James Dowey, chief economist and CIO at Neptune
Whatever happened to the good old days of chugging along at 3% a year? That was the average rate of real economic growth in the advanced world from the end of World War II until the late 2000s.
Despite all of the recessions and social changes along the way, it proved a remarkably stable trend. But, by comparison, over the past decade we have come up short.
Since 2007, advanced world real economic growth has instead averaged only 1.2% per year. This is not just the effect of including the Great Recession in 2009 - between 2010 and 2015 growth still averaged only 1.8% per year.
This slowdown matters, both for the real economy and financial markets. Average annual income per head in the advanced world is today about £3,000 lower than it would otherwise have been had the post-WWII trend been sustained.
For investors, if it is likely that slow growth persists in the coming years, then one should factor this into forecasts for expected investment returns, which would likely be lower than the returns achieved during the past few decades.
True, economic growth is far from the only factor that determines aggregate investment returns, so slow growth could be offset by its codeterminants. However, where we stand today, this looks like wishful thinking.
As the McKinsey Global Institute has recently documented, since 1980, falling discount rates, a rising share of corporate profits in GDP and rising corporate pay-out ratios (including share buy-backs) have all boosted investment returns, but today retain little scope to do so much further.
Emerging markets may provide a bigger impetus for aggregate investment returns over the coming years than they have in the past, via both EM assets and the impact of EM economic growth on DM assets.
However, they still represent a small source of returns in most investors' portfolios. As such, advanced world GDP growth is likely to be a key determinant of real investment returns over the next decade.
What is the cause of the growth puzzle that we now face? What are the prospects for a recovery to the old 3% trend and what economic policies would encourage it? How should investors best respond to the phenomenon?
In 1930, Britain found itself in similar circumstances, economic stagnation in the 1920s having defied the pre-war optimism.
In that year, John Maynard Keynes wrote that most people believed the economy was suffering from the "rheumatics of old age", when instead the problem should be thought of as a result of the "growing pains of over-rapid changes, from the painfulness of readjustment between economic periods".
In my opinion, Keynes analogy is fitting today. Moreover, the misdiagnosis is giving rise to ineffective economic policy making and much unclear investment thinking. Today's conventional wisdom is represented by a preoccupation with three rheumatic conditions:
1. Demand-side Secular Stagnation: the idea, propounded by Lawrence Summers, that there is less scope for capital investments today than in the past, owing to slower population growth and the rise of capital-light business models - which in turn reduces economic growth;
2. Supply-side Technological Termination: Robert Gordon's claim that the low hanging fruits of economic progress via technological innovation have already been picked, and
3. Debt-Hangover: the possibility highlighted by Kenneth Rogoff and Carmen Reinhart that today's advanced economies are hampered by the weight of their elevated debt burdens accumulated in recent decades.
Although there is some merit to these arguments, I believe that something else is the main reason for the growth puzzle, something much akin to Keynes growing pains of interwar Britain.
Creative, destructive and Darwinian
In 1942, Joseph Schumpeter introduced economists to the work of Charles Darwin, describing the process of creative destruction, which he believed lay at the heart of economic growth.
According to Schumpeter, the economy is a collection of techniques - technologies, recipes, business models - competing with one another for application in the servicing of society's wants and needs.
New techniques are born of mutation, often as an adaptation or cross-fertilisation of existing techniques, and drive inferior ones out of the economy. The fittest techniques survive and spread and the firms that master them win. The more intense the process, the faster the progress in our material living standards.
Contra Robert Gordon's Technological Termination, it appears to me that the Darwinian tailwinds of material economic progress are blowing particularly hard today.
Rapidly falling communication and computational costs have sped up the rate of Schumpeter's mutations and the speed of their transmission throughout the economy.
Nevertheless, Schumpeterian growth does not make for a quiet life, as it severely compromises business survival and job security.
Indeed, the anxiety Schumpeterian growth creates provides fertile ground for the deep pessimism of those such as Summers and Gordon. The reality is that today's economy is particularly creative, destructive and Darwinian.
But if material progress is rapid, then why is the economic growth rate so low? The answer is that our economic statistics are very bad at capturing economic growth of the creative destruction variety.
Although our national statistical agencies are able to competently measure growth when it simply consists of us doing more of what we were doing before, there is no easy way for them to value the real contribution of new goods and services except for by their market value, which often belies the accrual of a significant consumer surplus above the price paid.
In a more Schumpeterian economy with a faster flow of new goods and services, there is more consumer surplus for our statistics to miss.
Phillipe Aghion has recently estimated that the failure to account for creative destruction is likely causing us to underestimate economic growth by about 1% a year. If correct, this observation would largely solve the growth puzzle.
Recovery prospects
If this alternative diagnosis is right, then what are the prospects for a recovery in economic growth? Indeed, if the growth rate is mis-measured, does it even matter if it recovers or not?
It matters more in the context of financial markets than the context of living standards. This is because while consumers are actually doing a lot better than the current political-economic discourse acknowledges, firms, and hence their equity holders, can only appropriate priced returns, not consumer surplus.
Meanwhile, a recovery in measured economic growth is policy-dependent, and we need to correct the mis-diagnosis before the correct policies rise to the top of the agenda.
If growth is better than our measurements tell us, then central banks engaging in aggressive monetary stimulus, in particular by forcing nominal interest rates into negative territory, are figuratively pushing on an accelerator while looking at a broken speedometer.
It is a real possibility that they are now doing more harm than good.
Rather, with extremely low real interest rates, it should be easy to achieve a net positive social return on government spending - which would also boost priced economic growth. Recent months have seen increased talk of a pivot from austerity towards fiscal expansion. This is good news.
But the correct economic policy for the Schumpeterian age would involve a more profound shift in thinking. It would recognise that the government has a bigger role to play in the economy in the 21st century than in the 20th century for three reasons:
1. The government has historically played an enormous role in technological innovation, providing around half of all R&D funding in the US and UK economies since WW2, and around two-thirds of funding for ‘basic science', which ultimately drives the biggest leaps forward. If the potential returns to innovative effort are much greater today, then logically the government should increase R&D spending.
2. The greatest scope for advancing human living standards today is not by enabling faster accumulation of more and better material goods but by improving health outcomes through innovation in medicine.
Based on the calculations of Kevin Murphy and Robert Topel at the University of Chicago, the estimated lower bound of the present value cash equivalent of curing heart disease in the advanced world alone is around a staggering $260trn, which is about three-and-a-half times the size of current global GDP.
Pursuing these gains would ultimately mean having health expenditure rise significantly as a share of GDP - and since there are severe market failures associated with private health care expenditures, this should largely be allowed to occur through the public component.
3. The increased role of technology in the economy may increasingly disrupt jobs and even depress the demand for labour, increasing the desirable size of redistributive and social programmes, even based on a purely pro-growth agenda.
Investors should become fans of bigger government in the 21st century.
What would a thoughtful portfolio look like in a Schumpeterian world? The trend towards passives is an important corrective to high active investing fees.
However, creative destruction is bad news for aggregate equity indices, as incumbent firms face greater pressure from challengers wielding new technology and business models.
Likewise, systematic tilts towards "value" and "quality" become less likely to pick up real value and quality and earn risk premia. Rather it will become even more important to engage in active investing focused on understanding the ‘real world' and avoiding the losers from creative destruction.
Important information
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