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The Economics and Politics of Social Democracy: A Reconsideration

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Yves here. This history of the decline of social democracy comes from a vantage that might strike readers as novel: that of economic policy and how that played out in politics. By Servaas Storm, Senior Lecturer of Economics, Delft University of Technology. Originally published at the Institute for New Economic Thinking website Social democracy, the political force that shaped post-1945 Western Europe more than any other political movement, is in terminal decline—or so it appears. In recent years, in European country after country, voter support for social-democratic parties has collapsed. In France, Greece and the Netherlands social democrats hold less than 10 percent of the seats in parliament. In Germany and Italy, social-democratic parties are at a historic low. Britain’s Labour Party’s

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Yves here. This history of the decline of social democracy comes from a vantage that might strike readers as novel: that of economic policy and how that played out in politics.

By Servaas Storm, Senior Lecturer of Economics, Delft University of Technology. Originally published at the Institute for New Economic Thinking website

Social democracy, the political force that shaped post-1945 Western Europe more than any other political movement, is in terminal decline—or so it appears. In recent years, in European country after country, voter support for social-democratic parties has collapsed. In France, Greece and the Netherlands social democrats hold less than 10 percent of the seats in parliament. In Germany and Italy, social-democratic parties are at a historic low. Britain’s Labour Party’s last electoral win dates back to 2005— half a generation ago. The result has been a remarkable, steady decline in the political relevance and influence of Europe’s social-democratic parties. The long-run decline of electoral support for social democracy reflects a failure of social-democratic parties in Europe to strike a convincing and effective balance between ‘short-term practical relevance’ and ‘progressive, egalitarian reformism’ (Bhaduri 1993). This paper argues that this failure originates in a flawed macroeconomic thinking.

Short-term practical relevance requires social democracy to accept, at least partly, the very socio-economic and political conditions of ‘really-existing capitalism’ which it purports to change in the longer run. Once social democrats chose to work within the rules of capitalism, they had to abandon their radical goal of systemic transformation and commit themselves to maintain private property in the means of production. After all, the capitalist class has the power to block any egalitarian transformation of the property-rights and economic system by sharply reducing firm investment, which, in turn, reduces demand and employment in the short run and has negative impacts on long-run growth as well. Hence, working within the capitalist system creates an inescapable dilemma for social democracy: its policies must at the same time strengthen the productive power of capital and counteract the (political) power of capitalists. Through the state, social democrats had to assure capitalism’s efficiency and the growth of its productive capabilities, while at the same time mitigating adverse distributional effects.

Phase I (1950-1975): Co-Operative Capitalism, Partly Enabled by ‘Wage-Led’ Demand

The Keynesian revolution in macroeconomics led to a drastic reorientation of European social democratic thinking: away from the revolutionary ‘nationalization of the means of production’ to the ‘nationalization of consumption’, as Swedish economist Bertil Ohlin (1938) put it. Reformism was abandoned—and capitalism accepted—on the condition that it be regulated and disciplined by the state, without any need to socialize the means of production. Social democrats developed a full-fledged ideology of the ‘welfare state’, as the means to nationalize consumption and bring about mass-consumption-driven economic expansion. Thus, during the 1950s and 1960s, Keynesian demand management helped sustain a full employment regime, which featured high real wage growth, shortening of the working week, and the build-up of welfare states. What was critical is that the high wage growth, the shortening of the working week and welfare-state expansion did not hurt the profitability of firms. To the contrary, the ‘golden age of co-operative capitalism’ managed to avoid a profit squeeze, because of four factors which more than offset the negative impact of higher wages on the profit rate.

First, aggregate demand was ‘wage-led’ (Bhaduri and Marglin 1990), which meant that higher wages led to higher demand and hence to higher capacity utilization; higher capacity utilization raised the profit rate of firms. Second, the pressure of high wages on the profit rate was reduced, because higher demand and higher utilization led to higher labour productivity through the Kaldor-Verdoorn relation. The third factor was that high wages were supported by fiscal policy intended to keep the economy (and utilization) close to full employment. The fourth and final factor was the high growth of world trade, enabled by the Bretton Woods system of stable exchange rates, and the restrictions imposed on cross-border capital mobility in most economies. Full-employment-oriented fiscal policy was the key ingredient, because it made possible (and stabilized) high productivity growth and hence high wage growth, helped by the overall wage-led nature of demand. Taken together, the four factors safeguarded adequate profit rates for firms, and thus offered a solution to the dilemma facing European social democracy.

