Income Inequality, Population Aging and Economic Stagnation

In a 1938 paper, economist Alvin Hansen had argued that the post-Great Depression economy of the United States could be in secular stagnation – an economic condition where growth is low or negligible because of low population growth rate and reduced immigration. He proved to be wrong because of Keynesian policies to recover from the Depression-era economy and the post-war baby boom years which significantly raised the population growth. But Hansen could be correct now: developed economies could be experiencing secular stagnation due to a different set of conditions.

Economic growth in advanced countries after the Great Recession of 2007-2008 has been anemic. In the presence of austerity measures and, therefore, in the absence of any significant fiscal expansion (fiscal expansion being a Keynesian policy prescription), economic recovery has been slow and prolonged despite quantitative easing and zero and negative interest rate policies of central banks.

Advanced countries are experiencing two phenomena at the same time: income inequality is rising and the working population is aging. Both of these trends do not bode well for consumption which makes up close to 70% of the gross domestic products (GDPs) of these countries. As income inequality rises, lower and middle income portions of the population whose marginal propensity to consume (MPC) is higher than that of the upper income group will not have sufficient disposable income to spend thus putting a downward pressure on consumption. Also, once in retirement, bulk of the aging population will have less income, their capacity to take on new debt will be significantly less, and will not be able to consume as they had during their earning years.

Despite the expected tendency to consume less because of lower and uncertain incomes in the face of rising income inequality, majority of the households in lower to middle income quintiles have thus far spent more than they could afford by raising their debt-to-income ratios until the housing bubble burst. The ensuing financial crisis has crimped debt-driven spending, further dampening GDP growth in advanced countries for the foreseeable future.

Then, what to do about secular stagnation? Keynesian policy prescriptions actually work. First, income redistribution is necessary. A tax policy which taxes the wealthy to provide quality public education and healthcare for the rest of the society is needed. More importantly, wages have to be made less unequal by a tax policy which ensures equitable wage distribution in the corporate sector through more socially responsible corporate governance. Also, expansionary fiscal policy that raises government investment in public works and infrastructure to renew it and to create jobs should work just as it did in response to the Great Depression though the short-term boost any economy receives from war should be avoided (it has been argued that primarily the US entry into World War II had put the United States back on a growth path more than public works).

The world is experiencing a paradigm shift in how it uses energy and water, two critical resources for economic development and growth. All governments around the world would be wise to incur tax expenditures to incentivize the ongoing transformation so that fiscal policy is in support of and in coherence with the expansionary monetary policy that is underway globally to make monetary easing more effective by showing avenues where the private sector can gainfully invest and be an important part of the long term structural change the global economy is undergoing.

That fiscal policy has not adequately or not at all supported monetary expansion in the post-financial crisis period since 2009 is a fact. This must change if the developed world is to extricate itself from grip of both income inequality and the consequent secular stagnation because the financial cycle which is ahead of the economic cycle in the United States faces the danger of collapsing at some point, despite the extraordinary monetary policy, if economic growth does not support the high private corporate valuations.

Are We Facing a Permanent Rise in Income Disparity?

In the 1950s and 1960s, economist Simon Kuznets had advanced the hypothesis that as an economy develops, income inequality first rises and then falls. An inverted U-curve, also known as the Kuznets Curve, graphing income inequality on the Y-axis and income-per-capita on the X-axis depicts the Kuznets’ hypothesis. Kuznets was describing the effects of structural changes in the economy caused by industrialization and the attendant shift from agriculture to industry and migration of labor from rural to urban areas. More broadly, the Kuznets Curve is helpful in understanding the distributional effects of technological change: as technological change happens income inequality initially rises because of the need for new skills and labor displacement by new technologies – also known as technological unemployment – and it later falls as labor adjusts to new technologies by acquiring new skills and wages rise. Productivity increases and economic growth rises over the period of the Kuznets Curve.

Kuznets Curve

Kuznets Curve

Income disparity has steadily increased since 1969 because of innovations in computing and financial services. The 40-year period from 1969 to around 2009 has been dubbed the Third Industrial Revolution. The First Industrial Revolution of 1784 was brought about by technological advances in steam, water and mechanization of production. The Second Industrial Revolution of 1870 consisted of division of labor, electricity and mass production. In all three industrial revolutions short-term disruptions of the labor market by new technologies gave rise to technological unemployment and later, typically in a generation’s time (roughly 18 years), as labor acquired new skills to suit the new structure of the economy, wages rose and income inequality narrowed.

