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Invested: 2017 An economic odyssey

Wednesday, November 23, 2016 13:24
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We still live in the shadow of the global financial crisis of 2008. Investors need to be clear about this in order to prosper.

Countries that have failed to recover their previous dynamism have not grown. Economic growth allows the redistribution of more of the fruits of growth to those closer to the bottom of the income distribution. The government taxes those who have done well and transfers it down the income distribution in the form of health, education and social protection expenditure.

Without that redistribution, living standards stagnate and resentment builds. Populists exploit this resentment by lying through their teeth about their ability to deliver more growth and less inequality.

In the past, the ‘elites’ could be relied upon to fatten their own purses first and redistribute second. Without redistribution, typically via the tax system, the people see the purse-fattening much more clearly.

Which brings me back to the global financial crisis. People aren’t stupid. Before the crisis, they see those above them in the pecking order doing very well indeed. Then they see those above them make the most appalling mistakes as the crisis unfolds. And then, once the crisis has happened, they see . . . nothing. Nothing happens. Those above them keep their jobs, their living standards stay high, either because they receive golden parachutes, or they just stay where they are. In a paroxysm of bluster, denial and moral hazard, the system just keeps going.

Those at the bottom, who rely more and more on transfers from the government to make ends meet because their wages haven’t risen in years find those transfers going down, because of austerity imposed on them by the people who made the mistakes in the first place.

Hang on a second, they say. We didn’t cause this mess. But they read in the papers that they all partied. The result is widespread, if largely inchoate, anger. They feel duped.

A version of this story is playing out in every country in the advanced world. I expected Trump to win, because my thinking changed after the Brexit result, which I called incorrectly.

This matters for investors because it changes the likely composition of their portfolios.

Let’s define populism as pretending that the actual constraints that apply when you govern won’t apply when you govern. Populism matters for investors because it changes the likely composition of their portfolios.

Economists Rudiger Dornbusch and Stephen Edwards studied the macroeconomics of populism using Latin America as a case study. They found that, typically, populist policies make people poorer over the medium term. But they play really well when you’re trying to get elected.

Populists promise instant action to defeat long-standing social and economic challenges. If the standard reaction to economic problems since 2008 has been monetary policy—using nominal interest rates and the size of the central bank’s balance sheet to affect credit flowing into the real economy – then populists promise a response using fiscal policy.

We’ll rebuild our shattered nation. Build that wall. Fix those airports, and so forth. The basic equation of every government is that it’s spending minus what it takes in in taxes plus whatever it has to borrow to balance the books has to equal zero. If government spending goes up, and taxes go down, because the populist promises tax cuts, of course, borrowing must explode.

In the private sector, dividend-issuing listed companies that make the stuff infrastructure spending requires – say concrete manufacturers – are in for a big boost. Minutes after Hillary Clinton called president-elect Donald Trump, Cement Roadstone (CRH), which manufactures a wide range of materials for the construction industry, experienced a huge jump in its share price, from $32.41 to $35.36 in under two hours. Other companies can expect the same.

One of the big problems with Trump’s infrastructure plan is that many of the highest return infrastructural investments you can make, like fixing roads, repairing structurally-deficient bridges, revitalising schools and so forth, do not generate a commercial return and so are excluded from his current plan. So “rebuilding” may simply be code for “give rich people more money via tax credits”.

It has never been cheaper to borrow as a sovereign nation. This is especially true of advanced economies. Never. So, for a while, this will work well until the price of bonds rises. Both public and private levels of debt will increase. Interest rates will rise above their low, low levels after a period of time, while the payoff from a capital stimulus will increase the economy’s growth rate and hoover up any remaining low-skilled workers currently unemployed.

I should say that this is exactly, and I mean exactly, the strategy Japan tried in the 1990s. It didn’t work then, because the underlying problem was not too many immigrants or even too little demand. The underlying problem was an ageing population which sapped productivity and an overhang of debt in the corporate sector.

All of the above assumes nearly frictionless migration, which we know is going to change.

What happens if we define globalisation as that moment in time when the rate of increase of trade is greater than the rate of increase of economic output per person? Imagine there are only two countries, called ‘home’ and ‘foreign’. Increasing trade makes the people who own the production facilities that make the things being traded much better off – they are the winners – but it also allows them to outsource their operations to cheaper countries, making workers in the ‘home’ country poorer and the workers in the ‘foreign’ country richer. The ‘home’ country workers are the losers, the ‘foreign’ country workers and the home country capitalists are the winners.

