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November 17, 2020 - January 16, 2021
A key and central conclusion of our work is that the Great Reversal of demography and globalisation will lead to more inflation. When this takes hold, though it may be a few years from now, and expectations adjust, then nominal interest rates will rise. Of that, we are confident. But the more difficult and interesting question is whether nominal interest rates will rise by more than inflation, i.e. whether real interest rates will rise, or whether the reverse will happen and real interest rates will fall.
Ex post, savings have to equal investment in a closed economy, i.e. the world. So, if one points to a particular country, say China, where savings have exceeded investment and there is a current account surplus, then by definition there is another country (or countries such as the UK or USA) where savings have been below investment and there is a current account deficit. What we need to look at is the ex ante desired savings versus investment dynamics on a global scale, and think of the equilibrating interest rate as a global price.
One of the great difficulties of trying to analyse the likely path of real interest rates is that there are so many factors involved. For example, in Heise’s book (2019), on Inflation Targeting and Financial Stability, he lists eight driving factors in four categories,
In some of our other work, we have focussed on the importance of the relationship between the rate of growth (g) and the real interest rate (r), and we take the view that macroeconomic management becomes much more difficult if r rises above g. Another of our main conclusions is that g, the rate of growth of real output, must decline, as the growth of the workforce slows, and in many countries absolutely declines. Moreover, it is commonly assumed that an intrinsic relationship exists between potential output growth and the equilibrium real interest rate.
Cyclically too, much of the perceived link between growth and interest rates, we suspect, comes from observing a decline in both growth and interest rates during economic slowdowns and connecting the two. The decline in real interest rates cyclically also has more to do with the behaviour of ex ante investment relative to ex ante savings and, in particular, to the greater amplitude of the swings in investment relative to those of savings. As desired investment falls sharply (while desired savings tend to remain more steady) towards the trough of the cycle, so do interest rates. Similarly, an
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The declining trend in real interest rates over recent decades, from 1980–2015, is prima facie evidence that ex ante savings have exceeded ex ante investment over this period—but that is likely to reverse.
The main problem is that demographic changes normally have the same directional effect both on ex ante savings and on ex ante investment. Slower population growth will lower savings (assuming a constant dependency ratio), but will equally lessen the need for more capital, houses, equipment, etc. However, this doesn’t tell us whether the capital/labour ratio will fall or rise, thereby raising or lowering the marginal productivity of capital. With both ex ante S and ex ante I moving in the same direction, assessing the likely balance between the two becomes problematic.
the data (Diagram 6.1) show that age-related consumption is flat, or even rising, with age. This must, and does, imply a considerable transfer from workers to the old.
Almost inevitably, health expenditures will rise further (Diagram 6.2), while the retirement age simply hasn’t kept up with longevity.
As China’s labour force dynamics change direction, the savings-investment balance within and even outside China will change as a result. Demographics will ensure that China’s extraordinary savings will fall. Prior to modern times, the (relatively few) old in China were cared for in the extended family.1 But the one-child policy, extended for too long, has meant that support has gotten more and more scarce for the aged. With an insufficient social safety net, personal savings rose to plan for retirement. Add to this the incentive on the managers of state-owned enterprises to retain, rather than
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China’s ageing will also reduce excess savings among oil exporters. The economic impact of China on the world economy has been great. One dimension of this has been to impart upward pressure on the price of raw materials including, notably, oil.
all those countries which have had current account surpluses (large net savings) are either ageing rapidly (China and Germany), or are likely to see their relative advantage reduce (the petro-currency countries). A large proportion of overall capital, and of personal wealth, is tied up in housing and housing-related infrastructure.
One aspect of the demographic impact that does not suggest a ready answer is the behaviour of the corporate sector. There are two polar arguments. The popular argument is that the corporate sector will respond to demographic headwinds by slowing down the rate at which it accumulates capital so much that the capital/labour ratio falls. Our view is that the corporate sector is likely to respond by raising the capital/labour ratio, i.e. by adding capital to compensate for labour, which is the factor of production that will be getting scarcer and more expensive.
We fully expect technology to have a significant beneficial impact on productivity and hence on restraining inflation and nominal interest rates. But we prefer to take an agnostic view because we have no particular expertise in predicting the pace of innovations.
Structurally, it is still early days and perhaps until recently the relocation of production abroad remained an alternative and attractive option. The demographic headwind and the associated increase in wages have not yet affected large parts of AEs.
Even at this early stage, signs of a new capital expenditure cycle are already being seen in Japan.
