Ending the Era of Ponzi Finance

Ending the Era of Ponzi Finance

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Ending the Era of Ponzi Finance

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  • Ten Steps Developed Economies Must Take

    There are ten steps that developed economies must take to definitively end the era of Ponzi finance. Some are sacrifices required of various stakeholders. Others are new social investments, both public and private, that are needed in order to return to a sustainable growth path. Although there are tensions and tradeoffs among these steps, they are all necessary to put the developed economies on a more positive economic footing.

    1. Deal with the debt overhang—immediately. A precondition to addressing the fallout of the unsustainable policies of recent decades is a fast cleanup of the debt overhang. In previous papers, my colleagues and I have discussed the various options for doing so. Put simply, some combination of writeoffs and restructuring, austerity, higher taxes, and sizable inflation will be necessary.

    The critical starting point is to accept the fact that many of today’s debts will never be repaid and to embrace debt restructuring and defaults. Current policies, designed to avoid that outcome, only postpone the ultimate resolution of the crisis and will result in even bigger losses down the road. Better to move quickly and act now, despite the likelihood of considerable near-term pain.

    All stakeholders will have to contribute to the necessary cleanup. Creditors and holders of financial assets will have to accept losses. Taxpayers will have to accept higher taxes—with a special burden on the wealthy, because unless politicians begin to address the unequal distribution of income and wealth, they will not have the credibility to implement other painful measures needed to get the developed world back on track. As difficult as that will be, especially for those who have been prudent and saved for retirement, the sooner the developed economies bite the bullet, the sooner everyone will be able to repair their personal balance sheets before they retire. Otherwise, we risk experiencing a lost decade—or more—in which the fundamental underlying problems are not resolved and the value of current savings continually erodes.

    2. Reduce unfunded liabilities. Once debt restructuring is under way and the broader public sees that wealthy owners of financial assets are contributing to the necessary cleanup, it should be easier for politicians to take another painful step: addressing openly and directly the trillions in unfunded liabilities that are weighing down budgets and balance sheets across the developed world. It will require a combination of several measures to bring these unfunded liabilities under control.

    • Raise the retirement age. As unpopular as this measure will be, it is the most important lever to reduce future costs. In an era of shrinking workforces, the math simply doesn’t work. The sooner the public knows what to expect, the sooner it will be able to plan for this scenario. Seen in this light, recent political initiatives toward earlier retirement, as we are currently witnessing in France, are extremely counterproductive.

      See “French President Francois Hollande Cuts Retirement Age,” The Telegraph, June 6, 2012, and “France Gives Workers More Benefits,” The Wall Street Journal, June 6, 2012.
    • Reduce social-insurance payments. Even with a higher retirement age, it will be necessary, at least in some developed countries, to also reduce future payouts. Again, the sooner the public has a clear picture of what the changes will be and when, the sooner it can begin to prepare for them.

    • Manage health care systems for greater efficiency. In many countries, especially the U.S., health care is the primary driver of increased government spending. But higher spending on health care is not necessarily a sign of better health outcomes. Although the U.S. spends 17.6 percent of GDP on health care, U.S. life expectancy is between 1.7 and 3 years less than it is in the U.K. (which spends only 9.6 percent of GDP on health care) and in France and Germany (which spend 11.6 percent). The health care systems of the developed countries—and not just the U.S.—offer huge potential for more efficiency with no loss in effectiveness. (See “Health Reform Should Focus on Outcomes, Not Costs,” BCG article, October 2012.)

      OECD, OECD Health Data 2012, June 2012, and U.S. Central Intelligence Agency, “Life Expectancy at Birth” in The World Factbook 2012.

    3. Increase the efficiency of government. Parallel to reductions in government spending on social-welfare benefits, another key to reducing government’s share of GDP and increasing economic growth is to make government itself more efficient. A smaller government sector does not necessarily mean a weaker government. By defining the right “rules of the road” for society and business, governments can set the tone and priorities for development in a more effective as well as a more efficient way.

