The U.S. Economy in Decline: What Stagflation Tells Us

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(Cross-posted from Daily Kos)

Our economic situation has been all over the news. Banks are failing, credit is contracting, the auto industry is crying for a bailout. Clearly, the U.S. economy has gotten derailed, and we’re now faced with the unenviable task of getting it back on track. The trouble is, we don’t know which track is the right track.

Or do we?

Suppose there exists a valid interpretation of economic forces and outcomes, one that explains our current situation, yet one that no one will acknowledge, even to knock down.

About 12 years ago I picked up Cities and the Wealth of Nations: Principles of Economic Life by Jane Jacobs (better known as the author of The Death and Life of Great American Cities) at a used bookstore in upstate New York. Jacobs wrote this book in 1983, in response the emergence of stagflation. As an informed and educated layperson, she examined economic history with a critical eye and an urbanist’s heart, looking for the laws that explained what was going on — which the economic theories of the time did not.  

When I read her findings, they rang uncannily true. Yet when I’ve tried to introduce her theories into discussions of the economy, people with training in economics dismiss them as ridiculous — yet will not explain to me why they are.

Therefore, since we’re in the midst of another wicked attack of stagflation, I’m laying this theory out before you all, along with some personal conclusions concerning what it says about our economy and what must be done to repair it, in the hope that someone among us can either confirm or refute it. Simultaneous confirmation and refutation would be pretty cool, too.

Chapter 1 of Cities and the Wealth of Nations begins with a discussion of stagflation circa 1983:

In the United States, the unthinkable has happened. The country’s manufacturing economy has gradually but steadily been eroding, and much of what remains has been slipping into technological backwardness relative to industry in Japan and the more vigorous parts of Europe. Great American industries that once led the world flounder and founder. Productivity rates diminish. Military production has become increasingly indispensable to keep skilled people at work and to prevent whole regions of the country that rely heavily upon military work from collapsing economically.

Looking back over the last 24 years, this looks rather less like a predicament than like somebody’s master plan for fin-de-siècle economic life. But as President-Elect Barack Obama pointed out during the primary season, this economic malaise scared the daylights out of Americans at the time, to an extent that made them willing to accept the Reagan administration’s radical conservative economic policies in the hope of bringing “morning” back to their wallets.

After a brief digression into the curiously differing effects of Marshall Plan aid in various parts of Europe — the Netherlands and West Germany bounced back vigorously, while previously poor and backward Southern Italy stayed poor and backward despite the magnitude of investment — Jacobs provides a survey of economic theory, touching on Richard Cantillon, Adam Smith, John Stuart Mill, Karl Marx, John Maynard Keynes, A.W.H. Phillips and Irving Fisher; how each of them viewed the relationship between employment and prices; and how each of those theories fails to explain stagflation. “Far from explaining what it is or what can be done about it,” Jacobs concludes, “from start to finish they have explained, instead, that stagflation cannot exist!” (An interesting tidbit: In the discussion of Phillips, Jacobs notes, “In America [in 1960] an inemployment rate between 3 and 4 percent was deemed to represent full employment on grounds that the slack represents people changing jobs or just entering the labor market for the first time.” Yet by the mid-1990s, Alan Greenspan was claiming that an unemployment rate above 6 percent constituted “full employment.”)

Inspired by Arthur M. Okun’s invention of the “economic discomfort index,” Jacobs then reveals her epiphany:

Just so, we can think of stagflation as a coherent condition in its own right: a condition of high prices and too little work.

The moment we think of it so, we instantly realize that this condition is not abnormal or unprecedented. Rather, it is the normal and ordinary condition to be found in poor and backward economies the world over. The condition is abnormal only in economies that are developing and expanding or have been doing so in the recent past, which of course are exactly the economies which have harbored, among so much else, economic scholars and thinkers from Cantillon right down to Milton Friedman and Arthur Okun.

The conclusion, then, is that something in the U.S. economy has gone terribly wrong:

If I am correct, the emergence of stagflation in formerly developing and expanding economies is appalling in its implications and portents. It is not just a problem of inflation to be gotten under control along with a problem of unemployment to be dealt with by mastering inflation, or vice versa. It is a condition in its own right, the condition of sliding into profound economic decline.

