Consequences Of Downward Trending Growth – Analysis

Governments contend with debt and sluggish growth; many worldwide risks – known and unknown – could add complications.

By David Dapice*

Mick Jagger of the Rolling Stones once studied economics, but gave it up for singing. When asked why he left economics, he reputedly said, “There are too many variables.” Anyone, skilled in forecasting or not, must share the feeling. The US economy finished the year with low unemployment and inflation, GDP growth near 3 percent, and a volatile stock market up from the 2016 presidential election, if not for the year. Despite high corporate profits though, investors are nervous about hard-to-predict variables.

In short, there are risks, many anticipated and others unknown. While most economists see US growth near 3 percent for 2018, few would rule out a recession as possible if not probable by 2020. Indeed, four out of five chief financial officers from major companies expect a recession by 2020. Likewise, the International Monetary Fund forecast the world economy would grow at 3.7 percent in 2018 and this year. But the forecast is fragile, dependent on a lack of major shocks.

The trade war looks likely to be extended and intensified. If escalated, it will slow growth in both the United States and China, as well as countries that sell to them. This is because tariffs act much like an oil price increase in an oil-importing country, creating price pressures while decreasing economic activity. Oil is not greatly responsive to prices in the short term – it takes time to do much more than turn down the thermostat or drive less. Anything transported by oil or using oil – most products – costs more. People have less to spend after paying for more costly oil. While imports from China may be more price responsive, it takes time to shift production elsewhere. The dislocation to US farmers and other exporters hurts economic activity while imports cost more. Economic activity slows even as prices rise. The US Federal Reserve, in a bind, must decide whether to cut interest rates, allowing inflation to grow, or raise them and increase unemployment.

The trade war alone would not be a huge concern. US trade with China is 3 to 4 percent of GDP, and even with tariffs, the impact is only a few tenths of a percent in lost growth. However, China is slowing and has a lot of bad debt in its credit system. A sharper decline in growth is a real possibility despite China’s ability to pump up credit growth again – something that aggravates its long-term problems. With lots of empty real estate and a shrinking workforce, China is in a weaker position than a few years ago.

Many emerging markets export to China, and weaker demand for raw materials would hurt their growth. Emerging markets are already stressed: Many governments or local corporations borrowed US dollars at a time when interest rates were low, and now the strong dollar and rising interest rates make repayments burdensome. The IMF shows China growing at 6 percent or a bit more for 2019 to 2021, but again, this assumes no major disruption. Improving projected growth in Latin America and Africa depend on this assumption.

Then, of course, there is the overall uncertainty for Europe: Brexit, Exitaly, France’s yellow-vest clashes, political uncertainty in Germany. If the euro were to fail or a major economy such as Italy faced rising interest rates that create Greece-like problems, the path is uncertain: Would the European Central Bank again “do whatever it takes” and expand buying of government bonds? Would Germany veto this? The members of the Italian coalition, unaccustomed to governing, struggle to compromise even with each other. Given the size of Italy’s economy and its debt, held by many euro banks, a debt implosion would have a significant contractionary impact on euro bank lending and the EU economy as a whole. The obvious solution is to create money, but that may not happen. Brexit, in contrast, would be terrible for the United Kingdom if disorderly, but not a disaster for the European Union. The IMF shows EU growth falling from 2.7 percent in 2017 to 1.8 percent by 2020, and this could be optimistic.

Economists forecast the US economy to slow to a respectable if unexciting 2.5 percent or so in 2019, but below 2 percent after that. This reflects sluggish productivity growth and a stable labor force as baby boomers retire and the forecast assumes no major disruption from a government shutdown or constitutional crisis. Still, there is a reckoning from the tax cut and 2018 spending spree, curiously begun at a time of full employment. The government is generating trillion dollar deficits when revenues are high. Long-term Treasury yields are falling now, suggesting slowing growth. This could lead to lower short-term Treasury rates and a weaker dollar, which ironically would tend to drive up borrowing costs, especially with the huge deficits. Higher long-term interest rates – which the Federal Reserve does not normally control – would hurt housing, autos and some investment; raise the deficit in itself; and make loans for infrastructure repair more expensive. The reduction in “fiscal space,” essentially the flexibility to react to adverse events with fiscal policy, is another real uncertainty weighing on investment.

It is useful when thinking about economic growth to take the perspective of a business. New investments must pay for themselves. This may be easier with new software, which saves labor and can pay for itself in a year or less, but is much harder with a factory or piece of machinery while the outlook is muddy. Brexit uncertainty has depressed investment in the United Kingdom, for example. One reason Donald Trump’s attempt to encourage coal is not working is uncertainty over a possible carbon tax or similar regulation. Consider investing in Europe with the EU’s existential problems or the United States with its inability to conduct sustainable fiscal policy or repair infrastructure. Businesses and investors prefer caution to a near-death experience or bankruptcy. This caution translates into lower productivity growth – in the United States, labor productivity growth has been less than 1 percent a year since 2010. With slow growth in the number of workers and slow growth in output per worker and depressed investment levels, it is not surprising that overall growth is slowing.

Then add the list of unknown unknowns: Will there be a cyber-apocalypse? – the question was raised not by some wild-eyed cyber-punk but the US 2018 Economic Report of the President. The hacking of a half billion names from a major hotel chain, attributed to official Chinese hackers, gives some idea of what might happen if the financial system or the utility grid came under determined attacks from an unfriendly government or criminal group. Disruptions to oil supply if Iran blocked routes is another low-probability event that cannot be ignored though oil stockpiles and alternative sources would soften that blow to an extent. Such shocks would be severe and hard to predict. Both known risks and unknown shocks could interact to produce more severe and surprising outcomes.

The upside of these problems, even migration and climate change, is that they are amenable to better policy – which does not make those policies popular or easy. The political class must find a way to be honest with voters and persuade them that what is necessary is reasonable. That requires listening as well as making speeches. Nations can tackle these challenges together, or find them impossible to resolve alone.

*David Dapice is the economist of the Vietnam and Myanmar Program at Harvard University’s Kennedy School of Government.