Author: Satyajit Das
Driven by massive monetary stimulus from central banks, the performance of financial markets, especially stocks, have decoupled from that of a moribund real economy. Financiers assume that the strong rise in equity markets anticipates a strong economic recovery. However, there are fundamental reasons why the world may be entering a period of low or no growth. If that turns out to be the case, then the optimism of financial markets may prove premature.
Arthur Miller wrote that “an era can be said to end when its basic illusions are exhausted”. The central illusion of the age of capital -economic growth- may be ending.
All brands of politics and economics are deeply rooted in the idea of robust economic growth, combined with the belief that governments and central bankers can exert substantial control over the economy to bring this about. Economic growth has become the universal solution for all political and economic problems, from improving living standards, reducing poverty to now solving the problems of over indebted individuals, businesses and nations.
Politicians and policy makers relentlessly pursue growth. In his 1929 novel The Great Gatsby, F. Scott Fitzgerald identified this fatal attraction: “Gatsby believed in the green light, the orgiastic future that year by year recedes before us. It eluded us then, but that’s no matter – tomorrow we will run faster, stretch out our arms farther”.
But in nature, growth is only a temporary phase which ceases with maturity. As academic Jay Forrestor noted: “Past civilisations have grown into overshoot and decline. In every growth situation, growth runs its course, be it in seconds or centuries.”
Growth is a relatively recent phenomenon. In a deliberately provocative 2012 National Bureau of Economic Research paper entitled Is US Economic Growth Over? Faltering Innovation Confronts The Six Headwinds, economist Robert Gordon found that prior to 1750 there was little or no economic growth (as measured by increases in gross domestic product per capita).
It took approximately five centuries (from 1300 to 1800) for the standard of living to double in terms of income per capita. Between 1800 and 1900, it doubled again. The twentieth century saw rapid improvements in living standards, which increased by between five or six times. Living standards doubled between 1929 and 1957 (28 years) and again between 1957 and 1988 (31 years).
Other measures show similar trends. Between 1500 and 1820, economic production increased by less than 2% per century. Between 1820 and 1900, economic production roughly doubled. Between 1901 and 2000, economic production increased by a factor of something like four times.
Gordon controversially questions whether economic growth is a continuous process that can persist forever. He argues that growth and improvements in living standards will slow significantly. For “shock value”, he speculates that future growth rates may be 0.2%, well below even the modest 1.8% between 1987 and 2007.
Low or no growth is not necessarily a problem. It may have positive effects, for example on the environment or conservation of scarce resources. But the current economic, political and social system is predicated on endless economic expansion and related improvements in living standards.
John Steinbeck identified this tendency in The Grapes of Wrath, his novel about the depression: “when the monster stops growing, it dies. It can’t stay one size.”
Artificial Growth Hormones
Over the last 30 years, a significant proportion of economic growth and the wealth created relied on borrowed money and speculation. Since 2001, borrowing against the rising value of houses contributed to around half the recorded economic growth in the US.
Global trade is built on a financial model. Sellers of goods and services, such as China, Japan and Germany, indirectly finance purchases by lending foreign exchange reserves to countries like the US and the now deeply troubled “Club Med” economies of Southern Europe.
Financialisation is borrowed money and speculation. Debt allows society to borrow from the future. It accelerates consumption, as debt is used to purchase something today against the promise of paying back the borrowing in the future. Spending that would have taken place normally over a period of years is squeezed into a relatively short period because of the availability of cheap money. Business over invests misreading demand, assuming that the exaggerated growth will continue indefinitely, increasing real asset prices and building significant over-capacity.
Debt driven consumption became the tool of generating economic growth. But this process requires ever increasing levels of debt. By 2008, $4 to $5 of debt was required to create $1 of growth. China now needs $6 to $8 of credit to generate $1 of growth, an increase from around $1 to $2 of credit for every $1 of growth a decade ago.
Debt also became a mechanism for hiding disparities in the distribution of wealth in many societies. The democratisation of credit allowed lower income groups to borrow and spend, encouraging housing booms, in order to deal with the problem of stagnant real incomes.
