Long Read

Economic Optimism, Dark Politics

Since the crisis, advanced economies have been stuck in a so-called “new normal” of sluggish growth. But the global economy is now finally firing on all cylinders again (with the notable exception of Brexiting Britain). So is this a potentially short-lived cyclical spurt, as economic pessimists fear – or might the United States and the eurozone finally be shifting on to a sustainably higher growth path? In my view there are good grounds for economic optimism, but that positive outlook is clouded by huge political risks.

Economic pessimists who believe that the good times are unlikely to last split into two camps. Supply-side pessimists fret about the imminent return of inflation. Last year’s combination of strong growth, low inflation and booming equity markets was too good to last, they reason. Starting with the United States, advanced economies are hitting capacity constraints. Unemployment is very low. Wages are picking up. Interest rates are on the rise. Slower growth and lower corporate profits beckon. But this reasoning seems, at best, premature. While it is, of course, a lagging indicator, core inflation remains subdued in the US and extremely low in the eurozone.

Demand-side pessimists believe that demand is weak for structural reasons, trapping the economy in “secular stagnation”. While spurts of strong growth are still possible in such an environment – and thanks to cheap credit, spurts may even become booms – demand eventually fades or crashes, bringing the economy back down to its feeble long-term growth path.

There is some truth to this. Wages have fallen as a share of economic output in many countries and their distribution become more unequal, both of which reduce consumption and thus business investment.

But much of the reason why demand has been depressed in recent years is that households have been weighed down with huge debts and sought to reduce them. That deleveraging has been painfully prolonged, especially in the eurozone, but it is not permanent. Indeed, there are three good reasons to believe that advanced economies could escape from their mediocre “new normal” and reach a higher growth path.

The first reason for optimism is that advanced economies are finally escaping the long shadow of the financial crisis. Banks and households have largely repaired their balance sheets and consumers are spending again, with plenty of pent-up demand. That, in turn, is prompting businesses to finally increase their investment.

Second, even in the US, which is most advanced in the economic cycle, the labour market is far from tight. Ignore America’s record-low unemployment rate. The labour-force participation rate among prime-age workers remains well below where it was throughout the pre-crisis cycle. So employment can continue to increase (and with it consumption and investment) without sparking wage inflation. Markets’ panic about recent wage rises is exaggerated; even with modest productivity gains, they are consistent with stable inflation. Indeed, among blue-collar workers, wage growth remains weak.

The eurozone has even more room to grow. Unemployment remains above pre-crisis levels in most countries. While the lost decade since the crisis has doubtless eroded some workers’ skills, motivation and employability, labour-market reforms in the likes of France, Spain and Italy also offer the potential for higher employment. In France, indeed, the unemployment rate is plunging.

Even in Germany, where unemployment is extremely low, core inflation remains comfortably below target. Whether it is due to fear of automation or fear of foreign competition, or simply the weaker bargaining power of labour, wage pressures are weak even in tight labour markets. Headline figures for wage settlements negotiated by IG Metall, Germany’s biggest union, are unrepresentative of the economy as a whole; real wages rose by a mere 0.5% in the year to the fourth quarter of 2017.

Third, the pessimism about productivity growth – and thus the economy’s long-term speed limit – is overdone. Productivity growth tends to be cyclical. Its prolonged post-crisis slump is partly an artefact of subdued investment by both businesses and governments. A recent study by the McKinsey Global Institute found that lower growth of capital per hour worked had contributed around half or more of the decline in productivity growth in many countries.

There are already signs that productivity growth is picking up; see, for instance, the latest figures and forecasts from the Conference Board. Far from hitting the buffers, advanced economies have the potential to shift to a higher growth path in which higher investment leads to higher productivity growth that in turn validates the higher investment decisions.

Looking forward, the ongoing digital revolution will eventually deliver hefty economy-wide productivity gains, as it did in the US between 1995 and 2005. My point is not that economic statistics from the industrial age understate productivity gains from the internet age; they do, but that means the economy is growing faster than official statistics suggest, not that it can grow faster than now without hitting capacity constraints.

The case for optimism is that while it takes time for the many of the productivity gains from digitalisation to be realised, they will eventually filter through. In some sectors, such as education, digital investment has so far been meagre. In others, businesses are duplicating their costs (and thus lowering productivity) by maintaining old analogue systems alongside new digital ones; think of newspapers that continue to print physical copies along with their online editions. Some sectors are investing heavily in new technologies that aren’t yet mature: think of all the investment being poured into both electric cars and self-driving ones, which have yet to yield significant sales.

Perhaps most importantly, businesses and sectors that have invested a lot in digital technologies are still grappling with how best to make the most of them. Remember that the huge productivity gains from electrification took time to emerge, mostly once factories and the broader pattern of production had been reconfigured to take advantage of distributed electric power.

