Something else to blame on Bankers

Worries about a decline in productivity growth can also be pegged on a common villain

A popular topic these days among economists is to point to a decline in improvements being made by new technologies.  The claim is that the most substantial inventions such as electricity, telephones, cars and planes, and even the humble toilet are all things from the past and further innovations are either more difficult to bring into fruition or the economy is less geared to coming up with new gadgets.  The result of a lack of progress is that growth in productivity (for example, what each worker can produce in an hour) has been in decline since a peak around 1970.  Some counter arguments include that it takes time for new ways of doing things, such as making the most of the Internet, to have considerable influence on our lives and that the effects build up over time to make bigger and bigger contributions to productivity.  But there is one obvious culprit that is overlooked – the finance sector which not only caused damage to the global economy by collapsing in a crisis of its own making but also may have contributed to the slowdown in innovation by side-tracking the best and brightest of a generation and this is another reason to clamp down on the excesses of the banking industry.

To make a case against the finance sector, it is useful to consider how new inventions come into being in the first place.  Some happen just by chance but inventions typically require a significant amount of money and effort.  A system where this money and effort is rewarded is seen as being necessary to induce individuals or companies to invest their resources in such activities.  Individuals and companies will also have other options in terms of where to apply themselves and will only choose to undertake the development of a new technology if the rewards are deemed to be high enough.  Furthermore, it could also be argued that even more effort is required to come up with something new as the considerable amount of knowledge that has already amassed in different fields means it takes a big investment in time to become an expert in any field. 

Yet, in contrast to this, imagine a new industry where smart and ambitious people could make previously inconceivable amounts of money relatively easily compared to other pursuits - this is finance.  Deregulation of the banking sector which kicked off in the 1980s and picked up speed in the 1990s created an environment where clever minds could come up with new financial products which would make themselves and their employers very rich.  This innovation within finance allowed for increased borrowing which would have boosted the global economy by enabling better use of limited savings and lowering interest rates.  With ordinary people also benefiting through cheaper and more available mortgage lending, the banking sector had created a boom that everyone wanted to continue.  But the rapid increase in lending needed to be kept in check and it has become obvious in hindsight that debt level rose too high with disastrous consequences. 

As well as the global financial crisis in 2008 and 2009, the excesses of the banking sector may have also attracted talented individuals away from efforts to push forward the boundaries of progress.  Money and effort are key ingredients in innovation but many of the ideas which are the origins of something new come from a curious and creative person.  But with many of the sharpest minds lured in by the lavish rewards in banking, there would be fewer innovative ideas being realised outside of finance.  If the resulting creativeness had borne fruit in the form of faster growth, putting the best brains to work in banking would have been worth it.  But as we now know, the outcome was completely the opposite.

Along with the perils of excessive lending, the misuse of one of the most valuable resources available with dire results is another reason why banking should be limited in its scope.  Making money from money is easy compared to what is required to make a success out of a new product or service so the rewards for innovation need to be higher in areas which will make a substantial difference.  But for all of the reasons to clamp down on the finance sector, it is still a crucial part of the economy and too many restrictions on banking could be even worse than too few (refer to Another Reason not to Bank on Europe for more on this argument).  The bankers have been bad but we were all enjoying the party.

A New Inconvenient Truth

The reality which faces the West that politicians dare not speak of

The rise of countries such as China, India, and Brazil will be a tectonic shift in economic power but it is also a change that is long overdue.  The relative dominance of Europe and the United States in the global economy is a historical accident brought about by the early formation of capitalist economies in these parts of the world.  The response to these new challengers will define the role that the United States and Europe play on the global stage in the future and the initial signs do not look good. 

The Western world spearheaded by Europe and the United States have generated the bulk of the wealth in the global economy for most of the past century.  As early ago as 1990, the United States accounted for around 23% of global GDP and the countries which now constitute the European Union accounted for roughly 32% while respectively only making up 5% and 9% of the world’s population.  Yet, growth in the countries such as those grouped together under the label of BRICs (Brazil, Russia, India, and China) is the beginning of the end to this distortion in the distribution of global wealth.  The BRICs countries, who accounted for just 8% of global GDP despite making up 43% of the number of people worldwide in 1990, have seen their share of global GDP increase to 18% as of 2010.  The figures for the United States and the European Union have dropped back respectively to 23% and 26% in 2010 and this is a trend that will continue for decades into the future.

