In early October the IMF cut its forecast for global growth in 2012 from 3.9% to 3.6%. This was then followed by the OECD slashing its 2013 growth forecast from 2.2% to 1.4% at the end of November for those 34 wealthy countries that comprise its membership. Nothing remarkable in that you might say. However, perhaps more remarkable was the IMF’s paring of forecast growth for 2012 in the UK from an expansion of 0.2% to a contraction of 0.4%. Even more remarkable still was the IMF’s sharply revised estimate of the UK’s sustainable growth rate from 2.7% per annum to just 1.7%. Not that the world’s sixth largest economy was singled out. Indeed the US, the world’s largest and Japan, the third largest, both received similar treatment. Only Germany surfaced unscathed with its trend growth rate of 1.5% remaining intact.
Changes to trend growth rates of this magnitude are very rare indeed. In fact, trend growth in the UK hasn’t changed much at all since the Industrial Revolution, despite the many innovations of the intervening 160 years. That said, the IMF admitted that its estimate of the UK’s sustainable growth rate pre-crisis was over inflated given the role of credit in exaggerating the UK’s actual rate of growth at the time.
Trend growth matters in an investment context as it forms the bedrock to long-run investment returns. Indeed, the long-run return on any risky investment comprises the trend economic growth rate, expected inflation and an appropriate risk premium, which depending on the type of investment and the economic and political backdrop at the time of the investment being made, should compensate the investor for factors such as unexpected inflation, illiquidity, volatility and the risk of default.
So why the dramatic paring of trend growth? Well trend growth is determined by a country’s potential output which, in turn, is fuelled by the size and productivity of the labour force and the available capital stock. Just as trend growth tends to stay relative constant over time, so too does its component parts unless, of course, the economy is hit by a massive shock that not only results in the economy experiencing spare capacity (a polite term for unemployment) but also when that spare capacity permanently disappears without trace as disillusioned workers drop out of the workforce and the capital stock with which they once worked lays idle and becomes obsolete.
There are, however, a number of other reasons for this downgrade in sustainable growth, the first of which, perhaps ironically, concerns the size of the financial sector and the extension of credit to the private sector. In a working paper entitled “Too much finance?”, the IMF suggests that, while the financial sector is supposed to promote growth by allocating capital to productive parts of the economy, this can backfire. If the financial sector becomes too large – defined as when credit to the private sector reaches 80% to 100% of GDP – then the odds of a crisis and the misallocation of capital to less useful sectors of the economy are dramatically increased, so lowering the trend growth rate. Moreover, just as Japan discovered to its cost during its lost decade, trend growth can also be compromised by not forcing undercapitalised banks to recapitalise or, in extremis, fold. Similarly, the increasing prevalence of zombie companies – those without sustainable business models that cannot invest or innovate and so slowly lose customers and employees – being kept alive by banks’ reluctance to write down non-performing loans and as an unintended consequence of ultra loose monetary policy is another significant drag on growth.
Then, of course, there’s the size of public debt and the inference from a number of empirical studies that once a country’s public debt-to-GDP ratio hits 90% to 100% then the result is a 1% decline in the trend growth rate. However, although it is highly unusual for heavily indebted countries to reduce their debt burden by anything more than 10% over 15 years, history tells us that all is not lost.
Indeed, those that put their indebtedness on a downward trajectory, with debt reduction based on enduring structural reforms rather than temporary measures, while employing an accommodative monetary policy – principally ultra-low real interest rates (notwithstanding the unintended consequence noted above) – and growth-supporting initiatives which benefit from the multiplier effect, such as infrastructure spending, can, in fact, grow at a faster rate than less indebted countries whose indebtedness is on an upward path. Indeed, this exactly what the US did post-war, eventually putting trend growth back on an even keel.
With the UK very much in fiscal lockdown mode, with little sign of it abandoning its fiscal austerity programme but with every suggestion that public-private infrastructure spending will yet take centre stage, against the backdrop of an ultra accommodative monetary policy, let’s hope history is about to repeat itself.