    • Increase the efficiency of the social-welfare system. The administrative costs of welfare systems is an area ripe for rationalization. One change to consider is replacing traditional means testing, which can very quickly become highly bureaucratic and resource intensive, with a guaranteed minimum income. An idea supported in the past by liberals such as Martin Luther King Jr. and John Kenneth Galbraith, but also by conservatives such as Friedrich Hayek, Richard Nixon, and Milton Friedman, a guaranteed minimum income has the advantage of eliminating most procedures for means testing and freeing up resources traditionally used in the allocation and distribution of money.

    • Free up the public-sector workforce. It is also important to reduce the number of public employees as a percentage of the overall population. In a period when labor will become increasingly scarce, it is critical that as many people as possible actually generate GDP (rather than merely consuming and redistributing it). This is not to say that public-service employees do not contribute to the overall welfare of society. But in a world of scarcity, the tradeoffs become more visible. And government inefficiencies are significant, especially in European countries.

      António Afonso, Ludger Schuknecht, and Vito Tanzi, “Public Sector Efficiency: An International Comparison,” Public Choice, June 2005.
    • Implement structural reforms. Besides reforming social-welfare and retirement systems, it is important to maximize the economic potential of the economy. Therefore efforts to increase competition, by abolishing rules that block new entrants, and to increase the flexibility of labor markets need to be implemented fast. According to a study by the IMF, the growth potential of economies in Western Europe could be increased by 4.5 percent over five years through the adoption of such measures.

      Bergljot Barkbu, Jesmin Rahman, Rodrigo Valdés, et al., “Fostering Growth in Europe Now,” IMF Staff Discussion Note, June 18, 2012.

    4. Prepare for labor scarcity. Countries need to start now to prepare for the coming era of labor scarcity. Doing so will require a series of initiatives to reduce the decline of the workforce.

    • Increase workforce participation by the elderly. In general, people will have to work longer, and the elderly will become a key component of the labor force. This change is beginning to happen already, driven primarily by the relative lack of well-educated and employable younger people. In the U.S., for example, the participation rate of workers age 65 years and older has increased significantly, from less than 11 percent of the total population in the mid-1980s to 16.7 percent in 2011. Since the depths of the recession in 2009, the majority of jobs created—about 3.5 million out of the total of 4.2 million—have gone to workers older than 55. As this trend continues, however, there will be a need for increased investments in training and education, and businesses will have to adapt their processes to the needs of older people.

      U.S. Bureau of Labor Statistics, “Labor Force Participation of Seniors, 1948–2007,” July 29, 2008, and “Labor Force Statistics from the Current Population Survey,” Table 3 (Employment status of the civilian noninstitutional population by age, sex, and race), 2011.
      Chart Of The Day: 55 And Under? No Job For You,” Zero Hedge, October 24, 2012.
    • Increase workforce participation by women. Growing participation by women in the labor force has been a major source of economic growth in recent years in the developed world. And yet, in many countries, the share of women in the workforce is still below the high levels reached in Switzerland, Sweden, and Norway, where between 77 and 82 percent of all women work. Women should also be encouraged to study economically relevant subjects such as science and engineering.

      OECD, OECD.StatExtracts, Annual Labour Force Statistics summary tables, (female civilian labor force as a percent of the population aged 15–64).
    • Encourage family formation. Even as women enter the workforce, they should also be encouraged to have more children. Successfully addressing current economic woes will go a long way toward improving the fertility rate (experiences such as Germany’s reunification demonstrate that birth rates are highly sensitive to the social and economic environment). Of course, both increasing the participation of women in the workforce and encouraging larger families will require additional social investment in the form of widely available high-quality childcare.

      Jonathan Grant et al., “Low Fertility and Population Ageing: Causes, Consequences, and Policy Options,” RAND Corporation Monograph Series, 2004.

    5. Develop smart immigration policy. Even if developed countries take all these steps, it will still not be enough to reverse demographic trends. Therefore, these countries also need to become far more open and attractive to immigrants.

