Download `Are the Advanced Economies in for a Long Period of Economic

Emma Falconer
Are The Advanced Economies in for a Long Period of Economic
Stagnation?
This clearly depends which economies are ‘advanced’, what a long period is, and the definition of
economic stagnation. For this essay I shall refer to advanced economies as those in the G20. The
G20 membership comprises a mix of the world’s largest advanced and emerging economies,
representing about two-thirds of the world’s population, 85 per cent of global gross domestic
product and over 75 per cent of global trade.i A ‘long period’ is by reference to the longest and
deepest depression in the last century - The Great Depression, when US output took eight years to
return to its previous levels. Finally, economic stagnation I will define as a time when the economy is
experiencing little (under 1%) or no growth - factors of production are not increasing in quantity nor
improving in quality.
We can first appeal to history to compare the advanced world’s current situation to those in the
past. Having some knowledge of history is vital to understanding contemporary economic
phenomenaii. There are similarities between the Great Depression and the recent financial crisis.
Both were caused by a failure of major investment banks and the largest commercial bank of the
time. Both similarly saw a subsequent sharp decline in consumption. Does this mean that developed
economies are in for the same aftermath - where negative growth lasted 43 months and the US
economy only reached its 1929 level of output in 1937iii? I would argue no - because there are major
differences between the economic slumps, and after all the UK is predicted to reach its Q3 2008
output levels in Q2/3 2014. The action by policy makers has differed - governments in 1929 were
limited by two beliefs. Firstly, they were convinced that maintaining a balanced budget was
necessary, and secondly, they strongly supported the Gold Standard. This led to a tight fiscal and
monetary stance, whereas since 2008 key institutions have been expansionary in at least one of
these forms. This has allowed a quicker, demand-driven, recovery. (I will later discuss the risks of
this).
A more recent example of stagnation can be seen in Japan’s history where banks failed to balance
liabilities with reserves. This triggered an economic downturn that saw declines in home and equity
prices, and a crash in share prices. This has been argued to have caused a balance sheet recessioniv.
If households and firms hold large amounts of debt, then in a crisis, no matter what the monetary
stimulus, there will be no growth until current debt is repaid. If we saw a balance sheet recession in
advanced economies today we could see stagnation until all debts are repaid, which could take up to
a decade. If this was the case, the UK’s policy of austerity and monetary stimulus would have been
unsuccessful. However it is now predicted to be the fastest growing G7 countryv in 2014. This
indicates that it was a lack of lenders, not borrowers that was causing the recession, and means the
risk of long stagnation because of a balance sheet recession is lower. (I will later consider whether a
borrower-funded recovery may be not something to rejoice at).
"History may not repeat itself but it does rhyme” was said by Mark Twain. Therefore in the examples
above we can see the potential for a long period of stagnation, but the differences between the
recessions mean the long term consequences are unlikely to be the same. We must, then, turn
towards economic theory and statistics.
Did the recent crisis and its causes have the potential to create long term economic stagnation for
advanced economies?
Emma Falconer
The recession has been referred to as a ‘financial crisis’ for good reason, as it started with the failure
of leading banks. Institutions such as Lehman Brothers failed to balance their liabilities and risks with
sufficient care, and when this leaked, the subsequent ‘run on the banks’ started a domino effect
across developed nations. The serious consequences of this can be seen where the weak financial
sector created a malign environment for investment in many EU countries. In Greece reconstruction
and reforms have been needed but the government’s debt has seriously limited its effectiveness,
and Greece’s unemployment rate reached a record high of 28% in November 2013vi. There was,
then, potential to cause a complete loss of confidence in the financial system, which could have led
to significant unemployment rate and spare capacity that would take years to recover from. In this
way long run economic stagnation could have occurred.
However this potential has not been realised. The reaction of the US Federal Reserve to save leading
banks meant their reputations were not irreparably damaged. Indeed expansionary policies in most
developed countries, whether monetary or fiscal, have started to pull countries, such as the UK and
US, back into growth (admittedly after several years of stagnation). Even Greece’s economy is
expected to expand by 0.6%vii this year. The recession could even, in the extreme, help some
advanced economies improve their prospects for long run growth. The UK has in the past been too
reliant on its financial sector and imports; if in recovery it can restore balance this will lead to a more
stable economy.
So, if the recession’s roots won’t cause long run stagnation, what else could? The traditionally
advanced economies are becoming less influential in the world, as their share of global output is
decreasing. According to G-20, emerging economies are leading the global recovery. If these
developing economies continue to grow at the rates we are currently seeing, advanced economies
will almost certainly be in relative stagnation. Furthermore, foreign direct investment may be
directed towards developing nations and if this is a substitute for investment in advanced
economies, this could slow the latter’s growth - if economic growth was a zero sum game. However
in reality developing countries’ advancement is in fact more likely to help growth than cause
stagnation in advanced economies. Germany’s surplus has been in part driven by its investment in
high growth economies. This shows the benefits of the world’s changing structure. Relative
stagnation is not a negative prospect; wealth being redistributed round the globe will decrease
poverty, and a severely skewed income distribution harms the pace and sustainability of growth
over the longer term.viii
It does not seem, however, that in 2014, the advanced economies are in for a long period of
economic stagnation. Positively, we are seeing most recovering - across mature economies the
growth outlook is now at 2%, an increase from 1.3% in 2013ix. The medium term outlook is also
encouraging as output gaps are closing; the US and the EU are due to grow 2.4% and 1.2%
respectivelyx. Thankfully, this is not stagnation. However, significant structural and long term issues
lie at the heart of developed economies today, and the figures above are short and medium term
predictions only. The long run worrying problems, that I will now discuss, pose a more relevant
question - not whether economies will be stagnant, but will they become too volatile?
