What kind of growth do we want after the crisis?

By Mark Dominik

Around the world, we are beginning to emerge from the deepest economic downturn since World War Two. Growth has resumed in all of the G7 economies, although it remains fragile – Italy, for example, saw its economy shrink in the fourth quarter of 2009 after growing in the third – and is supported by massive government stimulus programmes.

Over the coming quarters, governments around the world will need to gradually and carefully exit from fiscal stimulus programmes as economic growth becomes more self-sustaining. This is particularly true in the UK, where the deficit is high and must be reduced over time both to reassure markets and for reasons of inter-generational equity.

But economic recovery and deficit reduction alone will neither reassure markets nor promote inter-generational equity. Alongside economic recovery and deficit reduction, we must also ensure that our future economic growth differs from the growth we have experienced over the past three decades, both in quality and in composition. Achieving this will require three major changes: first, we need to shift from our narrow focus on GDP, unemployment, and inflation to a broader set of indicators of economic well-being; second, we need a more activist government that promotes sustainable growth and economic diversification; and third, we need corporations to maximise long-term stakeholder value rather than short-term shareholder value.

Historically, we have relied too much on blunt metrics like GDP as indicators of economic progress. Coupled with the short time horizons of many investors and politicians, our over-emphasis of these metrics led us to neglect a series of interlinked indicators that both provide a more accurate view of economic well-being and could have provided us with an early warning of the impending crisis.

This broader basket of indicators includes: the population’s level of education and change in educational attainment; capital stock and its growth rate; the rate of technological innovation; the level of productivity and its growth rate; living standards; the distribution of wealth; the level of debt (aggregate, government, household, financial, and corporate); the structure of the economy; the balance of trade; and the level of environmental degradation.

The 22-member Commission on the Measurement of Economic Performance and Social Progress, which was established by French President Nicolas Sarkozy and chaired by Nobel Prize-winning economist Joseph Stiglitz, has underscored the need to broaden the set of indicators we use. Had we made better use of a broader set of indicators, we might have understood that the kind of growth we experienced over the past three decades was unsustainable – and that the UK was particularly vulnerable to a downturn.

Indeed, there were many warning signs. In terms of productivity, for example, the UK lags far behind its peers. It is 11% less productive per hour worked than Germany, 16% less productive than France, and 19% less productive than the US, as I’ve written on LabourList previously. This is in large part due to a chronic underinvestment in infrastructure and equipment, and a less skilled workforce.

The UK doesn’t do much better in terms of living standards and the distribution of wealth. When Margaret Thatcher came to power in 1979, the Gini Coefficient – which is a measure of income equality where 0 would indicate perfect equality of income and 1 would indicate perfect inequality where one person within the population has all the income – was 0.25. More recently, it has varied between 0.34 and 0.37 – in the neighbourhood of Egypt, rather than that of our European peers. This rising inequality is accompanied by severe deprivation around the country; as just one example, life expectancy is more than 10 years shorter for inhabitants of Blackpool than it is for those of Kensington and Chelsea.

A number of macroeconomic indicators would have warned us that our recent growth paradigm was unsustainable. “Debt and Deleveraging“, a recent study by the management consultancy McKinsey, notes that household debt as a percentage of disposable income increased 52% between 2000 and 2008. Largely driven by increases in house prices, this increase in indebtedness has been accompanied by a massive transfer of wealth from those least able to afford it – the young and the poor, who struggle to get onto the housing ladder – to the already well-off. This mountain of household debt led, in turn, to an unsustainable wave of consumption; as we consumed more than we produced, the trade deficit rose to nearly £45 billion in 2007. And along the way, while we were consuming and accumulating more and more household debt, the economy became increasingly concentrated in financial services, creating an unhealthy dependence on a single sector as the generator of economic growth.

We must not allow this to happen again – but preventing a return to the unsustainable growth paradigm that has characterised the UK for the past three decades will require reform at a number of different levels.

It will require a more activist government that takes a broader view about the economic health of the country. This government activism would address the series of market failures that left the UK particularly vulnerable to an economic downturn, and has led to economic over-specialisation and an over-concentration in certain unsustainable sectors.

As part of its increased activism, the government should aim to increase investment in key enablers of sustainable economic growth across a diverse set of industries – namely, infrastructure and equipment. We should increase investment in infrastructure and equipment by at least 2% of GDP per year, which would halve the investment gap we have with Germany. Some of this will need to come from public coffers, but by creating the right incentives and investment environment, public capital will be able to “crowd in” much larger flows of private capital. If spent efficiently, this increased investment has the potential to lead to a step change in the UK’s productivity, and could dramatically improve the country’s economic resilience.

UK businesses will also need to step up to the challenge and adopt an entirely different mindset. Over the past three decades, too many decisions have been made with the narrow objective of maximising short-term returns to shareholders. This focus on short-term profits is not sustainable.

The legendary investor George Soros has written at length about this, most notably in The Crisis of Global Capitalism:

“The common interest does not find expression in market behaviour. Corporations do not aim at creating employment; they employ people (as few and as cheaply as possible) to make profits. Health care companies are not in business to save lives; they provide health care to make profits. Oil companies do not seek to protect the environment except to meet regulations or to protect their public image. Full employment, affordable medicine, and a healthy environment may, under certain circumstances, turn out to be the by-products of market processes, but such welcome social outcomes cannot be guaranteed by the profit principle alone.”

Adopting the principles of stakeholder capitalism would provide corporations with a more sustainable framework within which to operate. Under stakeholder capitalism, business leaders would give more or less equal consideration to the interests of shareholders, workers, and the community within which their businesses operate. Decisions would be made with the objective of maximising long-term satisfaction among all stakeholders, rather than maximising short-term profits. This model recognises that a firm is not the instrument of its shareholders – seeking to extract the greatest profits possible in the shortest possible time – but, rather, a coalition of suppliers of diverse resources (capital, labour, management), with the objective of increasing their common wealth by generating goods and services that have real value.

Stakeholder capitalism has been used in Germany for decades, and has led to steady, high quality, broad-based economic growth. Embracing stakeholder capitalism does not mean that shareholders would be shortchanged – indeed, many studies indicate that stakeholder capitalism is both better for society and better for investors, because it produces higher-quality returns and discourages excessive short-termism.

As we emerge from the crisis, we have a great deal of work to do – and that work is not limited to reducing the deficit or promoting GDP growth. Growth is only good insofar as it is sustainable. If we hope that growth over the coming decades will be of a different quality and composition than that which we have experienced since Thatcher came to power, we must make some serious reforms. Given our recent experience, we would be foolish to pass up the chance to change.

This article was published as part of the Young Fabians’ Future of Finance Network launch yesterday.