    With the oldest native population and an immigrant population close to zero, Japan faces the most severe challenge. But Germany also struggles to attract well-educated immigrants because of the language barrier. Although immigration to Germany has increased since the financial crisis (up 20 percent in 2011 and an additional 15 percent in the first half of 2012), most of these immigrants are from countries in southern Europe such as Greece, Portugal, and Spain. This internal Eurozone migration only serves to weaken the economies of the periphery further; moreover, whatever economic benefits Germany gains from these new immigrants will likely be canceled out by the higher transfer payments that will be necessary to keep the weak economies in the periphery of the Eurozone from collapsing. From a European perspective, encouraging immigration from outside of Europe has to be the goal.

    Even the U.S., which has long prided itself on being a nation of immigrants, needs to revise its policies. Since World War II, the U.S. system of higher education has attracted the world’s best students, and the U.S. has benefited economically from their presence. For every 1 percentage point increase in foreign students in the U.S., there has been an increase in patents in the neighborhood of 9 to 18 percent. And networks of immigrant entrepreneurs have played a central role in U.S. technological innovation, most notably in Silicon Valley, where more than half of start-ups have been founded or cofounded by Indian or Chinese entrepreneurs.

    But in the years since 9/11, the U.S. has become far more restrictive, and as emerging markets have gained in attractiveness, a much larger share of foreign students are returning to their countries of origin. According to one survey of foreign graduates, “fewer than 10 percent of Indians and Chinese ‘strongly’ desire to stay in the U.S.” In a two-speed world with diverging economic trends, the developed economies will compete against one another and with emerging markets for the same limited talent pool.

    A smart immigration policy should focus on attracting well-educated and highly motivated people who want to build their own lives in their new country and contribute to its economic growth. A good model is Canada, where a full 20 percent of permanent residents are foreign born and immigration enjoys widespread public support. Canadian immigration policy is highly selective: it has an economic orientation that aims to attract skilled individuals who will improve the human capital of the country’s aging labor force. And it emphasizes both effective integration (settlement and integration policies include programs to facilitate entry into the labor market and mastery of both French and English) and permanent migration (to give both immigrants and Canada itself a stake in favorable long-term outcomes).

    6. Invest in education. Education has to play a significant role in the future growth potential of the developed economies. Quality education will be the decisive factor in protecting and increasing GDP per capita. It is also the foundation of social mobility and a precondition to fully utilizing the innovative capabilities and entrepreneurial talent of a society’s members. For both reasons, it needs to be another key target of social investment.

    • Improve average education levels. The developed world can no longer afford to let a sizable share of its youth lack access to quality education. Not everyone can become a top student, but raising the average level of education, notably in the basic skills of reading, writing, and math, will improve labor market access and reduce the social-welfare burden. Education systems such as Germany’s, which directly link school with learning on the job, should be implemented in other countries as well.

      The German system of vocational education is a best practice. See “Vocational Education: The Missing Link in Economic Development”, BCG article, October 2012. However, it should not be confused with the general German school system, which still produces a high number of dropouts who are not able to access apprenticeship programs because of a lack of basic skills.
    • Improve the quality of teaching. Not all investments in education necessarily improve the quality of education. After all, between 1970 and 2007, the U.S. government tripled spending on education in real terms—without any significant overall impact. The one type of investment that has had a demonstrated impact however, is the education, training, and compensation of highly qualified teachers. As Finland’s high-performing educational system shows, excellent teachers and modern technology are critical to improving student outcomes.

      Andrew J. Coulson, “Has Federal Involvement Improved America’s Schools?” Cato Institute, November 5, 2009.
      Linda Darling-Hammond, “What We Can Learn from Finland’s Successful School Reform,” National Education Association, 2010. World Bank data on the pupil-teacher ratio (in primary education) show that Finland lowered its ratio from 22.2 in 1971 to 13.6 in 2009.
    • Encourage the study of topics relevant to future economic development. Finally, it will be important to direct students toward those subjects that are the most relevant to economic development, notably science and engineering. To some extent this will happen automatically, as students become aware of the attractiveness of the careers for which such studies prepare them. But the shift can be accelerated—for example, by limiting the available slots for less economically relevant subjects or by providing financial incentives for students to choose more economically relevant subjects.

