Monday, 25 November 2013

Where have all the bubbles gone

The UK economy may be in the midst of a stellar year in which growth has returned, most unexpectedly, but there are special circumstances that have benefited us.  Elsewhere in the developed world, we face a persistent economic stagnation. Across the developed world employment rates are low, wages and disposable income are depressed; real interest are still negative; government debt is staggeringly high and rising; companies and individuals prefer to hoard cash than invest and to cap it all it looks like deflation is now stalking the planet. 

Despite extraordinary efforts by the world’s central bankers in the aftermath of the Lehman’s default, which has included the massive increase of liquidity (QE) and negative real interest rates, five years on the outlook is pretty poor.  Larry Summers re-coined the term secular stagnation to characterise the economic landscape and went on to float the idea that the west has grown on the back of asset bubbles for the last 20 years (Property, DotCom, Emerging markets, Sub-prime, etc) and that any return to pre-2008 levels of growth will demand some new bubble to help us along.  Larry Summers suggests the level of real interest rates required to generate full employment might be, say, -2 or -3 per cent.  More practically bankers in both the Fed and the ECB are now contemplating negative interest rates on short term money they hold over-night as a way of stimulating demand.  

Where have all the bubbles gone

Every economist worth his salt has now picked up the Larry Summers gauntlet and the responses have been pouring in - as to why secular stagnation is a figment of his imagination (Ben Bernanke) or is some cases additional proof to support the credibility of the theory (Paul Krugman).  But there can be no doubt that at the lower bound of interest rates and with inflation at zero or close to it there are very few options for the current crop of central bankers.

This failure in interest rate equilibrium and the resulting systemic short fall in demand could be for all kinds of reasons:

1.       Probably the most obvious cause of the slowdown in growth and the consequential deflationary pressure, over the last five years, has been the broken markets for lending.  The banking sector has to recapitalise to become safe enough for the regulators and this is squeezing liquidity from the market.  But the credit crunch does not explain the trend before 2008.

2.       The aging population profile in the West has been proposed as a macro reason for declining demand and linked to this lower population growth generally.  This certainly might be important and the UK might provide some supporting evidence as our recent migration rates have certain helped boost demand.

3.       Another dimension is technology – some claim that the rate of technology advancement has slowed and that this hinders growth.  A weird idea is that the internet is now providing entertainment for free (Facebook, Twitter, etc) and that this has in some way lowered growth.

The confusion in the minds of bankers and governments is dangerous.  Consider a scenario where current interest rate equilibrium (constrained by the lower bound) enforces an anaemic growth pattern and if this is so there will have be tough fiscal measure.  Without growth deficits can only be reduced by raising taxes or cutting expenditure.  So someone need to come up with the answer to this problem of low / no growth pretty quickly or things could turn ugly.
The problem that has been nagging at me is that during this period of low growth there has been the relatively stead level of asset prices – following the credit crunch, as one might have expected asset prices fell, but recently prices have been rising rather than staying  low until the recovery is secured.  In reality asset prices recovered very quickly and remain stubbornly high despite low growth.  So we have this strange set of circumstances where consumer demand is but asset prices are very high.

The main problem here is that asset prices are stuck at levels that make rapid growth unlikely, the Dow has just breached 16,000 for the first time. The world has become capital rich and income poor. This imbalance in the relationship between those who own assets and those that rely on income from these over-priced assets is killing us. The benign environment that exists for the owners of capital is driven by misguided policy making that reduces taxes on profits and allows owners to avoid their tax obligations. This in turn means that:

1.      There are too many badly run businesses that are not investing for the future and there are many poor performing business that have not been sold or restructured (Zombie companies)

2.      This lack of investment (coupled with the banking crisis in liquidity) in new ideas encourages the owners of capital sit tight on their under-performing assets.  The Private Equity industry has been an obvious offender (see the chart below) 

3.      As businesses bump along the bottom they squeeze employee salaries and so consumer demand drops

4.      This imbalance between the owners of capital and employees is accentuated by negative real interest rates and deflation.  Small scale savings have been decimated whilst the mega rich have seen asset prices rise and rise

Dead money pooled by the PE industry

We need to encourage the owners of capital to unlock cash in their business for investment in human capital and other projects this should be done by modifying the tax regime away from low taxes on profits and capital gains towards greater incentives for investment.    By raising taxes on profits and capital gains and providing compelling incentives for investment we can change the game, kill off secular stagnation and create a new bubble to inflate growth and wealth.

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