In chapter 2, Jacobs turns her lens on the national economy as the basic unit of macroeconomics, as universally assumed by figures as divergent as Adam Smith and Karl Marx. She proposes instead that economic forces be examined as the product of urban production and trade, and that major cities and their surrounding regions, rather than nations, should be the focus of macroeconomic thinking. As an example, she raises the example of the economically passive French hamlet of Bardou, in ancient times a mining village supplying Rome, today a vacation getaway for travelers from Paris, and in between . . . not much of anything at all, just a wilderness settlement of scattered cottagers scratching out miserable lives on subsistence plots. Bardou was never in charge of its own economic destiny; it prospered only when it was touched by the prosperity of distant cities.

Jacobs then introduces her central concept of import replacement. What drives the growth of existing cities and the formation of nonexistent ones, she posits, is the local manufacture of goods formerly bought from someplace else. This process of import replacement requires innovative spirit and the ability to operate independently on a small scale. It ignites a cycle of economic activity:

• Replacements stimulate more replacements, not only of finished goods but also for goods used in the production process
• The wealth retained permits expansion, so that the replaced products can be exported as well as consumed locally.
• The capital raised from these exports funds more innovation and allows the purchase of other imports, which may themselves be replaced later.

The generation of capital in this manner allows a city to adapt when another city becomes able to produce the same goods more cheaply — it simply stays ahead of the curve, producing something else that it can consume domestically and export. This cycle allows the economy to expand in five ways: enlarged markets for imports, job growth, transplants of city work into exurban locations, new technology and growth of capital.

In chapter 3, Jacobs discusses the hinterlands of city regions and how they are transformed by urban growth. She contrasts these in chapter 4 with supply regions, which are rural regions that supply distant city markets with goods but do not get any further benefits from those cities’ vitality and diversity. Instead, they tend to become exploited monocultures, supplying a single resource — cotton, wheat, beef, copper, oil — which may enjoy some prosperity while commodity prices are good but do nothing to build their own economic capacity. Their lack of economic diversity and self-sufficiency makes them highly vulnerable to market shifts. Sometimes, however, supply regions do get their acts together and create import-replacing cities for themselves; this is how Boston and Philadelphia became thriving cities that were vigorous enough to break free of the British Empire in the 18th century, and how the “Asian Tigers” burst onto the world market in the 20th.

Chapters 5 and 6 involve regions that workers willingly abandon and those from which they are forced out by technological advances that reduce the need for manpower. In the former, workers typically leave to work in distant import-replacing cities, from which they send remittances back to their families at home, infusions of money that increase standards of living but do nothing to stimulate economic growth in the abandoned region. In the latter, the workers who stay typically prosper, but those who are forced out of work fall into lives of misery and become restless populations of squatters or refugees. Jacobs observes that if these two trends took place at the same time, with some workers remaining to take advantage of higher productivity through technology while others left and sent back money, the effects would be generally positive, but they rarely do take place at the same time — except in the hinterlands of thriving city regions.

In chapter 7, she discusses “transplants” — city-born industries transplanted to locations outside the city, because of crowding in the city, cheaper labor outside it or both. Again, while these transplants do increase standards of living, they don’t do anything to stimulate local economic growth through import replacement, because the transplanted industries already have their own networks of suppliers and don’t need anything local. Also, transplants are unstable, as Sun Belt residents can tell you, having enjoyed the benefits of transplants in the 1970s and ’80s, then watched grimly in the ’90s as they lost their transplanted industries to Mexico and China. But again, an entrepreneurial spirit can take the knowledge gained from working in transplanted industries and use it to get import replacement off the ground, as happened in Taiwan.

Chapter 8 deals with what happens when capital is invested in regions without import-replacing cities. In a nutshell, as long as no import replacement happens, the investment bears no fruit in the long run. Jacobs cites the example of the TVA, whose primary long-term contribution was the production of cheap electricity — essentially turning the Tennessee Valley into a supply region for power — and eventually it couldn’t even provide that competitively anymore. None of the money from the TVA went to creating urban industries that produced for local consumption, and so the region remained economically passive.