We are once again in a period of profound technological change, but this time there is pervasive anxiety that it could be different from past such changes. The Fourth Industrial Revolution, as the zeitgeist is called, is producing cyber-physical systems blurring the line between the physical, digital and biological spheres. With the focus in the information technology sector shifting to artificial intelligence, futurists are speculating about the coming singularity where machine intelligence surpasses human intelligence by the year 2050, becoming self-aware with the capacity to replicate and improve itself autonomously.

It has been estimated that computerization by artificial intelligence and robotics could displace 47% of total US employment. However, this technological unemployment could be different from technological unemployment during past industrial revolutions because intelligent machines could permanently displace human labor, and the total number of jobs created – because new technologies could require much higher skill levels – could be far fewer in number than the total employment needs of a country. Productivity could rise substantially, economic growth could also rise, but at a high level of income inequality in an economy where every job from analytics and financial trading to accounting and routine secretarial work could be automated by the year 2050 in developed economies. There could be a wide gulf between high skill/high pay and low skill/low pay jobs in an economy, exacerbating income disparity.

The contribution of this article to the literature on economic growth and income inequality is that the exponential nature of technological advancement during this Fourth Industrial Revolution could lead to permanently high income inequality in contrast to the Kuznets Curve hypothesis. It is, therefore, little surprise that ideas such as Universal Basic Income (UBI) are being entertained by developed economies so that poverty does not increase substantially due to permanent displacement caused by technological change.

Is the Growth Story of the United States Essentially Over?

Well known Financial Times’ economics commentator Martin Wolf concludes his opinion piece on global growth “An end to facile optimism about the future” by saying that “[t]he view that steady and rapid rises in the standard of living must endure is a pious hope. The tendency to believe that some “structural reforms” will fix this is, similarly, an act of faith. It is essential for policy to promote invention and innovation, so far as it can. But we must not assume an easy return to the long-lost era of dynamism. Meanwhile, the maldistribution of the gains from what growth we have is a growing challenge. These are harsh times.” Wolf, in his article, was opining on Robert Gordon’s book “The Rise and Fall of American Growth” which documents and analyzes US economic development and growth from 1870 to 1970 and the subsequent slow down: Gordon says that invention and innovation in the US have not had the same impact on both standard of living and quality of life since 1970 as they had between 1870 and 1970 and that he does not expect them to in the future.

A quick look at the US economy shows that most of American growth comes from within its borders. It has been a long while since America’s net exports in its gross domestic product (GDP) have been positive. Since about 1981 the United States has always imported more than it exported and net exports have been a drag on US GDP. International trade became a foreign policy tool for the US by entering into trade agreements which were largely pacts to import foreign goods and services in exchange for advancing US interests such as democracy and market economics. The opening of China by Nixon and China’s rise since then and the North American Free Trade Agreement (NAFTA) are salient examples of US trade and foreign policies. Two generations of such trade and foreign policies since 1981 have taken their toll on the American middle class and resistance to them, which began with the defeat of George H.W. Bush in 1992 by Bill Clinton, is now peaking in the society leading to the rise of the likes of Bernie Sanders and Donald Trump. The American growth story may not, however, be over.

Invention and innovation in the United States may not be of the same nature as they have been between 1870 and 1970, but equitable implementation of the idea that large developing countries such as China and India can grow with the help of free trade is sufficient to contribute to the growth of both America and the rest of the world. The opening of other economies to existing American technology and business models for their domestic development is a win-win for America and the rest of the world: billions of new consumers, as development creates new middle classes elsewhere, will be added to the global economy benefiting American multinational corporations and the domestic populations in the rest of the world. The key to such robust growth in America and the rest of the world in a manner that is sustainable requires the evolution of institutions of democracy and open market economics. We are increasingly seeing the interdependence of capital and product markets worldwide. As this happens one would only see benefits of it accruing to America and the rest.

The only path, besides government policies encouraging invention and innovation, to continued rise in the standards of living in America, and the developed countries in general, is to promote development in the rest of the world and to ensure that the gains from this are equitably distributed.

These are not harsh times but times of profound and hopeful change in the world where countless people are aspiring to better their lives by not only accessing the same inventions and innovations which have benefited America between 1870 and 1970 and thereafter but also themselves eager to invent and innovate.

The Global Economy and Market Dynamics

Volatility has characterized the global financial markets thus far in 2016. Slow growth in two successive quarters in the United States beginning in the last quarter of 2015 and continuing into the first quarter of 2016 and weak economies in most of the rest of the world has sapped market confidence in the global economy. The US Federal Reserve’s decision to hold back interest rate increases because of slow US growth and market volatility has not helped the markets. Brexit has shocked the global financial markets toward the end of the second quarter of 2016 reigniting worries about slow global growth. India remains the only bright spot on the global economic landscape.

