Will the global economy be better this year?

With the start of a new financial year we regularly hear the comments that this year will be better than the previous one. London-based economist Andrew Hunt gives his view of whether this will actually be the case.

Tuesday, April 1st 2014, 2:39PM

by Andrew Hunt

As is now customary it seems, financial markets ended last year and began this year by expecting “better things” from the global economy. Once again, though, these expectations are now under pressure as Europe’s nascent economic recovery (particularly within the Periphery) has apparently run out of steam, Japan’s underlying economic data has remained lacklustre, growth within the Emerging Markets has stalled and even the US has begun to produce some notably more equivocal data that does not seem to be merely the result of some inclement weather in the Northeast of the country.

In practice, we suspect that much of the optimism over the outlook for the global economy in 2014 had been based on the prior strength that had been visible within the financial markets; although global equity markets possess a rather uninspiring record as economic forecasters, there is always a tendency for analysts to raise their growth forecasts following a sharp run up in asset prices and this certainly seems to have been the case in late 2013. We would argue, though, that markets should not in fact have been too surprised that the global economy has failed to live up to expectations given that in most countries and indeed regions around the world, household income trends remain very depressed. For example, in the USA, household real disposable incomes may be 2% higher than they were this time last year but there has been negligible growth in real incomes since the middle of 2013 despite the reported increase in the number of employed people.

Similarly, in Japan, we find that real wages have fallen by 1.5% as nominal wage inflation has remained low but the weak Yen has led to an increase in people’s everyday cost of living. Even if we make allowance for the slightly better employment situation in Japan of late, we find that the fact remains that Japanese total household incomes are lower than they were a year ago and on this score at least we can see that Abenomics and the “money printing” by the central bank that it instigated has if anything backfired on its instigators. Meanwhile, in Continental Europe, it is clear that real disposable incomes have fallen for the last three years while in the supposedly strong UK, household real disposable incomes have been essentially flat for 18 months – the recent rise in UK spending has been financed not from income gains but from the “one-off” compensation payments that the banks have been obliged to pay to households for “insurance mis-selling”.

Quite simply, it would appear that particularly developed world households – although many of the Emerging Markets have the same issues – have simply not had the real income growth that would allow them to spend more without having to resort to the heavy use of credit and we find in the post-2008 world that few banking systems or potential borrowers are prepared to return to the old deficit spending models of behaviour that were popular prior to the GFC. Hence, global consumer spending trends, particularly in nominal terms, have remained weak despite the optimistic predictions that were being made at the beginning of the year.

At first sight, one could perhaps seek to blame the world’s corporations for being too aggressive with regard to holding their wage levels down. Certainly, there is a case that can be made that since the financial markets began to “demand” that companies produced “free cash flow that they could use to fund dividends or stock buy-backs”, companies have been too parsimonious with regard to pay awards despite the fact that this has implied that they have been impoverishing their own customer base. At this point, one is always reminded of the oft-quoted incident when Henry Ford II showed off Ford’s new robots to the union representatives and enquired what the union would do when the robots failed to pay union dues? The union official apparently replied that the robots wouldn’t buy cars either and this logic is as true today as it was when Keynes first formally noted the existence of the paradox of thrift: if you don’t spend money as either a producer or a consumer the circular flow of money around an economy will stall and cause a slump.

We do not believe, though, that companies are solely to blame for the current weak real income growth amongst households. According to our analysis, there has been a marked slowdown in underlying productivity growth and “value added growth” in the core parts of the global economy since around the mid-1990s, when the original PC-internet boom faded. This lack of productivity growth has implied that companies should not/cannot pay their staff higher real wages.

One could argue that if companies were to be more focused on capital spending and investment in the real economy, productivity might rise but even here we would not be too hard on companies – they are, after all, being encouraged to focus not on real CAPEX but rather on stock buybacks, not just by investors but also by the central banks. For example, the Fed has created financial conditions that favour companies issuing huge quantities of corporate bonds simply so that they can buy-in equally large quantities of their own equity and so gain higher share prices without having to worry about actual real investment or the long-term future of their companies. We are certain that the FRB and others’ encouragement of “financial engineering” (or “Zaitech” as it used to be known) is one of the primary reasons that real investment spending and productivity growth have remained so weak over recent years.