The co-operative compromise unravelled in response to the ‘stagflation’ of the 1970s. The reason for the breakdown was more political than economic: decades of (near) full employment had unleashed, as Michaɬ Kalecki (1943) warned, forces which directly threatened the authority structure of capitalism—forces which became manifest in growing wage pressure, heightened worker militancy, calls for more redistribution, and growing demands for a radical democratization of society, the economy and the workplace. The breakdown of the Bretton Woods system in 1971 added further fuel to stagflation, leading to heightened uncertainty for exporters, competitive exchange rate devaluations (triggered by the devaluation of the U.S. dollar), a slowing down of world trade growth, two oil-price shocks, and import-cost inflation (Halevi 2019). Demand growth declined, which in turn depressed productivity growth—and this drove up the wage share even more. The ‘indiscipline’ of workers, the collapse of the Bretton Woods order, and the consequent ‘profit squeeze’ led governments to implement structural policy reform aimed at improving the ‘climate’ for private investment and finance.

Phase II (1975-End of 1980s): Co-Operative Capitalism With ‘Profit-Led’ Demand

The collapse of wage-led growth and the crisis of stagflation brought back, with a vengeance, the dilemma of social democracy—in a profit-led system, profits must be protected from demand of the masses, because if profits are not ‘sufficient’, then eventually wages and/or employment must decline. Reviving private investment became the focal point of a new wave of conservatism, which, championed by British Prime Minister Margaret Thatcher and U.S. President Ronald Reagan, centred on wage moderation, monetarist inflation control (instead of full-employment-oriented fiscal policy), the deregulation of labour and financial markets, privatization, (corporate) tax reductions, globalization and (accompanying) military build ups, and the scaling down of ‘nanny’ welfare states (Halevi 2019).

The stagflation seemed to prove that in an open profit-led economy, full employment demand management and radical redistributive policies are not in the material interest of wage-earners, because they result in high wages and poor international cost competitiveness, and therefore low profitability, sluggish investment and stagnation. Some social democrats internalized this lesson quickly. West-German Bundeskanzler Helmut Schmidt (1976), a leading European social democrat, articulated it in Le Monde as follows: “The profits of enterprises today are the investments of tomorrow, and the investments of tomorrow are the employment of the day after.” Other social democrats needed more time—Francois Mitterand, the social-democratic President of France, who was elected on the promise of Keynesian demand stimulus, capitulated only in 1981-83 after bond and currency markets started to protest against his – half-hearted – fiscal stimulus.

Schmidt’s argument won the day and became the cornerstone of the post-1970s social democratic consent of capitalism. Perhaps the clearest expression of this reorientation of social democracy within the EU is the Dutch ‘Polder Model’ consensus on strict real wage restraint. Dutch real wage growth was kept below productivity growth, which raised the profit share and lowered Dutch relative unit labour cost. Dutch unemployment declined steeply in the 1980s and 1990s, exactly when unemployment in other E.U. countries remained high or even increased. This way, the Dutch social democrats set the example to emulate, and from the late 1980s onwards, their European comrades followed suit, choosing to co-operate to reproduce capitalism and rather drastically tone down whatever was left of their initial reformist intentions. However, social democratic consent was still based on the common understanding that aggregate demand mattered for profits and investment. Keynesianism was not dead yet. Social democrats could continue to argue in favour of fiscal stabilization, (decent) minimum wages, collective wage bargaining, and welfare-state support for the unemployed, the disadvantaged and the elderly, because these ‘Keynesian’ interventions could be argued to contribute to stabilizing aggregate demand and protecting the profit rate. ‘We are all Keynesians now’, captured the mood in this period.

