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Neoliberal regime has failed, need to change course

Geneva, Jan 2001 — The promised benefits of Neoliberalism have failed to materialize at least for the majority of the world’s people, and if the world continues down the present path, economic prospects for the majority of people, in both developed and developing countries are dismal - with more of the same disappointing performance of recent decades or quite possibly serious political and economic instability around the world as occurred in the 1930s, the last ‘market dominated era’..

A central lesson drawn from the experience of the decades between the World Wars was that the economic and political fate of the world could not safely be entrusted to unregulated, free market national and global economic systems....(as) this was a path to economic instability, global depression and political chaos. In the aftermath of World War II, national economies, even those in which markets played a very powerful role, were placed under the ultimate control of governments, while international economic relations would be consciously managed by the International Monetary Fund (IMF) and World Bank. Trade was expected to rise in importance, but it was thought at the time that the degree of global financial integration would remain modest, with cross-border money flows under tight government control. The global prosperity that characterized the quarter century following the war— the “Golden Age” of modern capitalism—reinforced belief in the wisdom of social regulation of economic affairs.

The economic instability that erupted in the 1970s as the structures of the Golden Age unravelled has led the world back to the future. The troubles of that decade created a powerful movement, led by business and, especially, financial interests, to roll back the economic regulatory power of the state, replacing conscious societal control with the “invisible hand” of unregulated markets—just as in the period preceding the Great Depression. Though governments still play a large role in most economies, they have ceded an enormous proportion of their economic power to global markets and private interests.

Enthusiasts of Neo-liberalism, promised that this new laissez-faire era would dramatically improve economic performance in both developed and developing countries. Unfortunately, these promises have not been kept.  Two decades after the neo-liberal revolution, the promised benefits have yet to materialize, at least for the majority of the world’s people. Global income growth has slowed, as has the rate of capital accumulation; productivity growth has deteriorated, real wage growth has declined, inequality has risen in most countries, real interest rates are higher, financial crises erupt with increasing regularity, less developed nations outside East Asia have fallen even further behind the advanced and average unemployment has risen.

Two distinct, and logically incompatible, theoretical perspectives are used by Neoliberals in defence of their call for maximum deregulation, liberalization, privatization and global economic integration.  Neoclassical general equilibrium theory is by far the most influential and widely used theoretical underpinning for the Neoliberal position, and the only fully specified and widely sanctioned theoretical paradigm offered by economists to justify their support for Neoliberalism. The IMF and World Bank rely on Neoclassical general equilibrium models to support Neoliberal policies, and such models are the stock in trade of the international trade and labour economists who tout globalization’s benefits.

There is also a second set of arguments, based partly on Schumpeterian ideas about innovation, economies of scale, the positive effects of monopoly power, and the inefficiency of marginal cost pricing, that have been used to defend Neoliberalism.

In the standard Neoliberal view, absent government interference, both national economies and the integrated global economy are believed to operate efficiently, more or less like the models of a perfectly competitive market system found in neoclassical micro economic textbooks. In an unregulated economy with maximum competitive intensity, relative price and profit signals create micro economic efficiency: resources flow to their most productive possible uses.  Competitive pressures also keep factor markets at or near market clearing; in equilibrium, there is full employment and optimal capacity utilization. Since interest rates, set in efficient financial markets, assure that investment will equal saving at full capacity output, given Say’s Law (French classical economist Jean Baptiste Say’s Law of Markets that supply creates its own matching demand), full employment is assured, and inflation control becomes the only legitimate macro policy objective. To contain inflation, Neoliberals support reliance on monetary rather than fiscal policy, and the independence of Central Banks from democratically elected officials.

In this view, when fully liberalized, global financial markets will allocate world savings efficiently. As Neoliberalism progresses, real interest rates should decline (once inflation is defeated), investment should rise, and the flow of funds from the capital rich North to the resource rich South should increase. The most productive investment projects will be funded, no matter where in the world they are located.  And, since markets allocate resources efficiently, developing country governments are urged to end their reliance on industrial policy.  Replacing state economic guidance with liberalized markets will thus improve output and productivity growth rates in the less developed world.

In sum, defenders of global Neoliberalism argued that it would raise real GDP, productivity, and investment growth rates well above their values in the troubled 1970s, equalling or perhaps exceeding Golden Age performance, while eventually lowering unemployment, inflation and real interest rates. Financial markets would become more stable. Economic performance in developing countries would improve as capital and technology flows their way, creating eventual convergence between North and South.

