Risks to Long-Term US Growth

By Don Alexander, MBA
Associate, RSD Solutions Inc.
(Mr. Alexander is also a lecturer at NYU and SunySB)

Global growth is slowing – especially in advanced-technology economies and the outlook according to the IMF’s semi-annual World Economic Outlook forecasts confirm this trend.  Regardless of cyclical trends, long-term economic growth may grind to a halt in developed countries.  The recent two hundred fifty years of per-capita income growth maybe a mirage.

 

A basic tenet of economic theory is that economic growth is a continuous process that will persist over time.  Robert Gordon claims that the rapid growth progress made over the past 250 years could well turn out to be a unique episode in human history because economic growth was a one-time occurrence centered on 1750-2000.  He questions whether this assumption about growth is true.  He examines this question in a recent study Is US Economic Growth Over? Faltering Innovation Confronts the Six Headwinds  (VOXEU, Sept. 11^th).  He also writes a longer version Center for Economic Policy Research Policy Insight 63 (Sept. 2012) and NBER WP 15834 (March 2010).

 

Gordon notes that cycles are not continuous.  In particular, there was minimal growth before 1750 and there is no guarantee that growth will continue.  He argues that the rapid progress made over the past 250 years could well turn out to be a unique episode in human history.  Growth in the frontier economy gradually accelerated after 1750, reached a peak in the middle of the 20th century, and has been slowing since.

 

The big peak in US growth came between 1928 and 1950, the years that span the Great Depression and WWII. The cause this economic growth spurt is subject to debate, but growth has steadily declined in intervals plotted since 1950.  He notes the importance of innovations during the initial US growth spurt on per-capita consumption and productivity growth, especially before 1972.

 

However, the process of innovation may be battering its head against the wall of diminishing returns, facing six headwinds that are in the process of dragging long-term growth to half or less of the 1.9% annual rate experienced between 1860 and 2007.  Given the diminishing returns from innovation, it may take 2070-2100 to see a doubling of US per-capita consumption from 2007 levels, given the slowdown in the cycle.

 

Even if innovation were to continue into the future at the rate of the two decades before 2007, the US faces six headwinds that are in the process of dragging long-term growth to half or less of the 1.9% annual rate experienced between 1860 and 2007. These include demography, education, inequality, globalization, energy/environment, and the overhang of consumer and government debt. A provocative 'exercise in subtraction' suggests that future growth in consumption per capita for the bottom 99% of the income distribution could fall below 0.5% per year for an extended period of decades.  The numbers in the 'exercise in subtraction' have been chosen to reduce growth to that of the UK for 1300-1700.

The pessimistic/provocative view adopted by Gordon suggests that it may take almost a century for income per capita to double from its 2007 level.  The outcome may turn out to be much better than that. But the point of this paper is that it is likely to be much worse than any epoch of US growth since the civil war.  It raises questions for policymakers on job creation and for creation of risk scenarios.

http://www.voxeu.org/article/us-economic-growth-over

Financial Reform Agenda: An Interim Report

By Don Alexander, MBA
Associate, RSD Solutions Inc.
(Mr. Alexander is also a lecturer at NYU and SunySB)

Five years after start of crisis, the global financial system is still under stress.  A host of regulatory reforms are under way to make the financial system safer, and are aimed to make markets and institutions more transparent, less complex, and less leveraged.  However, policymakers have failed to address other issues such as "shadow banks" and "too important to fail" institutions.

The IMF in its latest Global Financial Stability Report (GFSR) summarizes current reform progress in The Reform Agenda: An Interim Report on Progress Toward a Safer Financial System (Sept. 25^th).  The report suggests that there is still a lot of work to do and some difficult issues left to tackle. 

Most reforms are in the banking sector and impose higher costs to encourage banks to reduce risky activities. Basel III requirements of better-quality capital and liquidity buffers should enable institutions to better withstand financial distress.  The new banking standards may encourage certain activities to move to the nonbank sector, where those standards do not apply. Alternatively, big banking groups with advantages of scale may be better able to absorb the costs; as a result, they may become even more prominent in certain markets, making these markets more concentrated.