The message of chapter 9 is simple and blunt: Places that are bypassed by urban economic activity or lose their ties to it “sink into hives of rural subsistence” and gradually even lose the knowledge of past innovations, such as craft techniques.

Chapter 10 is another essential chapter, in which Jacobs argues that the path to stable economic growth is through trade with other city regions at the same level of development. In other words, Peru does not benefit from trading with the United States; it benefits from trading with, say, Bolivia. Mutual reliance, combined with innovation and improvisation, leads to sustainable growth. Trade with substantially more developed economies, on the other hand, is a dead-end relationship that leads to dependence and vulnerability. This is how, in the 19th century, cities in the American North developed vigorously by trading among one another, while the development of Southern cities was stunted by their preferring to supply agricultural goods to cities in the North and in Europe rather than develop city industries of their own. It’s how early Venice avoided becoming the thrall of Constantinople, and why the reality of St. Petersburg could never live up to the ambitions of Peter the Great. It’s also why (heresy alert!) tariffs are sometimes necessary: as the means by which backward economies can get their domestic production started, without the threat of being swamped by foreign competition (though Jacobs also acknowledges that, over time, they discourage the innovative spirit essential to economic growth).

In chapter 11, Jacobs introduces the concept of currency fluctuation as a feedback mechanism governing the growth cycle:

As we all know, when a nation’s currency declines in value relative to currencies of other nations with which it trades, theoretically the very decline itself ought to help correct the nation’s economy. Automatically its exports become cheaper to customer nations, hence its export sales should increase; and at the same time, its imports automatically become more expensive, and this should help its own manufacturers. Theoretically, then, a declining national currency ought to work automatically like both an export subsidy and a tariff, coming into play precisely when a nation begins to run a deficit in its international balance of payments because it is exporting too little and importing too much.

This, of course, presumes that we’re manufacturing something and haven’t shipped the entire process to some overseas sweatshop; but never mind that for now. Jacobs goes on to compare currency fluctuation to a feedback control, such as the way our brain tells our lungs how to breathe based on the levels of oxygen and carbon dioxide in our blood. If this sounds sort of like the “invisible hand” of market forces, well, it is, and Jacobs cites several cases in which the invisible hand works properly and well. But she goes on to argue that national currencies are a poor feedback control, especially in nations with more than one dominant city region:

To picture how such a thing can be, imagine a group of people who are all properly equipped with diaphragms and lungs but who share only one single brainstem breathing cener. In this goofy arrangement, the breathing center would receive consolidated feedback on the carbon-dioxide level of the whole group without discriminating among the individuals producing it. Everybody’s diaphragm would thus be triggered to contract at the same time. But suppose some of those people were sleeping, while others were playing tennis. Suppose some were reading about feedback controls, while others were chopping wood. Some would have to half what they were doing and subside into a lower common denominator of activity. Worse yet, suppose some were swimming and diving, and for some reason, such as the breaking of the surf, had no control over the timing of their submersions. Imagine what would happen to them. In such an arrangement, feedback control would be working perfectly on its own terms but the results would be devastating because of a flaw designed right into the system.

I have had to propose a preposterous situation because systems as structurally flawed as this don’t exist in nature; they wouldn’t last. Nor do they exist in the machines we deliberately design to incorporate mechanical, chemical or electronic feedback controls; machines this badly conceived wouldn’t work. Nations, from this point of view, don’t work either, yet do exist.

Nations are flawed in this way because they are not discrete economic units, although intellectually we pretend that they are and compile statistics about them based on that goofy premise. Nations include, among other things in their economic grab bags, differing city economies that need different corrections at given times, and yet all share a currency that gives all of them the same information at a given time. The consolidated information is bad specific information for them even with respect to their foreign trade, and it is no information at all with respect to their trade with one another, as opposed to their international trade. Yet this wretched feedback is powerful stuff.

