There has been a steady decline in the efficiency of capital over the long-term in developed economies, and this deterioration has continued over the postwar period. We have also had a large fall in investment over the past 30 years. Unless there is a sharp reversal in these two adverse trends, the sustainable rate of growth will be much slower than it has been in the past. Read more

In the US, real gross domestic product per head has grown at a stable rate over the long-term, with glitches such as the one caused by the Depression being made up by subsequent recoveries.

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World growth over the past three years has fallen below its five-year rate and below its very long-term one, as chart one shows. It seems therefore reasonable to assume that we are experiencing what is at least a cyclical downturn. But the chart also shows that the trend since 1980 or 1990 seems to be a rising rather than a falling one. It doesn’t therefore seem to me reasonable to assume that the world is about to experience of the sort of longer -term slowdown that can reasonably be described as secular stagnation, though of course this may happen. Read more

One of the most encouraging features of the US economy has been the recent improvement in the level of labour participation, which is the proportion of those aged 15 to 64 who wish to work (i.e. employed plus unemployed).

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Unemployment cannot fall much more in Japan, the UK and the US without inflation rising. The actual growth of gross domestic product therefore needs to slow, through a decline in the strength of demand, to each economy’s trend growth rate. Monetary policy will be dangerously off course if central bankers are too optimistic. This is a high risk as consensus estimates for these trend rates are way above those indicated by recent changes in labour productivity (table one). The Bank of England, for example, predicts that GDP per hour worked will rise over the next two years to nearly two per cent per annum. Read more

We are currently inundated with bad information. It is one of the reasons why the economy has been doing poorly. Our future depends on our decisions and bad information leads to bad ones being made.

Claims made about the cost of corporate equity and the returns that companies should therefore seek to make for their shareholders are prominent examples of misinformation. For example, according to KPMG, Britain’s five largest banking groups must “urgently tackle” low returns for shareholders. I am quoting from an article by Emma Dunkley in the Financial Times April 8 2015: “Big banks should become more profitable, says the report. It is claimed that value for shareholders is still being eroded six years after the crisis. None of the banks achieved a return on equity above 8 per cent last year, compared with an average of 11.6 per cent in 2009.” Read more

Dear readers, I am on blog holiday at the moment but plan to publish my next blog on or around Wednesday, 20th May. Regards, Andrew Smithers.

Jean Tirole

Jean Tirole  © Getty Images

Ronald Coase, who won the Nobel Prize in 1991, remarked that one of the advantages of the award is that it can draw attention to neglected areas of economies. I hope that this will occur with the award of the 2014 Nobel Prize for Economics to Jean Tirole. For several years I have been commenting on the damage being done to the UK and US economies by the way corporate behaviour has altered in response to the change in management remuneration. Happily from my viewpoint, this is also a concern of Mr Tirole’s, who is the co-author with Roland Bénabou of a paper, shortly to be published in the Journal of Political Economy, called “Bonus Culture: Competitive Pay, Screening, and Multitasking”. I hope that the publicity that usually surrounds the work of Nobel laureates will at last lead to wide discussion of the damage done by current management remuneration systems. I fear that my own efforts to generate interest in this problem have not so far proved very effective.

The Bénabou/Tirole paper comments that in recent years we have seen a literal explosion of remuneration, both in levels and in differentials, and it is claimed that these stratospheric pay packets are needed in order to retain talented people and give them incentives to perform. The authors note that, paradoxically, this trend has been accompanied by mounting revelations of poor actual performance, severe moral hazard and even outright fraud and that the change in behaviour has also had a negative impact on the rest of society. They explain how competition for talent leads to an escalation of performance pay, shifting effort away from long-term investments, risk management and co-operation. The result is a bonus culture that takes over the workplace, distorting decisions and causing significant efficiency losses, particularly in the long run. Read more

On current trends, Japan’s gross domestic product will grow faster than that of the US over the next 10 years. As Japan’s population is expected to fall and that of the US to rise, the relative improvement in living standards will be even greater. This will be denied by many economists and journalists, for whom Japan’s relative weakness is an item of faith.

