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Phelps: what is “good” economy

(Edmund S. Phelps)

Professor at Colombia University and director of Center for Capitalism and Social Research

The 2006 Nobel Laureate in Economics for his in-depth study on inter-temporal tradeoffs in macroeconomic policy

Professor Phelps will be invited to attend the China Development Forum in March

Editor’s note:

China is trying to have its people benefit from reforms and give them more sense of gain in co-construction and sharing. At China Development Forum 2016 Phelps demonstrated his understanding of “good” economy from the perspective of building an innovation-oriented country. This paper summarizes Phelps’ opinions about the cause of secular stagnation, his countermeasures, and his understanding of “good” economy.

What's Wrong with Western Economies?

Over the past three decades, the center of world economy has been shifting from the West to the East. Phelps argues that the current economic vitality of most western European countries is at the lowest level since the 19th century and the total factor productivity in America has been experiencing weak growth since the 1970s, which is caused by the lack of new inventions or new industries. He believes that American innovation began to decline as far back as the 1960s. This is caused mainly by vested interests and the pressure created by families and schools.

Unfortunately, innovation which is the urgent demand in America now has not been the new president Trump’s focus so far. First, it is wrong for Trump to blame the plight of US workers on trade rather than on the lack of innovation. Second, Trump is assuming that supply-side measures to boost after-tax corporate profits will raise incomes and create jobs. But such an approach could also lead to an explosion of public debt. Finally, Trump thinks that bullying corporations will boost output and employment. If this thinking persists, there will be more interference in the business sector to protect incumbents and block newcomers. This will clog the economy’s arteries, and if this continues, the corporatism will threaten to drive a silver spike into the heart of innovation – and the American working class.

The slow development of productivity is due to sluggish innovation. Economic freedom cannot guarantee a nation’s return to prosperity. A country must have the vitality of imagination and creation, which depends on profound human values. So it is imperative to carry out education reforms. Phelps holds that entrepreneurs with a higher education degree share a higher probability of success and well-rounded education would encourage more young men to go for entrepreneurship and innovations. In order to kindle their desire for imagination and innovation, the education system has to expose students to humanities, and literary classics should be offered to them in high schools and universities in western countries. Humane values should be passed down to the young generation and give them the guts to work for imagination and creativity and encourage them to pursue this kind of economic model.

Get out of the doldrums: Supply side, Demand side, or Innovation side?

Confronted with the accumulation of wealth in developed economies, lack of rise in real wages and the drop of employment-to-population ratio, scholars who are in support of supply-side reforms believe that lowering the tax so that to improve the income and create more jobs is the solution while for those who are in favor of demand-side reforms think that government measures are the only way to promote employment when spontaneous demand and the employment rate are on the decline. In this regard, Phelps notes in Supply Side, demand side, or Innovation Side? that neither of the two opinions truly understands what are real economic growth and recovery,  nor do they understand that falling productivity is caused by weakened innovation.

He is convinced that when impacted by the shrink of demand, normal economies would react in two ways. On one hand, they would adapt to the new opportunities, which means new business models would turn up, complementing or replacing the old ones when the scale of the existing corporations begins to shrink. On the other hand, they would strive for indigenous innovation, which means some of the laborers who are supposed to become employees would start their own businesses when some companies stop staff recruiting, and this would gradually bring about new investment. On the contrary, stimulus policies with the goal of full employment would discourage innovation and reduce the potential for future employment and growth. When innovation is restricted, the rise of public or private investment boosted by whether the supply side or the demand side will only lead to diminishing returns.

What is “good” economy?

Phelps does not think that it is sufficient to switch from investment to consumption as the engine of growth, nor is the shift from manufacturing industry to service industry since these are just changes in output mix. What deserve more attention in China are laborers and their experiences.

Phelps disagrees with the ideas about laborers expressed by mainstream economists in the European Continent. Productivity per hour in countries such as Germany and France is much higher than that of Britain and America owing to the efficient allocation of resources and investment in education, but they also have low employment-to-population ratio, short working lives and low job satisfaction. In general, jobs in Europe are not as exciting or challenging as they should be.

What’s good economy? He says in Mass Flourishing that good economy offers good lives, and efficient allocation of resources is just one of the prerequisites which also include a satisfactory life quality, appropriate consumption, entertainment, and sufficient public services. On top of this, full autonomy and freedom should be given to workers for them to express themselves, to give full play to their talents, to show their skills and to achieve something through their own efforts. These are personal experiences that have nothing to do with money. So he describes the excitement and satisfaction brought by overcoming challenges and barriers with the word “Flourishing”. What this requires is an economy with entrepreneurship and an innovative spirit, an economy which involves all people from the top elites down to the grassroots of society. He deems that most innovations and entrepreneurship come from the private sector. For instance, in the transport field, innovations like the Uber mode and self-driving technology are both from the private sector.

He hopes that China would target at “good” economy like this and he is quite optimistic about it. In the late 1990s, China was rated as the fourth most innovative country in comparison with the G7 countries, and 10 years later, China moved up to the second place.