In the long run, Jacobs concludes, the feedback provided by national currencies causes less robust city regions to wither, eventually leaving only one dominant city region intact, as the fluctuation of the currency responds more and more exclusively to what that one city region needs.

In chapter 12, Jacobs drops a bomb: Unremitting military spending, “transfer payments” (read: welfare and subsidies to poor regions) and dead-end trade with less developed countries, all of them essential to the functioning of an imperial economy, are also “transactions of decline” that bleed wealth away from the processes by which economic growth occurs. Military garrisons absorb the products of economic activity but send nothing back out; effectively, they’re a transplanted industry that doesn’t even have a market to sell its products back to. (War is an even bigger drain — one might as well take all the money that’s spent and literally burn it.) Subsidies and welfare payments simply buy social stability with money that might otherwise be invested in economic growth, and trade with nations too underdeveloped to supply their own goods without substantial foreign aid — usually in the form of loans that will never be repaid — is a no-win arrangement.

In chapters 13 and 14, Jacobs concludes that the United States’ greatest problem is its dependence on faulty economic feedback controls and transactions of decline, which create instabilities that are increasingly difficult to control:

If business cycles are indeed caused as I hypothesize, then the appearance of deep national depressions that are not self-terminating would mean that a nation’s cities, taken as a whole, are becoming ominously weak and dilatory at replacing imports: as a group are losing vitality. In that case we must also expect stagflation in due course, that characteristic of poor and backward economies, since a nation in which city economies have been enfeebled is necessarily a nation in process of becoming poor and backward. . . .

Consider the plight this creates for nations, quite as much as for cities. To develop in the first place, and then to continue prospering thereafter, nations must have import-replacing cities and enough of them. Nothing else in their grab bags of economies suffices: not supply regions, not clearance regions, not regions workers abandon, not transplant economies, not artificial city regions, not stagnated cities. Yet to hold themselves together as systems, nations must drain their cities in favor of transactions of decline and must undercut volatile intercity trade in favor of supplying settlements that can’t replace imports.

Here’s what all this says to me about what the United States needs to do to get itself back on track economically:

1. We have to admit the truth about what our feedback controls are telling us. Forget the GDP. Forget our supposedly low inflation (which seems not to count anything but the stuff on the shelves at Wal-Mart). The falling dollar tells us that we’re falling behind. Our out-of-control trade deficit tells us that we’re falling behind. The number of discouraged unemployed tells us that we’re falling behind. We cannot sustain ourselves as a nation without manufacturing something that we can afford to consume ourselves. Right now, I’m honestly not sure what that something is.

2. We have to disentangle ourselves from our military engagements. The “peace dividend” of the 1990s undoubtedly contributed to the economic vibrancy of that decade. So did the creation of jobs through the high-tech sector — the first real burst of new production for domestic consumption we’ve had since the 1950s — because, let’s face it, the only way to confront poverty that doesn’t involve welfare and subsidy payments is to make sure there are enough jobs to go around. “Structural full employment” is a crock.

3. We should repeal all free-trade agreements with nations less economically developed than we are. We don’t really benefit from exploiting them, and they don’t benefit from being exploited by us. Let them establish free-trade agreements among one another. Our primary trade should be with Canada, Europe, Japan, Korea and Taiwan.

4. We need to reduce our energy needs so that we don’t depend on foreign suppliers. Green energy production strikes me as an ideal industry to develop.

5. We need to stop outsourcing every goddamn thing we figure out how to do. These innovations benefit us only to the extent that they operate in our own cities and work in tandem with other American suppliers and innovators.

6. Maybe — and this is a radical idea that I think few would accept — but maybe we need to abandon the dollar and go to a system of regional currencies. We’ve already got a system of 12 Federal Reserve banks. What if each one establishes its own separately fluctuating currency? We’re finally at the stage, technologically, where computers could keep track of all the exchange rates moment-to-moment, and we could live essentially cashlessly.

No. 6 is a pipe dream. Nos. 1 through 5, however, should be part of the Obama administration’s economic platform.