One reason for this concern is emerging bubbles - where markets overheat and asset prices rise
above the fundamental value of the asset. It is likely they are being funded by a rush of credit
availability as banks start to recover and hoard less cash. This effect may be exacerbated by the
monetary stimulus central banks have been implementing (to stimulate spending during the
recession) if it is only just being loaned to borrowers. Take the UK as an example - the Bank of
England’s Quantitative Easing scheme had created £375bln by Jan 2013, but a significant proportion
of this cash was hoarded by the banksxi. Now, as banks become more willing to lend, the housing
Emma Falconer
market has seen house prices increase by 10% in the last yearxii. This bubble is even worse in certain
areas, in particular London, where the equivalent figure is 19%. The danger of rapidly rising prices
for an economy is not stagnation, but volatile movement. This is because the bubble eventually
bursts when borrowers default on their loans - explaining why a borrower-funded recovery is not
desirable. When the bubble bursts prices plummet, and the resulting wealth effect from this can be
disastrous for an economy. In this way we can see an unstable pattern forming, because advanced
economies’ expansionary policies have been too focused on increasing consumption.
Another reason why advanced economies face volatility, and not stagnation, is that many policies
that are being implemented are designed to boost only short run growth. I will give two examples of
this. Firstly, France’s introduction of the 75pc top tax rate means the growth may increase
temporarily, because of the ability to redistribute money and raise government spending (or reduce
debt). However in the longer run top earners will relocate their skills abroad, detracting from the
skill of the workforce, and limiting growth.
For our second example, we look to Japan. Abenomics focuses on boosting growth by raising
inflation via short-term stimulus spending, monetary easing, and reforms to boost labour markets.
The short term stimulus, let us presume, will work in the short run. There is then the danger of
market bubbles forming as I previously discussed (although deflation is currently a problem, if all
banks recover and release cash at once, bubbles are still a risk). Worse than this, Japan could see
hyperinflation - and this would be difficult to control, as Japan’s national debt of $10.46 trillionxiii is
too large to afford rises in interest rates. The aim of the government is that real interest rates will
fall, but this relies on the short run stimulus package causing inflation, which is also increasing debt.
Abe announced in Oct 2013 that consumption tax will rise to 8%xiv, to help improve the deficit - but
this could stop inflation and recovery, as wages haven’t matched higher prices yet. The point here is
that it is almost impossible to increase spending, reduce debt (increases), stimulate inflation with
growth, all at the same time. Each of these aims has conflicting consequences - and large, sharp
increases in AD, which these short run proposals aim to do, does not mean Japan is headed for a
smooth recovery and trade cycle, but a tricky and unpredictable one.
Isn’t this what Abe’s third ‘arrow’ aims to avoid? Structural reforms should help long run growth,
and yes, in fact they could increase productivity and help stability. However the fiscal and monetary
efforts could give the government an excuse to postpone these crucial reforms; and the IMF in Oct
2013 warned this “could lead to a return of deflation and increased bank holdings of government
debt.”
Advanced economies have different plans on how to stimulate growth and avoid stagnation. In an
economic Utopia, these would all create stable growth patterns. On the other hand, they could have
no effect, and the economies could draw to a standstill; economic stagnation would occur. In my
opinion the most likely event is that short run boosts and spurts will give economies temporary large
positive output gaps, which will be then followed by large downswings. This we will see if
governments place too much focus on fiscal and monetary stimulus and not structural and
productivity supply-side improvements; if the third arrow of Abenomics is not implemented. The
trouble is, short spurts of growth (which provide popularity) are just too tempting for governments.
In conclusion, repeated patterns of boom and bust mean that in the short run we are likely to see
recovery. However this is not growth - a key factor in growth is investment, and in volatile
economies this reduces, because firms are less confident of the future. Therefore a fluctuating
economy may not be the same as economic stagnation, but in the long run it does harm growth. It is
arguably worse than stagnation, because it is more risky for economic institutions, destroys
Emma Falconer
investment projects and causes cyclical unemployment (lowering living standards and in long slumps
harming the skill of the workforce). Where do I think advanced economies will be in the next eight
years? Fluctuating along a continuously vicious and volatile trade cycle, with changing and
precarious growth patterns.
Total word count: 2117
References
i
www.g20.org
Ha Joon Chang: A Users Guide to Economics.
iii
Ha Joon Chang: A Users Guide to Economics.
iv
Richard Koo: The Holy Grail of Macro-economics
v
IMF predictions 2014
vi
Greece government figures 2014
ii
vii
viii
Greek government made the forecast in a first draft of its 2014 budget
The Richard Dimbleby Lecture by Christine Lagard
ix
Global Economic Outlook | The Conference Board
x
Global Economic Outlook | The Conference Board
xi
BBB.co.uk/news/business
‘Taking the Heat Out’, The economist 21st June 2014, figures released 17th June
xiii
Cfr.org
xiv
Cfr.org
xii