Obama's latest attempt to revive growth and jobs through pumping US $450 billion jobs-plan in the economy is regarded by many as short-term measure to avoid double-dip recession, stagflation and bolster his chances of re-election for the next 4 years, beginning 2013.
Earlier QE-1 and QE-2 did not do the trick and instead lowered US debt ratings. Interestingly, currently the private sector in US is sitting on the largest amount of surplus cash but is not willing to invest. The consumers that support 60-70 percent of the aggregate demand are unwilling to spend and the economy is caught in a 'liquidity trap' with almost zero interest rates? In these interesting times, how does one search for a 'virtuous cycle of growth" in the largest economy and the west in general.
For the benefit of readers the definition of 'virtuous cycle' is repeated here. It is a 'beneficial cycle of events or incidents each having a positive effect on the next'. The historical overview in the next few paras of how the virtuous cycles were generated in the USA during the past 50 years or so can suggest some answers to the question that 'are there some indications of underlying beneficial events or incidents' that are likely to promote the next 'virtuous cycle of growth' in US and Europe? My basic premise in the light of historical review is that although a combination of 'beneficial incidents or events' rescued previous downturns and periods of slow growth these do not appear to be on the horizon currently, but may be 'incubating' in the US or other parts of the world.
Since 'virtuous cycle' is under discussion, it would not be out of place to briefly mention business cycles. One of the earliest version of EC101 business cycle theory, traced the phenomenon of economies or growth behaving cyclically, ie, reaching a bottom and then automatically turning up and vice versa to Newton's third law of motion that 'emotions were the most important actor in causing the business cycle'. However later versions of business cycle theory super imposed on this laissez-faire explanation, various other cycles such as inventory cycle, technology and innovation cycles, regulatory cycles, wars and discovery of minerals and even to new land for recessions and bubbles in the economy. At the most policy makers and governments could fine-tune these cycles to reduce their severity or control exuberance but not prevent them, and even in some cases create mini-cycles within the larger cycles, with their attempts at fine-tuning. During the time of Paul Volcker and Alan Greenspan the world started believing in the permanent demise of business cycles and existence of virtuous cycles. However, the recession of 2008-09 demonstrated that virtuous cycles tend to delay the downturn and/or prolong the peak but never to eliminate the business cycle.
My premise is that virtuous cycles in USA from 60's onwards were generated by Wars, technology and innovation and the latest one by discovery/or tapping into a huge pool of surplus labour in China and India and to some extent by EU in eastern Europe. Lets take the case of Wars, ie, Vietnam, Iran-Iraq, and War on Terror. As manufacturing in the sixties, seventies and till early eighties remained a significant part of USA GDP, and combined with low debt-to-GDP ratio, the first two wars fed the growth rate momentum and job creation to generate a virtuous cycle. This is not to ignore that the growth momentum was punctured for short durations by policy induced and external events (oil price increase) even during this period. The war to liberate Kuwait was however a short one without much long-run spillovers and lacked complimentary positive beneficial incidents. Similarly the role of War on Terror being the costliest in the last 50 years or so, in generating/strengthening virtuous cycle became limited as manufacturing as a contributor to the USA GDP was declining due to flight of capital (FDI) to China and India and a plateau in technological advancement with little spillover/multiplier effects in the economy. Moreover, rising debt-to-GDP ratios restricted domestic public investment. It was also a period that apart from the financial sector, regulatory cycle was reaching its peak in all major sectors of the economy.
Since 60s, the beneficial cycle of events and incidents that reinforced the virtuous cycles of growth was the continuous stream of technological innovations taking place in the background and resultant high growth rate of the pure knowledge economy that outstripped the growth of real economy. The civilian and military use of space technology along with technological innovations in the commodity sector further reinforced the virtuous cycles of growth in the sixties and seventies. The conservation technologies developed in response to oil price shock of 1973 and then again around 1978-79 helped to shorten the recessions and bring about an upturn. However the most profound effect on sustaining the virtuous cycles was the development of IT and communication technologies that generated long virtuous cycles of growth from 1990s onwards. These technologies not only lead to increase productivity in the service sector, but, opened up a whole avenue of hardware manufacturing thereby creating job opportunities. With the advent of 21st century the growth of technological innovations that could significantly shift the supply curve, had almost reached a plateau and jobs along with profits and wealth created in 80's and 90's were sustaining the virtuous cycle in the west, as demonstrated by surging financial and housing sectors.
