The long view

By Buttonwood

SOMETIMES the best way to tell a story is through a graph.

There has been much talk in recent months of "secular stagnation" after the former Treasury secretary Larry Summers

made a speech on the issue in February

. As you can see the problem for the developed world has not arisen overnight. The chart shows the rolling 10-year growth rate for leading economies in both real and nominal terms. This smooths out the effect of the economic cycle. Either way, the trend is clear; nominal GDP growth has slowed below 4% a year, real GDP growth below 2% (in Italy, it is negative).

There are many potential explanations for this shift, but the most plausible relates to demography. Growth was rapid in the aftermath of the Second World War, as Europe was reconstructed, and some of the benefits of pre-war technological change filtered through to the economy; then from the mid-1960s onwards, the baby boomers joined the workforce. But the birth rate fell and the baby boomers are retiring. Below are the numbers from the OECD for the old age support ratio, the number of workers aged 20-64 relative to those aged over 65.

1950 1980 2010 2050 (projected)

US 6.97 5.04 4.59 2.53

UK 5.58 3.74 3.59 2.14

Germany 6.26 3.68 2.91 1.54

France 5.13 3.96 3.50 2.04

Italy 6.99 4.21 3.00 1.46

Japan 9.98 6.67 2.57 1.27

As you can see, things are going to get a lot worse, rather than better. Why is old age dependency a problem? After all, a lower birth rate means there are fewer dependent children. Yes, but the cost to society of old people is greater, once you factor in pensions, healthcare, nursing home care and increased longevity (a 65 year old can expect to live for 20 years or more). Crucially, the workforce is no longer growing; indeed it is expected to shrink in Italy, Germany and Japan. The EU is set to lose 40m workers over the next 40 years; without immigration, that would be a 96m decline.

Economic growth consists of having more workers and making them work more efficiently (productivity). Even if one is not as pessimistic as Robert Gordon about technological change, one can see that productivity will have to work very hard indeed to offset demography.

What about the other factors? Larry Summers noted that those periods which tended to have rapid economic growth were also marked by the build-up of debt and asset bubbles, or as he put it

the record of industrial countries over the last 15 years is profoundly discouraging as to the prospect of maintaining substantial growth with financial stability

Sometimes bubbles can have positive economic impacts; the railways and canals were built in a flurry of speculation in the 19th century. Many investors lost money but the economy gained from the increased capacity and lower transport costs. The economic benefits of property booms are not as great, especially if the effect is to create derelict apartments and houses (eg Ireland and Spain).

Why have so many bubbles built up recently? One key factor seems to be the decline in the level of real interest rates (this is the focus of the Summers essay); lower real rates have encouraged investment in financial assets for all sorts of reasons.* Summers argues that a number of factors have pushed down real rates: companies have reduced demand for debt, in part because the new breed of tech companies has less need for capital investment; slower population growth is associated with lower real rates; wider inequality means more income in the hands of the rich, who save more than the poor and central banks have also accumulated vast reserves (a greater supply of savings means a lower real rate, other things being equal).

It is worth noting here that some of these trends are self-reinforcing. Higher asset prices have exacerbated the trend towards inequality, since the rich own more assets than the poor. Low real rates and the tendency for the central banks to bail out markets whenever they falter have also fuelled the growth of the finance sector, which has seen the biggest relative rise in salaries.

The legacy is a high level of debts across the developed world. Some economists tend to dismiss the impact of debt, arguing that one person's liability is another person's asset; when M&G recently pointed out that global gross debt was approaching the $100 trillion mark, someone tweeted that net debt is still zero. One would have thought the last few years would have proved the folly of such a philosophy. First, if debt is secured against an asset, such as a property, then a fall in asset prices means that both creditor and debtor can lose; the debtor loses his or her deposit/equity (and sometimes their house) and the creditor takes a writedown on the loan. Secondly, debt needs to be refinanced on a constant basis. The higher the value of debt relative to GDP, the more debt needs to be refinanced each year; if creditors lose their willingness to roll over that debt, a financial crisis can ensue.

The final catch is that taking on debt is a sign of confidence; the lender and the debtor must be confident the money can be paid back with interest. This confidence is most likely in a world of rapid economic growth and higher asset prices. But that world may have gone, making it more difficult to bring down the debt burden. A debt-deflation spiral remains a real possibility. So how do we get the lines in those charts pointing up again?

* These have been much discussed in past blog entries. Briefly, there is a push factor as investors are forced out of low-yielding cash, and a pull factor as the present value of future cashflows from risky assets appear to rise.