Saturday, September 9, 2017

Real Growth, Nominal Growth, Productivity, Demographics, and Inflation

Usually, most of my blog posts are pretty structured into key parts. This post will be a bit different. It'll be more of a rant that flows through the parts outlined in the title: real growth, nominal growth, productivity, demographics, and inflation. The rant will detail my view of why inflation, growth (both nominal and real), and productivity will lag across the world going forward.

In the global economy today, we're in a period of low productivity growth across the developed world. In combination with that, demographics in the developed world are aging rapidly while little inflationary pressure exists. Global growth has been very slow in this period. In response to all of these issues, we've seen governments take up policies of low interest rates and central bank balance sheet expansion.

With the exception of the Federal Reserve at the US, almost every single major OECD country has a central bank either a zero interest rate policy or actively expanding its balance sheet including the ECB, Japan, Canada (which just increased interest rate to .75%, but is still effectively close to 0) and others. The countries who aren't at the ZLB or at low interest rates more generally are in bubble territory including Sweden, Australia, and some others (see chart below for bubble economies). Of course, there's also countries that crossover between these groups.

On the other side of the global economy, we've seen a huge over-investment in emerging market production (especially China). Also note that ~45-50% of the German economy is exports while much of Northern Europe runs large current account surpluses. So in effect, we can say that this part of the world has excess capacity. Due to excess capacity (overproduction), there's enough supply for industrial good globally to keep a lid on prices. This has been a key factor in low inflation.

As I've explained in other posts, shutting down excess capacity isn't easy. In a normally functioning liberalized economy, excess capacity gets shut down cuz investors or banks start closing production facilities and factories that operate at a loss. Then, they consolidate resources, streamline production processes, and crush costs while choosing to not run what operates at a loss. However, we have many countries across the globe (especially China) that don't have liberalized markets or financial systems. So instead of having waves of takeovers and corporate consolidation, they're actively encouraging excess capacity via policies that continue to drive and perpetuate imbalances for social reasons.

What do I mean by social reasons? Shutting down factories or production facilities operating at a loss, streamlining production processes, and increasing efficiency in supply-chains by crushing excess cost are all policies that increase unemployment and place downward pressure on wages. Instead of taking up these policies and dealing with the social unrest they create, we have many governments across the globe actively engaged in supporting these supply-side structures. How do they support them? It varies from country to country, but all of the primary mechanisms fundmentally transfer resources to producers--usually implicitly.

In essence, policies like ZIRP or NIRP (negative interest rate policy) effectively let zombie companies roll over excess capacity at little to no cost. Central bank balance sheet expansion creates liquidity expansion that shifts risk profiles of portfolios creating a rotation to higher risk assets. In other words, the policy of QE effectively causes risk spreads to converge. By doing this, it allows firms using items like junk bonds to get much lower yields. Deflationary pressure pushes down yields more generally as does low growth overall.

What ends up happening is that more and more capital gets (mis)allocated into share buybacks or into supporting excess capacity for firms that effectively become zombie companies. In Germany, excess capacity is being sustained by a very weak currency (Euro) and policies to basically drive down wages that make German manufacturers high competitive. That also applies to Northern Europe, albeit to a lesser extent than Germany.

In open economies, firms stay competitive due to advances in technology or through human capital investment. In closed economies, firms profits come from either suppressed wages, undervalued currencies, or through interest rate policies designed to prevent unemployment or other social issues. In effect, entire countries are refusing to adjust economic imbalances in order to not create social dislocation. As we all know, this comes at an economic cost.

When firms using bad production methods are not being closed down, when inefficient supply-chains continue to persist, and when production is sustained via government policy to make corporate financials seem okay, there are real costs to be borne. Rather than the traditional policy of creative destruction in capitalism where bad firms are shut down and production processes are streamlined, there's none of that. That's a key factor in driving low productivity. When a firm has no incentive to increase the level of technology it's using, it doesn't improve its productivity. It doesn't produce more outputs per input. Instead, it keeps doing what it's doing knowing that the government will provide it a backstop.

In terms of inverted demographics, resources must be diverted from future investment to take care of the elderly. That creates a productivity drag. Not only can aging demographics create a productivity drag, but they also necessarily imply a large portion of your populace is shifting from a very high income base to a lower income base--almost necessarily meaning lower consumption levels. That places downward pressure on demand for consumer goods. If we see rapidly aging populations in economies with real consuming power, that acts as a deflationary force globally as well as internally.

In other words, we have structural forces across the global economy that create both deflationary pressure and lead to low productivity across the OECD. Considering real growth is a function of workforce size and productivity of the workforce, it's no surprise real growth rates are low. Low inflation means relatively low nominal growth as well.

The idea of inflation magically appearing with high growth in this kinda economic environment, especially when we consider the fact that the world is basically in depression, is pie-in-the-sky thinking. These are things that will not happen anytime soon. The world will not magically see significantly higher growth or significantly higher inflation unless there's some serious correction of structural global imbalances first.


  1. Just stumbled upon your blog and it's very insightful so far, but I think we are more into a somewhat deflationary stagnation than a depression. To me a depression would have meant a lot more bankruptcies, and an overall reduction in everyones balance sheets, which has not happened. To me we are just trying to make this depression as slow and easy to get through as possible, which I think will have desastrous effects on long term capital accumulation, both human and physical.

    1. For the US, I'd agree with you. Outside of the US, I'm unsure that's the case. Greece, Spain, Italy, Portugal, etc are in depression. Venezuela is in depression. Argentina is seeing soaring inflation alongside Russia. The world has become more unstable. And the parts of the world that haven't corrected yet will see large corrections. When Australian and Canadian house prices correct, their economies will experience a very serious downturn. Recall that the Great Depression wasn't called that until after it was over. I suspect the same here.