The corporate sector of the USA has thus far preferred to increase ROE, i.e., the return on equity, by leveraged buy-backs of shares and to increase output by employing more. If wage growth eats into corporate profits as it has recently begun to, then there should develop a greater willingness to invest in order to raise labour productivity and protect corporate profitability.
On the other hand, non-financial corporate debt ratios have now climbed so high that any rise in interest rates, or fall in profitability, could put the solvency of many highly leveraged companies under pressure. Should this happen, they would have to cut back new investment severely for short-term self-protection, thereby worsening the macro-economy still further.
The personal sector will therefore move from the surplus of the past towards a deficit. It follows, almost by definition, that in order to equilibrate the economy, the public sector should move out of deficit towards greater surplus. But this will be extraordinarily difficult, particularly because of the pressure of the need to increase payments for medical care and pensions,
we think it highly likely that the fiscal position will not move sufficiently strongly into surplus to offset the larger deficits that we expect to see within the private sector.
In many of the studies surveying the reasons for declining real rates of interest over recent decades, considerable weight has been put on risk aversion and the flight to safety;
During this period, central banks have hoovered up much of the available outstanding stock of riskless government debt in their QE policies, and the potential for default or redenomination has made the existing debt of several European and Latin American countries apparently more risky.
An argument that has been put forward, e.g. by these authors, and also Marx, Mojon and Velde, ‘Why Have Interest Rates Fallen Far Below the Return on Capital?’ (2019), has been that aversion to risk and illiquidity has driven an increasing wedge between the return on capital and riskless interest rates. Because the required return on capital remained high, thereby deterring investment, riskless interest rates had to be lower in order to equilibrate the macroeconomy. We are not convinced by these arguments. If there was concern about illiquidity, then the wedge between relatively riskless bonds
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That still leaves the question of why the return on capital has remained so high relative to the riskless rate. In our view, the rise in equity valuations is a natural consequence of the decline in riskless rates since, as rates fall, equity prices have to rise to a level at which the future return on holding such equities falls to the point at which the future expected return, adjusted for risk, is in line with the riskless rate.
EqUiTy RP
What does remain a serious question is why conditions in which profitability has been so high, and both equity prices extremely high and interest rates so low, has not led to a much greater demand for corporate investment. In our view, the answer to this has nothing to do with risk aversion, but rather the incentive on corporate managers to maximise the short-run return on equity (RoE),
During these last 30 years, central bankers have remained the best friends of Ministers of Finance. By bringing interest rates steadily downwards, they have enabled the debt burden of sharply rising debt ratios to be completely offset.
Largely because of the political context which we see unfolding, we think it highly likely that short rates will be held below the increase in inflation which we see developing over the next few decades. In contrast, however, as this new, uncomfortable, world emerges into clearer sight, long rates will start rising and very likely rise above the current rate of inflation. So, one of our conclusions is that the yield curve, which is currently flattened to an unusual degree, will probably steepen sharply.
Global inequality began to fall, from about 2000 onwards, as the rise of real incomes and real wages in much of Asia, led by China, greatly outpaced that in the West. For the previous two centuries, global inequality had risen steadily, not because inequality was rising within countries, but because income inequality was growing between countries,
Besides the peasants and working classes in China, and neighbouring Asian countries, S. Korea, Taiwan, Vietnam, Thailand, Malaysia, Singapore, Indonesia, etc., the other main winners over the last three decades have been those with good technical skills and qualifications, the managerial class and those with wealth for capital investment. As we showed earlier in Chapters 2 and 3, the combination of globalisation (essentially the China effect) plus the highly favourable trends in demography led to an unprecedented surge in the effective labour supply during these recent decades, more than
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But there were losers also. These were the lower middle classes in the Western advanced economies.
Although global inequality has started to fall, as inequality between countries has declined quite sharply, inequality within countries has in the vast majority of cases risen, in many cases rather strongly, reversing the decline that took place from about 1914 until about 1980.
Redistributive fiscal policies have helped reduce, but not fully offset, rising nationwide income inequality
The redistributive effects of fiscal policies seem to have flattened (in many European countries) or diminished (such as in the United States). The average redistributive effects (the change of Gini coefficients between before and after tax and transfer) have declined from 53 percent to about 50 percent in the group of selected OECD countries over the last decade (Figure 6 top right panel). This reinforces earlier findings that the fiscal redistributive role has declined over the mid-1990s to mid-2000s
There are two main constituent reasons for such trends in inequality. The first, already discussed in Chapter 3, is that trend growth in the returns to capital have been much stronger than the increase in real wages
The second main constituent reason for the increase in inequality is that the return to human capital, as proxied by educational attainment, has risen alongside the return to fixed and financial capital. In contrast, the return to muscle-power and simpler repetitive tasks has stagnated.