    7. Reinvest in the asset base. For more than a decade, the developed economies have reduced investments in public infrastructure and productive assets. Given the importance of the quality of capital stock to productivity and economic growth, it is time to reverse this trend.

    • Modernize public infrastructure. World-class infrastructure is an important precondition for economic development and national competitiveness. Airports, railway systems, highway networks, and energy grids need to be modernized and sized according to future demand. In order to minimize public debt, infrastructure modernization has to be done in cooperation with the private sector. Indeed, governments should involve the private sector not only in financing but also in the management of public projects; this will maximize efficiency by improving strategic planning and governance, reducing process complexity and time to completion, and improving prioritization and selection of projects.

      See The Global Infrastructure Challenge, BCG White Paper, July 2010
    • Increase private-sector investment. Over the past few decades, Western multinationals have used their free cash flow mainly to invest in developing economies. Now that these investments are paying off, it is time for them to reinvest in the efficiency of production sites in their home markets and work off the investment backlog. Governments need to encourage private investment. Tax policies should make it more attractive to invest and less attractive to distribute—for example, by providing tax credits for domestic investment or by raising taxes on dividends. Structural reforms also have to be undertaken to remove labor market impediments to increased investment.

    8. Increase raw-material efficiency. The age of cheap resources may have come to an end. Developed countries have to increase their efforts to decouple economic development from resource consumption.

    • Pursue alternative-energy technologies. Although almost half of new power capacity added worldwide in 2011 was in renewables, fossil fuels still contribute around 80 percent to the total power generated. And with the discovery of new techniques for exploiting fossil fuels—take, for example, the shale-gas boom, which may turn the U.S. into a net exporter of energy—it will be tempting to slow the transition to renewables. But such solutions will only be temporary. Governments need to accelerate the transition to renewables through investments in national infrastructure and innovative pilot projects. Because of their very long investment horizons, ambitious and highly innovative projects such as Desertec (solar power plants in northern Africa intended to supply energy to Europe) and Masdar (a zero-waste, zero-carbon city for 40,000 citizens in the United Arab Emirates) rely on public funding.

      Renewable Energy Policy Network for the 21st Century, Renewables Global Status Report, June 2012.
    • Promote “material efficient” production and products. With energy and raw-material prices rising, it is a strategic priority for businesses to continuously improve the production efficiency of their supply chains. Furthermore, companies need to invest in material-efficient products in order to satisfy changing consumer demands. Politicians should put in place effective policies so that efficient technologies are developed and applied by companies and consumers.

    9. Cooperate on a global basis. Competition among countries will become more intense in the years to come. All countries will try to increase their exports; all will try to attract the best-educated immigrants; and all will try to secure scarce resources, from water to oil to commodities. This increased competition will pay dividends in the form of new and innovative products. But even as they compete, the world’s countries must also cooperate. The problems of the developed economies can only be addressed in a cooperative way on a global scale. Otherwise, the world risks descending into a vicious circle of beggar-thy-neighbor economic policies leading to much lower growth and slower improvement of living conditions worldwide.

    The emerging markets are not immune to the problems facing the developed world. After all, the developed economies are important markets for the export-driven economies of emerging markets. What’s more, in recent decades, emerging-market countries have become significant creditors for the developed world. China alone holds more than $1.2 trillion in U.S. Treasury bonds and, according to one investment research firm, had an estimated €500 billion to €600 billion in European sovereign debt in 2011.

    • Support economic restructuring in the developed world. The creditors have to help the debtors pay back their debts. This will require the deficit countries to run a trade surplus and the former surplus countries to run a deficit. The emerging economies need to adjust their business model, focusing less on export-based growth and more on domestic consumption. These countries might also support economic adjustment in the developed economies by participating in efforts to reduce the debt overhang in an orderly way through restructurings and redemption funds.

