Thursday, April 24, 2014
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What’s Stopping Robust Recovery?

MILAN – The growth map of the global economy is relatively clear. The US is in a partial recovery, with growth at 1.5-2% and lagging employment. Europe as a whole is barely above zero growth, with large variations among countries, though with some evidence of painful re-convergence, at least in terms of nominal unit labor costs. China’s growth, meanwhile, is leveling off at 7%, with other developing countries preparing for higher interest rates.

Many advanced economies must still address the end of the pre-crisis growth pattern generated by excessive domestic demand. In such economies, that pattern not only typically depended on leverage; it also enlarged the non-tradable side of the economy and shrank the tradable side. And yet, given that the non-tradable sector is constrained by its reliance on domestic demand, recovery – if it comes – will depend on the tradable sector’s growth potential.

To realize that potential, the tradable sector has to re-expand at the margin: as a weakening currency causes imports to fall and real unit labor costs decline as nominal wages flatten out, unemployed labor and capital flow toward external markets for goods, services, and resources.

This is already happening in the United States, where exports are above their previous peak while imports remain subdued; the current-account deficit is declining; and even net employment in the tradable sector is increasing (for the first time in two decades). Indeed, recent data suggest that more than half of the acceleration in US growth is occurring on the tradable side, even though it accounts for only about one-third of the economy. And that contribution is probably an underestimate, because income generated on the tradable supply side produces income that becomes demand on the non-tradable side – a multiplier effect that crosses the tradable/non-tradable boundary.

The US economy is relatively flexible, and this kind of structural adjustment in the private sector occurs reasonably quickly. And yet employment still lags, owing to longer-term factors like labor-saving technology and reconfigurations of global supply chains, in which lower-value-added segments and functions tend to be concentrated in lower-income countries.

One reason the US recovery is only partial is fiscal drag, a lingering effect of the post-2008 downturn, which shifted some leverage to the public sector, resulting in a growing debt burden that has been addressed – controversially so – by immediate austerity.

But the main problem is that public-sector investment remains well below growth-sustaining levels. The hard part of fully realizing potential growth is shifting the composition of domestic demand from consumption to investment without adding leverage. That means paying for it on the public-sector side, via taxes and a reduction in household consumption (and in wealth accumulation).

It also means getting the balance between domestic and external demand right, and appreciating the sensitivity of medium- and long-term growth to the composition (and size) of domestic aggregate demand. Against this background, monetary policymakers must be cautious, because low interest rates can shift the growth model back toward leverage and domestic consumer demand, stalling the structural shift to the tradable side that is underway.

Several European countries also became too dependent on domestic demand and need to rebalance toward the tradable side. But the challenge for them is much bigger and the process slower. In the first decade of the euro, nominal unit labor costs rose sharply in Greece, Ireland, Italy, Portugal, and Spain, while virtually flatlining in Germany. Absent the common currency, these divergences would have been accompanied by exchange-rate adjustments – certainly after (and perhaps even before) the pattern of excessive leverage and domestic demand ended.

But such adjustments cannot happen in a monetary union, so unit labor costs are slowly re-converging via a protracted process of flat nominal wage growth and slowly declining real wages (a process that would be quicker with higher inflation in Germany and Northern Europe). With domestic demand in short supply, this slow road essentially postpones or impedes growth via expansion of the tradable sector.

The speed of structural adjustment is also strongly influenced by how easily employment can shift from an economy’s non-tradable to its tradable side and across segments of global supply chains. Countries’ degree of labor-market flexibility varies considerably, and the reforms that increase it are critically important. For example, the German reforms of 2003-2006 increased flexibility significantly (though in a more benign global and eurozone setting).

Much is made of Germany’s large current-account surpluses. But, just as the eurozone’s struggling economies have an overvalued currency, Germany has an undervalued one, which tends to produce external surpluses and, by definition, an excess of savings over investment.

An undervalued currency also tends to produce an unbalanced growth model of the opposite kind: an outsize tradable sector and insufficient domestic aggregate demand. Because the non-tradable sector in advanced economies tends to create more jobs, this model can lead to an employment problem (even if it is partly masked by cutting hours rather than workers).

In principle, Germany could try to boost domestic demand by leveraging up; but, unless the exchange rate adjusts upward to shrink the tradable sector at the margin, doing so would be inflationary. The European Central Bank would then have to intervene to maintain the credibility of its commitment to price stability, which is its primary mandate. It is little wonder that Germany finds it difficult to achieve a sustainable pattern of balanced growth in the eurozone as it is currently configured.

Anyone familiar with China’s structural shifts on the supply and demand side will recognize some similarities with the German case.

The main point is that restoring growth requires a careful analysis of structural balance, attention to demand constraints in the non-tradable sector, and a focus on the impediments to expanding the tradable sector. Some of those impediments are supply-side rigidities; others have more to do with bloated domestic demand. Neither can be ignored if robust recovery is to be achieved.

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  1. CommentedRobert Mullen

    It is bad logic to say "an outsize trading sector hurts employment growth because the non-tradable sector tends to create more job." This is just a indirect way of saying the productivity of the non-tradable sector is lower that that of the tradable sector. Thus our advice to Germany and China amounts to suggesting they run their economies more inefficiently, more like the US.

  2. CommentedJose araujo

    IMHO, excess leverage is a symptom of excess savings, which is a sign of demand shock. IMHO excess leverage isn't dragging the economy, lack of demand is. The trick IMHO is how to convert savings into demand, and once demand grows investments will also grow. To accomplish this, policies must be taken in order to punish unproductive capital and force it to enter the economy by direct public consumption or taxing idle capital or monetary expansion.

