Will economic growth still be the norm?

Capitalism is an economic system that has generated masses of wealth but can we expect that to continue?

The recent trials and tribulations of the global economy would have made more than a few people question their faith in capitalism.  Stagnating economies shackled by convoluted politics and a chronic lack of business confidence have made economic growth seem like a thing of the past.  The capitalist system has powerful forces within it that drive the generation of wealth but the mechanisms which generate growth have been damaged by excesses built up in the run up to the global financial crisis.  It is still too early to tell when and even if the previous rate of economic growth can be reached any time soon. 

At its core, capitalism is a battle for productivity and efficiency.  Companies compete against each other to supply goods and services for a better price or higher quality than their rivals with higher profits as a reward.  Any products that are offered with even a slightly lower price tag or in a way that attracts more customers will ensure a greater market share and prosperity for the business selling it.  As such, firms have to constantly strive to improve their offering or else their survival will be called into question.  Companies that can do a better job of satisfying the needs of their customers lure in more business and increase in size.  This results in resources in the economy such as workers and money for investment being drawn into firms with the best business plans where typically fewer inputs are required to make customers happy.  And it is this relentless shift to businesses which produce more for less that is the key to growth. 

So, trying to stop capitalism is like trying to stop people making money.  But capitalism can suffer when resources are not available for successful companies.  Take workers for example.  A business looking to grow needs more employees but high levels of mortgage debt and the drop in house prices in many Western countries mean that people are not free to sell up and move somewhere else for a new job.  Immigrants, both skilled and unskilled, provide greater access to the necessary human resources but places such as the US and the UK are making it tough for foreigners to get visas.  

Lending by banks allows for rapid expansion of businesses but the finance industry is struggling with the consequences of having been too generous in the past and banks prefer to keep the cash in their vaults.  As a consequence, successful firms are hamstrung by a lack of funds for expansion. A further hurdle to success is competition from so-called zombie firms – companies that should go bust but are kept alive by low interest rates and banks not wanting to incur any bad debt.  This stops the productive firms from grabbing the market share that should reflect their better business practices.

The situation with the banks is made even more complicated by new regulations applied to the finance industry.  Deregulation over the previous decades unleashed creativity at banks which boosted the economy to begin with but went on to sow the seeds for the global financial crisis.  Re-regulation is necessary to ensure that banks can’t bring the global economy to its knees but the financial sector also needs to be free enough to move money around to more productive uses.  The uncertainty over where this new balance might be makes for a difficult environment for banks to operate in.

Whether the current growth path will be a temporary slowdown or a permanent shift to a slower rate of expansion is as yet unclear.  Capitalism has bounced back from previous setbacks but the past is not always a good guide for the future.  Even if a revival of the previous pace of progress is a possibility, more than three years have passed since the worst of the financial crisis hit the global economy in 2009 and the light at the end of the tunnel still seems some way off.  While capitalism has been seemingly unstoppable in the past, only time will tell if or when economic growth can be kick started once more. 

Recessions, Ice creams, and the UK economy

The UK economy is set for a triple dip recession but it may not be the last.

Children love ice cream cones but a chocolate coating makes it even better.  Ice cream can be covered in chocolate not once but twice and a double-dip ice cream cone was a real treat.  It is a pity that recessions don’t work the same way.  This is particularly true in the case of the UK which may be in the midst of a triple-dip recession after real GDP fell in the last three months of 2012.  Even worse than this is that the fear that a weak UK economy may dip into negative growth a few more times this decade. 

A double-dip recession is a relatively common flavour of recession.  It occurs when an economy rebounds after a recession but the ensuing growth is not strong enough to be sustained and the economy weakens again before an upward trajectory is finally achieved.  The reasoning behind such a growth path is that businesses and households will hold back on spending during a recession due to heightened cautiousness and uncertainty about the future but spending will pick up again once the economy seems to be improving.  If the delayed burst of spending is premature or small in size, the boost to the economy is only temporary and growth stalls until the economy has worked through the issues that caused the first recession.

