What in the World Is Wrong?

By Charles Alexander

Slow growth and swift inflation stymie rich and poor nations alike

Recession. The word no longer seems adequate to describe the relentless turmoil that is shaking the world economy. More and more politicians, businessmen and economists are beginning to have a few haunting fears that this economic decline could spiral out of control, leading to a breakdown in the economic system. Said Canadian Prime Minister Pierre Trudeau at the recent Versailles economic summit: "We are moving from crisis to catastrophe." Warns Paul McCracken, former chairman of the Council of Economic Advisers under President Nixon: "The world economy is balanced on a knife-edge and could easily plunge into another era of international economic disintegration."

While nations have struggled with the twin scourges of swift inflation and slow economic growth, millions of people have lost their jobs. Steep interest rates have destroyed thousands of businesses. Countless companies have been unable to modernize obsolete factories. The promise of economic expansion, always the driving force of capitalism, suddenly seems in jeopardy.

Despite a wrenching retrenchment, the international economy appears to be no closer to a robust recovery than when the agony began. Indeed, for many countries the problems are intensifying, and governments that have tried to expand their economies while others were battling inflation are rethinking their policies. Rocked by a falling currency, France slapped a four-month wage and price freeze on its economy and devalued the franc by 10%. Beset by near record interest rates and high unemployment, Canada unveiled an austere budget that would limit salary increases for its federal workers to 6%, or about half the rate of inflation. Faced with an alarming government deficit, Belgium took the unprecedented step of prohibiting cost of living increases to pensioners and wage earners now receiving more than $530 per month.

As virtually every country has curbed its money supply in the fight against inflation, high interest rates have created a worldwide financial crunch. Scores of nations deeply in debt are finding it difficult to meet their payments. Private banks have cut off credit to whole areas of Eastern Europe, Latin America and Africa. Some bankers and economists fear a prolonged contraction of credit that could disrupt world trade. Says Fritz Leutwiler, chairman of the Bank for International Settlements: "When all the banks get worried at once, there may be a squeeze. The [international financial] markets are extremely vulnerable."

Not since the Great Depression of the 1930s has an economic downturn had such global reach. The crisis has become epidemic, almost inescapable. It infects both strong and weak economies, rich and poor nations, capitalist democracies and Communist dictatorships.

In the U.S. and Western Europe, the slump has swelled the ranks of the unemployed to a post-World War II record of 22 million, or almost one out of every ten workers. Even in West Germany, one of the foremost economic powerhouses of the postwar era, joblessness has nearly doubled since 1979, to 6.8%, and the pace of business bankruptcies has increased more than 100%. Says Karl Otto Poehl, president of the West German Bundesbank: "Resignation and pessimism are more widespread than at any time since the war."

For most of the less-developed countries, the global downturn has been devastating. In Costa Rica, where unemployment has risen to 17%, the government is stepping up a program to hand out bread, rice, beans and other food to the jobless. In Tanzania, where inflation is running at 29%, the government has dropped 966 projects from its budget, including the construction of several schools and the country's new capital at Dodoma.

Communist nations have fared no better than free-market ones. In the Soviet Union, where factories are increasingly outdated, annual growth has slowed to less than 2%, in contrast with 4.8% only five years earlier. After a third consecutive dismal harvest, the Soviets this year will have to import a record 44 million tons of grain. The Soviets' East European satellites have run up $60 billion in debt to Western governments and banks, including $25 billion owed by Poland alone.

Perhaps the only oasis in the world economic wasteland is the far-eastern rim of Asia. By selling high-quality products at low prices, Japan, South Korea, Singapore, Taiwan and Hong Kong have garnered prodigious growth and captured hefty shares of the world markets for autos, steel, shipbuilding, electronics and clothing. Nonetheless, sluggish growth in the West has started to cut into the demand for Asian exports. Moreover, tightening trade restrictions pose a threat to Asian economies. Japan, for example, had to curb its car exports to the U.S. and several European countries, after having been threatened with quotas.

Evidence is building that the world economy is going through more than a temporary, cyclical downturn. Says Herbert Giersch, director of West Germany's Institute for World Economics in Kiel: "The stagnation of the European economy will not be solved before the end of the decade." Chase Econometrics, a U.S. consulting firm, has projected that between now and 1991, annual growth in most industrial countries will average only 2% to 3%. Worse, Chase predicts that unemployment in the U.S. and Europe will hover around 8% to 9% over the next decade.

Such forecasts are shocking and sobering for an entire generation of Americans and Europeans who have lived through an unprecedented period of postwar prosperity. In the halcyon years between 1950 and 1972, growth averaged about 5% annually and unemployment stayed below 4%. Living standards surged, and world trade blossomed as never before. Growth seemed easy, almost an inalienable right.

