Subitha Subramaniam assesses the long-term economic landscape, and explains why our investments must become more resilient.
The winds of change, it seems, are sweeping through the capital cities everywhere. After 43 years of membership in the EEC/EU, the UK’s citizens have voted for Brexit. The meteoric rise of fringe parties across Europe continues to destabilise the political centre and impede the formation of stable governments. Even the remarkable ascent of Donald Trump reflected a growing polarisation of the electorate, exposing a deep and irreconcilable rift within the Republican Party. Political instability appears to be on the rise everywhere.
Some of the upheaval in politics can be traced to enduring economic shifts. For over two decades now, globalisation and technical innovation have progressed at a furious pace, suppressing the wages of lower and middle income workers. Sharp increases in unemployment that accompanied the financial crisis have only worsened the insecurity of these workers. Fiscal austerity that followed the financial crisis further deepened worker anxiety by chipping away at safety nets.
Now, disenfranchised workers are seeking to turn back the economic tide by taking charge of the political debate. The socio-political capital of economies, which has risen strongly since the end of the Cold War, has recently been besieged by a backlash against globalisation and rising inequality. The consensus around the political centre is rapidly disappearing – and with it political stability.
To see through the fog of political upheaval, we need to sharpen our focus on the enduring economic shifts that shape society and drive political agendas. Ignoring these trends inevitably leads to misinterpretations of and overreactions to short-term volatility – in politics, in economics and ultimately in markets itself.
What trends will define the long-term landscape?
We first start by filling in the canvas with a rough outline of the world’s economic potential. Over the long-term, the world grows either because healthy demographics provide a steady stream of new workers or because workers become more productive. We therefore need to forecast how the two key ingredients – growth in the number of workers and the growth in the productivity of workers – are likely to stack up over the long term.
During the past 50 years, the world’s population has more than doubled; rising from 3.4bn to 7.4bn today. This strong growth has provided a sizeable demographic tailwind, accounting for roughly half of all global growth (3.2 per cent per annum) during the period.
Demographic trends over the next 50 years, in contrast, will not be so favourable. Population growth is set to slow to just 0.5 per cent per annum, with a substantial amount of the growth coming from less developed countries that have historically suffered either from political instability or economic mismanagement (Nigeria, Indonesia, Bangladesh, Ethiopia, Pakistan, DRC, Uganda). These are economies which have repeatedly struggled to harness their growing populations in a productive manner.
The United Nations is projecting that the population of advanced economies will not only start contracting but will also undergo substantial ageing. The world’s population will also be materially older, and economies will depend heavily on the increased participation of older workers.
We estimate that the growth lift from demographic trends is unlikely to exceed the 0.5 per cent increase in population growth per annum. In other words, the long-term potential for global growth will be at least 1 per cent lower than its historical rate of 3.2 per cent.
The productivity challenge
With fading demographics, long-term global growth will come to lean heavily on productivity growth. What drives long-term productivity? At a base level, productivity growth is driven by the pace of technical progress (better ways to make things using less time and resources), the levels of capital stock (enabling the adoption of more mechanised and automated processes), market structures (appropriate rewards for innovations) and government regulation (establishing and protecting the rules of law).
Over the past 50 years, productivity has grown by 1.6 per cent per annum. In large part, this was driven by the productivity surge that followed the rapid growth in computing power and the penetration of the internet. The sharp increases in emerging market capital stock (particularly in China) have played a key role in accelerating emerging market productivity.
It is worth noting that productivity growth across the developed world has stalled over the past five years. Increasingly in this post-industrial society, physical capital is being substituted away by human or intellectual capital. Platform business models (which often benefit from hyper scale and network advantages) are increasing the utilisation rates of existing assets and reducing the need for more physical investments. For example, ecommerce is continuing to reduce the demand for malls; platforms like Airbnb and Uber are chipping away at the demand for hotels and automobiles.
Over the next decade, productivity growth will face material challenges. First, as the world economy continues to develop, there is an ongoing powerful shift in employment towards the service sector. Services typically capture activity between people (hairdressers, teachers, doctors, actors, athletes) and productivity is much harder to not only increase but also measure.
Second, the proliferation of the internet is leading to an explosion in zero marginal cost business models that provide information, communication and entertainment for free (Google, Facebook, YouTube, Skype, Tripadvisor). These zero marginal cost businesses have driven out many traditional providers of information goods and services, lowering GDP and productivity. Free goods may improve the quality of our lives, giving us something known as consumer surplus. However, for GDP and profits they reduce transactions and lower productivity.
Finally, pace of productivity growth in emerging markets is also set to slow from the breakneck speed of the past decade as China rebalances away from its investment-intensive growth model. A slower China will inevitably lead to slower growth in other emerging markets, as their economies have become much more intertwined with that of China. We therefore expect a slower-pace emerging market catch-up in the coming decade.
What’s slowing us down?
Productivity growth, particularly if broken down into its component parts, appears to be on a secular downward trend. The long-term evolution of the three key drivers of labour productivity – education, capital investment and technical progress (improvements in production technology) – has been weak.