The ability to maintain high rates of economic growth through additional debt is now questionable. The world is being forced to “delever” – reduce debt.
Following the onset of the global financial crisis (“GFC”), individuals and companies began the long slow process of reducing debt. The resulting shortfall in demand was filled by governments who borrowed heavily to prevent the “Great Recession” turning into the D word - Depression. It was heroic bet on growth and inflation. In the words of writer François Duc de La Rochefoucauld: “Hope, deceitful as it is, serves at least to lead us to the end of our lives by an agreeable route.”
Now, governments are forced to embrace austerity as investors focus on their public finances. The need for governments as well the private sector to reduce debt simultaneously reduces demand and locks the world into a negative spiral of ever lower growth.
Extend and Pretend
Growth was also based on continuation of policies that led to the unsustainable degradation of the environment. It was based upon the uneconomic, profligate use of mispriced non-renewable natural resources, such as oil and water. Toxic debt and toxic emissions increasingly clamour simultaneously for attention.
There are striking similarities between the problems of the financial system, irreversible environmental damage and shortages of vital resources like oil, food and water. In each area, society borrowed from and pushed problems into the future. Short-term profits were pursued at the expense of risks which were not evident immediately and that would emerge later.
Another common theme in the parallel crises in finance, environment and management of scarce resources is mis-pricing. In the period leading up to the global financial crisis, risk, especially the ability of individuals and firms to repay borrowings, was under-priced. The true cost of polluting the environment or consuming certain resources has also been under-priced.
In all cases, there was significant privatisation of gains whilst losses were socialised. Financiers entered into increasingly destructive transactions, extracting large fees leaving taxpayers to cover the cost of economic damage. Andrew Haldane, Executive Director for Financial Stability at the Bank of England, in a March 2010 paper compared the banking industry to the auto industry – both produced pollutants, for cars, exhaust fumes; for banks, systemic risk.
In the early 20th century, German economist E.F. Schumacher observed that human beings had begun living of capital: “Mankind has existed for many thousands of years and has always lived off income. Only in the last hundred years has man forcibly broken into nature’s larder and is now emptying it out at breathtaking speed which increase from year to year”. That observation is now just as true about the economic and financial system as it is about the environment.
The approach creates inter-generational issues, an economic war between the old and young. In his novel Rabbit is Rich, John Updike’s hero Harry Angstrom passed judgement on the post war generation: “Seems funny to say it, but I’m glad I lived when I did. These kids coming up, they’ll be living on table scraps. We had the meal.”
Losing the Commanding Heights
The current crisis calls into question the ability of governments to maintain control of the economy of Lenin’s commanding heights – the most important and strategic elements of the economy.
In the eighteenth century, Western societies shifted from medieval systems of aristocratic and religious authority to models of reason, scientific method, rational discourse, personal liberty and individual responsibility. A tenet of this new faith was the ability to control the economy and markets with the application of applied mathematics and statistics.
In 1965 President Johnson’s Council of Economic Advisers led by Walter Heller stated: “Tools of economic policy are becoming more refined, more effective, and increasingly freed from inhibitions imposed by traditions, misunderstanding, and doctrinaire polemics.” The Council declared that economic policymakers could now “foresee and shape future development.” University of Chicago Professor Robert Lucas raised the bar on self-congratulation claiming in 2003 that macroeconomics had “solved, for all practical purposes” the problem of economic depression.
More recently, US Federal Reserve Chairman Ben Bernanke argued that improvements in monetary policy helped create the Great Moderation. In 2007, on the 10th anniversary of its independence in 2007, Bank of England Governor Sir Mervyn King spoke of a “sea change” in economic stability which he believed could not be dismissed “solely as a result of luck”.
But policy makers may not have the necessary tools to address deep-rooted problems in current models. Revitalised Keynesian economics may not be able to arrest long-term declines in growth as governments find themselves unable to finance themselves to maintain demand. It is not clear how if, at all, printing money or financial games can create real ongoing growth and wealth. Former German finance minister Peer Steinbruck questioned this approach: “When I ask about the origins of the crisis, economists I respect tell me it is the credit financed growth of recent years and decades. Isn’t this the same mistake everyone is suddenly making again?”
