At the time of his autumn statement, George Osborne had to confront some uncomfortable truths about the growth of the economy, the single most important determinant of private and public finances alike. He is not alone. All over the world politicians, companies and individuals have been struggling to come to terms with economies that have not been functioning according to plan.
Ever since the financial crisis the hope that this is a “normal” economic cycle has been frustrated. In spite of record low interest rates and huge government borrowing, the two traditional remedies for a lack of economic animal spirits, the economies of the rich world have only limped along, at best. Fingers are variously pointed at banks, debt levels, fiscal policy or demographics. Whatever the cause, something seems to be different.
The collapse in world economic activity after the financial system seized up in 2008 was the most severe since the 1930s and involved the first period of falling consumer prices since then. No wonder people were scared. Although the financial system avoided total collapse and the worst fears failed to materialise, what has happened subsequently has been less reassuring.
The US, so far the best of the bunch, has at least managed tepid growth and is now a bigger economy than it was at the peak of the last economic cycle. Even so, unemployment, which rose rapidly during the slump, has remained high; the growth in jobs has not been enough to absorb the numbers joining the labour market. Meanwhile, the difficult work of addressing the scale of state borrowing starts now. Almost all of the examples of deficit reduction in history have involved periods of rapid economic recovery. Even though the US’s so-called “fiscal cliff” was avoided at the beginning of the year, the effects of reducing the public deficit in such a lacklustre period of growth are hard to call.
The US’s frustrations pale by comparison with the challenges elsewhere. After being hit hard by the slump in world trade and then by the earthquake and tsunami in March 2011, Japan’s economic Groundhog Day continues, as business demand has once again begun to shrink. In the eurozone, as well, activity is receding, having failed to regain its previous peak, while the UK potentially faces a “triple dip” recession. Europe’s “periphery” meanwhile is suffering the worst conditions since the 1930s, with economies shrinking rapidly, youth unemployment exceeding 50 per cent in some countries and growing social unrest. These are unusual and disturbing developments.
Perhaps equally disturbing is the chronic failure of mainstream forecasters to anticipate these changes. It’s possible that this is the result of a series of freak events such as the “unforeseeable” financial crisis (in reality, it was not only predictable but widely predicted). Evidence is accumulating, however, that the underlying model may be wrong.
Maps are an apt metaphor. A map which included all the detail of the world it represented would, like the map in Lewis Carroll’s Sylvie and Bruno, be as big as the world itself. To demand exactitude of an economic model is to ask the impossible. A model which captured the full complexity of the reality would fall into the same trap as Carroll’s mapmakers—one might as well use the real economy itself. The alternative, creating a model small enough to be useful, involves far-reaching decisions about what is important.
Most models define the ups and downs of the economic cycle using the economic components “inventories” and “capital spending”. The largest elements in the economy, consumer and government spending, are relatively inert; it’s the changes in these two components which are important.
There are good reasons to question the idea that the ups and downs of capital spending will continue to dominate the economic cycle in the rich economies in the way that they have in the past. Much of the world’s new industrial capacity is now built in China which has become extraordinarily reliant on building physical infrastructure. Rich countries, meanwhile, have become more susceptible to the fluctuations in confidence brought about by the availability of credit and rises and falls in asset prices, in particular houses.
The rich countries face headwinds from two intimately linked phenomena: high levels of debt and ageing populations. Neither of these features heavily in conventional models of the economy. So called “wealth effects” (the feel good or feel bad factor which derives from, for example, the ups and downs of house prices) were not quite respectable until recently. Now, if one listens to what Ben Bernanke, chairman of the Federal Reserve says, they are an important instrument of policy. Practice is already leading theory.
Of all the things which are largely excluded from conventional maps of the developed world’s economies, the most important is the state of the compact between their governments and their citizens. For years governments were not only able to redistribute income from one section of the population to another (after deducting their own substantial expenses, of course) but were also able to borrow on a large scale. Financial as well as pension and social security promises were to be honoured in some more prosperous future. As populations age, the myth underlying the western prosperity of the here and now is revealed to be the dream that it is possible to live well for 85 years by working for 40.
“Ricardian equivalence,” the idea that people internalise governments’ financial behaviour and recognise that more borrowing now means more taxation later, has a patchy record in practice. But there is now a suggestion that it, or something like it, might be gaining traction.
Median household incomes in the US have hardly grown for more than a decade in real terms and, all over the rich world, expectations of future income growth are declining. At the same time, the reality of inadequate pension provision has only just begun to dawn. In the UK, for example, a pension fund of £1.25m (beyond most people’s ability to save) will purchase a pension of only £30,000 a year at age 65, according to Equilibrium Asset Management.
Under these circumstances the perception of the state’s willingness and ability to honour its pension and social security promises becomes crucial. Ironically, the shift towards deficit reduction and fiscal austerity appears to have had the effect of calling both into question. In the UK, child benefit has been removed from some middle-class households and there is increasing discussion of a residence tax on more expensive houses. Both raise challenges to two basic assumptions of retirement planning: the universal entitlement to a state pension and the ability to live rent-free in a house already paid for.
Ultra-low interest rates have failed to reignite demand for mortgage lending and banks report weak demand for credit. Recognising the already large scale of future obligations together with a diminishing ability to discharge them has doubtless played a role.
Even over a shorter time frame, the question of state finances looms large. As HSBC’s head of foreign exchange strategy put it, “politics is the new economics.” At the centre of the eurozone’s travails are fundamental questions about who will pick up the bill for the losses from the collapse of the periphery’s bubble economies. For the moment the crisis is in remission, with the European Central Bank’s support operation for peripheral bond markets looking like a success, but there is no sidestepping the fact that the losses will need to be borne by someone. Not only does the idea of Europe pooling its debt in order to share the burden work to the detriment of Germany, which would have the most to lose from this arrangement, but already other malign consequences are appearing. Germany and Austria now share with the Philippines the dubious honour of having the some of the highest levels of house price inflation in the world. German Bundestag elections are in autumn 2013, which suggests that a lid will be kept on the wider debate until then—but the ugly politics of austerity in southern Europe may not allow that luxury.
As the US begins to address its own huge budget deficit, Europe will be on policymakers’ minds. European attempts to cut spending and raise taxes have, in some eyes, been counterproductive. Estimates of the so-called “fiscal multiplier,” which translates a change in public spending into a change in economic activity, are suddenly an area of hot debate. Previously it appeared that a reduction of say, 100, in the public deficit meant that output would be some 50 below what it would otherwise have been. Evidence from Greece, Spain and other so-called “adjustment economies” (Eurospeak abounds in euphemism) suggests that in some circumstances the impact might be twice what was previously estimated. The impact of tax rises and spending cuts on a weak economy will be watched with apprehension.
With interest rates close to zero and fiscal policy constrained, traditional remedies for economic weakness are unavailable. “Unconventional” monetary policies like the Bank of England’s quantitative easing programme or the Federal Reserve’s asset purchase programme are now the norm. For investment markets, indeed, they are now the main event. As for their effect on the economy, that is less clear cut.
The ageing of the rich world makes these problems different from those faced before. Individuals as well as investors will demand to know more about how politicians intend to resolve the Great Government Ponzi Scheme. The intervention of central banks will continue to sustain markets—but for how much longer?
