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Inertia Creeps

A look at the factors affecting slowing economic growth and the continued increase in public debt; including falling output and the ageing population.

Economic growth fell sharply during the global financial crisis. It has since recovered to moderate levels, but its fundamental structure has changed. A recent study by the International Monetary Fund (IMF) suggests this structural change is largely due to economies facing lower “speed limits”.

An economy’s speed limit (referred to by economists as potential output growth) defines how rapidly it can expand its production of goods and services without increasing inflation beyond a healthy level.

So why has this speed limit reduced? There are three key factors at play here: output levels, demographics and structural debt.

Falling output

The IMF raises an important point – it argues potential economic output is now at lower levels than before. The decline began in the early 2000s in developed economies and post 2009 in emerging economies.

Before the crisis, the principal cause of the slowdown in developed economies was a decline in the growth of total factor productivity (TFP) – a measure of the efficiency of all inputs to a production process. Increases in TFP usually result from technological improvements or innovations and so one explanation of the slowdown was the waning of the beneficial economic impact of the 1990s IT revolution. Another was the declining rate of improvement in human skills. After the crisis, potential growth fell still further, partly because of the collapse in investment and the lukewarm recovery of capital expenditure intentions by the management of firms.

The ageing population

Demographics have also been a key factor in slowing the speed limits in developed economies. In 1971, about 2% of the UK population was over 65, it has now risen to over 16% and by 2050, will be a quarter of the population. Longevity is one of the great achievements of civilization today, but as a consequence, the UK population will rise by 15% between now and 2050, while the working-age, tax-paying population will only rise by 4%.

In emerging economies too, demographic factors have been at work. The decline in the growth of the working-age population is particularly dramatic in China where capital expenditure growth is also falling after a huge investment boom in the 2000s. TFP growth might also fall in the longer run, as the rate of catch-up on advanced economies slows.

Continued debt growth post 2008

The third factor in the mix is the level of global debt affecting countries across the economic spectrum. Worldwide and in aggregate, debt has grown to an unprecedented level. That poses new risks to financial stability and may also undermine global economic growth.

Seven years after the dislocation of credit markets resulted in the worst financial crisis since the Great Depression of the 1930s, debt continues to pile up. In fact, rather than reducing indebtedness, all major economies now have higher levels of borrowing relative to gross domestic product (GDP) than they did in 2007. Global debt has grown by £38 trillion between 2007 and 2014, raising the ratio of worldwide debt to global GDP by 17%.

Global household debt is also reaching new peaks. In only a few countries, such as Spain, the UK and the US, have households deleveraged. In many others household debt-to-income ratios have continued to rise and, in some cases, now exceed the peak levels seen pre 2008.

Government debt is unsustainably high in some countries and above healthy levels in many. Since 2007, global government debt has grown by 76% to £39 trillion. Some of this debt stems from the crisis and is a result of public policies to finance bailouts and stimulus programs. Debt also rose as a result of the recession and the weak recovery. With lower potential growth going forward, tax revenue will also grow less than expected.

As high as government debt is today, we need to bear in mind present debt levels don't include the future liabilities of state pension systems which, in several countries, are substantial and rising year by year. Without sensible reforms - such as in the UK - pension costs will rise even more for many countries. Australia has been a pioneer in terms of pension reform for over 20 years and has reaped huge benefits - a healthy public balance sheet and solid pension levels for the retired.

What about putting assets in the equation?

Before we get all too depressed about the amount of debt in the world, let's look at the other side of the balance sheet.

Asset values have recovered from the financial crisis and by mid 2014 had regained lost ground and are now comfortably outstripping growth levels relative to debt. This is good news for middle class households in countries where debt has recently been rising at a faster rate than income. Increasing asset values are neutralising these rising debt levels meaning households in general are better able to balance their books.

Many large non-financial companies in both developing and emerging countries have had strong balance sheets even before the financial crisis, and since then have accumulated additional amounts of cash. Liquid assets held by US corporations, for example, have increased to almost US$2 trillion. Capital expenditure has only started to rise since mid-2014 and very late in the cycle at that. Small and medium-sized enterprises (SMEs) are in very different shapes, depending on the region they sit in and on how local their business models are. But all in all, corporate health remains in the pink.

The quality of bank assets has improved rapidly in many countries since 2010 and will continue to do so as long as employment expands in the economies they operate in. This is especially true for the US, Scandinavia, several Asian countries, the UK and Canada. Meanwhile, banks' funding mix is the safest it's been for a long time and stricter regulations ensure that bank liquidity and capital ratios will remain at solid levels.

In some countries, such as the UK, China and Japan, governments also own a healthy level of assets including state-owned companies, properties, infrastructure and forests. Although the value of these assets is difficult to determine (as few are traded on public markets and, in a democracy, the sale of state assets requires voter consent) it is fair to say that, for many countries, they would not make much of a difference. It's present and future liabilities where the focus of attention needs to be.

An extraordinary experience

One remarkable fact remains - the global economy has managed to survive largely intact without a sustainable resolution of the financial crisis.

Between 1929 and 2008, deleveraging during national and regional debt crises has largely been achieved by austerity programs, massive default, high inflation or outgrowing over indebtedness. Needless to say, none of these experiences featured prominently in the past seven years. There were some memorable defaults and belt-tightening policies in a few countries, but that was it, except for lots of sticking plaster from central banks.

Instead of tackling the roots of the financial crisis head on, creative monetary policies were begun under the leadership of the Fed (as the US central bank is called by its friends). Massive buying of public and private debt, commonly referred to as "Quantitative Easing" injected vast amounts of liquidity into the financial system, debased fiat currencies (those currencies that a government has declared to be legal tender), held inflation expectations in positive territory and revived investment markets.

Monetary policy was never intended to be a solution for reducing over indebtedness but it has ensured most debtors would stay solvent and has bought them time for the heavy lifting of balance sheet repair.

We can conclude from the brief overall evaluation on global assets and liabilities in the previous section that net-debt is manageable for firms, financial institutions and households. However, quite a few governments are much more indebted (net of saleable assets) than the households, firms and financial institutions of the same country.

For six of the most highly indebted countries, enhancing the process of deleveraging would require implausibly high real-GDP growth or (a repeat of) substantial fiscal austerity. To reduce government debt, countries may need to consider new approaches, such as more efficient debt-restructuring programs.

What can be done outside the ongoing crisis resolution experiment?

Besides skilfully operating the monetary policy framework created post 2008, the world economy needs

  • more innovation;
  • higher successful investment in entrepreneurial capital; and
  • policies that counteract the growth-decelerating impact from demographics.

If these things do not materialise then we will all have to adjust to a new reality of lower economic speed limits.

Conclusions for investors

Potential economic growth has fallen from pre-financial crisis levels for both developed as well as emerging countries. This is due to demographics, the changing foundations of economic productivity and high global indebtedness.

In principle, debt is a useful source of financing economic growth. But how it is deployed, monitored, and managed needs improvement. Too much debt in the system today, especially the over indebtedness of governments, needs to be addressed.

If we don't see significant progress with public deleveraging across major economies over the next three to five years, we will need to fundamentally re-evaluate government bonds as an asset class. This is especially true, if and when, current monetary policies reach the end of their shelf lives, as seems likely soon. After all, those that hold government debt are certainly not paid enough in yield for the investment risk they bear.

Sources:

International Monetary Fund (IMF), The Financial Times, McKinsey Global Institute (MGI), Art Market Research, Nationwide, Bank for International Settlements (BIS), Standard & Poor's, Dealogic, City University, Bank Credit Analyst, Lloyds Banking Group

Important information

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