Phase III (early 1990s – Now): Final Surrender to TINA

Social democracy’s compromise with ‘profit-led’ capitalism broke down in the early 1990s, under the impacts of two powerful forces. The first one was the collapse of communism in the Soviet Union and much of Eastern Europe. The collapse of communism deprived European social democracy from its ideological ‘doppelgänger’ and left it with nothing distinctive to offer, except its “exhausted language” (Judt 2010). The second force to undermine the compromise of the 1980s, no less important than the first, was the demise of Keynesianism. The victory of Thatcher-Reagan conservatism might not have happened, as Tony Judt (2010) argued, without a supporting intellectual revolution—one which succeeded in overthrowing the Keynesian consensus and turning ‘government’ into the problem, rather than the solution. This is the essence of the neoliberal turn in Europe’s political formation: rather than entrusting the state, or the ‘Staatsvolk’ in Wolfgang Streeck’s (2016) terminology, with the task to stabilize the unstable capitalist economy, the new conservatism relegated to deregulated (financial) markets, or Streeck’s ‘Marktvolk’, the task to maintain the stability of the social and political order.

In macroeconomics, the ‘intellectual revolution’ gave birth to the New Consensus Macroeconomics (NCM) in the 1980s. NCM rejected Keynesianism by arguing that the stagflation of the mid-1970s ‘proved’ that the Phillips-curve trade-off between inflation and unemployment could only exist in the short run, for as long as actors in the economy were wrong about (actual and expected) inflation. In the longer run, once actors had learned from experience and correctly started to anticipate the rate of inflation, the NCM claims that the Phillips Curve is vertical at a given rate of unemployment—the ‘natural’ rate of unemployment, also known as the non-accelerating inflation rate of unemployment (NAIRU).

Accordingly, monetary policy could only affect the unemployment-inflation trade-off in the short run, but economic activity could not deviate from its ‘natural’ level, as determined by the NAIRU, in the long run. Likewise, fiscal policy cannot have permanent, long-run, impacts without causing unmanageable accelerating inflation, which would force the central bank to increase the interest rate. Higher interest rates would, in turn, crowd out private-sector investment—and unemployment would converge back to the NAIRU. There is, in this approach, only one way to structurally raise growth and permanently reduce unemployment in a non-inflationary manner, namely imposing structural reforms on the labour market, which lower the NAIRU. This way, the NCM created the governing myth that governments and central banks should refrain from intervening actively, using fiscal and/or monetary policy instruments, to smooth short-run fluctuations or to steer the economy, but rather concentrate on creating the structural conditions for deregulated (labour) markets to grind out the ‘natural’ long-run equilibrium.

The NCM has one profound policy message, which constitutes a radical denial of the promise of Keynesian demand management in a wage-led economy: macro-economic policy faces an inescapable trade-off between ‘growth’ (or ‘efficiency’) and ‘equality’. What it means in common parlance is that any policy intervention to reduce inequality, for instance by means of labour market regulation and welfare-state redistribution, carries a welfare cost, because it raises the NAIRU and hence must lower growth. Vice versa, any attempt to permanently raise economic growth means lowering the NAIRU by deregulating the labour market and downsizing the welfare state—which must raise inequality. Andrew Glyn (2006) appropriately called it the ‘Nasty Trade-Off’ between higher wages and more jobs—or, more generally, between economic growth and egalitarianism.

The death of Keynesianism left it clueless and without any effective policy levers to counteract the power of capitalists. The ideological emptiness created by the collapse of communism and the demise of Keynesianism in favour of NCM was filled by ‘Third Way’ pragmatic compromising, strategic rebranding and technological tinkering. The defining feature of New Labour of the ‘Third Way’ variety is its complete internalization of the idea that the ‘Nasty Trade-Off” really exists. As a result, New Labour discarded fiscal policy activism in favour of rule-based fiscal austerity, supported the independence of central banks (in effect, handing over the levers of monetary policy to unelected and democratically unaccountable technocrats), completely submitted to ‘reactionary’ financial interests (of the ‘Marktvolk’) by endorsing central-bank inflation targeting and deregulation of financial markets, and, in doing so, lost all sense of shared purpose. Peter Mandelson’s statement that “we are all Thatcherites” captures the new mood perfectly.

