Turn away from protectionism and growth will come
In one fundamental respect, the field of economics has not changed much in the past three centuries. When Scottish-born Adam Smith published
in 1776 he asked what is still the most important question: “What drives economic progress?”
Of course, in a world of hashtags we now have to settle for the much more trivial-sounding “productivity puzzle”. But the essence of the problem remains the same. Consider the following: living standards that rise at 2pc per year will double roughly every 35 years. For living standards that rise at 1pc per year, it will take 70 years.
In the West, the experience of the post-war period is that growth bounces back strongly after a downturn. In a normal cyclical recovery, strong investment increases capital per worker, and, in turn, productivity.
Frustratingly, productivity growth has underperformed enormously so far throughout the post-Lehman upswing. While major advanced economies, including the UK, currently enjoy a record number of jobs, the average worker does not produce much more than a decade ago. Because worker output has languished, headline GDP growth has been around a third lower than normal. Real wages and revenues have increased more slowly. Confidence and the appetite for risk-taking have been depressed. Meanwhile, the growth impulse from economic policies designed to speed up the recovery has disappointed. Austerity and balance sheet repair has gone on longer than expected.
The consequences extend well beyond the measurable economic effects. Much of the creeping political disenfranchisement of recent times can be attributed to stagnating living standards and the risk that future generations could find themselves worse off than their parents.
Political and economic systems that do not enable people to get on will struggle to last. This is quite possibly the most pressing economic and political issue of our time.
What is going on? Are we collectively out of ideas that could push us forward? Anecdotal evidence suggests the opposite is true. Rates of innovation in energy, artificial intelligence and robotics seem to be accelerating. Each on its own has the power to boost productivity.
People often identify the current productivity weakness as a postfinancial crisis phenomenon. This is wrong. Growth rates in worker output per hour had already started to slow in the mid-2000s as Western economies, enticed by excess short-run returns, started over-investing in real estate with borrowed money. Households then took out extra credit against their rising home values to finance higher spending. Major capital misallocation, disguised as proper growth, meant major economies underinvested in the essential capital and equipment that could have raised output and worker productivity in a sustainable way.
When the bubble finally popped it had lasting negative effects. Burdened with high debt and unproductive assets, advanced economies had to go through a long period of balance sheet repair that is not yet fully complete.
Weak productivity growth during the last decade is the price we have paid. In the coming years things should improve modestly if the right policies are followed and some crucial mistakes are avoided.
Last year marked the partial return to normal cyclical dynamics. In the US, the UK and Germany, where the economic cycle is the most advanced and unemployment is low, continued strong demand will put increasing strain on available resources. Firms will need to decide whether to raise productive capacities through capital investment or simply raise prices.
So far the signs are mostly good. US firms are responding positively to the Trump fiscal stimulus and tax reform with higher investment spending. In Germany, firms are investing more as they encounter labour supply constraints. Even in the UK, where Brexit uncertainty clouds the economic outlook, investment is expanding nicely. In a world where demand is growing, UK firms seem more concerned about losing market share than a hard Brexit.
Meanwhile, inflation across the advanced world remains close to the 2pc rate that major central banks see as desirable. Central banks can exit their stimulative monetary policies slowly, keeping the cost of capital low. With luck, healthy demand growth should translate into a broad-based upswing in investment and productivity in the coming years.
The risks to this optimistic outlook are obvious. Confidence remains fragile. Firms and financiers remember the pain of the financial crisis. In addition, central banks and governments are not well prepared to deal with the next downturn.
The major risk is a Trump-led trade war. While the current planned US and China tariffs will only have a small measurable effect on global output and inflation, the risk that uncertainty weighs on firms’ production and investment is significant.
Sentiment in Europe has already softened due to the trade skirmishes. If the current tit-for-tat between the US and China does not de-escalate soon, the pick-up in investment growth could be spoiled before it builds any serious momentum.
After much of the hard work in fixing the problems that led to the crisis is done, it would be a pity if the long-awaited good times were spoilt by misguided economic policies.
‘With luck, demand growth should translate into a broad-based upswing in investment and productivity’