A Difficult Year for the Economy With More To Feel Uneasy About Ahead
2015 has been a difficult year for the economy. The reassuring regularities of the business cycle, which used to provide reliable signals for market action, appear to belong to a past characterised by other features now seemingly historical, such as inflation, positive risk-free nominal returns and the widespread conviction that the supply of credit is, and ought to be, unlimited. The realisation is dawning that the apparent prosperity of the decade-and-a-half up to 2007 merely reflected a credit-induced spending binge. Policymakers failed to recognise this at the time because of their obsessive focus on targets related to consumer price indices (CPI), where rates of increase were temporarily suppressed by the processes of globalisation. Consequently, their policies allowed, through the mediation of credit expansion, massive time-shifts in consumption from an as yet undetermined future. That future has now arrived, together with the shortfalls in demand created by those policy-induced time-shifts. Since the short-term expedients that central banks have adopted in response to the resulting deficiencies in demand have distorted capital market prices, investors feel unsure where value is to be found. The prospects are that 2016 will present even more challenging conditions for those seeking performance from their asset portfolios. The political and economic issues that surfaced this year seem set to stand in sharper relief in the year ahead.
What the past twelve months have revealed is how uncomfortable most investors feel when faced with geopolitical risks. To be sure, it had been difficult to ignore these risks ever since President George W Bush launched his ‘war on terror’ in 2001 but, it seems, international tensions have increased markedly since the early days of 2014 when turmoil erupted in Ukraine. Perhaps international political concerns have had a general effect in dampening expectations regarding future investment returns but, over the past twelve months, it would be hard to point to a significant market impact from any specific geopolitical event. Indeed, the strongest market reaction was to a shift in China’s foreign exchange stance which was seen, rightly or wrongly, as carrying profound economic implications. Clearly, however, we are not living in the world that was envisaged after 1989, when the Berlin Wall fell. Shortly after that signal occurrence, academics were publishing books that suggested ‘the end of history’ had been reached. Even at the time, that seemed a large claim to make. After all, elections, revolutions, famines and wars were still going on, while these exercises in futurology were falling from the printing-presses. As their authors later clarified, however, they defined ‘history’ as the struggle between liberal, free-market socio-economic systems, on the one hand, and centrally-planned totalitarian structures on the other. It followed that what looked like the definitive triumph of one of these contending models must constitute the end-point of ‘history’. Though this approach to understanding history seemed to omit a great deal, it was not without precedent. On the other side of the political fence, Karl Marx had maintained that war was a class-based phenomenon. Yet it would be stretching interpretations to justify such a claim. It would be difficult, for example, to make a case that the first well-documented conflict in history, between the ancient Egyptians and the Hittites, had much to do with class considerations. Human beings, it seems, can find a wide range of issues over which to fight and slaughter each other. In taking a view on what constitutes the essence of history, though, it is perhaps inevitable that we should adopt a perspective that reflects our preconceptions regarding what is really important in human development, irrespective of the objective realities.
the global economy may have to accommodate not only repayment of a peace dividend that was misappropriated but also diversion of resources
The key practical point is that the ‘end of history’ gave rise to the notion that there should be a ‘peace dividend’. This idea reinforced the economic optimism of policymakers during the 1990s. It encouraged them to err on the side of expansiveness when taking macro-economic policy decisions. However, the period since 2001, and especially the past two years, has shown that, whatever the ‘end of history’ is taken to mean, it did not justify cashing a ‘peace dividend’. In some respects, indeed, the world appears more troubled now than it did before 1989. Consequently, the global economy may have to accommodate not only repayment of a peace dividend that was misappropriated but also diversion of resources, over and above that repayment, to strengthen internal and external security. Sooner or later, investors will arrive at a full appreciation of the implications that flow from adverse geopolitical developments. But their response will most likely proceed in piecemeal fashion, as and when company reports bring the bad news to their attention.
Another feature of the year now past has been the realisation that there are limits to what monetary policy can achieve. The confidence that Mr Bernanke displayed in his seminal speech on deflation in November 2002, when asserting that a central bank can always boost nominal incomes and inflation, is all but dispelled. There is, instead, much talk of the need for structural reform to assist central banks in their efforts. This theme is likely to emerge even more clearly in the year ahead, with Japan providing a test-case. There are dwindling hopes that the ‘monetary arrow’ of Abenomics will reach the Bank of Japan (BoJ)’s target of 2% inflation any time soon. All the same, and in a reverse of the position two years ago, the government is exerting pressure on BoJ, it seems, to desist from further easing rather than to intensify its efforts. There is recognition there that, in the real world, so many indirect effects influence outcomes (in this case, the damaging impact of a weak yen and rising import prices on household spending power and on the profitability of SMEs) that textbook monetary action is impracticable. Admittedly, the ECB will probably continue to trumpet the efficacy of monetary policy but that is because no other type of response to the euro zone’s weak economic performance currently appears feasible. The policymaking structures are not in place for euro zone-wide fiscal action and structural reform. Only in the ECB does the euro zone find unity of purpose, for better or worse.