Certainly, we strongly suspect that the relative lack of investment by companies at present is one of the reasons that productivity and real wage growth has remained so low over recent years in much of the global economy but if households were more productive in aggregate, then we suspect that they would indeed earn more and if they earned more, then not only would they be able to spend more, their existing debt ratios would also tend to fall with the result that their balance sheets would be less stressed and the global economy might finally escape from the post-GFC slump.

Conventional wisdom, though, suggests that the best route to a recovery lies through central banks simply printing more money (despite the counter-productive impact that this type of policy has already exerted on Zaitech and corporate investment) and through aggressive debt reduction policies in the public sectors, such as those articulated by Rogoff and Reinhardt in their book “It’s Different This Time”. Indeed, the authors of this book suggest that the global economy cannot recover until debt ratios are brought down (particularly, but not exclusively, in the public sector) and balance sheets are repaired. Furthermore, the authors suggest that this should be achieved by people, companies and governments each saving “harder” – the very thing that Keynes advocated should not be allowed to occur in the 1930s. Nevertheless, the Rogoff and Reinhardt theory, along with the continued high level of faith in the efficiency and omnipotence of central banks, has become not just conventional wisdom but also the basis for many countries’ continued pursuit of growth-sapping public sector austerity regimes. Clearly, rising taxes and falling levels of government spending have contributed to the weak household income trends that we believe are constraining the household sector’s ability to sustain growth within the global economy.

We would argue, though, that there are times in which it can indeed be different “this time”. For example, in 1815 and following several decades of war against France and her allies, the UK’s debt ratios were stretched and in particular the level of outstanding public sector debt had reached the equivalent of over 200% of GDP, a level that dwarfs that of most countries even today. According to Rogoff and Reinhardt and the new conventional wisdom, this debt ratio should have crippled the economy but, instead, thirty years later the UK economy, with only around 3-4% of the world’s population, had moved from producing 5% of global manufacturing output to perhaps a quarter of all global output. Plainly it was very “different that time” for the UK at that time and the driving forces that made this possible were the invention of the steam engine, the improvement in transport links, the reform of the agricultural sector, the Royal Navy’s (albeit rather biased) expansion of world trade and a whole host of other technological and supply side factors that made UK productivity and hence incomes rise.
Interestingly, few people can name the Prime Ministers during this period and fewer still can name the Governors of the Bank of England at that time (in fact, there were 30 different governors between 1815 and 1870!).

The lesson that we draw from this example is that if the world is to recover from the GFC, we need more supply-side reform, more encouragement of productive investment and more investment in technology. The political pendulum, though, has clearly been swinging against such things over recent years and therefore the central banks have been obliged to continue to be the primary focus for many governments with regard to their “recovery strategies”, despite the fact that we learnt long ago that central banks can only affect nominal, not real, variables. Nevertheless, it does seem that the onus of providing a recovery will likely remain on the central banks this year and to this end we can imagine that 2014 may see even more QE-style policies from Japan, Europe and perhaps even the US.

Consequently, for much of the remainder of this year, we suspect that central bank policies will in general remain generally supportive for asset prices, although we also suspect that from time to time we will see periods of what may be quite intense and disturbing volatility when financial markets intermittently chose to focus – or are obliged to focus, either by some event that cannot be ignored or by the central banks’ occasional threats to withdraw QE – on the continuing problems in the real economies. In terms of the latter, we do wonder if the fast-deteriorating state of China’s economy may cause a “reality check” on the markets later in the second quarter but, in the near term at least, we suspect that asset markets will remain driven by the sheer weight of money that the central banks seem intent on forcing into the financial system, despite the disappointing returns in terms of results within the real economies that these types of strategy have so far generated.

Andrew Hunt
International Economist, London

Andrew Hunt International Economist London

« Buy not sell in May and go away?

KiwiSaver belongs to the KiwiSavers »

Special Offers