COMMENTARY
The basic idea of this essay by Professor Joseph Stiglitz is OK ... but it is based on the prevailing concepts of economics that have no way to come to grips with the issues and possibilities of this century.

There is a need to understand where wealth comes from, and how it gets moved around in a modern economy ... and how more wealth can be created. Aggregate demand is an idea that has a correlation with business activity and earning profits. An alternative is to think about needs and how economic activity and the deploymnent of economic resources can satisfy needs in the most efficient way.

Advertising has been used for several decades to create wants that could be satisfied by the business community ... but how many of these wants have any relevance in real quality of life.

Certainly the modern economy is in an unhealthy state ... but some of the components of the economy are very effective. It is not beyond human ingenuity to restructure the organization of these components so that all the important needs of our gloabl society are met, and there can be more and more quality of life for all.

This is not the old idea of 'wealth redistribution' that was politically popular 100 years ago. It is simply the idea that some aspects of modern economic activity can be many orders of magnitude more effective, and yet the structure of society does not reflect these possibilities. A big change and improvement is possible.
Peter Burgess

The underlying cause of the financial collapse is growing inequality; the solution is strong government expenditures.

IMAGE Growing financial inequality is the underlying cause of the global financial crisis [GALLO/GETTY]

As the economic slump that began in 2007 persists, the question on everyone's minds is obvious: Why? Unless we have a better understanding of the causes of the crisis, we can't implement an effective recovery strategy. And, so far, we have neither.

We were told that this was a financial crisis, so governments on both sides of the Atlantic focused on the banks. Stimulus programs were sold as being a temporary palliative, needed to bridge the gap until the financial sector recovered and private lending resumed. But, while bank profitability and bonuses have returned, lending has not recovered, despite record-low long- and short-term interest rates.

The banks claim that lending remains constrained by a shortage of creditworthy borrowers, owing to the sick economy. And key data indicate that they are at least partly right. After all, large enterprises are sitting on a few trillion dollars in cash, so money is not what is holding them back from investing and hiring. Some, perhaps many, small businesses are, however, in a very different position; strapped for funds, they can't grow, and many are being forced to contract.

Still, overall business investment - excluding construction - has returned to ten per cent of GDP (from 10.6 per cent before the crisis). With so much excess capacity in real estate, confidence will not recover to its pre-crisis level anytime soon, regardless of what is done to the banking sector.

The financial sector's inexcusable recklessness, given free rein by mindless deregulation, was the obvious precipitating factor of the crisis. The legacy of excess real-estate capacity and over-leveraged households makes recovery all the more difficult.

The straw that broke the camel's back

But the economy was very sick before the crisis; the housing bubble merely papered over its weaknesses.

Without bubble-supported consumption, there would have been a massive shortfall in aggregate demand. Instead, the personal saving rate plunged to one per cent, and the bottom 80 per cent of those in the US were spending, every year, roughly 110 per cent of their income.

Even if the financial sector were fully repaired, and even if these profligate Americans hadn't learned a lesson about the importance of saving, their consumption would be limited to 100 per cent of their income. So anyone who talks about the consumer 'coming back' - even after deleveraging - is living in a fantasy world.

Fixing the financial sector was necessary for economic recovery, but far from sufficient. To understand what needs to be done, we have to understand the economy's problems before the crisis hit.

First, the US and the world were victims of their own success. Rapid productivity increases in manufacturing had outpaced growth in demand, which meant that manufacturing employment decreased. Labour had to shift to services.

The problem is analogous to that which arose at the beginning of the twentieth century, when rapid productivity growth in agriculture forced labour to move from rural areas to urban manufacturing centres. With a decline in farm income in excess of 50 per cent from 1929 to 1932, one might have anticipated massive migration. But workers were 'trapped' in the rural sector: They didn't have the resources to move, and their declining incomes so weakened aggregate demand that urban/manufacturing unemployment soared.

For the US and Europe, the need for labour to move out of manufacturing was compounded by shifting comparative advantage: Not only are the total number of manufacturing jobs limited globally, but a smaller share of those jobs will be local.

Globalisation has been one, but only one, of the factors contributing to the second key problem - growing inequality. Shifting income from those who would spend it to those who won't lowers aggregate demand. By the same token, soaring energy prices shifted purchasing power from the United States and Europe to oil exporters, who, recognising the volatility of energy prices, rightly saved much of this income.

The final problem contributing to weakness in global aggregate demand was emerging markets' massive buildup of foreign-exchange reserves - partly motivated by the mismanagement of the 1997-98 East Asia crisis by the International Monetary Fund and the US Treasury.

Countries recognised that, without reserves, they risked losing their economic sovereignty. Many said: 'Never again.' But, while the buildup of reserves - currently around $7.6 trillion in emerging and developing economies - protected them, money going into reserves was money not spent.

Where are we today in addressing these underlying problems? To take the last one first, those countries that built up large reserves were able to weather the economic crisis better, so the incentive to accumulate reserves is even stronger.

Similarly, while bankers have regained their bonuses, workers are seeing their wages eroded and their hours diminished, further widening the income gap. Moreover, the US has not shaken off its dependence on oil. With oil prices back above $100 a barrel this summer - and still high - money is once again being transferred to the oil-exporting countries. And the structural transformation of the advanced economies, implied by the need to move labour out of traditional manufacturing branches, is occurring very slowly.

Government plays a central role in financing the services that people want, such as education and health care. And government-financed education and training, in particular, will be critical in restoring competitiveness in Europe and the US. But both have chosen fiscal austerity, all but ensuring that their economies' transitions will be slow.

The prescription for what ails the global economy follows directly from the diagnosis: Strong government expenditures, aimed at facilitating restructuring, promoting energy conservation, and reducing inequality, and a reform of the global financial system that creates an alternative to the buildup of reserves.

Eventually, the world's leaders - and the voters who elect them - will come to recognise this. As growth prospects continue to weaken, they will have no choice. But how much pain will we have to bear in the meantime?

Joseph E Stiglitz is University Professor at Columbia University, a Nobel laureate in economics, and the author of Freefall: Free Markets and the Sinking of the Global Economy.

The views expressed in this article are the author's own and do not necessarily reflect Al Jazeera's editorial policy.

This article was first published on Project Syndicate.