So the grounds for cautious optimism are that advanced economies are finally putting the financial crisis behind them, have plenty of scope to grow without sparking inflation and have the potential to reap much greater productivity gains. And while demography seems set to remain a drag on growth – regrettably, there seems little prospect of Western countries admitting more hard-working young immigrants to expand and rejuvenate shrinking local workforces – it isn’t going to get much worse unless immigration is slashed.

Political peril

Set against those positive economic prospects are three big risks: productivity, policy and, above all, politics. The size and timing of productivity gains are hard to predict; growth may continue to disappoint in the near term. Central banks may tighten too far too fast in a bid to “normalise” interest rates prematurely. And populist politics and President Trump may wreck the domestic and international institutions that underpin economic growth.

The US Federal Reserve seems determined to press on with rate hikes this year and next even though core inflation is only 1.5%. That is not only premature. It may be unexpectedly harmful. The economy may be more sensitive to higher rates than the Fed thinks, because both corporates and households have grown used to a very low interest-rate environment. Markets too could prove more fragile than expected. While the Fed could, of course, reverse course if it blunders, it would soon hit the zero lower bound again. A U-turn would also undermine its credibility, and in particular that of new chair Jay Powell.

A perhaps less obvious risk is that if the US tightens too fast, it could miss out on the possibility of shifting to a higher growth path. Alan Greenspan took a calculated gamble in the 1990s in allowing the economy to run hot and reap the productivity gains from the new internet economy. While the dotcom bubble eventually ran away with itself, it would have been a mistake to miss out on those productivity and wage gains.

Arguably, the Fed ought to be relaxed even if wage growth outpaces productivity growth for a while. In the US and many other countries, wages have risen much more slowly than labour productivity since 2000, so the labour share of gross domestic product (GDP) has plummeted. That has not only depressed demand; it has also undermined support for capitalism. To frame that in monetary-policy terms, the Fed has undershot its inflation target by a total of 7% since the crisis. If it had a price-level target, or took a more flexible view of its inflation target, it ought to tolerate a period of above-target inflation for a while until wages catch up lost ground.

In the eurozone, the big questions are when the European Central Bank (ECB) will end quantitative easing (QE) and what happens when it does. Higher government bond yields would be problematic for countries such as Italy that have barely stabilised their public debt as a share of GDP. Without QE, yields will also be more sensitive to economic and political shocks. Looking forward to November 2019, when ECB President Mario Draghi’s term ends, the possibility that he could be replaced by the likes of Bundesbank President Jens Weidmann, or more likely a monetary hardliner from a small northern European country, could lead to premature rate hikes and jeopardise hard-won financial stability.

The third risk is politics. For sure, economies can sometimes sail through even major political crises like the attempted impeachment of President Bill Clinton in the late Nineties. As the history of Latin America shows, populist policies, such as a fiscal splurge, often boost the economy in the short term. But undermining the domestic and international institutions that underpin prosperity eventually takes its toll.

Markets remain unduly blasé about Italy. A coalition between the anti-establishment Five Star Movement and the far-right League (formerly Northern League) cannot be ruled out. While an overt move to leave the euro seems unlikely for now, the prospect of reversing economic reforms and running up even larger public debts is very real. Italy remains the eurozone’s weakest link.

Italy is a microcosm of the broader threat posed by illiberal nationalists to local economic prospects and in the case of President Trump also to the liberal international order.

Regrettably, populism is unlikely to fade any time soon. It’s often argued that faster economic growth will take the sting out of political discontent in the West. But not if almost all the gains go to the rich. While rising median wages would help, they need to be sustained for a long time. Strong wage growth in 2016 didn’t stop the Brexit vote or Trump’s victory. Politics operates with long and variable lags. Indeed, if Americans finally notice their fatter pay packets while Trump is president and credit him for them, his chances of re-election will rise.

While current conditions matter, expectations of the future matter even more. The strongest predictor of populism is pessimism about the future – people’s belief that their lives and those of their children will be worse. Perhaps their biggest fear is that if the Chinese or immigrants don’t steal their jobs, robots and artificial intelligence (AI) will. That insecurity cannot be cured by stronger growth – it requires political action. Indeed, higher growth driven by faster technological change adds to the insecurity. The disruption that excites Silicon Valley investors is disruption that ordinary people fear.

While rising wages and reduced insecurity are necessary to quell the populist backlash, they may not be sufficient, because it is also motivated by a loss of status for voters who feel ignored and despised, a loss of trust in elites who seem incompetent, self-serving, out of touch and corrupt, and a cultural backlash over immigration and identity issues. Bold political reforms are needed to address this, which only France’s president Emmanuel Macron seems committed to deliver.

Over time, populist politics undermines the rules and institutions that underpin our prosperity. In both the US and the UK, senior politicians impugn the independence of the judiciary, central bankers and civil servants, and single out particular businesses for criticism.