Critics contended that Say’s law has no legitimate defence, not even as a crude approximation to empirical reality. The state must hence use macro policy in pursuit of rapid growth or full employment or these objectives will not be consistently achieved. Financial markets are inherently unstable. And every development success in the post World War II period, from the high growth Latin American countries in the Golden Age through the economic ‘miracles’ of East Asia, relied on anti-liberal, state guided growth. But IMF, World Bank and WTO pressures plus widespread financial liberalization are making it impossible to maintain state guided growth, and therefore impossible to achieve economic development.

A brief look at the data, shows that the evidence supports Neoliberalism’s critics.

The promised benefits of Neoliberalism have yet to materialize, at least for the majority of the world’s people. Global income growth has slowed, as has the rate of growth of capital accumulation, productivity growth has deteriorated, real wage growth has declined, inequality has risen in most countries, real interest rates are higher, financial crises erupt with increasing regularity, the less developed nations outside East Asia have fallen even further behind the advanced, and average unemployment has risen....

Liberalization has proceeded at an impressive pace in the past two decades. For example, financial capital has become extraordinarily mobile. In 1977, in the midst of petrodollar recycling, about $18 billion of currency trades took place daily; rising to $590 billion in 1989 and $1.5 trillion by 1998. Foreign direct investment flows, which averaged $50 billion a year in 1981-85, rose to $160 billion annually in 1986-91, and were $331 billion in 1995.

But, such hyperactive capital flows have been accompanied by increased volatility of exchange rates, and frequent bouts of domestic and international financial instability..... (and) near continuous outbreak of financial crises. Freedom of capital flows has not brought lower real interest rates as promised. For the G7 nations, for e.g., real long term interest rates averaged about 2.6% from 1959-70, and 0.4% from 1971-82, but jumped to 5.6% in the 1982-89 period, and averaged 4% from 1990-97. High interest rates are one reason why inequality has risen in recent decades; ever larger shares of national income are being transferred from workers and other income claimants to owners of financial assets, who are the richest group in society.

Most studies report a slowdown in capital investment. According to World Bank data, the annual rate of growth of world real gross domestic investment was 7.0% from 1966 to 1973 at the end of the Golden Age. It then fell to 2.2% from 1974 to 1979, rose modestly to 2.8% from 1980 to 1989, then fell slightly to 2.7% from 1990 through 1996, the last year for which data is available. Investment growth was especially sluggish in the developed world. OECD countries had an average annual growth of real gross capital formation of 6.3% in 1960-73, 1.5% in 1973-79, 2.4% in 1979-89, and 1.5% in 1989-95.

Other crucial performance indicators display the same pattern. For example, the unemployment rate in OECD countries was 3.2% in 1960-73, 5% in 1973-79, 7.2% in 1979- 89, and 7.1% in 1989-95. The growth of labour productivity, a crucial economic indicator, also deteriorated in the Neoliberal era. In the OECD area, it was 4.6% in 1960-73, 1.8% in 1973- 79, and 1.6% in 1979-97.

Most important, world economic growth has slowed significantly.  According to data compiled by Angus Maddison for the OECD, while annual real GDP growth in the world economy averaged 4.9% in the Golden Age years from 1950 to 1973, it slowed to 3.0% in 1973-92. Western European growth rates fell from 4.7% in the early period to 2.2% in the latter one. Latin America’s growth averaged 5.3% from 1950-73, but only 2.8% from 1973-92. Africa grew at a 4.4% pace in the first period, but at a 2.8% rate in the second one. Asia, the last bastion of state led development, was also the only major area not to experience a significant post Golden Age slowdown, maintaining growth between 5% and 6% for the entire era.

And in the decade of the 1990s. World GDP growth averaged but 2.5% from 1991-98, after the Neoliberal regime had been firmly established—by far the slowest growth rate of the post-war era.

The growth rate of world real per capital GDP growth was just as disappointing, averaging only 1.0% per year in the 1990s, less than one third its Golden Age pace. Most of this growth was in Asia. Developed nations had an average GDP growth rate of only 2% from 1990 through 1998. Latin America growth averaged 3.4% from 1990-98, better than in the “lost decade” of the 1980s, but much lower than in the Golden Age.  Desperate Africa showed GDP growth of only 2.2% a year from 1990-98. By way of contrast, the state-led economies of East Asia grew by 6.7% from 1990-97, prior to the outbreak of financial crisis in that region.