It is not that the economies in the United States and Europe have not been expanding in size but growth is not as easy to generate as elsewhere.  Loading up on debt helped to create a booming economy for a while but excessive lending eventually brought about a deep economic slump (for more info, refer to Tale of Two Recessions).  The global financial crisis has instead allowed other countries to catch up faster and to lay siege to the position of the United States and Europe at the top of the global pecking order.  The concentration of wealth in these Western countries has allowed them easy access to resources such as agricultural produce and mineral deposits from around the global as well as ready markets for their manufacturing goods.  But industrialization in countries which were previously just mainly sources of raw materials for the United States and Europe has given rise to competition – both in terms of other countries snapping up resources and of creating rivals to Western firms.  Economic power has also allowed Europe and the United States to shape global institutions to their liking. 

But this imbalance of wealth was never destined to last.  The gap between the rich and poor became too great and plummeting transport costs meant that goods could be manufactured anywhere.  The changes stemming from this will shape the world for generations to come and in ways which cannot yet be grasped.  Rather than bracing themselves to face the reality of this new challenge, both Europe and the United States have been embroiled in domestic issues as politicians struggle to deal with growing levels of debt. 

Economic theory espouses the benefits of free trade and an open economy where countries should specialise in what they are good at.  For the United States and Europe, this would be high-tech or high-value-added sectors such as product design, computer software, and precision manufacturing which make use of their skilled workers.  Yet, Western governments have shot themselves in the foot through mismanagement of their finances.  The resulting masses of public debt have restricted the ability of governments to invest in, for example, education which has suffered in many richer countries as governments focused more on cutting taxes.

Politicians in the United States and Europe need to be more honest with voters.  It is easy to convince voters that the good times will return and to try and hold off the inevitable.  But this will merely delay the day of reckoning and will make it so much worse than it needs to be when it does come around.  Many current policies, such as reducing immigration even for skilled overseas workers, run completely against what needs to be done and suggest that politicians either do not grasp the changes already underway or prefer to pander to the preferences of a public who is adverse to change rather than confront them with reality.  Sooner or later, this inconvenient truth will become apparent, but by then, it may be too late.

Both Good News and Bad News for Europe in 2013

Your Neighbourhood Economist predicts less panic about Europe in 2013 but much work still remains to be done

The turmoil in Europe dominated the headlines in 2012 as high levels of public debt and sluggish economic growth both acted to make investors nervous.  More than the actual problems with the economy in Europe, the real damage was done by a lack of decisive action by the leaders in Europe creating inflated fears about possible defaults and countries breaking away from the Eurozone.  But politicians managed to just muddle through with a big dollop of help from Mario Draghi at the European Central Bank (for a reminder - see "Whatever it takes").  There have been signs that enough has been done to stave off concerns over the immediate future of the Eurozone and its members.  An apparent return to normality is some good news for the Eurozone in 2013 but it is only the beginning.  The bad news is that there still remains a long slog for many countries in Europe to regain economic viability in the face of large and growing levels of debt and economies weakened by a lack of competitiveness. 

The economy in Europe was shackled in 2012 by worries about whether the Eurozone could hold itself together.  The uncertainty prompted firms to hold back from investing in Europe and companies in Europe have instead cut back on employing workers due to the weakening economy.  However, a possible breakup seemed to be less of a concern as 2012 drew to a close which was implied by the fact that investors are again buying bonds in countries that were once shunned such as Spain and Italy.  Draghi at the European Central Bank recently pointed to normalization in the finance markets such as bond prices having fallen (resulting in lower interest rates). 

Panic among investors and the resulting higher interest rates had added to the woes of troubled countries in Europe so an easing of stress levels and a return to a focus on economic fundamentals is a crucial step in the rehabilitation of Europe.  However, buyers of bonds can quickly cash out if the situation in Europe turns bad again so this is just the first (but still essential) phase of a recovery in Europe which will take considerably longer.  While anxieties in the markets about the near-term prospects for Europe have abated, the underlying problems in Europe still remain. 

