How a crash (of sorts) might come

History looks for a trigger for the economy crashing:  the 1929 stock market panic, the 1970s oil shock or the 2008 subprime meltdown.  But while the headline events can be a catalyst, sober analysis usually gives a more complex backstory of growing economic imbalances and disastrous-with-hindsight policy settings.

So casting the Covid shock as the proximate cause, what might be underlying drivers of a sustained deterioration in the economic climate?

First, even before Covid, we have been enduring a world wide productivity slowdown.  For the quarter century to 2005, the productivity of the world economy rose at a fair clip.  But even before the global financial crisis, the growth rate started falling to levels roughly half those prevailing earlier.

Possible explanations have been widely canvassed and include measurement problems, feedback from slow growth, lower skill levels, overregulation and a decline in innovation.

But what to do about it?  The World Bank’s standard policy prescriptions cover the field:

“ … efforts are needed to stimulate private and public investment; upgrade workforce skills to boost firm productivity; help resources find the most productive sectors; reinvigorate technology adoption and innovation; and promote a growth-friendly macroeconomic and institutional environment.”

Sensible textbook answers.  However, the problem with a productivity slowdown is that the expectations of rising incomes during the good times are hard to displace.  Voters don’t want to believe that the signals for economic restraint are meant for them; politicians are reluctant to tell them.  So implementing the more flexible market-led policies needed to sort the issue become harder, just when they are most needed.

Secondly, a global debt boom is overshadowing the economic outlook. In its Global Economic Prospects, the World Bank points to:

“ the largest, fastest, and most broad-based wave of debt accumulation among emerging and developing economies in the last 50 years. Total debt among these economies climbed to about 170% of GDP in 2018 from 115% of GDP in 2010.”

Moreover, many of the developed economies are shouldering outsize government debt burdens from the global financial crisis.

Previous debt accumulations of this magnitude have not always ended well.  Where debt finances imbalances or unproductive investment, subsequent write-offs will reduce wealth and economic growth.  Greece’s example – where propping up living standards with borrowing left the government too indebted to cushion the fall – demonstrates the possible correlation between scale of build up and severity of downturn.

One feature of the 2008 subprime crisis was that sovereign borrowers retained their creditworthiness and there was no generalised rise in interest rates.  We must hope for similar good fortune next time.

Thirdly, what are the chances of success in China’s economic transition? Because the growth of the Chinese economy since the 1980s is this generation’s economic miracle, it’s easy to forget it is still a poor country with a relatively unskilled workforce. GDP per capita is 61% of the world average (one seventh of America’s) and one quarter of the workforce are still peasants on the land.  Official (not wholly reliable) economic growth rates have been slipping for some years.

China got to where it is now by letting entrepreneurs into the market. Not a Western market – with clear property rights and reliable if expensive governance – but a more risky and opportunistic partnership with the governing authorities.

There may be a good deal more economic growth in this model.  But at some point, if above-average growth rates are to be maintained, China’s businesses and workers need to transition – and transition dramatically – to new industries, new forms of organisation, new technologies and skills.

This is not easy.  Japan failed to do it in the 1980s, pretty much at the time bookshops clogged up with titles on the coming Japanese century. With hindsight, it’s easy to see that building great export industries was only part of the job and the authorities failed to reform sheltered sectors like farming and retail.

China’s government also has some outstanding issues to deal with, from sectors impeding growth, like state owned enterprise and the security apparatus, to arbitrary governance, security of property and the potential for more isolation from Western countries.

True, it has good models to follow, like Hong Kong, Taiwan and Singapore.  But it seems to be moving away from their path.  The country’s economic success derives pretty much entirely from policies established a generation ago.  It’s hard to think of a new policy from the current administration of similar magnitude; indeed, it seems to show a preference for direct control and centralisation which its predecessor was careful to keep in check.

All of which suggests a degree of caution in assuming that the present Chinese government can pull off a second industrial revolution.

To be clear, none of these trends mean that the global downturn is going to start next week.  Rather they tell us how a period of slow growth and economic turmoil can emerge.

For example, look back again to the 1970s, a decade of low productivity growth. There was growth, just so much lower than expectations.  At the same time, economic and social problems seemed to bubble up to the surface, the solutions looked unpalatable and no-one seemed to be able to agree on anything.

It was a far cry from the easy optimism of the 1960s, with its confidence in government’s ability to soothe society’s irritations (and passing resemblance to the Clark-Key era).

So keep a close eye on how governments respond to the need for big and painful adjustments to Covid; scrutinise who they reward for not changing and whom they try to hold harmless; watch how much they borrow to avoid hard decisions; see if they create space for businesses to expand and profit, letting the unsuccessful fall by the wayside.

Because when things go really sour (like in the 1970s), it can take a political step change to get back on track.

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