Government intervention can cushion some of the costs of the crisis but cannot solve the fundamental problems. It is not self-evident that growth can be conjured up policy makers. If government deficit spending, low interest rates and policies to supply unlimited amounts of cash to the financial system were universal economic cures, then Japan’s economic problems would have been solved many years ago.
The problem is the economic model itself. As former Fed Chairman Paul Volcker observed on 11 December 2009: “We have another economic problem which is mixed up in this of too much consumption, too much spending relative to our capacity to invest and to export. It’s involved with the financial crisis but in a way it’s more difficult than the financial crisis because it reflects the basic structure of the economy.”
Into the Real
A return to economic growth requires a return to real engineering rather than reliance on financial engineering. It must reverse the trend to a state where the real economy simply supports trading and investment in claims on underlying resources.
Traditional growth relies on increasing population, sustainable and affordable resources, new markets as well as improved productivity and innovation.
While global population is increasing, much of the growth is in poorer nations. The population in more affluent developed nations is shrinking, with birth rates falling below replacement levels. In many nations, the working age population is declining as the generation born immediately after World War 2 reaches retirement age. However, with increased life expectancy, the size of this aged group creates demand for health and retirement income which must be supported by a dwindling number of workers. In developed countries, the aging population will constrain growth.
Environmental and resources constraints limit the potential for large increases in population. Without significant improvements in agricultural technology, it will be increasingly difficult to feed the population of the world which is rapidly approaching 10 billion.
Agronomists estimate that food production will need to increase by 60% to 100% by 2050 to provide sufficient food to the world, as well as more protein in the form of meat to the rapidly increasing middle classes of the developing world. But the amount of arable land has remained relatively constant at around 3.4 billion acres for the last decade. Increases in crop yields have become more difficult to achieve.
Writing in a piece titled Welcome to Dystopia, Jeremy Grantham, founder of asset manager GMO, observed: “We are five years into a severe global food crisis that is very unlikely to go away. It will threaten poor countries with increased malnutrition and starvation and even collapse. Resource squabbles and waves of food-induced migration will threaten global stability and global growth….Even if we could produce enough food globally to feed everyone satisfactorily, the continued steady rise in the cost of inputs will mean increasing numbers will not be able to afford the food we produce”.
Sustainable falls in the price of energy and other scarce resources are also difficult. The quality of the world’s oil resources is declining. Easier to extract and therefore cheaper fields are being exhausted requiring a shift to more difficult and expensive sources. Given its central role in transportation, rising prices of gasoline or related products is troubling.
New energy sources are expensive and may create new problems. Production of the bio-fuel to fill one 25 gallon SUV tank requires the corn sufficient to feed a single person for a year.
Financial policy measures -quantitative easing and competitive currency devaluations- are driving also up commodity prices. The loss of faith in paper money is feeding demand for real assets including commodities as investors try to preserve purchasing power.
The scope for new markets is limited. Since 1989, most economies, with the exception of North Korea, have integrated into the global trading system. In fact, gains from globalisation may reverse. Nation states increasingly favour domestic activity and maximising the share of limited demand usingbeggar-thy-neighbour strategies, such industry policy, trade restrictions, currency manipulation and controls on free movement of capital.
New New Things
Major technological change and innovations, at least on the scale of the industrial or computing revolutions, are not on the horizon.
Economist Robert Gordon argues that the rapid growth and improvements in living standards achieved since 1750 were driven by three different phases on industrial revolution: steam engines (industrial revolution 1), electricity, internal combustion engines, modern communication, entertainment, petroleum and chemical (industrial revolution 2) and computing (industrial revolution 3).
He finds that industrial revolution 2 was the most significant in its impact on productivity and improvements in living standards. To the consternation of the i-generation, Gordon argues that industrial revolution 3, while important, was less important than thought, creating only short-lived improvement in productivity.