First and foremost are the poor government finances and high levels of public debt.  Many countries in Europe are likely to suffer as their governments cut spending to reign in large deficits.  Even once government revenues and expenditure are back in balance, the actions of governments will be restricted due to a large mountain of debt and this will inhibit the ability of governments to deal with future crises and to invest in essentials such as education and infrastructure for the future.  The previous debt-fuelled boom period which peaked in 2007 resulted in some places in Europe such as Spain and Greece expanding too fast with wages and prices increasing more than what was sustainable.  The global banking crisis in 2008 and 2009 put an end to the excessive borrowing but the high wages and prices remain and require painful changes for these countries to regain competitiveness in the global economy. 

So while frantic headlines of a Eurozone breakup will hopefully be a thing of the past, the legacy of the sovereign debt crisis in Europe will continue in 2013 and beyond.  Sluggish growth is expected for a few years at least and harrowing adjustments in Europe will be required to create the foundations for renewed invigoration of the economy.  Furthermore, the trouble in Europe comes at an inopportune time – the economic rise of countries such as China, India, and Brazil has increased competition for resources and is a challenge to the dominant role of Europe in global affairs.  This places extra urgency for Europe to get back on its feet and Europe’s future role on the world stage depends on whether it can revive its economy or will fall into long-term decline (more on this soon).

Zombies causing havoc (with monetary policy)

Halloween has come and gone this year but stories of zombies are still haunting the dreams of some.  One person in particular is Mervyn King who is the governor of the Bank of England (the central bank in the United Kingdom) and the walking dead are making the difficult job of guiding the economy through a weak recovery into something even more treacherous.

Nothing is ever too exciting in economies so rather than brain-munching corpses, zombies instead refers to companies who are saddled with excessive levels of debt which should drive them into bankruptcy but who are artificially kept alive by lower interest rates.  But firms closing down is a necessary part of the functioning of an economy and here’s why. 

During periods of growth, an economy can expand so rapidly that not all funds are put to good use – too many firms may be making too much of the same products.  So, a recession is normally a time where the less successful are weeded out.  As part of a process which is referred to as creative destruction, some firms go bust and this frees up money and workers that can be put to better use elsewhere.  While it sounds a nasty prospect, it is crucial to the vitality of an economy.  Think of a jungle where no animal would die - eventually the jungle would be overrun and even the strong would struggle.

The Bank of England (BoE) released data last week showing that, while three out of ten firms in the UK are losing money, the number of firms going under is low compared to other recessions.  This could be seen as a good thing in the short term – fewer workers out of jobs mean that the slump in the economy is milder than it might have been.  It also means that companies which have viable businesses but are going through a rough patch can stay in business and go on to prosper in the future. 

However, the effects over the long term are less benign.  Zombie firms take business away from better run companies which hampers the expansion of successful businesses and hurts investment which is already sluggish as firms try to navigate a high degree of uncertainty (for more details, Tale of Two Recessions).  The rise of the walking dead has been given as a reason why the BoE now predicts that economic growth in the United Kingdom over the next few years will be slower than predicted with the economy not expected to reach the same levels as before the global financial crisis until 2015.

Like in the movies, zombie companies also have a weak spot – interest rates.  Because the zombies typically have large amounts of debt, higher interest rates increase the costs for these companies and act as magic bullet that will send them to their graves.  But increasing interest rates also makes everyone else suffer and hurts the economy in the short term.  This leaves Mervyn King and the BoE with a dilemma.  The current low interest rates are prolonging the lives of businesses that need to be put down but the harsh measures required to do this could kill off hopes for a recovery.  Such a conundrum and talk of zombies would be enough to keep Your Neighbourhood Economist awake at night.

Winning the election was the easy part…

In a presidential election which was more notably for the money spent (an estimated US$6 billion) than any notion of what each candidate would do in power, Barack Obama managed to pull off a relatively easy (but not emphatic) victory.  But now Obama faces a bigger challenge - the fiscal cliff.  The fiscal cliff refers to painful measures which will be implemented if Democrats and Republicans are unable to come up with a solution on how to deal with high government spending and low taxes.  But the political stalemate looks set to continue in the United States following an election which was supposed to help provide impetus for new policies but may instead result in further gridlock.