Now that those good times are becoming only a distant memory, stunned societies face the same baffling question: What went wrong? Some scholars have begun to think that the strong postwar growth may have been a historical fluke created by special circumstances. Says Harvard Historian Charles Maier: "Previously, Europe had gone through 500 years of history without a real concept of economic growth at all. Good years and bad years tended to balance each other out. In the 1950s and the 1960s the Western economies benefited from a great number of conditions that in retrospect seem quite unique." These favorable forces included an agricultural revolution that boosted food production and freed an army of workers to migrate from farms to cities, a vast expansion of educational opportunities and the availability of cheap energy. In addition, Princeton Economics Professor Peter Kenen points out, growth spurted because "the economies had been starved during the Depression and the war of capital equipment and durable consumer goods, and they needed to restock."

Perhaps the single most important turning point in the postwar period was the quadrupling of oil prices by the Organization of the Petroleum Exporting Countries between 1973 and 1975. Inflation, which was already a budding problem in the West, suddenly raged out of control. In the 1950s and 1960s, prices in the industrial countries had risen on average about 2% to 3% a year. For the 1970s that figure jumped to 9%. In the U.S., Britain, France and Italy, annual inflation had topped 13% by 1980.

It is tempting to blame OPEC for chronic inflation, but the real explanation is not that easy. Economists have become more and more convinced that inflation is a complex phenomenon resulting both from the energy problem and from several social and political developments that emerged in Western societies during the prosperous period after World War II. Some of the most important trends:

Energy Euphoria. Cheap petroleum was a major catalyst of the postwar boom, but it created a pervasive energy dependence throughout the industrial world. With the price of oil under $2 per bbl., most factories were designed and built with little thought given to how much energy they would consume. In many cases, businessmen replaced expensive workers with machines that used large amounts of fuel.

In the U.S., cheap energy shaped a whole society. Americans took for granted that they could drive cars as big as they wanted, as fast as they wanted and as far as they wanted. Suburbs sprawled for miles beyond industrial and urban centers. Builders put up houses without adequately insulating them for energy efficiency.

By the time the Arab oil embargo hit in 1973, Western nations were dangerously vulnerable. They could not rebuild their factories and homes or replace their cars overnight, and thus had to accept OPEC's quadrupling of oil prices.

Great Expectations. Along with the spurt of postwar growth came an explosion of expectations. Both in the U.S. and Europe, people came to expect regular wage hikes and an ever rising standard of living. They increasingly looked to governments for a wide array of social programs: generous old-age pensions, broad medical coverage, education loans and unemployment insurance.

When OPEC jacked up its prices, those expectations did not change. Instead of taking OPEC'S action as a sign that increases in Western standards of living would slow down, most workers demanded compensation for energy price rises, and wages spiraled upward. Businessmen hiked their prices to reflect higher costs. Pensioners and other recipients of government benefits expected cost of living increases in their checks. In short, energy price rises were translated into generalized inflation.

The West was strongly susceptible to this price spiral because of the institutions that had evolved during the postwar prosperity. Power had become more concentrated in large corporations, labor unions and lobbying groups ranging from the Gray Panthers in the U.S. to the National Federation of Farmers' Unions in France. Explains Economist Mancur Olson of the University of Maryland: "In stable, democratic societies, special-interest groups accumulate over time, and they push to raise prices, wages or government spending. They can only serve their member by trying to win a larger slice of the social pie." In aiming to shield themselves from inflation, such groups perpetuate it.

Asian societies have adapted better to inflation, partly because their people have been less rigid in their expectations. Japanese workers, for example, who are fiercely loyal to their firms, are willing to accept pay cuts during hard times. Says Samuel Brittan, a leading British economist: "The one part of the world in which there is real wage flexibility is Southeast Asia."

The Growth of Government. Demands for inflation protection have led to a steady swelling of government spending. Since 1960, in the major industrial nations the portion of gross national product consumed by government has gone from 28% to 38%. Though taxes have risen sharply during that period, they have not kept up with spending. Virtually every country is running a record budget deficit.

These shortfalls have driven up interest rates because government borrowing has absorbed funds that could otherwise have been loaned to private industry. When governments have tried to help finance deficits by increasing their money supplies, the result has been more inflation. Says Jan Tumlir, chief economist of the international organization GATT (General Agreement on Tariffs and Trade): "The decisive political issue for the 1980s will be to get government expenditures under control."

The Squeeze on Business. While governments have expanded, private industry has been pressured by high interest rates, rising taxes and wage demands. Wages, even after adjustment for inflation, have gone up faster than labor productivity, the amount of output per worker. In other words, businessmen have been paying more for labor but getting less for their money. On top of wages, businesses must pay ever higher payroll taxes. In West Germany, such taxes amount to 21.5% of an employee's wages.

Over the past decade, heavy tax and wage burdens, along with sluggish growth, have cut deeply into business profits. Confronted by lagging profits and steep interest rates, Western companies have been forced to slash their spending for capital investment. In 1970, the U.S. and Western Europe devoted about 4% of their national income to buying new equipment and building factories that would add to industrial capacity. By 1982, that ratio had fallen to less than 2%.