In the U.K., Tony Blair’s ‘Third Way’ economic policies intended to create a business- and finance-friendly economic environment (Osler 2002)—by means of the (semi-) privatization of public services, social dumping to attract foreign investors, tax cuts for the rich and social-benefit cuts for the (undeserving) poor, opting out of the European social charter, unconditional support for financial globalization, harsh law & order policies and deregulation of labour and financial markets, while turning a blind eye on rising income and wealth inequality.

But it is not just Britain’s New Labour. In the 1990s, it was widely felt that European social democracy needed a modern makeover, in order to become more market-friendly. As a result, social democracy became a conservative force, both politically and economically, in France, Germany, the Netherlands and Italy—and most governments adopted the strategy of blaming the EU and Brussels for unpopular policy reforms, which they themselves were (covertly) favouring. Labour law reforms such as the Hartz reforms by the Schröder government in Germany but also elsewhere, created a larger ‘disposable’ labour force, a flexible reserve army of the under-employed, and through this, raised (income, wealth and job) inequality in Europe.

The Economic Consequences of New Labour

New Labour’s compromise did succeed in reducing unemployment in Europe, but it rather spectacularly failed to improve overall macroeconomic performance. Real GDP growth continued its secular stagnation—notwithstanding the structural reforms introduced on New Labour’s brief. The reason for the growth slowdown is ironic: as is shown by study after study, aggregate demand in these six economies is robustly ‘wage-led’. This means that the New Labour strategy of wage restraint and structural reform, coupled with strict rule-based fiscal austerity (Storm 2019), which was meant to reduce the NAIRU, raise the profit rate and push up utilization, backfired. The reason: it did reduce demand and utilization and hurt both the profit rate and investment. To paraphrase Mark Twain, the report of the death of Keynesianism seems to have been an exaggeration.

But the macroeconomic damage done is larger. The labour market deregulation and supply-side measures which pushed more people into the labour market were, as noted above, successful: unemployment came down and labour force participation went up, which was exactly the intention. However, it is impossible to read this as (social and/or emancipatory) progress—because what it reflects on the ground is the growth of low-productivity, low-pay, generally temporary ‘alternative working arrangements’, mostly in private services industries—arrangements which in post-Schröder Germany are often ‘mini-jobs’, in Italy are all fixed-term contracts and in the Netherlands most often mean temporary self-employment. And at the macro level, the slowdown of economic growth and the increase in employment growth imply, when taken together, a decline in labour productivity growth.

This slowdown of productivity growth puts welfare states under growing fiscal pressure. The stagnation of wage-led aggregate demand and the growing job and income insecurity, characteristic of the New Labour compromise, helped to undermine its political legitimacy. The rapid growth of deregulated financial markets provided policymakers with an opportunity to defer this threat by enabling a strong growth of private borrowing, by households and firms, to keep ‘the show going’ by sustaining demand. Crouch (2009) calls it ‘privatised Keynesianism,’ and its defining feature is the dramatic increase in the system’s reliance on household and corporate debt to defer distributional conflicts and continue to meet the electorate’s welfare expectations.

The failed New Labour compromise has caused political damage as well. First, big parts of social democracy’s core constituency have defected to either the more extreme Left movement or to (extreme) right-wing populist parties. There is a growing polarization in the polity—with growth on the far left and even more on the far right. In Italy, France and the U.K., this polarization has already seriously destabilized the established political system—to (as yet) unknown effect. Germany, the Netherlands and Sweden each have seen not just growing right-wing populism, but also a considerable shift of the political centre and ‘accepted political discourse’ to the right. Governing is becoming increasingly difficult under these polarized conditions. The other form of damage comes in more subtle ways: growing (income and wealth) inequalities have made class and status divisions more powerful, have considerably reduced (upward) social mobility, and strengthened residential segregation and segregation in education (Wilkinson and Pickett 2019). In contrast, in more equal societies, citizens trust each other, there is a greater willingness to help each other, and general attitudes to the social welfare state and taxation are more positive. Adam Smith (1776/1976, p. 88) put it like this: “No society can surely be flourishing and happy, of which the far greater part of the members are poor and miserable.” As inequality rises, all this goes in reverse. Seen this way, the recent collapse in support for social democracy is a largely self-inflicted wound—and unprecedented act of self-destruction.