There was another discovery of event or incident by corporate USA and Europe in mid-nineties that shortened the intermediate downturns in these economies and soon put them back on track to virtuous cycle of growth. It was the discovery of New frontiers of China, India and Eastern Europe (fall of Soviet Union) with their army of skilled and disciplined labour that turned China into a factory floor for the world, India into a IT hub and Eastern Europe into a two way market for goods and competitively priced labour for expanded European Union. This massive flow of FDI easily became a substitute for labour market inflexibility. Interestingly a century and a half ago, discovery of a similar huge pool of labour by an economy would have invoked massive import of labour. To some extent this is still happening on a limited and minor scale in Europe thanks to larger integration. This discovery had a dual effect of generating consumer surpluses (inflation under control, increasing housing/financial wealth) and producer surpluses that slowly began to build up housing bubble as well financial sector in shape of speculative trading, hedge funds and even more investment from profits in the New Frontiers respectively. In layman's language this shifted the demand curve of the world outward much faster than the supply curve. Somewhat similar phenomena occurred in Europe.
Unfortunately this specific driver of virtuous growth since mid-nineties and period of short downturns started sowing the seeds of present low and wobbly growth that may persist in the West for some time to come. With the start of a long drawn-out process of rebalancing of income and wealth in favour of China, India, Brazil, Russia and South Africa, the Great Recession of 2008-09 eroded the accumulated consumer surpluses but the corporate sector including the financial sector was clever enough to largely shield the accumulated producer surpluses of 90s through government pump priming but at the cost of higher debt/GDP ratios. In fact, the physical output of the New Frontier is more input-intensive leading to frequent bouts of commodity inflation and further eroding the real incomes in the West. Here we should not totally ignore the impact of rising incomes in the East on demand for quality goods and thereby commodity inflation.
The accumulated cash by corporate USA and no investments even at zero interest rate attest to the fact that opportunities for private sector investment in the West and even in the New Frontiers (unless export of sensitive technologies are encouraged) for generating producer surpluses have fallen victim to growth of knowledge economy or technological innovations (that could continually shift the supply curve outwards) that has almost converged to the dismal growth of real output. It is quite understandable that if an economy that is predominantly knowledge based fails to generate and adapt knowledge at a faster rate than the real economy, its sustainable growth rate is likely to suffer. In these circumstances, with sword of downward rating hanging, lack of political will to overhaul the fiscal system and thereby the debt profile in the short to medium term, it will be difficult to undertake a Keynesian type pump priming for a long time and in substantial amounts to once again generate a virtuous cycle of growth. The only hope is that technological breakthroughs are strong enough and frequent to coincide with the pump priming to support the virtuous cycles.
Although there may be many innovations and technological breakthroughs 'incubating' and waiting to be surfaced and commercialised in the West and specifically in the USA, it is worth mentioning one or two that may rapidly generate virtuous cycle of growth in the West:- a) Technologies for renewable energy generation, b) Technologies for efficient use of non-renewable energy and other resources and c) Technologies for increasing agriculture productivity (ideally if they are labour-intensive and genetically based). Investment into development of these technologies and their widespread adoption will have higher pay-off provided (and I repeat if) they can shift the supply curve outward, ie, either lower unit costs or increase productivity per unit use in generating a virtuous cycle of growth than any traditional economic policy instrument, by attracting the idle private sector investment funds searching for higher returns and profits. Higher consumer surpluses generated in both the developed and developing countries will increase overall world income, consumption more rapidly (than any personal income tax breaks) and increase exports of the West in the widespread use of first two type of technologies while in the case of third, the consumer surplus generated in the third world will continue to sustain another virtuous cycle of growth in the West.