Tuesday, 4 November 2014

My Firmest Conviction

'So what are your firmest convictions?'  What a question! My firmest conviction is that, all being well, the sun will rise again tomorrow – although even that has been subject to doubt from Hume onwards. More pertinently, I think Hayek is absolutely persuasive when he argued  that competition is justified only because it discovers information which can be discovered in no other way. Yes, this does undermine one's faith in economic forecasting, but  I can't see how it can be wrong, and what's more, our everday experience forces us to acknowledge it is right.

Nevertheless, one learns something from failure. And the failures which have pressed themselves upon me this year have been my efforts to anticipate swings in the business cycle. I spend a great deal of time looking at factors effecting returns on capital and labour, measuring swings in private sector savings/investment balances and the underlying cashflows associated with them. This year, this approach has not so much failed, as been largely beside the point. The expected dynamics of the business cycle have either not appeared, or have been so weak as to be only marginal drivers of economic outcomes.  Subcycle dynamics in investment behaviour, in inventory behaviour, in savings/investment choices, in credit totals,  in pricing, and in labour markets have all simply not driven economic cycles as one would expect.  Where expansions are obvious – and particularly in Anglo-Saxon economies – they have been resolutely a-cyclical.

For example, in the US the recovery of capital spending has been maintained, but has hardly accelerated beyond the 2010-2014 trendline, as one would expect. In US labour markets, the quit rate has remained stubbornly low despite the sort of rise in the openings rate that you would expect to get people moving jobs.  And wages have simply not responded to the rise in the net openings rate.  It's much the same in the UK, where investment spending has remained muted, wage growth negligible, inflation receding and credit growth negative even as economic growth accelerates.

Globally, movements in private sector savings surpluses, which can normally be relied on to super-charge domestic demand in the early stages of business cycles,  have generally moved only sluggishly. In the US, for example, the private sector savings surplus appears to have been relatively static around 1.6%-1.7% for most of the last year.  In the Eurozone, the surplus has fallen maybe 50bps over the last year to around 5.1%. In Japan, the fluctuations around 6.6% of GDP over the last two years has been historically muted.  Only in the UK (and China) have there been significant fluctuations, and in both cases, private savings surpluses have risen, muting domestic demand rather than expanding it.

Why this a-cyclicality has emerged and persisted, and what characteristics a-cyclical expansions might show are for a later post.  For now, however, the conclusion is this: that in the absence of  sub-cyclical dynamics, economic outcomes will be determined by something far simpler and more fundamental: what's happening to growth factors. That is 'my firmest conviction'.

Absent the accelerators and dampeners which usually shape a business cycles, growth patterns will be determined by additions or subtractions of factors responsible for production.  The two most important of these are capital stock and labour. In practice, growth can be (crudely) disaggregated as the change in labour employed plus the change in output per worker. Output per worker, meanwhile, can be expressed as a function of changes in capital per worker. This crude arithmetic can be almost infinitely elaborated, but the underlying idea remains the same:  what comes out (GDP) is a function of what goes in (labour & capital).

Neither are easy to measure properly (plenty of people would argue you cannot measure capital stock at all), and they are obviously not the only factors. In the examples which follow, I estimate capital stock simply by depreciating all nominal fixed capital investment over a 10yr period (after 10yrs of data, you get an estimate) – where possible I exclude real estate investment in the calculation.  This tally obviously changes only slowly. For labour, I take have simply accepted official employment statistics.

Without elaborating, I think the charts which follow offer a reasonably clear-headed guide into the likely growth of the world's major economies (except China), and some likely characteristics of that growth. In some cases, it will also suggest some challenges.  At this point, I'm keener on demonstrating the set-up than elaborating conclusions.


Comment: With capital stock growth likely to continue rising smoothly,  there is a likely growth trajectory of 3%-3.1%. With growth in capital stock now beginning to outpace employment, we can expect recovery in labour productivity which leaves room for modestly rising real wages. 


Comment: Recovery of capital investment seems likely to continue, but the rise in employment is so fast that capital per worker is still stagnant. So productivity gains unlikely to accelerate, and wage growth likely to remain muted/disappointing. 


Comment: There are two problems here. The first is that since there's no sign that capital stock is likely to start growing any time soon,  the modest (but real) uptick in employment is unlikely to be accompanied by growth in labour productivity, so growth prospects are not good. The second problem is that the Eurozone is not best characterised as a single economy: rather, distinctly different fates would seem to await Germany and the rest.  We should expect this divergence of fates to hamper policy-making.  It is noticeable that official forecasts can barely acknowledge the underlying problem.


Comment: With capital stock growing at a healthy clip, and faster than employment, we should expect labour productivity to grow as well as employment.  Not only does that suggest a re-acceleration in GDP growth, but it also leaves rooms for real wage rises too.  It is difficult to share the official pessimism about this economy - I would expect upside surprises.

Eurozone Ex-Germany

Comment: The situation for the rest of the Eurozone could hardly be more different. Currently both labour and capital stock are shrinking, and even if employment does continue its tentative recovery, it is hard to expect labour productivity to rise when capital-per-worker is falling. As a result, it is difficult to expect much GDP growth, if any.  

Now, how does one set policy for 'the Eurozone'?


Comment: This is genuinely interesting: by the beginning of 2015, it is likely that both labour and capital stock will be growing, and the difference between the two will be narrowing. This forms a genuinely improving foundation for GDP growth. And given that downward pressure on labour productivity is likely to be the result of the rise in capital stock, that growth would at this point be likely to survive even a short-term downturn in hiring. It might be best to forget about the ability or inability of Abenomics to re-set Japan's economic assumptions, and just look at the improving growth-factors picture.

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