US economic outlook generally tends to influence the rest of the global economy given the size of the American economy and the large role the US dollar plays in global trade. The most watched indicator of US economic health is the Fed’s outlook of the US economy and the expected reaction function of the central bank. Beginning with 2016 the Fed’s outlook has been one of uncertainty for the US economy which has made the markets volatile.

The Fed putting its expected gradual interest rate hikes on hold signaling an uncertain economic outlook both for the US and for the US in the context of the rest of the world typically depresses the US dollar relative to other currencies, oil and equities. Bond prices rise because of flight to safety and bond yields go down. Gold, typically an inflation hedge, rises as a safe haven commodity asset to hold during uncertain economic times despite inflation being low.

On a relative basis, in the current global economic context, despite slow and uncertain growth in the US, the shock of Brexit to the UK and the rest of the EU is strengthening the US dollar because of weakness in the British pound and the euro. Together with the US dollar, the Japanese yen is also acting as a safe haven currency, strengthening relative to the US dollar and other currencies despite Japan’s economic troubles. Investors are seeing the US dollar and the Japanese yen as being relatively stable compared to the uncertainty in the UK and the EU. China has reacted to the uncertainty in the UK and the EU by weakening the trading band for the Chinese yuan.

Potential risks to the global economy are currently the US and China. Recession in the US, prospect of which is low at the moment, or further slowdown or a crisis in China in an environment of already extraordinary global monetary stimulus can further lower global bond yields as bond prices rise due to flight to safety and also cause an equity sell off. Gold, in exclusion of the US dollar and the Japanese yen, could further rise and oil could fall off steeply. Such an environment might need a strong fiscal stimulus worldwide for the monetary stimulus to be effective – only further delaying the global economic recovery.

One can only hope that adverse economic conditions do not materialize in the US and in China.

Brexit

Britain has chosen to exit from the European Union (EU). Europe and the rest of the world had expected the British people to at least choose narrowly to remain in the EU. The choice to leave the EU was an unexpected result of the referendum and hence a shock for the global financial markets which have been left to come to terms with the consequences of Brexit.

The immediate reaction of the equity and currency markets has been to fall steeply in expectation of the worst case scenarios of Brexit consequences to play out: recession in the United Kingdom (UK); political turmoil in Britain as demands for the exit of Scotland and Northern Ireland from the UK resurface; the spread of political and economic contagion in EU and the Economic and Monetary Union (EMU) as other EU and EMU member countries seek to exit; and finally, the fragile economies of the EU and the global economy being pushed into recession. But really, what can be the consequences of Brexit?

UK is a small economy. It had a GDP of about 3 trillion USD in 2015. It ranks second behind Germany in Europe and mostly trades with the EU and the United States. Brexit only increases the trade friction between the UK and the EU until new trade agreements both with the EU and bilaterally with specific European countries are entered into. The exit negotiations of the UK from the EU after the invocation of Article 50 of the Lisbon Treaty are expected to take about 2 years and therefore there would be no immediate effect on trade and hence no immediate repercussions for either the UK or the EU economies.

The global economy is far too big for the temporary fall in the British pound and the euro to affect it too negatively. If anything, British and EMU goods would be cheaper for other countries thus boosting UK and EMU exports. Brexit, having come at a time of global economic slowdown, by hampering UK and EU recoveries could slow global economic recovery but will not adversely affect it.

The future of Britain could be similar to that of Norway and Switzerland. Frankfurt could become the second major financial center after London in Europe and that would be good for the continent as a whole.

Though the possibility of secession of Scotland and Northern Ireland from the UK is real, it is premature to expect the unravelling of the EU and EMU because of Brexit. To go on with the European project of ever closer economic and political union, the EU needs to focus on economic recovery to address unwarranted nationalist sentiments and requires responsible political leadership at a time of change.

The financial markets will subside in a few weeks after the Brexit shock.

China in Transition

It is difficult to talk about the Chinese economy without considering the two Chinese economies: one old and another new. China is a middle income country that is aspiring to become a high income developed nation. In this process it is gradually moving away from the drivers of growth of the past 30 years – infrastructure, construction, manufacturing, heavy industry and exports – to the new economic engines of increased domestic consumption, high technology and services.

The 13th Five-Year Plan for China’s development aims to double the size of the economy by 2020 from the 2010 level. China wants to achieve it through inclusive sustainable growth by planting one foot in the future and one in the past over the next five years: it has outlined old economy infrastructure projects while emphasizing new economy high value sectors such as high technology and research and development to boost services.

The challenges China faces are one, the debt overhang from the rapid growth of the past three decades; two, encouraging consumption in a society that is culturally biased toward saving; and three, transitioning to an innovation economy from an economy which assembles together other countries’ innovations. In the long run, keeping up domestic consumption depends upon innovation and product cycles.