Besides economic conditions, other factors in Western societies have contributed to the investment slump. Environmental-protection groups like the Sierra Club in the U.S. and the Greens in West Germany have helped create a regulatory atmosphere that has been hostile to industrial growth. In the U.S. particularly, an extremely low personal savings rate (5.7% of take-home pay vs. 18.7% in Japan) has reduced the potential pool of funds available for investment. Says Herman Kahn, director of the Hudson Institute, a New York-based research group: "People are really not willing to sacrifice for economic growth any more."

The decline in capital spending is perhaps the most important reason why the West is losing ground to Japan and its Asian neighbors. Japan's rate of investment in new plants and equipment is 8%, or four times as high as that in the U.S. and Europe. While the West is increasingly saddled with obsolete, energy-wasting factories, Japan is more quickly building up-to-date facilities that churn out sturdy products at the cheapest possible cost.

The steady deterioration of the Western economies has put ever greater pressure on political leaders to find a way to revive growth and reduce unemployment. If they resort to the traditional remedies of increasing government spending or their money supplies, they run the risk of fueling inflation and ultimately hindering growth. Wrote Rimmer de Vries, chief international economist for New York City's Morgan Guaranty Trust Co., in his respected newsletter, World Financial Markets: "It is widely appreciated today that any tradeoff between inflation and unemployment applies only to the short run, and that in order to achieve long-run economic growth it is essential to reduce inflation and inflationary expectations."

Alan Greenspan, who was chief economic adviser to President Ford, argues that the inflation cycle can be broken only if governments reduce their spending and keep their money supplies expanding at a slow pace. Says he: "The monetary authorities have to remain tough. Faster money growth might push interest rates down temporarily, but it would also reinforce fears of inflation. Such fears would drive interest rates right back up."

In the past month, Portugal and New Zealand, as well as France, have tried to attack inflation directly by imposing controls on wages, prices or both. Though attractive in principle, such policies are difficult to administer in practice. To make them work, governments must monitor hundreds of thousands of wage and price decisions. Moreover, past experience with controls, including the wage-price freeze imposed by President Nixon in 1971, shows that inflation returns once the restrictions are lifted. Says Economist Clifford Hardin, who was a member of the Cost of Living Council that oversaw Nixon's freeze: "Wage and price controls can't work. They are self-defeating."

Inflation will be easier to tame if Western nations work to encourage more energy conservation and new production. While most European governments have levied gasoline taxes of $1 per gal. or more, the U.S. has flinched at raising its federal 4-c--per-gal. tax even slightly. "Conservation of gasoline in the U.S. should be pushed a bit faster and further than market prices alone have done," says James McKie, professor of economics at the University of Texas. He supports a federal gasoline tax of at least 10% of the price of a gallon.

America has also been slow to remove price controls from natural gas. Such restraints discourage energy saving and siphon away profits that the gas industry could use for new exploration. Says Economist Robert Pindyck of M.I.T.: "With artificially low prices, people consume more than they should. They waste it."

Another crucial policy issue facing all nations is the proper role of government in revitalizing industry and promoting technology. At the Versailles summit, French President Franc,ois Mitterrand urged that governments take the lead in planning the areas of technology that should be pursued and in financing those ventures. In the U.S., Felix Rohatyn, a partner in New York City's Lazard Freres investment banking firm, has called for a new Reconstruction Finance Corporation that would disburse government loans to help rebuild America's industrial base. Critics of this kind of national industrial planning argue, however, that public funds would too often flow not to the most deserving industries but to the most politically powerful ones.

Industrial experts like William Abernathy and Robert Hayes, professors at the Harvard Business School, think that the burden of revitalizing industry must ultimately rest on corporate managers. They contend that U.S. business executives have paid too much attention to finance and marketing and have neglected basic production techniques, the kind of fine details of efficiency that make Japanese companies so successful.

President Reagan believes that lower taxes can free money for investment and give a boost to business. Following his lead, Congress last year passed big corporate and individual tax cuts. So far, high interest rates have thwarted the impact of those tax breaks. If, however, Congress can bring rates down by slowing Government spending, many economists, like Rudolph Penner of the American Enterprise Institute, believe that the new tax legislation will increase investment.

Some executives in ailing industries like autos and steel want more than tax relief. They seek quotas and other barriers against certain cheap imports from Japan and even some European countries. Consumers, however, would suffer. Trade barriers tend to protect inefficient managements and raise prices, while foreign competition forces an industry to stay lean and keep its costs down.

One of the oft forgotten axioms of international economics is that in a system of free trade, in which each nation sells what it can produce most cheaply, everyone stands to gain. The decades of record growth after World War II were also a time of rapid expansion of world trade, whereas the Great Depression developed during a period of rising tariffs and international tensions. A return to protectionism would leave everyone poorer.

Clearly, the Western nations have come to a critical juncture. They must, cool off popular expectations and change the more-more mentality that has favored present consumption over investment for the future. To do that, they will have to curb government spending, control inflation and bring down interest rates. The world may never return to the heady growth of the postwar years, but correct and consistent policies can get Western countries out of their long-running slump. --By Charles Alexander. Reported by D.L Cortu/Bonn and Frederick Ungeheuer/New York

With reporting by D.L Courtu, Frederick Ungeheuer

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