The habit of looking at the change in GDP and assuming that this provides a good guide to the success of an economy is to blame for the prevalent view. It is a deeply embedded and near-automatic assumption that has blinded commentators to Japan’s relative economic success. In the recent past, demography has posed a far greater challenge for Japan than for other G5 countries but that has now changed. If, in other respects, Japan can maintain its past progress over the next 10 years, then the improvement in its demographic balance will boost the growth of its GDP and its living standards. Read more

The dramatic expansion of central bank balance sheets as a result of quantitative easing produces two extreme views. One is that it will cause hyperinflation and the other that it has had no adverse consequences. Neither of these strikes me as at all probable. Hyperinflation is not a serious risk, at least in the developed world, but it does seem likely that QE has adverse consequences. Having instituted QE, central banks are understandably unwilling to talk about its dangers and adjust their policies for them. However, it has probably increased the risks of a pickup in inflationary expectations and the dangers that this poses for the economy.

As chart one shows, we have had an upward sloping yield curve for the past 80 years, i.e. borrowing through issuing bonds has been expensive. Governments have nonetheless chosen to fund this. If this wasn’t just a stupid decision, then the added cost of funding must have produced a large benefit for the economy. I think that this benefit was real in that it helped to moderate inflationary expectations. Read more

There is a widespread belief that “labour is steadily losing out to capital”. This was, for example, the title of an article in The Economist last year (4 October). With the important exception of the US, the data show this to be a myth.

The ratio of labour incomes to gross domestic product is commonly used to justify the claim. This has several faults. First, the data do not support it, as there has not been a general decline in the labour share of GDP. Second, the fluctuations in the labour share of GDP are not matched by compensating changes in the profit share. Third, a serious look at the issue would use another approach and consider whether labour has lost out to capital in their share of corporate output. Read more

Usually the Fed waits too long before raising interest rates. The pressure to delay is particularly strong today. One reason is the sharp decline in the trend growth rate of the US. As I have pointed out in these blogs, this is the result of a sharp fall in the growth of the population of working age and in productivity. In the decade prior to the financial crisis (1997 to 2007), the numbers in the US of those aged 15 to 64 grew at 1.38 per cent per annum and is now forecast to rise over the next decade at only 0.18 per cent per annum (chart one).

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Conventional wisdom, those wrongheaded comments that sound authoritative, is flourishing. Much comes from seeing gross domestic product as the measure of economic success. As Japan’s GDP has grown slowly this has led the unreflective to assume that the country’s performance has been poor. As readers of this blog will know, this seems to me to be nonsense. GDP is a fair measure of a country’s economic power, but changes in GDP per head provide a better guide to the progress of a country’s welfare and GDP per person of working age is a better guide to the success of economic policy. The number of Japanese aged 15 to 64 has been falling and this has limited the country’s ability to expand its GDP. If the changes in GDP per person in major developed countries are compared, Japan stands out for its success rather than its failure.

I am by no means alone in pointing this out; the former Bank of Japan governor, Masaaki Shirakawa has also regularly done so. Judging, however, by comments in the financial press we seem to have been talking to brick walls. The damage done from seeing GDP as a valid measure of economic success has been magnified by an association that is commonly made between low growth and deflation. It is widely believed that Japan’s economy has performed poorly and that this has been caused by deflation. It would be more reasonable, though not much more, to praise deflation for the relative success of Japan’s economy. Read more

Quantitative easing involves buying bonds and this increases the Bank of Japan’s assets and the monetary base which, depending on the precise definition used, is nearly the same thing. As a result of the BoJ’s aggressive QE policy, its balance sheet has grown from 30 per cent of gross domestic product at the end of 2012 to 60 per cent at the end of 2014. Over the past year it has grown relative to GDP by 14 per cent (chart one). This compares with a fiscal deficit of around 8 per cent of GDP. Japan’s central bank is thus buying more than 100 per cent of the securities issued by the government to finance the deficit. Read more

Japan’s national accounts show that non-financial business has been a net lender to other sectors of the economy at an annual rate of 7 per cent of GDP since 2009. The accounts on an income basis are published much later than those based on expenditure data and the latest we have for the former have only recently become available.

