Behind Japan's and EU's crisis is capitalism's failure to ensure free markets in labour

It is interesting that just as the US Federal Reserve is winding up its bond buying programme (the so-called QE3), the Bank of Japan is expanding it. On 31 October, the Bank of Japan decided to up its bond-buying programme substantially, raising the annual buying target from 60-70 trillion yen ($725 billion) to 80 trillion yen.

The reason: weak growth and an inflation rate well below target. High inflation, once the bugbear of the world economy, is worrying everyone on the downside now. In the new economics of western capitalism, below-target inflation means bad news. Deflation is thought of as the bigger threat than inflation; hence the desperate money-printing exercise to somehow boost growth and inflation.

Left-of-centre economists like Paul Krugman believe that creating more debt and printing money is what is needed to help employment and economic growth. Krugman, in fact, wrote in his recent New York Times blog, that the west is now facing the exact deflationary crisis as Japan did over the last two decades, and its policy response is worse than Japan’s. The only answer is higher government spending. He wrote: “Everyone knows that in the early 1990s Japan tried to boost its economy with a surge of public investment; it’s less well-known that public investment fell rapidly after 1996 even as the government raised taxes, undermining progress toward recovery. This was a big mistake, but it pales by comparison with Europe’s hugely destructive austerity policies, or the collapse in infrastructure spending in the United States after 2010. Japanese fiscal policy didn’t do enough to help growth; Western fiscal policy actively destroyed growth.”

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However, if the Left is demanding more public spending to revive the economy, the Right is demanding the exact reverse - more austerity and less government. The Left says the poor are in pain and need the support of government spending; the Right says the pain will be prolonged if budget deficits are not fixed, and government is not shrunk.

The truth is both are half-wrong. The Right is wrong because austerity will affect the poor the most, as growth and employment fall and tax revenues collapse further. The Left is wrong because higher spending makes no sense unless we are sure where it is going. If it goes to the wrong places, it will not boost growth and employment, but asset prices. The higher spending should ideally go to build public infrastructure and/or write off the debts of the poor. But it is actually going to inflate asset prices.

This was demonstrated perfectly after the Bank of Japan announced an enhanced stimulus. Every asset class - from stocks to the US dollar to even the Sensex zoomed. The bulk of the higher spending is thus going to create an asset bubble when economies are slowing or even declining. When this bubble bursts, we are going to return to 2008. Or worse.

The problem with economists from both the Left and Right is that they are choosing to ignore the two elephants in the room: capitalism is, in practice, mishandling two key factors of production, capital and labour. (When we say economists, we are here talking largely about those who are fine market economics and capitalism, but only disagree on what government ought to do, and where and how much it should spend. We are not talking of Marxist economists, who decry “neo-liberal” policies.)

Both capital and labour are not subject to the fundamental forces of markets. Capital moves too freely, and largely escapes taxation. Labour faces the highest tariff and non-tariff barriers in the form of immigration controls. It is also taxed higher in many places.

It beggars the imagination that market-economy believers are not comfortable opening up the one market that remains constrained by politics - labour. And we are not even talking permanent migration, but only temporary migration for jobs and careers. Racism and xenophobia are the only explanation.

The crisis in capitalism will start abating when the west accepts that market forces work best when they are allowed to operate freely.

Consider Japan. It has almost zero immigration. Its deflation is largely the result of an ageing population that is comfortable with its level of affluence. So it is happy to accept low-growth and even a marginal loss of prosperity as it is culturally homogeneous and domestic labour is not any worse off than capital in bearing this hardship. And so when the government artificially tries to pump demand and growth by forcing inflation, the economy simply refuses to move. The solution to Japan’s stagnation is greater import of labour.

Economies move when there is an aspirational demographic pressure from below for greater prosperity, not when the population is in a state of nirvana, content with what it has. The extra money being pumped in thus moves to assets - which inflate when there is too much money sloshing around.

It is worth recalling that even as the US saw little improvement in jobs after the Great Recession that started in 2008, the stock market boomed. The Dow has never been higher.

Europe, which is also ageing like Japan (at least its richer north) is trying out austerity under German and Scandinavian pressure, but is paying the price with low inflation and almost no growth.

Only the US, which is not as hard on immigration (or is not able to control it from the south), is now showing signs of revival.

So look at the evidence: Europe and Japan, which discourage immigration from outside, struggle. The US is doing much better.

The other elephant - giving capital an easy ride - though, remains more a US problem than in Europe or Japan. As Thomas Piketty’s book Capital in the 21st Century notes, when rates of return on capital are higher than economic growth, inequality will rise. As inequality rises, it means less spending power in the hands of a larger proportion of the population. The economic base narrows and growth falters. He thus calls for more taxes on capital.

In India, too, taxes on long-term capital gains are zero and short-term gains attract around 16-17 percent tax (with cess). As against this, salary income in the top band attracts 34 percent (including cess and surcharge).

The Left’s indirect agenda, when asking for expanding deficits and spending is that money printing (and inflation) will destroy the real value of capital, thus denting real returns, even while putting money in the hands of the poor.

A more direct approach would be to remove the tax-breaks for capital, tax inherited wealth , and going easy on taxing labour incomes. And, of course, freer immigration will also rejuvenate ageing economies as new tax-paying workers enter the job market, increasing the ability of the state to garner more revenues and invest in infrastructure and jobs.

Till capitalist economists, from Left and Right, are willing to recognise and shake hands with the two elephants in the room, capitalism will stumble from crisis to crisis.