    • Support efforts to reduce energy and commodity intensity. In global efforts to reduce carbon-dioxide emissions like the Kyoto initiative, the emerging markets oppose restrictive rules that could hinder their economic development. Irrespective of the implications for global warming, the direct consequence of the unchecked growth of carbon-based technologies will be higher commodity prices, which will amplify the problems of the developed economies. In contrast, efforts to become more efficient in the use of energy and other commodities would dampen price pressures, greatly improve economic growth, and support the adjustment process. According to the International Energy Agency, if effective policies were put in place to realize the potential of all economically viable energy-efficiency measures known today, growth in global primary-energy demand could be halved by 2035 and cumulative economic output boosted by $18 trillion.

      International Energy Agency, World Energy Outlook, November 2012.

    10. Launch the next Kondratiev wave. Last but not least, the developed world needs to prove Robert Gordon wrong. By investing in a growing and highly productive workforce and making it easier for engineers and technologists to innovate and for entrepreneurs to start new businesses, the developed economies need to unleash a new Kondratiev wave of global economic development.

    • Remove hurdles to innovation. Many government policies in the developed world are designed to protect traditional industries, whether through subsidies or favorable regulation. This practice not only makes the inevitable decline of these industries more expensive to the economy and society as a whole, but also leads to a loss of future technologies and future industries. As hard as it will be to lose income and jobs in traditional sectors, efforts to postpone the inevitable always fail. In the new world, governments have neither the money nor the time to protect traditional industries from change. Removing hurdles to innovation also implies more active antitrust policies, as the high levels of profitability that many industries enjoy today could indicate a lack of competition.

    • Encourage risk taking. Innovation tends to appeal to the young. Some of the most innovative companies—Apple, Google, Facebook, and Microsoft—were all founded by university students in their early twenties. Therefore, it is important for societies to encourage risk taking at a younger age and to make entrepreneurship more attractive and rewarding than working in other functions in the economy.

    • Increase social acceptance of innovation. In many developed countries, especially in Europe, the public has grown skeptical of innovation and new technologies. The classic example is biotechnology and its application in food production and in some parts of health care research. In our view, this resistance to innovation is largely a function of the average age of a country’s population. The higher the average age, the more the population seems inclined to protect the status quo and be wary of the new. Leaders in these societies will have to persuade citizens that only increased innovation can help deal with the costs of demographic change if overall levels of wealth are to be preserved.

    For a more general discussion of the ingredients for sustainable economic development and suggested measurement methodology, see Introducing the BCG Sustainable Economic Development Assessment: From Wealth to Well-Being, BCG report, November 2012
    In 2006, the immigrant population in Japan was only 1.6 percent of the total population. See United Nations Department of Economic and Social Affairs, International Migration Report 2006: A Global Assessment, October 2006.
    U.S. Immigration Policy Is Killing Innovation,” Financial Times, October 21, 2012.
    “U.S. Immigration Policy Is Killing Innovation.”
    In 2006, Canada had an immigrant population of 19 percent, compared with 13 percent in the U.S., 12 percent in Germany, 11 percent in Spain and France, and 9 percent in the U.K. And a 2010 survey found that only 27 percent of Canadians perceived immigration to be a problem rather than an opportunity, compared with 52 percent of U.S. respondents and 42 to 65 percent of French, German, Italian, and British respondents. See United Nations Department of Economic and Social Affairs, International Migration Report 2006: A Global Assessment, October 2006, and German Marshall Fund of the United States, Transatlantic Trends: Immigration, Key Findings 2010.
    Irene Bloemraad, “Understanding ‘Canadian Exceptionalism’ in Immigration and Pluralism Policy,” Migration Policy Institute, July 2012.
    China—Nicht der erhoffte weiße Ritter,” Deutsche Bank Research, September 16, 2011, and “China Says Willing to Buy EU Bonds Amid Worsening Crisis,” Reuters, August 30, 2012.