Fear of the New Holds Back Recovery

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We are witnessing "the crisis of the old order." The phrase, coined by the late historian Arthur Schlesinger Jr. to describe the failure of unfettered capitalism in the late 1920s, also applies to the present, despite different circumstances. Everywhere, advanced nations face similar problems: overcommitted welfare states, aging populations, flagging economic expansion. These conditions define the global crisis and explain why it struck the United States, Europe and Japan simultaneously. We need to move beyond daily partisan fireworks to see this larger predicament.

The old order, constructed by most democracies after World War II, rested on three pillars. One was the welfare state. Government would protect the unemployed, aged, disabled and poor. Capitalism would be tamed. A second was faith in economic growth; this would raise everyone's living standards while permitting income redistribution. Growth was ordained, because economists had learned enough from the 1930s to cure periodic recessions. Finally, global trade and finance served countries' mutual interests.

All three pillars are now wobbling. To be sure, the financial crisis worsened matters, and each country's situation is different. America's welfare state is less generous than Germany's. Greece's crisis began because it had vastly underreported its budget deficit; Ireland's stemmed from a burst housing bubble that led to a costly bank bailout. But these differences obscure large similarities.

Start with the welfare state. A blessing to many, it's also a common burden. Its expansion was huge. In 1950, government spending as a share of a nation's economy (gross domestic product) was 28 percent in France, 30 percent in Germany and 21 percent in the United States. By 1999, figures were 52 percent of GDP in France, 48 percent in Germany and 30 percent in the United States, according to figures compiled by the late economics historian Angus Maddison. Aging societies would boost future costs for pensions, social security and health care. From 2008 to 2050, the 65-plus population is projected to rise 40 percent in Germany, 77 percent in France and 121 percent in the United States.

Given this outlook, even countries without immediate crises are embracing austerity measures. All face a ruinous choice: The higher taxes or deficits needed to finance more welfare spending might further damage the economy, but cutting benefits stirs popular backlash. Still, benefits are now vulnerable. Ireland cut benefits for the unemployed by about 10 percent, reduced child payments by 16 percent and, beginning in 2014, will gradually raise the retirement age from 65 to 68.

On paper, faster economic growth could rescue governments from this trap. Unfortunately, this seems a mirage. Indeed, the old order's second prop - faith in routine economic expansion - is suspect. Economists exaggerated their understanding and control. They seem to have exhausted conventional policy approaches. Central banks such as the Federal Reserve have held interest rates low. Budget deficits are high.

Some American economists argue the United States should temporarily run even bigger deficits. Perhaps that would work, but Europe's experience counsels otherwise. Big deficits there led to higher interest rates, reflecting investors' greater fears of default. Default anxieties in turn weaken banks - large holders of government bonds - and, through them, the broader economy. Although the United States hasn't yet suffered this fate, it might, especially considering warnings from Moody's and Standard & Poor's that exploding federal debt could cause rating downgrades.

Austerity practiced by one or two overcommitted nations may succeed; their economies can grow by increasing exports to replace lost domestic spending. But prolonged austerity practiced by most advanced countries could be a huge drag on the world economy. To whom can they export? The obvious answer is China and other "emerging markets." But China frustrates this possibility by maintaining an artificially low currency that subsidizes its exports and sustains large trade surpluses. China sees trade as a jobs creator. It shuns the notion of trading for mutual advantage - the old order's third pillar. The political foundation of the global trading system is at risk.

We have left our collective comfort zone. Ideas and institutions that, on the whole, served well since World War II are under a cloud. The same was true in the 1920s and early 1930s. Then, the world's leading nations vainly struggled to maintain the gold standard, which - before World War I - had anchored a prosperous economic order. There was a natural impulse to cling to familiar ideas and practices in which people were invested politically and intellectually. This inertia contributed to the Great Depression's severity.

Amid today's unrelenting political uproar, something similar is happening. Economic weakness in advanced countries stems partly from the residual trauma on consumers and companies following the ferocious 2008-09 financial crisis. But the effect is complicated by a backward-looking mentality. Governments everywhere are striving to protect the old order because they do not understand and fear the new.


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