    The main problem we are facing is risk aversion and the change in the price of risk. Now we have been trying to reduce this price but it is not working because interest rates cannot be negative, it’s now time to either tax savings harder or expand monetary base to fuel consumption.

    1. CommentedJose araujo

      I beg to disagree, we have infinite supply of capital, in the limit, money supply can extend to infinite with the push of a button.

      With 20% of unemployment and higher youth unemployment its absurd to say that supply is the constrain., we are facing a demand shock, not a supply problem.

      Also debt, its supposed to affect demand, not supply, draging demand down is the common explanation, although I don't think that is debt dragging demand but unemployment and austerity.

    2. CommentedTejas Wolf

      There is no such thing as "excess savings". Savings is investment and there is never enough productive capital around. We have an infinite demand for productive capital and thus for savings.
      There is never a lack of demand as Keynesians would have it. Demand is infinite. The constraint is always the supply.
      The reason why the recovery is sluggish is because "debt expansion", which was the main growth driver of the past couple of decades is missing or partially missing.

  3. CommentedRalph Musgrave

    Spence claims: “Many advanced economies must still address the end of the pre-crisis growth pattern generated by excessive domestic demand.” Er, no. Prior to the crises there was no “excessive demand”: if there had been, there’d have been excessive inflation. And there wasn’t. However, there certainly was “excessive demand” in a particular sector: housing. Spence’s article contains further blunders, but I just don’t have time.

    1. CommentedTejas Wolf

      There was no inflation if by inflation you mean a sustained increase in the consumer price index. However, there was massive asset price inflation in the period till 2007 - and there is again massive asset price inflation.

  4. CommentedProcyon Mukherjee

    This is an excellent article which summarizes the issues brilliantly. My only question is that the tradable versus non-tradable sector analyses for the developed world should not be stereotyped into a framework where we conjecture as if the non-tradable sector is the preferred one for employment generation. In fact it is not, it is the problem rather than a solution. That Germany has a healthy tradable sector and continues to benefit from it should not be construed as a weakness. The reference to China in this regard, although somewhat similar, is actually not quite so. The steep wage increase that China has embarked on, and which is dissimilar to Germany, is preponing the advance of Lewis Point, something which would change the dynamics of trade-savings-demand in China.

  5. CommentedZsolt Hermann

    In a very simplified way we could look at what is happening to humanity the following way: Initially we place a certain number of independent cells into a petri dish. The cells start multiplying, spreading, growing, occasionally they get into contact but then either they have some positive or negative interactions with each other or simply move aside, giving each others space. But after a while there is not much more space until the cells reach a state when they have saturated, filled up the whole petri dish and there is nowhere else to grow, expand to, they are side by side, moreover they overlap.. What can the cells do to survive? If they continue the previous, present type of quantitative growth, expansion they have to start "eating" each other' killing the other cells to create more space, or they can start communicating with each other, building more and more complex interconnections, learn how to cooperate in a mutually complementing manner and thus create instead of the previously isolated, independent single cell organisms a qualitatively much higher level, much more intelligent and capable multi-cell organism that has a incomparably higher chance of survival. What is stopping robust recovery? The fact that we choose to remain isolated, independent, competing single cells, or a collection of a few cell instead of choosing to become this mutually interconnected and cooperating super-organism with infinite potential.

  6. CommentedStamatis Kavvadias

    Where are the comments from last week????
    Is this site useful at all?

    1. CommentedStamatis Kavvadias

      In what way would reduced taxes "curtail the export drive"? You mean it would curtail Germany's surplus by adding to consumption and growth. If you assume that imports would rise, which is likely, this would not reduce exports in any way.

    2. CommentedStamatis Kavvadias

      What is nonsense is what you mumble here. There is no reason for having a surplus other than not spending it. There is no reason Germany did not spend its surplus (e.g. to tax cuts) other than hoarding! If you could see any other reason you would say it, instead of trying to lecture me.

    3. CommentedTejas Wolf

      This is really, I mean really wrong what you wrote there. Germany is not "hording" and Germany is not pursuing some kind of mercantilistic policies. Quite the oppisite is true. Those who accuse Germany of prospering at the expense of others are in a mercantilistic and protectionist mind-set. The reason why Germany has a current account surplus is twofold: high productivity and an undervalued exchange rate. The EUR has forced Germany on a trade-orientation that meant that the export share of GDP has doubled in the past 15 years. Germany is not competing with the other eurozone countries but with producers in Asia and Latam, meaning that German producers must keep a very close watch on labor costs. Any talk of boosting wages, lowering taxes and so on to stimulate domestic demand and curtail the export drive is complete nonsense.

    4. CommentedStamatis Kavvadias

      This article seems biased.

      Why is it that countries should turn to the tradable sector? Growth of the tradable sector depends on global aggregate demand, which is low because of developed country indebtedness. Stiglitz argues, to the contrary, that we face the need for transition to economies based on services.

      The author argues that "The hard part of fully realizing potential growth is shifting the composition of domestic demand from consumption to investment without adding leverage. That means paying for it on the public-sector side, via taxes and a reduction in household consumption (and in wealth accumulation)." But when it comes to Germany, he forgets the reverse of his argument and says "It is little wonder that Germany finds it difficult to achieve a sustainable pattern of balanced growth in the eurozone as it is currently configured." What stops Germany (or other northern surplus countries) from exploiting its surplus by reducing taxes, so that disposable income is increased? This would lead to more growth and a better situation for the whole of eurozone and, in fact, the world!

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