Investments by companies in new factories or equipment are essential for an economy to return to sustainable growth.  But such investments fluctuate considerably depending on the business mood and companies will delay or terminate investment plans if the economy is not strong enough for the companies to earn a suitable return.  So growth will remain feeble with short periods of weak recovery followed by similarly short and shallow recessions.  Such is the background behind the triple-dip recession and why the third consecutive recession in the UK may not be the last.  This weak business cycle with minimal investment in the UK will continue until business confidence is revived.

 

What makes the state of the economy after a deep recession in the UK different from the plain vanilla type is the hard-to-digest problem of a banking crisis and the bitter tonic of austerity measures.  In the build-up to the global financial crisis, the UK economy was more reliant on its banking sector than most other countries.  High wages earned by employees in the finance sector helped boost spending and a willingness by banks to lend fuelled a real estate boom.  The excesses of the finance sector in the good times amplify the problems that need to be sorted when times turn bad.  The result in this case is that the UK economy is currently suffering from weak consumer spending and a decline in lending by banks.  Reregulation of banking activities has added further complication to sorting out the finance sector. 

The effect of the banks adding to the swings in the economy is further heightened through the government.  The buoyant finance sector provided extra income for the government when the economy was booming.  Not only did this boost of funds to the government quickly dry up after the global financial crisis but the government also had to use up valuable resources to step in to rescue the banking sector.  Having already spent the cash bonus, the government is now having to take money out of the economy in a manner which is the opposite of a fiscal stimulus through its austerity measures.  This is also not a problem that will be easy to sort out and government cut backs are expected to continue through to 2018.

Considering that a “triple-dip recession” is relatively new term, what comes next?  A quadruple-dip recession?  Even if the UK economy manages to survive without slumping to two consecutive quarters with negative growth (the common definition of a recession), years of slow growth are ahead.  The worst case scenario is Japan.  The extent of the economic stagnation in Japan is not measured in the number of recessions but in the number of decades for which there has been no substantial growth.  Japan also suffered a property bubble which triggered a banking crisis but on a larger scale.  Yet, like Japan, the UK still has a lot to do, such as finding the right balance between regulations and increasing lending at banks along with government measures to boost the economy.  Until this happens, hopes for recovery are likely to melt away like an ice cream cone on a hot day.

Winning the Ugliness Contest

Once popular with all the investors, the United Kingdom is beginning to fall out of favour as the diet of austerity measures proves to be too harsh.

A beauty contest is all relative.  It is not hard to be the prettiest when everyone else is ugly.  Such was the fate of the British economy during the Eurozone crisis.  It was not in the best shape but it still looked attractive compared to the turmoil in Europe and this lured in investors who snapped up bonds issued by the government.  But, with the worst of the Eurozone crisis now over and Europe no longer being shunned, it is the United Kingdom that is the object of attention for all of the wrong reasons.

The economy in the United Kingdom did see some benefits from the debt crisis across the English Channel in Europe.  The United Kingdom was seen as a haven in troubled times when investors needed to find somewhere secure to put their money.  As a result, the interest rates on government debt dropped below 2.0% to record lows (for more on this, see Not All Investors in Bonds Have Lost Money).  This has provided some relief as, even though slightly separated from the Eurozone and its troubles, the United Kingdom was in a spot of bother of its own with government debt of 82% at the end of 2011 climbing to 89% 12 months later.

But now that Europe is not the mess it was, the United Kingdom does not hold the same allure and its faults are starting to show through.  The austerity measures which have been introduced to tackle the budget deficit are sapping life out of the economy as money goes toward paying off government debt.  Following a decline in real GDP in the last three months of 2012, Britain is set to make headlines of the wrong sort with a triple-dip recession on the cards if the economy remains weak.  The dismal state of the economy means that Moody’s stripping UK government debt of its illustrious triple A rating last week was not much of a surprise as the reasons for the downgrading – the sluggish economy and high debt levels – were obvious to all.  But the attention on the ugly side of the UK economy is adding to the calls for more to be done to stimulate economic growth.

