Last weekend, the world’s central bankers, finance ministers and investors gathered at the spring meeting of the International Monetary Fund’s governing board in Washington, DC to hear the global financial watchdog’s latest update on the state of the world economy.
The news was positive. World GDP growth is forecast to be just under 4 percent both this year and next – stretching the global expansion into its 11th year. China and India, the great juggernauts of the emerging world, should grow at around 6.5 and 7.5 per cent respectively. The US – the largest economy in the world – will start to benefit from President Donald Trump’s opening of the fiscal floodgates, and as a result, seems set to break the 1991-2001 record for its longest postwar expansion. Even in Brexit-beleaguered Britain, the unemployment rate has just hit its lowest level since 1975.
Yet rather than revelling in this bonfire of the economic record books, expert opinion in the US capital – like the public mood across much of the West – was strangely full of foreboding. Among the general public, statistics such as those just quoted seem curiously at odds with the lived experience of a joyless recovery hallmarked by austerity and uncertainty.
The experts themselves have more faith that the numbers reflect reality. But among the professional forecasters, too, there is a nagging sense that the good times cannot last – that there is another downturn just around the corner, and that the longer we go without a recession, the more likely it is that there will be one next year.
Are these fears of false progress and impending doom misplaced, or are we indeed living in a fool’s paradise? Where does this mismatch between perception and reality come from? The answer is to be found, I think, in two critical features of the global recovery since 2008.
The first of these is the apparent gaping disconnect between finance and the real economy. The essence of what is disturbing here is simply put. Although the world economy’s real output is indeed some 25 per cent larger than it was in 2007, the level of debt has grown by vastly more. Global debt is now nearly 320 per cent of global GDP – 42 percentage points more than in 2007, and a historically unprecedented level.
This ballooning of global debt financed a huge reflation of asset prices following the crash of 2008. House prices, share indices, the valuations of classic cars and Old Master paintings – in most countries, they all recovered quite quickly from any falls they suffered during the crisis, and in many countries they have handsomely outpaced the growth of incomes since.
The decade of growth since the global financial crisis has, in other words, relied upon a tremendous inflation in paper wealth, financed, ultimately, by borrowing – either by the private sector, as in the emerging markets, or by government, the specialty of the developed world. Both the asset price reflation, and the build-up of debt to fund it, were directly encouraged by policy. Such was the explicit purpose of interest rates fixed at zero and quantitative easing (QE) – the expansion of money supply by central banks. Yet this trajectory is not sustainable indefinitely. The policymakers’ hope was that the rate of economic growth would catch up with the increase in asset valuations and debt, bringing the ratios of house prices, share prices and debt to GDP back into line with history.
This, in concrete terms, is what fixing the infamous productivity crisis would mean. But thus far, it simply has not happened – leaving asset valuations and debt levels floating without visible support at vertigo-inducing levels.
The potential for problems is real. For while it is notoriously hard to identify when the desynchronisation of finance and the real economy has reached a tipping point, there is no doubt that in today’s global economy, with its hypertrophied balance sheets, any financial dislocation would quickly rebound on the real economy.
The likely mechanism is simple. A “correction” in forward-looking asset markets – say, a fall in house prices, or a stock market crash – suddenly reduces households’ perceived wealth. The result is a sudden increase in those same households’ desired rate of saving, with a corresponding reduction in spending on goods and services.
Unless the shortfall in demand is made up through a bout of government-directed fiscal stimulus or a miraculous surge in exports, output will decline and the economy shrink.
The higher the level of asset prices, the greater the burden of debt and the lower the current savings rate, the more vulnerable the real economy surely must be to a sudden reversal, such as the one outlined. For a quick rain-check of how reasonable these macroeconomic misgivings are in today’s apparently benign economic climate, one can examine how a country measures up on these metrics.
The UK offers a salutary example. The median house price in England and Wales was more than 7.5 times median earnings at the last count – 7 per cent higher than even the ratios of a decade earlier. Household debt is nearly £1.9trn – £300bn higher than in 2007. The household savings rate dropped below 5 per cent in 2017 – its lowest level since records began in 1963.
No wonder that despite its rosy forecasts for economic growth in Washington, the IMF gave its annual overview of high finance – the Global Financial Stability Report – a rather more sanguine title: “A Bumpy Road Ahead”. The UK, for one, it seems, is living on fumes.
Laid out like this, it is tempting to criticise the policymakers who have overseen this dramatic divergence between the financial and the real economies. Yet that would not be strictly fair – at least, not without delving deeper into the reasons why policies such as QE were pursued.
