Has Western-style democracy become too expensive for capitalism?

Much ink has been spilled on the significance of 2016’s one-two populist punches as thrown by Brexit then Trump. What does it mean for the West? Most analysis concludes that parts of the West are having second thoughts about globalisation, and there is undoubted — if only partial — merit in this assessment.

The increasing free flow of trade, labour and capital that typically define globalisation have conspired to contain the income growth of Western middle classes since 2000. In parallel, the Digital Age has facilitated the income damping effects of technological advances and the globalisation of knowledge and know-how. As McKinsey has noted, almost 70 per cent of households in the 25 most advanced economies — some 560m people — have seen their real incomes stay flat or fall since 2005.

When historians look back on 2017 in a 100 years’ time, in addition to the “too-much-globalisation” explanation, two even more important mega trends will be identified as the main causes of this current upheaval.

While each cause is distinct, both are connected. The first is that democracy’s lifecycle is ageing. The second is that the centre of economic gravity is shifting back from West to East. The connection between these two mega trends is that, although the East has flirted with democracy, its new champions are not democratic nor are there indications that they are likely to be, at least in the sense that the West regards the concept. Only India’s ascendancy might yet give Western-style democracy a second chance and a new lease on life.

The central reason why Western democracy is in decline is that its capitalist bedfellow can no longer afford the financial demands that full-blown democracy is placing upon it. History has shown that capitalism can adapt, consorting with a variety of political systems in the past 5,000 years. Looking ahead, it will probably find another political host to aid its survival. Democracy — capitalism’s host over the past century — is far more brittle.

Democracy’s political demands have productively cohabited with the economics of capitalism for a century because the economic largesse that this arrangement produced was partially redistributed via the tax-the-winners and spend-on-the-falling-behinds mechanisms of social democracy. This persuaded those whose livelihoods required subsidisation to support this marriage of convenience. The rise of populism, the deepening divide between generations and the growth of anti-establishment political movements on both extremes of the political spectrum suggest this grand bargain may be losing its attraction. This cohabitation is threatened because the economic surpluses generated can no longer cover the level of political demands for subsidisation.

In fact, these surpluses have been insufficient since before WWII. But the stop-gap measures of Keynesian-inspired budget deficits — the real glue of democratic capitalist cohabitation — have made up the necessary differences even if these debt-financed transfers inexorably added to overall national debt.

This subsidisation process has become so ingrained in modern Western social democracy that few can imagine a world without it. What was originally a stop-gap measure has morphed into an addiction, one of chronic proportions. And, as Kenneth Rogoff and Carmen Reinhart have shown, once government debt exceeds around 90 per cent of GDP, it clogs up the arteries of growth. Once the ensuing slowdown of GDP growth happens, the growth in the surpluses available for redistribution shrinks too.

Fundamentally, the surpluses furnished by GDP growth are the product of just two inputs: the number of hours worked — a function of demographics — and the quality of work done in each of those hours — a function of labour productivity. Both demographic and productivity contributions to GDP growth are, in the West, now gravitating towards zero and, in some countries, are even below it. Even in the US, the structural underpins of GDP growth are now waning.

The demographic ageing of democratic societies was first recorded in Japan. It is now spreading to Europe, Canada and the US. The number of hours worked per annum are not growing as fast as they were from 1945 to 2000, when the population growth of the 50s and 60s Baby Boom was being absorbed into the workforce. Even in Australia, the median age rose from 28 to 37 in the 40 years to 2015.

Meanwhile, the second driver of GDP growth, increasing productivity, is also barely positive, even in the US. (Note that economists focus more on labour productivity, which is closely linked to average wages, and not capital productivity, which is more akin to corporate profits). Non-farm productivity growth has stalled, especially since 2000, with wage growth weighed down by the twin forces of supply chain globalisation and technological progress.

Donald Trump won the US presidential election by convincing disgruntled former factory workers in the critical swing Rust Belt states of Michigan, Wisconsin, Ohio and Pennsylvania that factories translocated from the US to Mexico and China had “stolen” middle class jobs from Middle America. A few factories have migrated, though the main effect of Asian and Mexican competition has been to limit wage increases much more than “steal” jobs. Rather than foreign competition, technological advance has destroyed most jobs. A study by Ball State University’s Michael Hicks found that 88 per cent of manufacturing job losses can be traced not to plants moving to Mexico or China, but to robots moving into US factories.

This combination of falling rates of growth in the number of hours worked and in the productivity achieved in those hours — reflected in a 12 per cent decline in real median US household incomes since 2000 — has mechanically weighed upon GDP growth, causing trend growth to fall from 3.5 per cent to less than 2 per cent in two decades.

With GDP growth surpluses barely growing, the glue of social democracy had to be financed mostly by debt. In 1980, the US National Debt was $1tn; in 2000, it was $6tn; today it is $20tn. And that is just the “on balance sheet” liabilities.

Globalisation and the Great Divide caused by advancing technologies have — as Thomas Piketty has shown — massively increased inequality throughout the West. Thomas Edison once noted that genius was 1 per cent inspiration and 99 per cent perspiration. Today’s digital divide is effectively separating the former, the 1 per cent — the inspired thinkers — from the latter, the 99 per cent — the perspiring workers. Rewards in income terms have flowed disproportionally towards the former and, already, that divide is now being reflected in wealth distribution, too.

A recent mutation of this logic has been the growing disenchantment of the youth with this unequal arrangement, as most are being progressively shut out of decent job opportunities that were open to their parents’ generation. The recent UK election — which saw the electorate start to swing towards the hard left on the back of an energised under-25s vote — and the fact that the youth of the US have made a socialist, Bernie Sanders, America’s most popular politician, are indications of this growing trend.

These fractures threaten the very fabric of democracy. The latter is predicated on the assumption that a clear majority of citizens must think that the democratic system works for them if they are to continue supporting it. In the US, with a majority of its citizens now predicting that their children’s generation will be worse off than their own, the American dream and with it, American democracy, is surely faltering.

As Western democracy stumbles, the East makes progress. With faster GDP growth, it generates the world’s most sizeable economic surpluses, even though — save for Japan — Asia has a far less sophisticated surplus redistribution mechanism embedded in its various political systems. With a few notable exceptions, Asian demographics are generally supportive while labour productivity growth is still materially positive, driven by its rising service economy and its labour moving up the value-added ladder.

The phrase “Cometh the hour, cometh the man” is usually meant as a compliment. But this is not so when it is applied to Mr Trump’s ascendancy to power in the US. Just as the West’s democratic dream is faltering and the US’s position as the world’s leading economic power is a decade away from being eclipsed, the US has elected a president who seems intent on withdrawing the US into its fortress and, by doing so, hastening both those declines.

Twenty-seventeen may well mark the year when the politics underlying the primacy of democracy and the economics underlying the primacy of the US both took decisive turns in new directions. It is distinctly possible that these developments will disadvantage both the US and the West at large.

Michael Power, Strategist, Investec Asset Management