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In my last blog, I showed that the trend growth rate of the US indicated by its Incremental Capital/Output Ratio (“ICOR”) was only 1.6 per cent per annum. As the US population is likely to grow at 0.8 per cent per annum over the next ten to twenty years, this would allow gross domestic product per head to rise at 0.8 per cent per annum. As chart one shows, this is well below the post-war average and is almost identical to the growth achieved over the past ten years. Continuation of recent growth would probably disappoint most expectations.

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There is a widespread view that the financial crisis has caused growth to slow in developed countries. In earlier blog posts I have shown that this is unlikely. The crisis did not cause the change in demography, which has been a very important contributor. The other major influence has been the decline in productivity, which is partly due to a large decline in investment which started well before the financial crisis.

Not only has investment fallen, but the investment that has been taking place has become much less productive. If this is temporary, then we can reasonably hope that we will see a bounce in growth and productivity. As I recently argued, the US has moved from a situation where the growth rate of the number of working age individuals has outpaced that of the total population to the opposite situation. As a result, a rise in productivity is needed to prevent living standards falling. It is therefore important to try to understand why the efficiency of capital has fallen. Read more

Investors rightly worry about the risks they run as well as their prospects for gain. The assessment of risk is complicated because for equities it varies over time. Holding a balanced portfolio of shares becomes less risky as years go by. While there is always a possibility of bad outcomes, if equity returns were random such risks would fall over time. But in practice they fall even faster because returns are not random but show “negative serial correlation”, which means that after periods of above average returns the chance of below average ones increases and vice versa.

No one would own equities if they didn’t expect them to give positive real returns. As they have in the past it is reasonable to expect them to do so in the future. If markets fluctuated in a random way, the most likely return in the future would be their long term past return which in real terms has been around six per cent per annum. Read more

Bad policies breed even worse ones. The disillusionment of voters provides the link. Disappointment with the economy is reinforced by the conviction that “‘They’ don’t know what they are doing.” Voters want new policies and new people. Sadly, this does not usually produce sound policies advocated by those who have correctly analysed the faults of the past. Realism seldom offers the instant gratification sought by the disgruntled, and populist policies thus usually represent a retreat from reason rather than a rise in analytical rigour. When countries have embraced populism, the resulting policies have habitually made matters worse.

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Financial crises commonly arise when there is too much debt and asset prices fall from excessive levels. Examples are to be found in 1929 in the US, 1999 in Japan and 2008 worldwide. Hyman Minsky, in his famous book Stabilising the Unstable Economy, set out the three stages in the pattern of borrowing that involve increasing risk. It starts with borrowers expecting to be able both to pay the interest and to repay the principal from the cash they expect their investment to generate. In the next stage their hopes are limited to paying the interest and refinancing the principal when the repayment falls due. In the final stage not even the interest is expected to be covered and the expected profit derives solely from the hope of being able to sell the debt financed asset at a profit. When continually rising asset prices cease to be an article of faith, the house of cards collapses.

There is then a rush to sell assets which sets off a recession, as borrowers seek to repay their debts. Companies which wish to reduce their borrowing don’t just avoid new borrowing — they seek to repay their existing debt. To do this they need to generate cash. This means spending less than they earn, and their intentions to invest then fall short of their intentions to save. The attempt to improve private sector balance sheets can therefore be described as a balance sheet recession, whose severity can be moderated as fiscal deficits cause the balance sheet of the public sector to weaken, offsetting the negative impact that comes from the strengthening of private sector balance sheets. Read more