In the UK, this is a local problem: a country renowned for its pragmatism and stability seems to be having a mental breakdown. But the danger with populism is that a country can eventually end up like Viktor Orban’s Hungary or pre-Macri Argentina.

In the US case, the populist rot is also a global problem. President Trump is undermining the dollar-based international monetary system and the global trading system, while threatening catastrophic war.

Since Trump took office, the dollar has fallen by some 15% against the euro and by 8% on a trade-weighted basis. That decline puzzles economists, since the US policy mix of monetary tightening and fiscal loosening is usually associated with a stronger dollar.

Some now argue that the dollar has weakened because expectations of future policy have changed, namely that while future Fed hikes were already priced in a year ago, stronger eurozone growth has led markets to price in rate increases there after 2019.

That may indeed be part of the story, although it does not explain why the dollar has weakened against other currencies or why the euro’s rise against the dollar has been much greater than against other currencies.

In my view, part of the dollar’s decline is due to politics. It arguably reflects a Trump discount: a loss of global trust in the US’s ability and willingness to lead the international system, whether it is maintaining open trade, supplying the safe asset of choice, or being the consumer and borrower of last resort. That is amplified by the uncertainty associated with the shift to a new Fed leadership and Trump’s recklessly erratic management.

Treasury Secretary Steve Mnuchin’s call in Davos for a weak dollar and Trump’s America First policies are reminiscent of Richard Nixon’s Treasury Secretary, John Connally. He infamously told the rest of the world that “The dollar is our currency and your problem.” Just as devaluing the dollar in the early Seventies led to the breakdown of the Bretton Woods dollar-anchored fixed-exchange-rate system, we may now be starting to see a shift towards a less dollar-dominated world. The euro may provide an alternative in the near term and the renminbi further out. Indeed arguably part of the reason for the continued popularity of bitcoin and other crypto-currencies is a loss of faith in central-bank money and the dollar in particular.

A loss of trust in the dollar is much more significant than simple currency weakness, with all its likely consequences for trade and capital flows. It also creates added uncertainty and dislocation for everyone who relies on the dollar-based system. Indeed, increased risk premiums could see US Treasury yields rising as the Fed shrinks its bond holdings.

A second area where Trump is undermining the international system is trade. For now, cyclical effects are winning out: global trade is booming. Globalisation is proceeding without the US. The EU is busy striking trade deals with all and sundry. The 11-country Trans-Pacific Partnership (TPP) is going ahead with a longer name and without the US. Canada and Mexico are hedging their bets in the face of the threat that Trump might pull the US out of the North American Free Trade Agreement (NAFTA).

But Trump’s absurd mercantilist obsession with reducing the US’s bilateral trade deficits is extremely dangerous and the threat of a catastrophic trade war is growing. Threatening other powers with trade sanctions to prise open their markets may in some cases succeed. But eventually China and the EU will stand up to American bullying, because the long-term costs of giving in outweigh the short-term economic costs of retaliation.

It is a fallacy that because China has a huge trade surplus with the US it is much more vulnerable to a trade war than the US. Since many “American” products are assembled in China, China has huge leverage. It could, for instance, easily shut down iPhone production on spurious grounds, such as factories’ non-compliance with local rules.

More broadly, the US is systematically undermining the World Trade Organisation (WTO), which has until now been an effective peaceful arbitrator of trade disputes. It is refusing to allow the appointment of new appellate judges, without whom the WTO’s dispute-settlement mechanism cannot function.

Trump’s spurious use of national security as a pretext for imposing emergency tariffs on steel and aluminium imports is particularly worrying. While WTO rules allow countries to restrict trade on national security grounds, this exception is designed for exceptional times such as war. Plaintiffs would have a strong case against the US at the WTO since Trump himself has repeatedly justified the tariffs on economic rather than national security grounds.

But this is a lose-lose scenario for the WTO. It may be loath to be seen to trample on supposed US national security concerns, but if it ruled in the Washington’s favour, this would provide carte blanche for other countries to spuriously curb imports on national security grounds. If it ruled against Trump, his administration would probably ignore the ruling, and might even pull out of the WTO, as it has previously threatened to do.

The big picture is that the world is rapidly shifting from a US-led rules-based order to a multipolar world of great power politics. That entails more uncertainty, greater politicisation and more potential for conflict. Ironically, it is the status-quo power, the US, not the challenger (China) that is doing most to undermine the liberal international order.

Trump’s irascible character and his appointment of John Bolton as national-security adviser and Mike Pompeo as Secretary of State increase the risk of nuclear war with North Korea and conflict with Iran. It is even conceivable, though still very unlikely, that trade war with China could lead to real war.

Rarely has the disconnect between economic sunshine and political storm clouds been so great. Just as the global economy is finally emerging from the long shadow of the financial crisis, and with the promise of huge technology bounties ahead, might it snatch political defeat from the jaws of economic victory?

Philippe Legrain
01.04.2018