Although the intentions of policymakers are clear and positive, the reforms have yet to effect a safer set of financial structures, in part because, in some economies and regions, the intervention measures needed to deal with the prolonged crisis are delaying a ‘reboot’ of the system. These intervention measures are aimed at preventing a collapse of the financial system and supporting the real economy, but can provide time to allow damaged financial systems to recover. 

The report added that despite improvements along some dimensions and economies, the structure of intermediation remains unchanged.   Financial systems remain overly complex, banking assets are concentrated, with strong domestic interbank linkages, and the too-important-to-fail issues are unresolved.  reforms in some areas still need to be further refined, far more work needs to be done to implement them, and that the system, in many cases, remains vulnerable, overly complex, and activities are too concentrated in large institutions. Reliance on non-deposit funding is very high, linkages across domestic financial institutions are very strong and complex, innovative financial products are taking on new forms to circumvent regulations.

Other issues to address include: the pros and cons of the restrictions of certain bank business activities, monitoring systemic risk and supervising shadow banking, the need to simplify products and reduce complex organization structures, the regulation of over-the-counter derivatives, and cross-border regulation and resolution for large financial institutions.  In addition, the report noted the success of the current and prospective reforms depends on enhanced supervision, incentives for the private sector to adhere to the reforms, the political will to implement regulations, and the resources necessary for the task of making the financial system simpler and safer.

The low interest rate environment is crucial for now; however, it may also be creating new vulnerabilities in the future.  Regulators and supervisors must be alert about the possible side-effects of these crisis-related measures so that they do not wake up to new risks down the road, due to long implementation lags and the crisis is ongoing.  Have you evaluated your exposure?

www.imf.org/external/pubs/ft/gfsr/index.htm -

The Law of Unintended Consequences

Don Alexander
RSD Solutions Inc.
NYU
SunySB

“This long run is a misleading guide to current affairs.
In the long run we are all dead”.

John Maynard Keynes

Central banks have embarked upon one of the greatest economic experiments of all time ‐ ultra easy monetary policy. In the aftermath of the economic and financial crisis which began in the summer of 2007, they lowered policy rates effectively to the zero lower bound (ZLB). In addition, they took various actions which not only caused their balance sheets to swell enormously, but also increased the riskiness of the assets they chose to purchase as well as creating long-term risks that are not fully understood.

William White, in a recent paper, Ultra Easy Monetary Policy and the Law of Unintended Consequences (Dallas Fed WP 126, Sept. 2012) evaluates the cost-benefit analysis of ultra-easy monetary policy by weighing the balance of the desirable short run effects and the undesirable longer run effects – the unintended consequences. 

The case for ultra-easy monetary policies is well known to convince the central banks of most AMEs (advanced market economies) to follow such polices. They have succeeded in avoiding a collapse of both the global economy and the financial system.

Nevertheless, White argues, that the capacity of such policies to stimulate “strong, sustainable and balanced growth” is limited. Moreover, ultra easy monetary policies create medium term effects ‐ the unintended consequences.  Hence the view, central banks have limited options.  One reason for believing this is that monetary stimulus, operating through traditional channels, might be less effective in stimulating aggregate demand. Further, cumulative effects provide negative feedback mechanisms that over time may distort traditional supply and demand relationships.

These policies may create real economy investment distortions, threaten the health of financial institutions and the functioning of financial markets, constrain the “independent” pursuit of price stability by central banks, encourage governments to refrain from confronting sovereign debt problems in a timely manner, and can regressively distort income/wealth.  The medium term effects can be questioned, considered together, they support strongly that aggressive monetary easing in downturns is not “a free lunch”.

When this crisis is over, the principal lesson for central banks is they should lean more aggressively against credit driven upswings, and prepare to tolerate the subsequent downswings helping avoid future crises of the current sort.  The current crisis is not yet over, and the principal lesson to be drawn from this paper concerns governments rather more than central banks.  Central banks have bought time to allow governments to follow the policies likely to lead to a resumption of “strong, sustainable and balanced “global growth. If governments do not use this time wisely, then the ongoing economic and financial crisis can only worsen as the unintended consequences of current monetary policies increasingly materialize. 

http://www.dallasfed.org/assets/documents/institute/wpapers/2012/0126.pdf