. Modern ‘underconsumption’ theory is closely associated with John Maynard Keynes, who believed that any deficiency in aggregate demand can be resolved by the intervention of the state: the government can always support aggregate demand during falls in household consumption (C) and corporate investment (I) by engaging in ‘deficit spending’ (G > T).

      During the post-war ‘Keynesian era’ of egalitarian capitalism, aggregate demand was supported not only by governments’ macroeconomic policies geared towards ‘full employment’, but also by relatively strong labour unions and collective bargaining institutions that ensured wages grew in line with average labour productivity – a complex of institutions that reflected a historical compromise between the industrial fractions of capital and the working classes (see chapters 2 and 3). Marxist scholars are sceptical about the political and economic sustainability of these equality-promoting institutions in a capitalist system that continues to be driven by profit maximization.

While these two interpretations are complementary, a demand-side interpretation is better able to explain the connection between rising inequality and the global financial crisis. The central claim that will be developed throughout this book is that governments in the advanced capitalist economies had to find new sources of aggregate demand in the wake of the stagflation crisis of the 1970s, which was widely interpreted as a crisis of the wage-led growth model of the post-war Keynesian era (chapters 2, 3 and 4).³¹ Growth in the Anglo-Saxon countries and several Southern European countries became increasingly reliant on household consumption. But rather than relying on rising wages or income transfers provided by the welfare state, poor and middle-income households became increasingly dependent on credit to finance their consumption.³² The expansion of household debt was only possible after the extensive liberalization and deregulation of the financial sector in the 1980s and 1990s, which boosted the supply of credit to households (as well to firms and governments) by nourishing competition between banks and encouraging them to take more risk. The unsustainable increase in household debt was a proximate cause of the global financial crisis of 2008. Economic growth in the Northern European countries, on the other hand, increasingly came to rely on external demand via increased exports: a combination of wage restraint and selective labour market flexibilization depressed household consumption, but it also strengthened the competitiveness of the export-oriented manufacturing firms by decreasing their labour costs.

In sum, two distinctive growth models emerged in the advanced capitalist world in the wake of the stagflation crisis of the 1970s. Most Anglo-Saxon and Southern European countries adopted debt-led growth models based on a credit-financed expansion of household consumption, whereas Northern European countries adopted export-led growth models, if we look at the contribution of these two sources of aggregate demand to GDP growth. Figure 1.10 illustrates the distinction between these two growth models by showing the average annual contribution of household consumption and net exports (i.e. exports minus imports) to GDP growth between 1985 and 2007. The average annual contribution of net exports was negative for debt-led economies, implying that their trade balance – that is, the difference between their exports and imports – was negative throughout this period: they imported more than they exported. A negative trade balance is a typical consequence of debt-led growth, as the expansion of household consumption ‘leaks out’ to the rest of the world in the form of increased imports: after all, households buy goods and services that are produced by domestic as well as foreign firms. Northern European countries were export-led in the sense that their trade surplus supported aggregate demand, whereas private consumption played a less important role in fostering economic growth during this period. Only a couple of countries like France and Italy were neither debt-led nor export-led, as depressed private consumption and a slightly negative trade balance contributed to relatively low overall growth between 1985 and 2007.

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