Improving the government finances was increasingly becoming a concern in the United States due to a large budget deficit of 7.8% of GDP in 2011 and rising government debt topping 100% of GDP in the same year.  Investors are still happy to buy government bonds as the United States is seen to have a more viable economy whereas similar levels of debt would cause panic among investors in Europe.  Yet, it is unclear how much longer investors will tolerate rising debt.  Politicians realise the necessity for action but are ideologically opposed to how to go about it – the Democrats want to see spending cuts accompanied with higher taxes on the wealthy whereas Republicans flatly refuse to even consider higher taxes. 

The origin of the fiscal cliff is an attempt by the two parties to force themselves into a compromise by upping the stakes.   Politicians passed the Budget Control Act of 2011 whereby, if an agreement on how to cut the deficit was not reached by the end of 2012, a range of deficit-reducing policies which are painful for both Democrats and Republicans (and the economy) would automatically kick in from the start of 2013.  Politicians have been too consumed with electioneering up until now for a deal to be struck and only have a short time left to figure out a compromise before US$600 billion of spending cuts and tax rises come into effect - the consequences of which is expected to push the United States economy into recession in 2013.

Just the possibility of recession as a result of these measures is already having an adverse effect on the economy.  The uncertainty created by the lack of a deal means that businesses are holding off from making new investments and hiring extra workers at a time when the economy should be on a path to recovery.  The election should have been a great chance for each party to convince the voters that they had a plausible solution but the outcome has only seen minor changes to the political landscape and the status quo has been maintained so that continued gridlock is a real possibility. 

Life would have been difficult for whoever won the election.  With the Republicans controlling the House of Representatives and the Democrats holding sway over the Senate, agreement between both parties is needed to pass any new laws.  But neither Obama nor Romney put themselves in a strong position due to the bulk of the campaigning being negative rather than providing any ideas on new policy direction (see An election with no winners).  As such, despite winning, Obama does not have much of a mandate - an entitlement to implement policies due to the perceived backing of a substantive majority of voters following an election.  The going will be made tougher with Obama having failed to exhibit much leadership in his first term as president.  Yet, Obama has come out of the blocks strongly with a bold statement that any new measures must include higher taxes for the rich.  On the other hand, Republicans are still not convinced that Obama has much support from voters and are likely to stand firm for now with regard to their demands for no tax hikes.

This sets the scene for last minute dramas and for uncertainty to continue to plague the economy.  The extent to which politicians can be trusted to make pragmatic decisions is unclear and Your Neighbourhood Economist is unsure of what will ensue.  Even Greek voters showed a considerable degree of pragmatism in backing pro-bailout parties in elections in June 2012 (Back from vacation in Greece).  Yet, like the situation in Greece, any possible solutions regarding the fiscal cliff are likely to be drawn out with stopgap measures likely before the end of the year (if at all) and more long-term policies discussed in 2013.  The prolonged uncertainty and political sideshows could have not come at a worse time but it is even more frightening to think that the worst may not be over. 

An Election with No Winners

Any crisis should be seen as a boon by politicians.  Problems become evident during times of turmoil and voters are more open to the prospects of sweeping change.  This gives opportunities for leaders to implement a raft of new policies and stamp their mark on the pages of history.  Yet, the opposite seems to be true with regard to the current presidential election in the United States.  The candidates have provided few details of what changes they would implement and how to better position the United States to face a rising number of challenges which stem from both internal problems and external threats.  The election has instead concentrated on the flaws of the candidates themselves rather than the ideas they espouse.  The United States looks likely to be bogged down for at least another four years until the next presidential election which may offer up a chance for decisive leadership.

The presidential election comes at a time when the country is in desperate need of leadership.  Obama has failed to deliver on his promises from the election four years ago.  It has been ironic than a presidential candidate that has given rise to so much hope among disparaged Americans has been so underwhelming even by normal standards to which presidents aspire.  In an election which should have been easy for any politician to beat Obama, Romney ended up the Republican candidate by default as other challengers each had their moment in the spotlight but all were deemed to be flawed.  But as the default candidate, Romney has struggled to even animate Republicans.  As such, the United States has been left without a genuine choice and campaigning has focused on the negatives of each candidates’ character due to a lack of new ideas. 