What Is To Be Done?

What sort of political-economy framework can the Left propose to explain its objectives and justify its goals? For a start, social democrats should discard the now discredited NCM thinking, and draw the right lesson from Keynes, namely that capitalism is inherently unstable and needs to be ‘wisely managed’ in order to become more efficient. Markets turned out to be ‘bad masters’, and now have to be turned into ‘good servants’. We need social and political organization to impose stability on unruly markets, including through imposing cross-border capital controls (when and where necessary). Social democrats also have to understand that it makes no sense to let financial markets determine the fiscal capacity of the state—this is a fundamentally political decision which involves matching society’s levels of taxation to its social (spending) ambitions and deciding on how to finance a public deficit (in case it arises). This is not a plea for Big States, nor for maximum monetary financing, but rather for meaningful deliberative democracy in which citizens have a say in politics when and where it matters most. It is a firm plea against the de-politicization of fiscal and monetary policy as well as against the corrupting influence of political money on democracy—which should have been obvious to social-democrats anyway.

Second, social democrats must reject the ideology of the ‘Nasty Trade-Off’ for what it is: a conservative fantasy. In the European economies, higher wages and progressive income redistribution do indeed improve macro-economic performance and benefit both workers and firms, especially when supported by aggregate demand management. Social democrats ought to stand for both fair real wage increases and a credible commitment in macroeconomic policymaking to full employment (rather than low inflation)—demands which do not conflict with productivity growth and profitability (if properly managed). Likewise, welfare states and protective labour market institutions must not be considered a cost and a drain, but rather constitute efficient frameworks which by helping nations to share the costs and benefits of globalization and technological progress, make firms more flexible and raise their international competitiveness. The above is by no means a covert defensive call for a return to an idealized past (e.g. the ‘golden age’), but instead it is an evidence-based diagnosis of where we are and how we got there and a recognition that there are alternatives to Thatcherism. Capitalism needs to be managed, and if citizens do not do it (through the political process) than ‘superstar’ firms, big banks, big-tech companies and billionaires will do it for us.

However, any reimagined social democracy worth the name must begin by imposing discipline on banks and financial markets—and by domestication, turn them from the powerful over-lords (who they currently are) into useful servants to the societal interest. This, in turn, requires a counter-revolution in economic thinking, one which overthrows the NCM in favour of more realistic (less utopian) and more humane approaches. NCM must be seen for what it is: stale nineteenth-century pre-Keynesian thinking, a parody of an accountant’s nightmare, in John Maynard Keynes’ (1933) words.

The global recession caused by the COVID-19 lockdown is making such a counter-revolution in economic thinking only more urgent. The current panicky ‘emergency Keynesianism’ which is upending decades of ruthless austerity in Britain, France, Germany and elsewhere does not come close to what is needed. Yes, governments will be paying “for the war against COVID-19” by taking on much more debt, but once the crisis is over, higher public indebtedness will turn out to be socially unjust and economically inefficient. After all, the Pavlovian response of politicians and a majority of economists, brainwashed by modern (NCM) macroeconomic theory, is a return to fiscal austerity with a vengeance, on the argument that debts must be repaid, bringing another lost decade of ruthless spending cuts (in public investment) and structural shortages and lowered wages in exactly those services, such as health care, social support and education, which are now deemed ‘essential’ during the health emergency.

A simple and effective, Keynesian and social democratic, alternative to fund the unprecedented public rescue packages would be much higher taxes on wealth, incomes and (rentier) finance. This way, the strongest shoulders will carry the largest burden without corroding and undermining economic growth and public health in the future. The longer-term impact of the COVID-19 recession will be chronically painful, if we do not apply the right lessons learned from earlier crises. While the virus may go away, helped by massive social distancing and the lockdown of the global economy, we must remain alert to the consequences of a longer stay or the arrival of a new mutant. To able to deal with these consequences, our crisis response now should not lock us in into a permanent state of austerity, greater inequality and heightened vulnerability to future health calamities. New-old social democratic solutions are needed more than ever before.

Three comments on this essay can be found here. The first is by Joseph Halevi and Peter Kriesler; the second is by Duncan Foley, and the third is by Thomas Ferguson.

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