When the uncompensated losers from globalisation outnumber the winners, and those people have a vote, expect to see some changes made. The ‘losers from globalisation’ debate is far from settled, but as Harvard’s Dani Rodrik and Oxford’s Kevin O’Rourke have repeatedly shown, the losers from globalisation have never been properly compensated. If it is true is that the losers are almost never compensated, it is also true that these losses are somehow compounding. My losses become my children’s losses. So I’ll vote in people to stop my children losing from migration like I have, no matter how noxious their rhetoric.

The result is the contraction of global trade flows and especially global labour flows. This alone is enough to constrict productivity growth in the medium term. If your country can’t get the really, really bright people to come to you, if you can’t get the really hard-working young women and men who will do the heavy lifting at the lower end of the income distribution to build your walls, then you can expect lots and lots of inflation, as wage demands for price levels to rise. This may well set off spirals of incremental increases in interest rates across the system. This will change incentives to hold assets across the system.

Let’s expand on that. Imagine you’re a company that is highly leveraged. You’ve borrowed up to your neck to buy, say, residential and commercial properties in Dublin.

Your plan is to hold these assets for a few years until their price rises, then flog them, and pocket the difference between what you paid and what you’re selling them at as profit. You’re using the flow of cash from the rent on the property to cover the ‘carry’ cost of the interest payments. Now interest rates rise quite a bit. All of a sudden, the maths change. The carry cost gets much higher than the rental income. Alone, this isn’t that big a deal. The problem is that the maths have changed for everybody like you at the same time.

It’s why macroeconomic factors like the interest rate matter so much. Depending on how much you’re leveraged and how fast you need to sell, you might well be in trouble, unless you can jack up rents and flog a few of those properties. Flog too many, of course, and the prices will come down. And then you are in serious trouble.

The price of housing and commercial property is rising rapidly in Ireland. Dublin is the second most expensive commercial property market in the developed world after London, with rents around €1,200 per square foot. Note: this crowds out residential investment around €500 per square foot where supply is scarce – in Dublin, precisely where people need more houses. This is just one example of how macroeconomic factors can seriously affect private sector balance sheets.

But that’s a digression. The real problem is ageing. Europe is ageing. The US is ageing. The economies of the advanced world are getting much older. This alone is enough to guarantee us problems into the future. Here, again, Japan has led the way.

Economists Toby Nangle and Charles Goodhart have a theory that explains much of what we’ve seen in the past few years. First, after 1991, the world hit a demographic sweet spot, where a rising proportion of the population being of working age and a wave of globalisation coming from the great doubling of the global workforce available to western capital after the Berlin Wall fell, resulted in a global glut of labour.


This vast oversupply of workers depressed the relative price of labour, pushing down labour’s share of national income in the advanced economies and depressing wage growth. The availability of cheap labour globally reduced the need for labour saving, productivity-enhancing capital investment in the developed world, which is why we now have so many AI-related innovations to look forward to. A lower demand for capital (and less inflationary pressure from wages) reduced both real and natural interest rates.

The result? Lower inflation, weaker wage growth, lower investment, falling real rates and rising inequality. Precisely what we’ve seen in the post-crisis period. Look at the world’s population. The rate of growth of the population aged 15-64 is nearly zero today, and has been falling since the early 2000s. The trend is much more pronounced in western economies. The only solution is vast migration, the one thing our populists are having none of.

So where are we? What does the future hold? If Nangle and Goodhart are right, we might see a reversion to national production, and so less free trade, rising real wages in stronger countries, and greater labour power in advanced economies, less inequality within countries, more inflation because not only will unit labour costs rise, but taxation will have to rise sharply to pay for the medical services and pensions of the newly-old, and eventually higher nominal, and perhaps, real interest rates.

If Dornbusch and Edwards are right, we’ll see the macroeconomics of populism lead us into expansionary fiscal policy, combined with very poor execution of these policies, and eventually either a balance sheet crisis or a sovereign debt crisis is the result. They write: “The final outcome of these [populist] experiments has generally been galloping inflation, crisis, and the collapse of the economic system.”

Each of these changes, on their own, would bring us into a new world. The combination of all of them, at varying degrees based on the institutions in a particular country, will reshape the advanced economies of the world.

The first great era of globalisation ran from 1870 to 1913. If this second great era of globalisation (1973-2016) is really over, then we can expect small open economies like Ireland to get poorer faster; and this risk outweighs many others, because we still live in the shadow of the global financial crisis of 2008.


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