The coalition government in the United Kingdom which is headed by the Conservative Party has been adamant in its stance that reducing the debt is the best way to perk up the economy.  But this has been increasingly called into question as the theory behind such policies has stumbled in the face of the economic realities.  Studies done by the IMF also show that cuts to government spending have more of a negative impact on the economy than previously thought (for more detail, see Time for Plan B?).  The downgrading of the debt will add to pressure for a change in tact as it may prompt investors to move their money elsewhere and interest rates on government debt will rise as a result.  The higher cost of borrowing will increase the government expenses and eat into the savings the government has made through its austerity measures.  The weaker economy will also reduce the tax revenue for the government adding to its woes. 

With the economy not looking so good in comparison to elsewhere, the government and the central bank will have a harder task to win over the confidence of investors and to come up with a suitable regime of policies to keep the economy in reasonable health.  One consolation is that the constantly changing political and economic situation in various countries struggling with the consequences of the global financial crisis means that the time that the UK economy spends in the spotlight may be short.  In the same week, an indecisive election result in Italy makes it likely that it will be dragged out in front of the international media as the new candidate for the winner of the ugliness contest. 

Central Banks: Doing more harm than good?

Central banks are working overtime to kick start the global economy but monetary policy is being relied on to do too much and may just be creating more problems.

With the global economy in a slump and monetary policy not gaining much traction, it seems natural for there to be doubts about the ability of central banks to manage fluctuations in the economy.  But it is not just an issue of whether monetary policy is working or not, but the questions extend further to whether the actions of central banks have intensified the swings in the business cycle.  Your Neighbourhood Economist has started to wrestle with his own concerns as even more creative monetary policies seem to be having little effect but the finger for blame should not be pointed at central banks.

The standard format of monetary policy revolves around the setting of interest rates.  The desired effect of any policy intended to lower the interest rates is to spur investment by making borrowing cheaper.  This basic policy format was deemed to be sufficient to deal with previous recessions over the past few decades and helped to build up a sense of infallibility that bolstered the reputation of central bankers such as Alan Greenspan.  But the extent of damage to the economy resulting from previous recessions, such as following the plunge in tech stocks in 2000 and 2001, was superficial in comparison to the global financial crisis.  As such, tinkering with the interest rates was enough to get the economy moving again in the past but interest rates close to zero have had little impact this time around.

The critical functions of finance having stalled in the aftermath of the current crisis with banks holding back from lending due to heavy losses in the finance sector coupled with new restrictions on their activities.  It is typical for recessions resulting from a banking bust to be longer and deeper so central banks have delved into a range of unconventional policies such as quantitative easing to kick start the economy.  The money supply has swelled up as central banks have been printing bundles of cash and providing banks with cash to splash out on lending.  Yet, the larger money supply has not fed through to make any substantial effect on the economy.  The surplus money sloshing around has been flowing into the non-productive parts of the economy such as asset prices rather than into businesses which produce assets and liabilities. 

It is this excess money that can jump around the global economy and cause unnecessary volatility.  Central banks act in a way to maintain this surplus cash in the global financial system due to a bias in their policies regarding periods of strong and weak economic growth.  Interest rates are slashed with further measures rushed out when the economy is on the slide but central banks are less aggressive in resetting interest rates to appropriate levels when growth takes off.  Furthermore, the perceived receptiveness of the economy to oversight by the central banks during only mild fluctuations in the economy has increased the faith in monetary policy to shield the economy from shocks.  So, when the economy is booming, the prices of real estate and share prices soar due to the excessive confidence of investors and households who think that the good times will last.  Spending by household increases while debt rises and savings drop off as people think themselves to have more money in these assets despite some of the rise in wealth being transient. 