Investment over the past decade has been inexplicably low, despite record profits and low borrowing costs. Businesses have been reluctant to invest, preferring to buy back shares and return capital to shareholders. Moreover, business dynamism, as measured by the number of firms entering and exiting the market place, appears to be on a downward trajectory. Perhaps incumbents, fearing disruption from low-cost start-ups from technology-enabled firms or emerging market competitors, have become risk-averse? There are no clear answers, but the fact remains that net investment in the economy remains low, and this has clearly been a drag on worker productivity.
Technical progress also appears to have slowed down in recent years. Recent innovations appear to have materially improved consumer welfare, but have yet to impact business efficiency. Robert Gordon from Northwestern University argues that the predominant use of big data has been in marketing, which is essentially a zero sum game. Yet others argue that there is typically a big lag between innovation waves and increases in productivity. Both, however, agree that the pace of technical progress in the current decade is lower than in previous ones.
These challenges suggest that over the long run productivity growth is unlikely to exceed 1.5 per cent. Together with a demographic lift of 0.5 per cent, the long-term potential growth rate of the world economy is likely capped at about 2 per cent.
With this rough estimate to hand, we can now colour in the details of the long-term landscape.
The impact of debtors
Debt matters when there is a lot of it. Today, there is a lot of it. The scale of the global debt burden is unprecedented and it distorts our future in a multitude of ways. While moderate debt levels enable us to bring forward future consumption and smooth income over a life cycle, excessive levels debt tend to suppress future growth as they divert income towards debt servicing. According to the Bank of England’s Gertjan Vlieghe, there is now conclusive evidence that highly indebted households and firms tend to reduce spending more sharply during downturns and therefore also lead to sharper recessions.
In the absence of default or inflation, high indebted economies depend heavily upon growth to erode the debt burden. Since the financial crisis, central banks have sought to stimulate growth for this very reason. Interest rates have been set far below natural rates of growth to create favourable conditions for the economy to deleverage.
There is, however, great uncertainty over how low interest rates need to go to provide the right conditions for deleveraging. For the first five years after the crisis, most central banks believed that interest rates at or close to zero would provide a sufficient uplift to growth and enable the economy to reduce its debt burden. Growth, however, remained disappointingly modest. Debt burdens as a result remained high and in some instances increased further.
More recently, central banks in key economies (euro areas, Sweden, Switzerland, Denmark and Japan) have taken interest rates below zero to test whether negative interest rates will be more successful in jumpstarting growth and eroding the debt burden. The theory goes that with such a wide wedge between growth and interest rates, businesses and consumers will borrow to invest and spend.
The transmission mechanism of monetary policy from the central bank to corporates and consumers, however, has not been smooth. Banks are the main conduit and have failed to pass on the cuts in rates to consumers and businesses. More recently, the ECB has introduced further incentives to encourage the banking system to pass lower rates onwards. It is yet to be seen whether such efforts will be successful. But central banks no doubt will continue to push through with creative and unorthodox solutions.
While there are as yet no clear frameworks that explicitly clarify the link between long-term interest rates and debt levels, we can assume that large debt burden will lead to policies that continue to repress interest rates to enable the world economy to grow out of its debt burden and reach its long-term potential.
The impact of savers
Long-term demographic trends are also putting downward pressure on real interest rates. Not only does slower population growth lower growth and real interest rates but ageing populations mean that households will need to save more to fund lengthier retirements, putting downward pressure on interest rates. The growing disparity in income levels within countries is also raising global savings as wealthier households tend to save more, further suppressing real interest rates. The ongoing shift in income to emerging markets also raises savings, as emerging market households tend to have higher savings rates.
Empirical work by Federal Reserve economists John Williams and Thomas Laubach identifies strong persistence in the decline of the natural rate of interest (which has hovered around 0 per cent since the financial crisis). This suggests that traditional models predicting a reversion to the long-run mean of 2 per cent are unlikely to be useful predictors in the future. A highly indebted world that encounters an excess of savings is likely to have real interest rates that settle around 0 per cent over the long-term.
Labour, automation and fairer wages
A final detail that we need to colour in is the disruption of labour markets by increased automation. The 20th century witnessed widespread mechanisation that transformed the production of physical goods. The 21st century is likely to experience an equally important transformation: the automation of the service sector.
From financial services, to healthcare and education, there are ongoing efforts to automate vast swathes of the service sector. And as technological innovation redraws the sector, the wages of middle-income workers the world over are likely to come under pressure. Meanwhile, for lower-income workers, increased awareness around social justice and the need for a truly living wage in developed economies ironically makes automation all the more appealing for businesses (McDonalds, for example, is already experimenting with automated order taking). Besides the obvious impact on workers, on a macroeconomic level lower incomes would also put downward pressure on global inflation rates and suppress real interest rates further.
As we peer into the future, then, the landscape that emerges is one of a slowing world economy, where policy-makers will seek creative solutions to offset the drag on economic potential arising from the unprecedented rise in indebtedness, income disparity and automation. This will be a world of repressed interest rates and suppressed wages, where political tensions will continue to mount as the strains of a slowing world economy collide against the forces of debt, demographics and automation.
Subitha Subramaniam is chief economist and co-head of asset management at Sarasin & Partners
Civil Society Media wishes to thank Sarasin & Partners for its support with this article