Wednesday, 14 August 2013

We Can Have Growth But No Stability

One of the questions I have been asked lately was quite simple and yet it appeared rather hard to answer: "Why do we need growth every year? Why are economists so obsessed with growth and not with stabilizing output to approximately the same amount every year?" The question is usually asked by people who do not view capitalism as a good economic system but are too unwilling to make a change. As a former professor of mine once stated, the best thing in the world is to be a contrarian in a capitalist country; you get to keep both your money and your ideology.*

To be fair, economists do focus on growth. They do it because what they have studied has promoted them to think like that and they consider it so obvious that they waste no time in thinking on why it matters. In fact, we all somehow assume growth is good, we are just unsure why. The simple explanation is that growth is good since it creates more demand, more goods and most importantly more jobs and more money. This is a purely economical (and simplistic) explanation and one which will undoubtedly come under some criticism on the grounds of what people should really focus on or what they should do in their lives (which is really beyond the scope of this article). Still, as far as economics are concerned, growth is assumed to improve the well-being of every individual. 

Ideally, the best outcome of the combined action of policy and markets is full and stable employment. Yet, unless in the cases of war or re-building what the war has destroyed, we have never experienced full employment, and I doubt whether we could ever do that again (unless in wartime). The problem is that if we try to stabilize the system at a level far lower than full employment we would be having more unemployed than we could ideally have and this would create frictions in the markets. Stability would be meaningless if we have too much unemployment; simple logic states that we could do better by improving something. Nevertheless, even a stability scheme would not be sustainable even at full employment for the following reasons:

1. Changing population
Imagine that we have a country with a population of X million people of which Y are in the labour force (obviously Y<X). The unemployment rate is currently 0. During this time, aggregate demand is stable on average. Now imagine that the population rises every year. Unlike conventional economic models, real people do not start working as soon as they are born; they usually cannot do that until they reach a certain age. Thus, the family has to provide for their expenses, which means that although population has risen over time, aggregate demand is still the same as the family still gets the same income (inflation might cause income or demand to rise but this is not a real rise). Thus, assuming that the person will enter the labour force when he or she turns 18, as soon as that age is reached the person enters unemployment. The reason is practically simple: as long as you have stable demand you have no reason to increase your costs by hiring an extra person.

Now, let's assume that it's not just 1 person who enters unemployment each year but Z and they are in fact more than those who retire if we have a positive rate of population growth. Then, by the time firms realize that they have to employ more people to get more income, the number of unemployed increases. Given that such decisions about demand do not really come up so easily (and in addition, every other firm has to act the same way if they want to get back the amount they spend) and people are occasionally picky about what type of job they would like to do (the essence of search and matching theories) growth would be present and unemployment would fluctuate as population rises. 

2. The variable change in demand
In addition to the previous, demand is never stable even in case of full employment. As population changes, be it either growth or decrease, demand is altered every time. This is especially true of specific product demand. When demand is unstable, firms change output to fit it and thus both unemployment and total output fluctuates. Obviously, if the fluctuations are not large then there is no trouble in the system; unemployment may fluctuate but on average it will be stationary. Yet, if fluctuations are so large that the average cannot be maintained then we can forget about the system's stability.

Then question then becomes: why is demand so variable? Is it just because population changes or is there something else hidden behind it? The answer is both: increasing population leads to higher demand and falling population to less demand. Yet, as already stated, increasing population also comes with an increased unemployment rate until the new demand is settled in the economy. Although this may be considered as transitory unemployment, its duration cannot be specified. Decreasing population on the other hand presents the opposite: as demand is lessened, then firms have to scale down their production and thus unemployment is again increased. In both cases, it can be argued that the markets will work in such a way that unemployment rate will be stable in the long run; yet whether this really holds and how long is this long run is debatable.

3. Nature
Do you remember the last time someone predicted a flood? An earthquake? From what we know, nobody has, and it's quite doubtful if anyone will ever be able to do so. In fact, even if we were able to predict them, although human casualties would be minimal, material damages would still be large. We cannot move plants and other infrastructure as fast as we can mobilize people. Hurricane Katrina caused $81 billion of damages in 2005, with Hurricane Sandy causing an additional $68 billion in 2012. If we were in a system in which stability and predictability were the main characteristics then any deviation would wreck panic in the hearts of people. Which brings us to the most important of the factors:

4. Human Psychology
Recent experience indicates that people can either get excited too fast and too much about something (e.g. asset bubbles) or become afraid of something just as fast (market crashes). As the current system (or any system for that matter) functions with people acting within it, it is as stable as its constituent parts. Given that human behaviour ranges from one end of the spectrum to the other, how can we expect a system which is comprised of humans to be stable? More so, people, when acting in large groups fall victims of group psychology of either exuberance or hysteria much faster than when acting alone; in larger systems, the mood swings would be even greater, with larger consequences on them.

To illustrate this, think of person who is not really affected by austerity measures, or who is affected just a little bit. This person may believe that if his income is cut by 10% then he should cut his expenses by 15-20% so that he could save for a rainy day. Now imagine what happens in the economy when 10% of the population decides to do just that (for a tale on what happens this provides an example): demand falls, unemployment rises and a vicious cycle is initiated. This was one of the reasons austerity has not been successful; people fear about the future and tend to react strongly to an event.

Although some could argue that booms may increase demand by just as much crashes reduce it, the truth is that crashes do not really push it down that much. Although human beings are prone to large mood changes (just think of yourself: do you feel the same two days in a row? Doubt it. Most of the times we do not even feel the same in two consecutive hours) we are also prone to optimism and hope. It is against human nature to keep down and do nothing for a substantial period of time and that is how we got to develop from living in caves to exploring space. As Cullen Roche puts it, a measured optimist is the best world view.

Returning to the original question on growth and stability: we cannot stop growth and neither should we try to do so. It's what made us progress through the ages, what brought us the tools we are using now. Stability cannot occur in any economic system as long as it is run by people. Even in traditional economic modelling, population growth equals economic growth. If the system has what it takes to succeed then it will, no matter how many oppose it; if it does not the it will collapse sooner or later. Stability cannot be enforced on a system comprised by people exactly because people are unstable. While many economic models in the literature usually provide for a steady state in their analyses  they never take into account any shocks which could come from within the system, such as agent irrational behaviour or declining population.

The fact is, we need growth for stability as well as for incentives. If we are to grow with a stable rate of, say, 2% per year, then a shock which would contract GDP by 7-8% (note: this shock does not even count as a depression) would mean that we would face high unemployment and deteriorating social standards. Since we cannot eliminate the possibility of a large shock occurring all we can do to safeguard both ourselves and the economy from its impact is have as much growth as we possibly can, before and after the shock. The more growth we have before, the less destructive the shock will be and the less difficult it will be to overcome it and we focus on growth after its occurrence. We do not just aim for stability because stability provides no incentives to create, innovate and develop. For that, we need growth as we also want to be sure that when bad times come (and they will, for sure) we will be less affected by them.

To sum up, stability is something we cannot hope for in a human-based system, at least not in the way we commonly seek it. What we can do to make the most of it, is not criticize growth but try to stabilize that; this will act both as the prevalent force for development as well as a cushion for bad times.

*My personal view on the subject (in case anyone cared) is that although capitalism is the best system we have had until now (or better yet, the only one which survived) it still has plenty of room for improvement. We have gone a long way from the uncontrolled system in the early 1900's where the rich could practically manipulate everything they wanted. Nevertheless, the current system is far from perfect; we should aim for a better future by continuing to improve on our existing structure and not by demolishing it.

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