Banks also act to extenuate the inflation of asset prices by increasing lending to further fuel this boom in property and the stock market while clamping down on new loans when things turn bad.   The finance sector was even more of a culprit in the build-up to the current banking bust due to new innovations when banks thought they could offload lending risks to other parties.  However, this just resulted in an underestimation of risk which blew up in many bankers’ faces during the crisis.  Support from governments and central banks for the finance sector adds to the reasons why banks would want to make bigger bets when economic growth is perky. 

Too much has been expected of monetary policy and this is having adverse effects on the economy.  Central banks have been given oversight of the long-term health of the economy while politicians can pander to the preferences of voters (see More Power to Economists for reasons why this is the case).  The absence of better management of government finances over the past decade has resulted in only limited options in terms of fiscal policy.  Increases in government spending would have been a more appropriate response to the current slowdown in economic growth as cash would have been fed into the real economy rather than just sitting in the vaults of banks as has been the case with the current monetary policy. 

As such, central banks have over extended themselves trying to kick start the economy.  There may be follow on effects from this as the huge quantities of money currently being printed by central banks are likely to exacerbate the trend of excess liquidity in the global financial system as it will be hard to mop up the extra cash once the economy starts moving again.  There are many villains in the tale of the missing economic growth – central banks may be seen as one of them but it is only because monetary policy is being called on to save the day when all else has failed.

Walking a Tight Line

Europe is being caught between convincing investors that all is well while trying to stop the improving outlook from feeding through to a strong currency.

All of the fires that had been keeping politicians busy over the past few years seem to have been put out – the Eurozone is no longer on the verge of collapsing, politicians have come up with a short-term comprise to deal with increasing government debt, and the outlook for the global economy looks likely to improve in 2013.  So with disasters averted, the focus is turning to generating growth in stagnating economies.  With domestic markets still sluggish, exports have been targeted as a route back to economic recovery and a weak currency is a crucial advantage.  But what seems easy in theory is tricky in practice.

This shift has been most pronounced in Europe.  The worst seems to be over with investors having been snapping up bonds from previously shunned countries such as Spain and Italy over the past few months.  But the long slog of getting the economies in Europe moving again still lies ahead (refer to Both Good News and Bad News for Europe for more on these two trends).  Exports have been targeted as a source of growth by tapping into perkier demand in emerging markets.  A weaker currency is an easy shortcut into foreign markets but such a policy is of little use (and could work to the determent of all) if other countries follow suit.  Hence, the rise of concerns about “currency wars” as the policy of central banks printing cash to prop up weak economies has also had the added benefit of lowering the value of currencies (for more on this, refer to Currency Wars).  Currencies will tend to fluctuate depending on economic forecasts with weak growth linked to a low interest rate which puts off investors from holding cash in that currency. 

The new government in Japan has been quick to push its central bank into pumping out more cash.  On the other hand, Europe has been hamstrung by fears about inflation from the overly cautious Germans as well as brighter prospects for its economy now that the dark clouds of the Eurozone crisis seem to have passed.  So the improving situations in Europe along with its less aggressive monetary policy could saddle the Eurozone with a strong euro which could scupper the recovery.  The euro had held up reasonably well despite the turmoil as the currency remained necessary for trading with the large single market in Europe.  The perceived turnaround with regard to the fate of the euro has resulted in investors rushing in to buy bonds of Spain, Italy, and the like due to their higher interest rates. 

A further problem is the different competing view on what would be a suitable policy with regard to the euro.  On one side of the argument, the French president Francois Hollande has called for a managed exchange rate with a target for the exchange rate set by the European Central Bank.  France is averse to market reforms which would improve competitiveness so a weaker euro is an easier option.  Jens Weidmann who is the head of the Central Bank in Germany sits at the other end of the spectrum and argues against a weak euro as this will increase inflation (due to imports becoming more expensive).  The Germans have also been among those most vocally critical of the Japanese government influence over its central bank and its aims to reduce the value of the yen. 