The reality is that the resort to potentially destabilising monetary and financial policies was explicitly driven by a second feature of the global economy over the past decade – one which is perhaps even more fundamental to explaining why the developed West’s objectively quite robust economic performance has seemed so much less than the sum of its parts.
It was Mervyn King, the then governor of the Bank of England, who first laid out the facts, in a press conference soon after the global financial crisis. Asked by a journalist whether the planned combination of loose monetary policy and fiscal austerity was a sufficient response to the deep recession of 2008-09, King directed his audience’s attention to the longer-term context instead.
He pointed out that ever since China had opted decisively for a market economy and engagement with global trade and finance in the late 1990s, the centre of gravity of the global economy had been migrating inexorably east. An epochal shift in the distribution of real global wealth, productivity, and power was under way.
This shift was without question generating unprecedented prosperity for the world as a whole. But one inevitable result was a decline in the relative fortunes of the West versus the Rest. The growth of China’s economy was compounding at 10 per cent a year, compared to 2 or 3 per cent in the developed world. The stupendous advantage in technology, power, and real incomes that the developed West had for so long enjoyed over the emerging East and South was therefore being ceded at a rapid rate.
The enormity of this transformation had been obscured in the mid-2000s by soaring asset prices and the unwarranted strength of Western currencies. Seen from inside the bubble of the US housing boom, or from the lofty heights of a pound that bought 15.5 Chinese yuan (rather than the 8.8 it buys today), there seemed to be little evidence of relative decline. The global financial crisis woke us from our dream, however. The West was poorer than it had thought.
Policymakers were therefore faced with a double challenge. Their first job, to be sure, was to stimulate the cyclical recovery from the deep recession. Interest rates at zero and at least an emergency injection of fiscal stimulus would be good for that. But they also had to confront the cold fact of the West’s reduced (at least in relative terms) standing in the world. The most they could do on that front was ease the pain of adjustment to reality. Neither monetary policy nor government spending could reverse the rise of China.
King’s account of what was happening has proved prophetic – not something one can often say of economists’ predictions. The most recent statistics from the ONS show that real average weekly earnings in the UK are today around 5 per cent less than they were a decade ago – a stagnation of average incomes, in real terms, unseen since detailed records began.
It could certainly be argued that different policies might at least have allowed average real wages to keep up with the growth of real GDP. It would not change the fact that a decade ago, the UK’s GDP per capita was nearly five and a half times that of China’s, where today it is only two and a half times as large.
It is here, I think, that the key to the gap between the experience and economic reality of the past decade is to be found. Even as our economies have achieved a cyclical recovery relative to their own recent history, we have begun to understand that we are locked in a probably unstoppable structural decline relative to the emerging world.
“Give me a one-handed economist!” Harry Truman famously groaned, because he couldn’t find one that didn’t answer all his queries with: “On the one hand… but on the other…” Yet on this occasion, the two-handed economists, and indeed the public at large, are right – at least when it comes to the developed West.
On the one hand, we really are in the midst of an unprecedentedly long and stable period of global economic growth. On the other, the days of the developed West’s undisputed economic pre-eminence are over.
In the grand scheme of things, the important thing to keep in mind is that this combination is unequivocally all for the good. The convergence of the developing world with the advanced economies and the consequent lifting of hundreds of millions of people out of poverty is what those of us who worked in international development had always dreamed of. That it has happened largely because of the policies of a single, Marxist-Leninist government unswayed by much of the policy framework that we preached in the 1990s and 2000s should not reduce our rejoicing in any way.
It would indeed be foolish, however, to pretend that the transition to a world in which the West enjoys a much smaller share of global economic power has so far been, or is going to be, simple.
The most immediate risk for the UK is clear. For as long as we continue to eat the lotus of low interest rates, we can continue to feel secure in the high value of our housing stock and our share portfolios. We will be content to save little and consume much, knowing it costs so little to wait for productivity to catch up.
Yet the Bank of England is already signalling that the time for cold turkey is nigh. The talk is of interest rate hikes, if not next month, then later this year. The supply of monetary morphine prescribed by King and his central banking successors is going to stop. They say that what doesn’t kill you makes you stronger. We are about, it seems, to find out.
Felix Martin is a macroeconomist and fund manager, and the author of “Money: the Unauthorised Biography”. He writes about economics for the New Statesman.
This article appears in the 25 Apr 2018 issue of the New Statesman, The Corbyn ultimatum