The replacement of repetitive low value tasks by technology was undertaken primarily in the 1970s and 1980s. Industrial revolution 3 did not fundamentally revolutionise productivity, but was focused on improving existing technologies, enhancing capability, power and also miniaturisation. Many recent innovations also centred on entertainment and communication devices.
The economic contribution -revenue, profits and employment- of many recent innovations are difficult to gauge. Some technologies merely displace existing products. Apple’s i-Phones have cannibalised Blackberries, portable music players and personal digital assistants. Google and blogs cannibalise existing industries, such as newspapers. Whatever their cultural impact, Facebook and Twitter may not have viable economic models.
Gordon argues that many innovations are non-repeatable – improvements in life expectancy, urbanization, improvements in food production, clean water, sanitation, faster transportation, increased female participation in the workforce, temperature control to facilitate productive activities in climatically challenging regions etc.
In recent times, productivity increases, especially the change in output per unit of combined capital and labour, have slowed. Easy productivity gains from outsourcing production to lower cost jurisdictions or reductions in workforce levels have been achieved.
Many new products and productivity measures reduce the number of workers needed. While creators capture large benefits, employment and income levels are not significantly boosted, limiting the benefit to the wider economy. Given consumption makes up 60-70% of economic activity in developed economies, this limits the impact on growth.
The prospect for innovation is also affected by educational levels and funding for research. Social activist Jane Jacobs identified the shift from ‘educating’ to ‘credentialing’, where educational establishments now serve to merely prepare students for employment. The increasing cost of education has also increasingly placed it beyond the reach of many or forced graduates to start their working lives with significant debts.
Scientific research funding has declined in real terms in many nations. This has affected the amount as well as the approach to research, shifting focus to safer proposals likely to receive funding rather than uncertain but potentially ground-breaking areas.
Large scale investment in pure research and development in basic science, such as that undertaken by the Bell Labs, Xerox’s Palo Alto ResearchCentre (“PARC”) or Lockheed’s “Skunk” Works, is less prevalent today. Researchers working at Bell Labs helped develop radio astronomy, the transistor, the laser, the charge-coupled device (CCD), information theory, the UNIX operating system, the C programming language and the C++ programming language. PARC contributed innovations such as personal computer, the laser printer, and the graphical interface. Without such investment in science, quantum leaps in innovation are more difficult.
While a factor, innovation and productivity increases may not be sufficient to restore growth to the stellar levels of the twentieth century.
The legacy of existing high debt levels will constrain economic activity. In the words of one analyst: It will be like driving with the handbrake on. A large portion of current income is now directed at servicing borrowings, limiting consumption and investment. Ultimately, the easiest way to kick-start growth is to write-off debt, removing this burden. But this would result in losses to lenders and investors, reducing wealth thereby limiting consumption and investment. Environment issues and resources scarcity remain additional constraints. The lack of easy policy options means that the world faces an unknown period of low, below trend growth.
Debates about the economy, assume the inevitable return to robust growth. Politicians everywhere repeatedly mouth the sacred mantra of economic policies that lays the foundation for long term growth. Even in Japan which about to enter its third successive decade of economic stagnation, the latest government recently outlined its growth strategy.
The reason is not difficult to discern. Writing about the US in The American Future, historian Simon Schama observed that no one ever won an election by telling the electorate that it had come to the end of its “providential allotment of inexhaustible plenty”.
Everyone must confront the prospect of a world with low or no growth. But people do not want to believe that this is a possible or likely future. They believe that a return to a world of strong growth is inevitable.
Like Fitzgerald’s tragic hero Gatsby, the incredulous battle cry everywhere is: “Can’t repeat the past? Why of course you can!” But as philosopher Michel de Montaigne asked: “How many things we regarded yesterday as articles of faith that seem to us only fables today?”
A book The World Without Us was based around a thought experiment – what would a world bereft of humans revert to. Society and markets increasingly need to focus on what a world without growth, or at least low and uneven rates of growth will look like.
© 2013 Satyajit Das All Rights reserved
Satyajit Das is a former banker and the author of Traders Guns & Money and Extreme Money