Squeezed between the two powers (France and Germany) in Europe is Mario Draghi, the president of the head of the European Central Bank, who takes a more nuanced stance.  It is Draghi who has done the most to stabilize the situation in the Eurozone (see Whatever it takes) and has tried to instil confidence in the fate of Europe while stopping the euro getting stronger as a result.   Draghi came out with a statement earlier this month that it was not the role of the European Central Bank to dictate the value of the euro.  However, strengthening of the euro and any resulting inflation would require action.  This would involve interest rates being nudged up from their current low levels and the growth prospects in Europe would suffer as a result – hence stopping a possible rise in the euro in its tracks.

If Your Neighbourhood Economist was to bet money on the outcome of this tussle, it would bet on Draghi.  The ability of the European Central Bank to act without being restricted by what voters might think gives a reason for investors to listen to what Draghi has to say.  The policy of the European Central Bank to do “whatever it takes” has helped to save the Eurozone despite no action having been taken as yet and this shows how an intention to act by itself can influence the market forces.  It may take more than words and a splash of extra cash to keep Europe on track but the situation could be significantly worse considering the competing opinions in Europe.

Disappearance of the “Strong Dollar”

The demise of this phrase from the lexicon of politicians in the United States says a lot about the changing landscape of the global economy.

It is easy to notice when a new term pops up but harder to spot when a phrase falls out of use.  Adherence to the principle of a “strong dollar” was a cornerstone of government policy in the United States for generations but it is not something that is referred to by politicians anymore.  Your Neighbourhood Economist would argue that this change in thinking by politicians about the US dollar that has mostly gone unnoticed is part of a wider picture of the changing global position of the United States.

It may seem strange at a time when countries are vying with each other to weaken their currencies (for more, see Currency Wars), but not so long ago, politicians in the United States would pledge their support for the notion of a strong dollar.  But the origin of the strong dollar was from a previous era when the United States was the dominant global trading power.  Trade flows in the thirty years following the Second World War typically followed a certain pattern – rich, developed countries such as the United States would import agricultural products and raw materials for manufacturing while importing manufactured goods back to the poorer, less developed countries. 

Manufacturing at this time was limited to a small group of privileged countries that benefitted from economies of scale stemming from their large and wealthy domestic markets.  Most other countries were limited to importing materials which ended up being plentiful and cheap due to the large number of other countries having nothing else to offer in terms of trading.  So the United States was in an advantageous position of being one of a few that supplied crucial manufacturing products but having a wide choice of trading partners in other goods.  Its dominance was extenuated with many other manufacturing countries being decimated following the War. 

This central role of the United States in the global economy also extended to its currency and the US dollar was used in trading between different countries and as a means for any country to store its wealth.  The widespread popularity of the US dollar increased its value which put the United States in an even better position.  A strong currency helped businesses in the United States by making imports cheaper but was only helpful in so far that there was minimal competition regarding exports.  

While the United States remained on top for a few decades after World War II, it inevitably faced numerous challenges.  The oil embargos in the 1970s were a shock to the system but it was the rise of Japan as a manufacturing rival that signalled that the good times were coming to an end.  Companies in the United States had grown flabby and slow due to a lack of competition.  Focused and ambitious Japanese firms easily outperformed their US rivals in areas such as cars and consumer electronics.  The revival of business in the United States was facilitated in part due to an agreement in 1985 to revalue the Japanese yen at a higher value. 

However, the new competition from Japan was just a sign of things to come as other countries in Asia such as South Korea and Taiwan followed in the footsteps of Japan culminating in the re-emergence of the sleeping dragon, China.  The global economy was in the process of becoming increasingly interlinked due to lower costs for transport and communication and the resulting surge in imports into the United States devastated some local manufacturing industries.  Surviving businesses in the United States lobbied for support from the government through protectionist measures.  Yet, politicians maintained their belief in the benefits of a strong dollar with reiterations of this policy being repeated as recently as during the Bush Junior administration.

