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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.