Ironically, only the outstanding performance of the state-guided, anti-Neoliberal East Asian economies that kept developing country growth, inequality, and poverty rates from being even more disappointing. For example, the proportion of the population living on less than $2 a day in Asia fell by 39% from 1987 to 1998, but no progress in poverty reduction took place in Latin America and sub-Saharan Africa in the same period.

Economic performance has deteriorated—on average and for majorities -- virtually everywhere but in pre-crisis Asia. And even the majority of people in those East Asian countries most affected by the recent crisis have lived through a significant deterioration in their economic environment.

A critical failure of neo-classical theory as applied to global liberalization, and one that is rarely discussed in the globalization literature is the question whether maximum competition really leads to maximum efficiency. Many of the most important global markets, in goods and services, are significantly mis-characterized by the basic assumptions of neoclassical micro theory. For this reason alone, without regard to the problems of aggregate demand growth and financial instability, the thesis that maximum liberalization in these markets will lead to the best possible outcomes is severely flawed.

Global trade and investment are dominated by key or core industries such as autos, electronics, semiconductors, aircraft, consumer durables, shipbuilding, steel, petrochemicals, and banking. They are characterized by large economies of scale, both in the production process (at the plant level), and with respect to the firm as a whole, in advertising and distribution efforts that build and maintain brand loyalty, in supplier networks, in access to finance, in research and development, and in the organization of the firm itself. The capital investment required to enter these industries with best practice or minimum cost capability is very large. The production process is not subject to the ‘law’ of diminishing returns: short-run factor substitutability is in fact quite limited. The assets of the firm, both physical and organizational, are significantly immobile, irreversible, or specific. Once in place, they lose substantial value if re-allocated to a different industry or sold on a second hand market.

The neoclassical assumption that firms are relatively free to enter and exit all industries, the sine qua non of the neoclassical thesis that maximum global liberalization will create static allocative efficiency in the global economy, does not exist. Exit is not free, but entails a major capital loss for the firm. A firm that moves from an industry with below average profits to an industry with above average profits will have less capital in the new industry than it had in the old. Even if the new industry has a significantly higher profit rate, it may well be more profitable for the firm to stay put. But if there is little freedom of exit, it follows logically that there cannot be substantial freedom of entry, even for newly produced capital. When capital is irreversible, and economies of scale prevail, entrance entails substantial risk of major loss.

Entry into core industries is thus unlikely unless demand growth has been quite rapid and industry profit rates high for an extended period, the entrant has some revolutionary innovation, or incumbents have misused their market power and become extraordinarily inefficient. In normal times, therefore, core industry firms can sustain above average, oligopoly profits. Since this argument about exit barriers applies both to existing and new capital, asset specificity drastically undermines the claim that unregulated markets have either static or dynamic allocative efficiency.

Asset irreversibility undermines freedom of entry through a second, independent channel. A profit maximizing outside firm will only enter an industry if its post entry revenues are expected to cover the full cost of the capital and organizational assets needed to survive in the industry; expected price must cover total cost per unit. But a firm already in the industry knows that if it were to exit, it would lose a substantial part of the value of its physical and organizational assets.

If incumbent firms want to deter entry in order to continue to achieve above average oligopoly profits, they can threaten potential entrants with a vicious price war upon entry. The fact that incumbents can survive for years even if price drops so low that revenues cover little more than variable cost, whereas a rational outsider would never enter unless price was expected to cover average total cost, makes their price-war threat credible.

Therefore, if, in a core industry, competition were to keep price equal to marginal cost, as would be the case with maximum or perfect competition, firms could never earn enough money to recoup their investment in fixed capital. In equilibrium, the average firm would be losing money: under perfect competition, neither the firm nor the industry could reproduce itself over time.

This logic brings us to a conclusion that is central to the globalization debate. Core industries cannot possibly be organized for long periods of time through perfect competition. Yet the assumption of perfect competition must be adopted by supporters of global Neoliberalism who wish to enlist the prestige of neoclassical economic theory - such as it is - on their side of the debate.

