A speech by Larry Summers to the IMF last week got people talking. It’s well worth listening to the whole thing because there is some great stuff in it. The bit that got everyone’s attention, though, is his comment on the lack of economic growth. Echoing the warnings of Robert Gordon, Tyler Cowen and Jeremy Grantham, Summers said that Western economies are entering an era of low growth or ‘secular stagnation’.
He argues that ‘natural interest rates’, the rates needed to get the economy growing again are, in effect, negative. In other words, even with near-zero interest rates, businesses and consumers are still reluctant to spend and invest. The only way to persuade them to invest would be to charge them for keeping their money in the bank.
Furthermore, this has been the case for some time; since at least the mid 2000s. Consequently, the economic growth we saw in the 2000s was driven not by investment but by asset bubbles. As Gavyn Davies explains in the FT:
The alleged consequence of the fact that the actual real rate is above the equilibrium is that there has been a prolonged period of under-investment in the developed economies, with GDP falling further and further behind its underlying long run potential. In a largely unsuccessful effort to close the gap, the central banks have created asset price bubbles (technology stocks in the late 1990s, housing in the mid 2000s and possibly credit today), since this has been the only means available to boost demand.
Which led Summers to pose the question, does the US need bubbles to maintain full employment? Zero Hedge wryly pointed out that the Onion was way ahead of him on this one, having written this in 2008:
Demand for a new investment bubble began months ago, when the subprime mortgage bubble burst and left the business world without a suitable source of pretend income. But as more and more time has passed with no substitute bubble forthcoming, investors have begun to fear that the worst-case scenario—an outcome known among economists as “real-world repercussions”—may be inevitable.
“Every American family deserves a false sense of security,” said Chris Reppto, a risk analyst for Citigroup in New York. “Once we have a bubble to provide a fragile foundation, we can begin building pyramid scheme on top of pyramid scheme, and before we know it, the financial situation will return to normal.”
Despite the overwhelming support for a new bubble among investors, some in Washington are critical of the idea, calling continued reliance on bubble-based economics a mistake. Regardless of the outcome of this week’s congressional hearings, however, one thing will remain certain: The calls for a new bubble are only going to get louder.
“America needs another bubble,” said Chicago investor Bob Taiken. “At this point, bubbles are the only thing keeping us afloat.”
Joking aside, though, the none of the growth in the western economies has been particularly impressive when compared with the periods after previous recessions. Could Larry Summers be onto something here?
Lots of people have piled into this debate. There are interesting thoughts from Clive Crook, Paul Krugman (twice), Izabella Kaminska, Marco Nappolini, Jeremy Warner, Martin Wolf, Chris Dillow, Dan Davies and the Economist. These are just the ones I have seen. Do a search on Larry Summers or secular stagnation and you’ll find that just about every economics and business writer has something to say on the subject. You’ll find every shade of opinion on whether he’s right, by how much and, if so, why.
The one I found particularly intriguing, though, was Duncan Weldon’s.
If we assume that that many Western economies have been plagued by some form of secular stagnation since the 1980s and that growth has increasingly relied on leverage and bubbles (in different sectors at different times) then it is worth asking what else has happened during this time?
A huge rise in inequality with the incomes of the top 1% detaching themselves from the rest, a falling share of investment in GDP, big rises in household debt and a slowing of wage growth for median earners and below.
Duncan refers to the work of Andrew Smithers, whose recent book was reviewed in the Economist last month.
Smithers found that investment by US firms has been falling relative to dividends since the 1980s and that the ratio is now lower than it has been at any time during the postwar period. As Jim Saft of Reuters observed:
Economist Andrew Smithers argues, convincingly, in his new book “The Road to Recovery: How and Why Economic Policy Must Change”, that much of this investment drought is down to executive incentives.
Smithers contrasts the early 1970s with today. Then companies invested about 15 times more in new equipment and ventures than they returned to shareholders via dividends. Now the ratio is less than two. As recently as the 1990s, this number was as high as six.
Why? The change toward ever greater executive pay, doled out in share options which are highly sensitive to short-term stock price movements, has changed how CEOs behave.
I’d be interested to see figures for the UK but Chris Dillow’s chart, based on ONS figures, suggests the picture isn’t all that different.
Now compare these graphs with Chris’s analysis of wages and profits.
As the share of GDP tipped back towards profits and away from wages, investment began to fall. This makes sense because high wages act as an incentive to invest. When wages are high, firms need to invest to improve productivity. When wages are low, they can increase production by hiring more people. As union power waned and trade barriers came down, production could be relocated to lower wage countries and the rise in domestic labour costs slowed or even stopped.
Here’s where it gets really interesting. As the highly remunerated few were able to take more of their company profits in bonuses, they amassed a great deal of wealth. In this IMF paper, Michael Kumhof and Romain Rancière argue that this growing gulf in incomes led to the the high level of household debt accumulated in recent decades.
[I]t arises as a result of increases in the bargaining power of high income households. The key mechanism, reflected in a rapid growth in the size of the financial sector, is the recycling of part of the additional income gained by high income households back to the rest of the population by way of loans, thereby allowing the latter to sustain consumption levels, at least for a while.
In other words, the corporate executives of the early postwar world paid their workers high wages. This increased demand and fuelled growth but also meant that companies needed to invest. After the 1980s, executives began to take a much greater share of wealth out of their companies. They then lent it, through the burgeoning financial services industry, to their now much lower paid workers. The debt based consumption filled the gap left by the wage-based consumption of earlier years. Or, at least, it used to.
When I was doing my master’s, we used to discuss the tendency to study organisational behaviour without looking at its social context. I remember writing an essay arguing that organisations are simply microcosms of society, the behaviour of the people in them shaped and influenced by the wider world. But the reverse is also the case. Organisations shape and influence their world too. We spend most of our waking hours inside organisations of one form or another and they produce most of the world’s wealth. Decisions taken in corporations, big and small, will eventually have an impact on the world around them.
What started in the 1980s as an assertion of management’s right to manage and a repudiation of the collectivist corporatism of the 1970s has resulted in a wealth imbalance that may have disastrous and long-lasting economic consequences.
It doesn’t look as though it’s going to get much better in the near future either. Based on OBR forecasts, the Resolution Foundation expects median wages to stagnate during the next five years, even though the economy is set to grow.
In summary, then, the picture Duncan Weldon, Andrew Smithers, Jim Saft and others are painting is that the way executives are rewarded, with huge bonuses linked to share prices, has encouraged short-termism and the extraction of large profits at the expense of investment. At the same time, the weakening of unions and worker bargaining power has enabled them to get away with it and has created a market for rising credit. If they are right, executive reward and corporate behaviour has been a major factor leading to an economic stagnation that may last for years. That should make all of us who have been involved in developing remuneration policies over the past couple of decades pause for thought. Could this be yet another case of something that looks right for particular individuals and organisations at a particular time, turning out to be catastrophic for the economy as a whole?