‘Structural reform’ was the buzz-phrase of 2015. There was a time, twenty years ago, when talk of structural reform was a way of broaching de-regulation of labour markets without immediately eliciting a hostile trade union reaction. The meaning of ‘structural reform’ has expanded since then. While labour markets are still a focus of attention for reformers in several of the advanced economies, product markets and infrastructure development are now also in their sights. The liberalisation of product markets through international trade agreements has been making halting progress but there are serious threats to the two major projects, the Trans-Pacific Partnership and the Transatlantic Trade and Investment Partnership, from the passions likely to be released in a US election year. If either of these agreements hits the rocks, investors should regard it as a major blow to hopes of lifting world trade growth, which has ground to a halt in recent years. Prospects for infrastructure investment are probably better than those for expanding global trade, seeing that strengthening the productive capacity of the economy is one form of government spending that is widely approved. However, the time-lags between plans and action in this component of overall expenditure are characteristically long. The build-up in spending is likely to be gradual and will be more clearly evident in the latter years of this decade than in 2016.
Among the structural factors that have been attracting more attention in markets in recent times are demographics. The prospective impact of demographics on economic performance seems set to influence financial markets even more powerfully in the year ahead. For the past twenty-five years or so, the OECD has been warning that the advanced economies face a challenge to growth from ageing populations. Those of working age as a proportion of the total would, according to these warnings, inevitably shrink, raising risks of future labour shortages and of inadequate pension provision. In this respect, too, the future has arrived. Some policymakers, such as those in Germany, seem to believe they can avoid the worst of these problems by stimulating immigration. But, when judged in terms of national welfare and the ability to support government debt over the long term, merely maintaining or increasing the GDP misses the mark. The target should be to improve GDP per capita. There can be no assurance that immigration will generate an increase in GDP per capita; it would not, if the average output of immigrants were less than that of the existing population. Since denuding other countries, especially those in the developing sector, of their most highly-skilled workers is regarded as bad form, the most likely outcome of mass immigration in the short run is likely to be a dip in GDP per capita. Perhaps the unexpressed hope is that the fertility rate of immigrants will turn out to be higher than that of the indigenous population. Then, in the long term, there may be hope of halting shrinkage in the skilled workforce as the children of immigrants pass through education and job training.
To maintain social peace, governments may be under pressure to devise policies to redistribute income
Another approach to the demographic challenge is to encourage indigenous women to bear more children. China took a step in this direction this year with the abandonment of its ‘one-child policy’ in favour of a ‘two-child policy’. The Japanese government is also considering action, through improved childcare provision, to boost the birth rate. As with immigration, though, these approaches do not promise a quick fix. If successful, they would lead, in the short run, to a rise in the ‘dependency ratio’ (the proportion of non-workers, young and old, to the total population) and, hence, intensification of the demographic bind. In any case, there can be no assurance that loosening the practical constraints on average family size that may have contributed to low growth, or even contraction, in the population would result in significantly higher birth rates. Low birth rates in many of the advanced economies could also reflect shifts in social priorities which are unlikely to be reversed by purely economic measures.
But perhaps by the end of 2016 the demographic threat to growth will be seen in an entirely different light, if Mr Haldane, chief economist at the Bank of England, is right in projecting 15 million UK job losses from the spreading use of robots and IT in the provision of goods and services. There is increasing talk of an imminent ‘Über moment’ in financial services when a large proportion, a half or more, of the present workforce will be rapidly displaced by technology. It seems likely this will become a more immediate concern as 2016 progresses. To maintain social peace, governments may be under pressure to devise policies to redistribute income from those deploying the new technology to those newly unemployed who had never previously considered their jobs to be at risk. In these conditions, it may be an advantage for a nation to have a shrinking labour force because that might lessen the pressure on its government to adopt redistributive measures.
There is then plenty to feel uncomfortable about as the New Year approaches. Reasons for concern go well beyond the current settings of macro-economic policy. Optimists may draw inspiration from the likelihood that a period of rapid political and economic change, such as the present, offers unusual opportunities for profit as well as the threat of unanticipated losses. But the prizes seem unlikely to go to those who continue to see the world through a prism that was already timeworn as 2015 opened. Indeed, investors are likely to have much more to think about in 2016 than the follies and foibles of central bankers.
About the author
Stephen’s career spanning five decades has made him one of the most respected and unique voices in the City of London. Disclaimer regularly publishes a selection of his elegant and thoughtful essays on the global economy, which he has been writing regularly since he founded Fifth Horseman Publications in the late 1980s. As well as an economist, Stephen serves as Treasurer of the Forum for European Philosophy and was elected to the Royal Institute of Philosophy.
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