Economic dynamics in the view of the Central Tradition
(Image by Henry Rogers Seager, Introduction To Economics, 1904) Permission Details DMCA
A few friends, under the impression that a little economic understanding might enable me to predict the future, have asked what I think is going to happen to the economy under a new administration. Never one to miss an opportunity to express my opinion, I offer the following.
To me, a discussion of economics includes growth, stability, and equity. Let's take economic growth first; what it is - and is not. Growth is not the stock market - that's already greatly over-valued relative to earnings. Growth is not corporate earnings, either - that's a consequence, rather than a cause. No, economic growth consists of demographic changes and changes in labor productivity and participation. If you add up all these changes, they show you the change in gross domestic product - GDP.
Let's take an example. Suppose population change is +1.0%, labor productivity change is +1.1%, the change in the labor participation rate (which equals the number of people in the workforce and the average number of hours worked) is -0.2%. Add the numbers (1.0 + 1.1 + 0.2) and you get 1.9% annual growth in GDP - a figure that's pretty consistent with recent years. Note that these figures are "real" and do not reflect inflation rates induced by increases in money supply or velocity.
Many economists look forward to GDP growth in the range of 2-1/2% to 3-1/2% per annum, midway between the rate of recent years and the much higher rates Trump promised. But growth doesn't just happen automatically in a mature economy; it is a function of the causative factors embedded in productivity and labor.
On January 14, 2017, Ruchir Sharmajan, chief global strategist at Morgan Stanley Investment Management, expressed well the majority opinion of economists in his New York Times opinion editorial. He correctly observed two objective phenomena - (1) a slowdown in demographic growth with lower birth dates, and (2) a declining labor participation rate with the retirement of more and more baby boomers. These, he noted, are causative factors that will continue irrespective of public policy.
That leaves only changes in labor productivity to generate future levels of GDP growth. If population growth remains at about 1.0%, and the labor participation rate remains flat, labor productivity must increase by 2.0% to generate a growth rate of 3.0%. And Trump's promises would require labor productivity increases in the range of unprecedented. But there's a problem. Growth models from the past might not provide us with adequate guidance in today's economy, and Sharmajan's article reflects a little too much dependency on a past that has changed.
Sharmajan, along with many mainstream economists, claims that goosing productivity will result in increased debt and inflation. These things impact, above all, economic stability. My own models suggest that debt and money supply (and sometimes monetary velocity) drive inflation, but both views are really too simple.
Why? Inflation comes in two flavors - cost-push and demand-pull. Cost-push inflation can come from excess liquidity that gets deposited in commodities and investment capital, pushing prices higher; we've seen some of this since 2009 with loose monetary policy. But demand-pull is different - it requires an increase in aggregate demand. As economic inequality has risen and become institutionalized - especially since the Reagan years - we've seen very little of this kind of inflation.
So if not inflation, what happens when you try to goose productivity through fiscal or monetary stimulation? So far, we've seen policies and proposals that channel this stimulus through corporate enterprise via tax cuts, low interest, and direct spending. Companies then invest the extra money, which is the goal of the policy; in years gone by it might have resulted in real economic growth.
But here's the thing. We've got to look at how and where capital investments are made. Choose from among these things: (1) mergers and acquisitions; (2) stock buybacks; (3) capacity increases; (4) labor productivity; and (5) new products and services. It's important to understand that only one of these categories can result in real and significant economic growth - new products and services for which there is potential demand. None of the others work in the conventional model to support aggregate demand!
Productivity investments reduce the labor content of products and services, and can do only one of two things in the economy. (1) They can enable the production of more goods and services with the same employment of labor. (2) They can enable the production of the same goods and services with less employment of labor. The first requires the existing promise of demand growth for the goods and services produced, and that's the problem.
As labor is taken out of goods and services through the process of capital investment, capital's share of GDP rises and labor's share declines. When labor's share of the economy declines, so does aggregate demand. Workers and their families spend a much higher percentage of their income than do rich people - capitalists. Aggregate demand is what drives every aspect of the economy, including capital investment, productivity, and inflation. And increasing income inequality inhibits aggregate demand.
So if the government tries to goose economic growth through monetary and fiscal policy, it addresses the capital share of GDP while largely ignoring the labor share. The problem here is economic equity, or the distribution of income and wealth. At today's level of economic inequality, aggregate demand will continue to decline under the policies embraced by the administration. A model that predicts growth and inflation discounts the effect of declining labor participation as a direct consequence of subsidized capital investment. And that's the point that Sharmajan misses.
A more likely consequence of goosing growth through monetary and fiscal policy is continued lethargy while huge pools of unspent liquidity build up among corporations and wealthy individuals - all while the large majority of the labor force loses buying power through job losses and wage suppression.
The end game? Consider where we're headed. As capital investment is supported by public policy, more investments are made. Each next investment presents a little higher risk and/or a little lower return than the previous investment; the best investments are always the first on the table. And since capital investments tend to replace variable costs with fixed costs, the dependency upon aggregate demand - revenues - increases. As capital chases growth, the aggregate risk within the macro-economy rises, built on the foundational expectation of a growing aggregate demand that is threatened by the very process of capital investment.