In the case of core industries then, the maximum competitive intensity sought by Neoliberal reforms may lead not to efficient resource allocation, but to the dynamic inefficiency associated with long term excess capacity, low profits or losses, and excessive indebtedness....  To make things worse, there is no guarantee that the most efficient producers will be the winners. Those most likely to exit are firms that go bankrupt because they relied heavily on debt to finance asset acquisition... Inefficient, conservative firms may have the least debt, while the most efficient firms may be most indebted because they invested aggressively in debt financed new technologies. Victory may well go to those with the deepest pockets, not to the most efficient producers..

Two important conclusions follow: First, core industries characterized by large scale economies and limited short run factor substitutability cannot, for long, be organized through the intense competition sought by Neoliberals. They are “natural oligopolies”: their firms must cooperate sufficiently to maintain industry price far enough above marginal cost to cover total cost per unit for the average firm inter-firm relations that are both competitive and cooperative or as Joseph Schumpeter called them “co-respective competition.”

Second, since core industries include many of the largest and most important industries in national economies and in world trade and investment, and serious ‘natural’ barriers to entry and exit are inherent in their basic structure, the central Neoliberal thesis that maximum liberalization, creating maximum competitive intensity, will lead to stable and efficient economic outcomes is fundamentally mistaken. These barriers could not be eliminated by the termination of every form of government interference with free market competition. For this reason, there is no legitimate foundation for the presumption that liberalization will lead, through increased competitive intensity, to the efficient allocation of new or existing resources around the globe.  On the contrary, maximum liberalization in core industries is likely to trigger a long period of destructive struggle leading to the kinds of inferior outcomes seen in the past two decades.

Indeed, globalization has already initiated what is likely to be a long period of restructuring through mergers, alliances and bankruptcies, that could eventually culminate in re-oligopolization across national lines, where no political jurisdiction either capable of, or willing to, regulate the new oligopolists in the public interest currently exists.

In a recent talk on the ‘new economy’, US Treasury Secretary Lawrence Summers represented this Neo-liberal Schumpeterian position, and argued that the world was moving inexorably toward an “information-based” world in which the most important industries would “involve large fixed costs and much smaller marginal costs,” and that this “new economy is Schumpeterian” because: “the only incentive to produce anything is the possession of temporary monopoly power; so the constant pursuit of monopoly power becomes the driving force of the new economy. In this view, Summers said, the “crucial implication for those of us in government is that policies that help to expand the size of markets in any way become that much more important.” Support for maximum deregulation and global integration follow: deregulation “ensures that government is not preventing or distorting the development of fast growing markets,” and “support for international trade becomes much more important because it enables us to take better advantage of the new economies of scale”.

There is an astonishing lack of any empirical evidence presented by Summers in support of these policy conclusions. If economies of scale are “huge” and rising rapidly, then it is not at all obvious that mere “temporary” monopoly power would provide an incentive strong enough to induce the investments needed to maintain dynamic efficiency. It would seem logical to assume that market power over an extended time period would be necessary to assure that “the high initial costs [can] be recouped.” If this is so, “would not a world of monopolistic giants require a powerful new domestic and\or international government agency to regulate them in the public interest?”

Replacing the deeply flawed neoclassical general equilibrium theory, with a few ‘stories’ about Schumpeter’s “gale of creative destruction” as the only line of defence for Neoliberal globalization seems a very risky ideological gambit.. There is no widely accepted formal—or, indeed, informal model of an integrated Schumpeterian market system, no analogue to the Walrasian general equilibrium system taught in every economics department. There is no well specified model that carefully investigates the systemic effects of a rolling sequence of massive, largely debt financed, immobile investments in one industry or technology after another, each of which is quickly devalued by the continuous gale of destruction Summers envisions? Arguments like those presented by Summers are either derived from formal models of a single isolated market, or are merely hunches or guesses about how things might possibly work in a simplistic Schumpeterian system. They have little if any professional standing, or claim to the pseudo- scientific status neoclassical economics aspires to. They thus provide a totally inadequate foundation on which to build support for a radical new global economic system such as Neoliberalism.

“The world is being asked to put its economic future at great risk based on nothing more than the guesses and intuitions of a small group of free market devotees.

[* James Crotty is Professor of Economics at the University of Massachusetts, Amherst. The above, in two parts, is based on and excerpted, with his permission, from the paper, “Structural Contradictions of Current Capitalism”, presented by him at the Conference on ‘Globalization, Structural Change and Income Distribution’, held at Chennai (Madras) in December 2000. A second part on globalization, the natural oligopolies and need to change course for development will be in the next issue of SUNS]

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