By Thomas Laskey, Investment Strategist, Aberdeen Solutions
After nearly ten years, the effects of the financial crisis are still hanging over us. Growth has been persistently weak, falling way below the previous long-term trend. Households, companies and even governments have been trying to save too much and spend too little. This chronic weakness in consumption and investment has resulted in weak "aggregate demand," and economic output is well below its potential. Unemployment has been too high and inflation too low across the developed world, in spite of low interest rates. People don't "feel" the recovery because median wages have been stagnant. This unpleasant cocktail has been labeled "secular stagnation," and has profound social consequences.
This is not a sustainable situation. Too many mechanisms are built in to the economy for an "output gap" (the amount that an economy's actual output is below its potential output) to persist indefinitely. Something has to give, but how do these imbalances equilibrate?
Classical economics had a straightforward answer to this question. Prices would fall to bring about equilibrium, essentially ruling out the possibility of a persistent output gap. But, at least in the short term, it turns out that prices cannot always adjust. Possibly for psychological reasons, employers seem to be unwilling to reduce nominal wages and retailers unwilling to cut prices - they are "sticky.". Rigidities in the system mean that the economy can run below potential for some time.
Given that, how does the output gap close? There are essentially two options. One is that demand picks up, growth accelerates and output goes back toward potential. The other is that the potential productive capacity of the economy is reduced relative to the previous trend, in what is known as a negative supply shock.
For most of the period following the Second World War the first option has played out, with output recovering quickly to potential. But this doesn't happen automatically. Keynesian economics is about using policy - fiscal, monetary or otherwise - to bring about a good equilibrium by boosting demand. An example of this is shown for the early 1980s, with the trend for potential output unaffected.
Following this playbook, since 2008 monetary policy has been eased dramatically in an attempt to boost growth, through interest rate cuts and asset purchases. But this has been insufficient to close output gaps, constrained by the lower bound on interest rates and held back by growth forecasts from policymakers that have proven overly optimistic. Meanwhile, fiscal policy has been largely counterproductive, tightening when textbooks would suggest loosening.
This presents a puzzle in itself: where has "deficit bias" gone? Why have lower taxes and higher government spending become unpopular, while belt-tightening has appealed to voters? The marketing that came with fiscal tightening - that debt had increased to dangerous levels - seemed to resonate with households also trying to reduce borrowing. This proved remarkably powerful in the face of both innate deficit bias and increasing evidence to support the rock-solid theory suggesting austerity would weaken the economy.
In the absence of sufficient policy support to bring demand up to potential output, we are left with the second option of potential output declining to meet the new level of demand.
"Hysteresis" is a process by which a persistent shortfall in demand has a negative effect on the productive capacity of the economy. The idea makes sense, as people who remain unemployed for a long time may drop out of the labor force and fall behind on skills, while companies invest less in new projects and equipment, reducing the productive capacity of the economy. These effects can be seen in the graph below, which shows the latest estimates of potential output.
However, despite hysteresis dragging down potential output and action from monetary policy makers to boost demand, we still have low inflation and output gaps in many regions of the global economy. What is the additional force that could bring about equilibrium?
In the Western world, in the face of stagnant wages, increasing inequality and rising populist sentiment, the people seem to have chosen an answer: protectionism.
In many ways, it should be little or no surprise that populism has been intensifying in this environment. Unhappy people are surely more likely to vote for change and lap up optimistic sound bites, however unrealistic. The resulting shift away from centrist parties and policies has been widespread, including Trump in the U.S., Brexit in the UK, the National Front in France, and the Five Star Movement in Italy.
A common feature of these populist platforms seems to be anti-globalization, whether left- or right-leaning. International cooperation on trade and immigration are targets, blamed for a wide range of ills on which they have little bearing. Protectionist policy recommendations follow, from travel restrictions to pulling out of trade arrangements.
As this movement obtains power, and especially if it gains more influence in Europe, the drive towards globalization over many decades might be under threat. On a large scale, increasing barriers to trade and migration results in a negative supply shock. An assault on free trade could reduce potential growth over many years. This is a truly ugly solution to the problem, but it is a plausible mechanism that could transform a persistent shortfall in demand into an economic force that brings about equilibrium.
What might the global economy look like in this scenario? Eliminating output gaps with protectionist supply shocks could conceivably help allow inflation to rise, but it does not obviously address the underlying economic causes of the populist policy shift. Wage rises might remain as slow as before, if not slower, as productivity stagnates. It is not clear that this is a sustainable situation either.
Bad policy has consequences. Blaming the rise of populism solely on weak aggregate demand is a stretch, but it must be a contributing factor. Policymakers had it within their power to avoid this predicament, but turned to austerity. Considerable damage has been done already, but one part of the appropriate response is unchanged - aggressive policy action to raise demand now.
Additional disclosure: International investing entails special risk considerations, including currency fluctuations, lower liquidity, economic and political risks, and differences in accounting methods; these risks are generally heightened for emerging-market investments.