LONDON (Reuters) - Ending the Great Stagnation that is taxing Western policy makers may depend as much on the Chinese Communist Party as it does on the world’s leading central banks.
Six years after the global financial crisis erupted, there is any number of explanations why Europe cannot shake off a Japan-style balance-sheet recession and why the United States is experiencing sub-par growth and high unemployment.
Governments and households racked up too much debt to sustain living standards. Demographic tailwinds have turned into headwinds as baby boomers retire and the surge of women entering the workforce has run its course. Many banks are still ailing and are building up capital instead of lending freely.
But two other factors cannot be overlooked.
Firstly, there is an excess of global savings, which has lowered the natural real rate of interest that equalizes savings and investment.
The result is a liquidity trap. Even with interest rates near zero, monetary policy is like pushing on a piece of string.
Secondly, the share of income accruing to labor has shriveled in most countries. With real incomes stagnant or falling, consumer demand is too weak for Western firms to justify investing their record cash piles, at least at home.
What links these two phenomena is the meteoric rise of China as the workshop of the world after Beijing joined the World Trade Organization in late 2001.
“That changed the world. That for me was basically the start of this globalization process,” hedge-fund manager Stephen Jen told a recent Reuters BreakingViews conference.
At a stroke, he said, the effective size of the world’s labor force doubled.
With Beijing repressing domestic consumption and holding down the yuan’s exchange rate to give it a competitive edge in world markets, foreign direct investment poured into China to take advantage of cheap labor, land and other inputs.
Exports duly exploded. China’s resulting current account surplus, though now declining, contributed to a glut of global savings that depressed U.S. interest rates and helped fuel the fateful boom in sub-prime mortgages.
China’s foreign exchange reserves today stand at an unfathomable $3.66 trillion.
Tens of millions of people have been lifted out of poverty by the rise of China and other poor countries plugged into global supply chains.
But outsourcing of production has hollowed out skilled jobs in advanced economies in what British financial analyst Tim Morgan, in his book ‘Life After Growth’ calls “a self-inflicted disaster with few parallels in economic history”.
Jen added: “If you are a laborer in the West, you have been hurt. It’s very clear. If you are a capitalist in the West, you have benefited immensely.”
Dominic Rossi, global chief investment officer for equities at Fidelity Worldwide Investment, noted that labor’s share of U.S. non-financial output held steady at between 61 percent and 65 percent for half a century.
“Then, something happened. From 2000, it plummeted and currently rests at an all-time low of 57 percent,” Rossi wrote in the Financial Times. Over the same period, median U.S. household incomes have fallen in real terms.
“Overall, labor is not participating in economic growth as it has done in the past,” he said.
The flip side is that U.S. corporate profit margins stand at 12 percent of gross domestic product, a record high, yet net corporate investment is only 4 percent of GDP, Rossi noted.
The picture of corporations awash with cash but reluctant to invest is mirrored in Europe.
So what is to be done?
Against a background of high debt and depressed incomes and investment, former U.S. Treasury secretary Larry Summers posited at a recent IMF conference that real interest rates consistent with full employment could now be minus 2-3 percent.
“We may well need in the years ahead to think about how we manage an economy in which the zero nominal interest rate is a chronic and systemic inhibitor of economic activity, holding our economies back below their potential,” Summers said.
He is not alone in worrying about the limits of monetary policy even as the risks of outright deflation grow.
Alan Blinder, a former Federal Reserve vice-chairman, expects inflation to be lower on average over the next half a century than in the past 50 years. As a result, central banks would keep hitting the zero lower bound (ZLB) on nominal interest rates.
“We have just experienced first-hand how difficult the ZLB can make it for a central bank to stimulate its economy out of a recession and, therefore, how large the potential social costs are,” Blinder wrote in a recent essay.
Bill White, a former chief economist of the Bank for International Settlements, blamed central banks for wrongly analyzing the strong disinflationary impulse imparted by the reintegration of previously isolated economies such as China into the world trading system.
“Globalization constituted a significant, long-lasting and positive productivity shock that should have been met with tighter rather than easier monetary policy,” White said in a speech to Omfif, a London think tank.
By leaning against what they saw as excessive disinflation, central banks have helped to create the imbalances now dogging the global economy and have postponed the adjustments needed to achieve sustainable, balanced growth, White argued.
“In short, ‘still more of the same’ monetary policies since 2007 have left us, in my view, with old problems unresolved and some new ones added as well,” he said.
Stephen King, chief economist at HSBC, shares the worry that the world has become addicted to monetary stimulus. He lists three main nasty side effects.
Firstly, manipulating the yield curve carries the risk of misallocating capital and so hurting long-term growth.
Secondly, inequality is rising sharply as ultra-loose policy inflates asset prices, thus favoring the rich at a time when wage earners are under the cosh.
Thirdly, monetary policy is being enlisted to try to generate the economic growth that politicians need to meet spending and entitlement pledges made to voters.
“Long term, it’s not so much a financial crisis that we face. It’s more a political and social crisis because these promises that we have made for ourselves will be broken,” King told the BreakingViews conference.
Seen in that light, if the West is in the grip of ‘secular stagnation’, as Summers suggested, the welfare state will have to shrink or taxes will have to rise to pay for it.
The draft agreement by Germany’s coalition partners to lower the pension age for some workers will be the exception rather than the rule.
“We are expecting people to stay much longer in the labor market,” said Stefano Scarpetta, director of employment at the Organisation for Economic Cooperation and Development. He said 67, not 65, would be the ‘new normal’ retirement age.
For some the gloom is overdone.
Holger Schmieding, chief economist at Berenberg Bank in London, expects the euro zone to emerge stronger from its near break-up thanks to structural and institutional reforms the bloc is belatedly implementing.
“By 2020, Europe could be a more dynamic region with an excitingly diverse culture and a still-strong degree of social cohesion,” he wrote.
And then there is China.
Skeptics insist it is only a question of when, not if, China buckles under the weight of bad loans misallocated by state-owned banks to an overpriced property sector and industries already suffering from overcapacity.
But just as traders learn the adage ‘Don’t fight the Fed’, it could be rash to bet against the Chinese Communist Party given its economic record since the launch of reforms in 1978.
Mark Williams and Qinwei Wang with Capital Economics, a London consultancy, said they felt more upbeat about China’s long-term economic prospects than they have ever been after reading the reform blueprint issued this month by party leaders.
“Questions will remain over implementation, but this is the most impressive statement of reform intentions that we’ve seen this century,” they said in a report.
The overarching purpose is to pass the baton of growth from investment to consumption; to let market forces and private firms play a greater role in the economy; and to reduce income inequalities that are straining the social fabric.
If China succeeds, rising real wages will boost demand for imports of consumer goods and things such as business services, health, education and tourism. Instead of being a drain on global demand, China could become a rich source of growth.
And with a per capita income in 2012 of just over $6,000, ranked 90th in the world, the scope for catch-up in China is still enormous. The same is true for other emerging economies.
The gradual convergence of their living standards with those of the rich world will continue to be the defining economic story of our times.
Mark Cliffe, chief economist at Dutch bank ING, also pointed to the huge growth potential of sectors such as new materials, big data, driverless cars, renewable energy, the Internet of Everything, 3D printing and biotechnology.
“I don’t think we should be too pessimistic. If we’ve learnt anything over the past five years, it should be humility about our ability to make forecasts,” Cliffe said.
Editing by Jeremy Gaunt