In an uninspiring election, Obama may be the lesser of two evils.  Obama has done a reasonable job of fixing the way in which the United States is seen by other countries in the world.  The Democrats as a party are also less entrapped by ideologues on the left and have been more pragmatic at a time when action is necessary.  On the other hand, the Republican Party has fallen under the sway of the Tea Party movement which has a virile hatred of government and taxes based primarily on ideological grounds.  The stubbornness of Republicans has stopped progress being made on dealing with the government budget deficit.  The party refuses to consider any tax increases to be implemented alongside cuts to government spending when this mix of more taxes and less spending is seen as optimal policy by many.  Instead, Republicans choose to squabble while Rome burns which may see the fall of another “empire”. 

There are signs that the United States may be heading into a period of gradual decline which its leaders refuse to confront.  Along with the rise of China and other emerging economies which is destined to reshape the global economy, the United States is also being challenged internally by problems such as a lack of investment in infrastructure and education, growing inequality and falling social mobility, and unsustainable levels of pensions and health care.  Obama has done little to solve these problems.  But there is a fear that a Republican president could make the problems worse.  Ballooning government debt in the United States during the Regan and Bush junior administrations has already shown Republicans to act more on ideology and less on economic realities.  Your Neighbourhood Economist would (if possible) vote for Obama - better the devil you know - but would rather fast forward four years in the hope for real leadership.

“It’s the economy, stupid” – or is it?

The phrase “it’s the economy, stupid” encapsulates the strategy used by Bill Clinton in his election battle with George Bush senior in 1992.  The blame for the recession at the time was attributed Bush senior and this helped Clinton to victory.  Twenty years later, Mitt Romney may have thought that a similar message would aid him in his bid to become president.  The four years that Barack Obama has been in power has coincided with the harshest economic downturn in living memory and a surprisingly weak recovery such that GDP has only edged up 0.7% between 2009 and 2011.  But the outlook for the economy has brightened a tad recently following the release of upbeat data on GDP and jobs in the United States.  Anecdotal evidence would suggest that this would be a boost to Obama but this may not hold true in an election where the candidates have sidestepped the big issues.

Economists like to point out that the state of the economy is a good guide to the plight of an incumbent in a presidential election.  Voters everywhere tend to hold politicians accountable for economic growth even though there is little that politicians can do to in this regard.  Obama was unlucky to have been voted in while the global financial crisis was still wreaking havoc.  The record of Obama’s management of the economy is hard to asses given the unique circumstances – Obama has been criticised for the assistance given to the finance sector and for the bailing out of firms such as the car maker GM but no one can know whether these actions actually staved off more wide spread disaster.

But it is economic welfare of the voters and their beliefs on how the future will pan out which is the crucial factor.  And in this regard, Obama has been getting small bits of good news among all of the doom and gloom.  In GDP figures for the third quarter (July to September) of 2012 released in late October, the economy was shown to have grown by 2.0% which is slightly faster than was expected.  Job data published one week later also exceeded expectations with 171,000 jobs being created in the US economy in October and unemployment below 8%.  Neither bit of news permits much optimism about the end of tough times and businesses will have to hire significantly more workers to make a significant dent in the unemployment rate (for more, see US Jobs Data).  But the signs of improvement may be enough to some to have hope.

But it is still unclear whether the slightly brighter outlook will be much of a boost to Obama.  Your Neighbourhood Economist would argue that news on the economy will only sway those who were undecided but these voters have been side-lined by campaigning which has vilified the personalities of the candidates rather than proposed solutions to the problems plaguing the United States.  So the election results are more likely to depend on how many Democrats and Republican can be bothered to vote for their respective candidates as both Obama and Romney have been underwhelming and failed to inspire a following from anyone else but their core supports.  Not the best way to decide who will be leading the country for the next four years and something that is likely to result in further disappointment (but more on that coming soon).