The implication of all this, i.e. that the very poorest have been protected, whereas the return to human and fixed capital has soared relative to the return to the unskilled and semi-skilled, has been that the lower middle class, say between the 20th and 70th income percentile, has come out the worst.
in recent hikes to minimum wage rates both in AEs and EMEs. Among the advanced economies, the following countries have raised or introduced minimum wages recently:
The wider question, however, is whether, and how far, the patent effect on individual categories of work spills over into explaining the relative stagnation of real wages, and of labour’s share of income, as a whole? Superficially one might think that, if labour-saving technology was largely responsible, productivity should have grown faster than has been the case in the last two decades. But what if public policy to maintain aggregate demand and full employment has its main practical domestic effect on low productivity service industries, and the ‘gig economy’? A plausible hypothesis.
Let us put the question another way; why would such technological developments change the slope and/or position of the Phillips curve? With the same level of overall unemployment, why would the associated aggregate wage/price outcome be less? Here the suggestion is that workers in the unskilled (gig) economy may have less relative bargaining power, and are less unionised, than those who previously worked in semi-skilled areas.
There is considerable evidence that concentration and monopoly power have been increasing in private sector industries in the USA in recent decades,
the suggestion is that the more powerful is the employer relative to the employees, the tighter must the labour market become, the lower must be the Natural Rate of Unemployment (NRU),
Thus, we have three different forces, technological change, concentration/monopolisation, globalisation/demography, all together tending to reduce the bargaining power of labour.
If the main cause of the weakness in wage growth/labour share is primarily globalisation/demography, as we think, then it will reverse over coming decades. If it is primarily a technological matter, then it may well continue, as artificial intelligence (AI), for example, kicks in. And whether concentration/monopoly in private industry grows, or lessens, in future is largely a matter for public policy, and could go either way. So our view is that the growing inequality within countries has been mainly caused by the unprecedented surge in labour availability, caused by globalisation and
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in the Brexit referendum, there was a negative relationship between the level of prior migrants in each constituency and the vote to leave, but a positive relationship between the percentage change in recent migration and the vote to leave.
So, the right-wing populist position on migration, and on reinforcing nationalism, were far more in harmony with the underlying views of those left behind, than the more widely inclusive position of left-wing parties. It is not clear whether and how this realignment of political views might change. In a sense, those voting for populist right-wing parties are correct. Among the factors that have made their lives more difficult in recent decades, globalisation has been one of the more significant. The coming to power of much more nationalist populist parties is likely to put a major spoke in the
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after World War II and into the early 1950s, the initial major concern/expectation was that the advanced economies might fall back into a further bout of stagnation/deflation. It was not until the later 1950s and 1960s that full confidence in Keynesian demand management to maintain reasonably full employment became widespread.
Quite quickly economists working in the Civil Service, especially Ministries of Finance, saw their function as to help their political masters to set demand, mainly via fiscal policy, to achieve that point on the Phillips curve that would minimise the political disutility of unemployment on the one hand and inflation on the other
It all then went horribly wrong in the 1970s, just as the second golden period for macroeconomics (1992–2008) went horribly wrong after the Great Financial Crisis (GFC). What then occurred, starting in the 1960s, but worsening dramatically in the 1970s, was that the combinations of unemployment and inflation that arose began to move outwards, towards the North–East, so we had simultaneously more inflation and, at the same time, more unemployment, ‘stagflation’ as it was termed
Once the importance of inflation expectations became factored into the analysis, by Phelps (1968) and Friedman (1968), this led on to the concept of the Natural (or Non-Accelerating Inflation) Rate of Unemployment (NAIRU or NRU).1 This is the level of unemployment at which, in the longer term once expectations have fully adjusted to outcomes, the rate of inflation would remain constant. The assessment was that the long-term Phillips curve would be roughly vertical 2 at the NRU. In the short-run, with expectations largely fixed, the Phillips curve would remain downwards sloping. But if the
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This concept, of a vertical long-run Phillips curve, was an important buttress for the subsequent move to Central Bank independence, with a mandate to concentrate on price stability via an inflation target. With such a Phillips curve, Central Bank measures to maintain price stability would not of themselves affect longer-run employment, growth or productivity, which were (in the long term) determined by supply-side factors, not by monetary, short-term demand-side policies.3 Thus, concentration on the control of inflation, via monetary policies, would be of itself beneficial, with no offsetting
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