The United States government policy regarding its currency eventually caught up with the realities of the repositioning of the United States in the global pecking order.  Nowadays, the only mention relating to the US dollar by politicians is belligerent moaning about the perceived injustices stemming from a belief that China is manipulating its currency.  This is part of an increasing vocal backlash looking to stem the flood of goods from overseas and reflects the difficulties that businesses in the United States are having as globalization increases the number of rivals.  Slower economic growth and an increasingly high debt burden means that exporting is becoming more important as the United States economy has to work harder to generate growth.  This is one of the many challenges that are likely to lie ahead as the United States scrambles to hold onto its global crown.

Lessons to be learnt?

Will things be different the next time around?
 

Booms and busts are an inevitable but undesirable element of a capitalist economy.  The current slump in the global economy is a harsh reminder of what can happen after the good times end.  Recessions following financial crises are particularly severe as a loss in confidence in the banking system leads to the wheels of finance seizing up.  The current stagnation in the global economy and the resulting economic suffering would suggest the potential for the collective will to push to apply the lessons that have been learnt in the aftermath of the financial crisis.  However, what is plausible in theory may prove difficult to implement in practice when the economy is growing again and the recession seems far off.   

Favourable circumstances enable a quicker pace of economic growth and help to spur on investment in a range of new technological and business fields.  Yet amongst this, inefficient and nonviable companies will also prosper and increased competition for resources will push up prices for labour and materials which acts as a brake on growth.  The slowdown as part of the business cycle is necessary as it helps to weed out the weaker companies and free up resources for the stronger businesses. 

There seems to be links between the boom time and the recessions that follow – the excesses which are generated amid rapid economic expansions have to be purged before the economy can begin to grow again.  The length and pace of the economic growth can be interrelated to the scale of the problems that are created during the good times and these have to be dealt with before growth can resume.  Excessive lending both fuelled the surge in growth and also has hampered the economic recovery with both households and government weighed down by too much debt.  More restrained growth could in theory result in more temperate slowdowns.

Therefore, it would be preferable for the governments and central banks (who control fiscal and monetary policy) to be more aggressive in moderating periods of expansion so as to limit the extent to which problems can build up.  Your Neighbourhood Economist would argue that the Eurozone crisis, high unemployment, and weak growth is too much of a price to pay for the previous lending binge and that governments and central banks need to be more alert to excesses which amass during rapid economic growth.  An assortment of measures such as higher interest rates, lower government spending, and specific policies to lower borrowing need to be considered as the economy approaches the top of the business cycle.

Yet, politicians would loathe being the ones to turn off the party music and put an end to the economic good times by popping the balloons.  Voters could instead be easily persuaded to vote for a party who would permit a higher level of growth.  There is also the possibility of hubris – it was Gordon Brown, the chancellor of the government in the UK, who infamously claimed that his government had put an end to boom and bust.  Even the conservative types in central banks want to court controversy by limiting economic expansions.  Even Alan Greenspan who was revered during his stint as the head of the Federal Reserve in the United States believed that it was not the role of the central bank to pop a bubble but only to deal with the consequences afterwards.

The argument for moderating growth over the business cycle is easy to make when the economy is in the doldrums but the timing and policies required will be more difficult to judge and find support for when the economy is roaring.  This problem is made even trickier by what seems to be a form of collective amnesia that takes hold during the good times.  Rather than remembering back to the previous boom and bust, even the most brilliant of minds tend to get caught up in the euphoria.  There is also typically a story to back up why this time is different –whether it be the potential of the internet during the surge in popularity in tech stocks or the steady hand of central banks and new financial wizardry in the lead up to the current bust.  

So it remains to be seen whether the leaders across the globe will apply the lessons from the past five years and whether voters will enable them to do so.  History suggests not.  But perhaps an even more depressing thought is that, even if there is sufficient commitment to apply the lessons, high levels of debt in developed countries and better prospects for investment elsewhere may mean that a level of growth where the policies above are required may not be reached for a long time (if ever).