As China grew into a middle income country with a per capita annual income of about USD 16,000 and a gross domestic product (GDP) of about USD 10 trillion it has become more expensive for the rest of the world to import products assembled or made in China. China’s hefty foreign exchange reserves it earned through exports have enabled China to secure resources around the world for future growth. As a result, China’s growth slowdown as it transitions from the old to the new economy which became exacerbated due to slowdown in the rest of the world economy has caused the overly supplied global commodity markets to nearly come to a screeching halt, dropping commodity prices steeply, demonstrating the impact China is having on the rest of the global economy.

Moreover, the economies of Asian countries neighboring China have also slowed down as China slowed showing the expanding trade links between China and its neighbors – as Chinese labor became more expensive, Chinese companies shifted their production to cheaper neighbors of China such as Vietnam. Also, the Chinese slowdown negatively affects the exports to China from its Asian neighbors.

From a macro perspective, a key aspect of China’s transition to a developed economy is its independence of monetary policy through a freely floating fully convertible currency – the renminbi. Such a renminbi depends on how well China transitions into a developed, high income economy.

The year 2020, should China’s president Xi Jinping’s goal of doubling living standards be realized, would be a watershed year for China as it joins the club of the wealthiest nations on earth.

U.S Unemployment and Fed Policy

Unemployment in the United States has fallen to 4.7 percent in May but the number of non-farm payroll jobs created in May was a paltry 38,000, far below the expectation of about 160,000. The low unemployment number is thus not because more people found jobs but because people dropped out of looking for jobs and, therefore, were not counted among the unemployed. A measure of unemployment which includes those who dropped out of searching for jobs stood at 9.7 percent.

Fed policy makers, including Fed Chair Janet Yellen, in public remarks, expressed the opinion that the Federal Open Market Committee (FOMC) could raise the federal funds rate sometime this summer because the U.S economy is growing and the labor market is tightening. Many now think that the May jobs report clouds the outlook for any interest rate increase in the coming three months because far fewer jobs than expected were created and the labor participation rate has decreased.

The decision facing the FOMC for the June meeting is to interpret the May jobs report as whether far fewer jobs than expected were created because the economy is at full employment or aggregate demand has weakened, substantially slowing hiring.

U.S GDP growth during the first quarter of 2016 was at a modest 0.8 percent while reliable forecasts for the second quarter – based on incoming data by both the Federal Reserve Bank of New York and Federal Reserve Bank of Atlanta – are exceeding 2 percent. In fact, the Federal Reserve Bank of New York’s “Nowcast” for the third quarter of 2016 is also exceeding 2 percent. U.S GDP outlook for the next 2 quarters based on incoming data, including personal consumption expenditures, is thus looking more robust than the GDP growth for the first quarter and is close to the potential growth rate for the United States. The forecast data does not portend a slowdown. Further, inflation is hovering close to but below the Fed’s target of 2 percent.

Though consumer sentiment presents a mixed picture for the summer months with data coming in below expectations, consumers are engaging in precautionary saving behavior and household wealth has increased because of a rise in home prices. Personal consumption expenditures and consumer sentiment do not point to any upcoming weakness in aggregate demand.

Given the data, the best interpretation of the May jobs report seems to be the behavior of the economy at full employment. Unless broader economic conditions deteriorate, the Federal Reserve can stay on course to raising the federal funds rate sometime this summer because, despite any small increase, monetary accommodation would continue to remain extraordinary.

Wages and Inflation

Disinflation and deflation have characterized the group of seven (G7) economies since the financial crisis of 2007-2008 despite the environment of extraordinary monetary easing. The rate of increase of prices slowed (disinflation) or prices fell (deflation) while the expectation of policy makers has been that more money chasing the same goods and services would drive up their prices for the overall inflation to reach the inflation targets of the central banks.

With the G7 economies stuck in a liquidity trap, cash from the very loose monetary policies is being hoarded with the central banks by the member banks of central banks.

Corporations are raising cash by issuing corporate bonds at very low yields and buying back their stocks with the cash and with their profits to increase their stock prices and valuations.

More money is thus not chasing the same goods and services to raise prices but it is either being unused in the vaults of central banks or is raising the stock prices of public corporations. In the United States there is also fear of a bubble in the venture capital market because of sky high valuations of startup companies.

In the real sector, inflation is rising slowly because of low energy prices due to slow growth of the global economy. The issue of the times is how to increase inflation back to the targets of the G7 central banks.

Technological change is causing capital to substitute for labor. Machines and robots are replacing or are increasingly complementing the work force. This is a trend that has only just begun. It is keeping a lid on wages and, hence, on prices. Labor has less bargaining power and corporations are not feeling upward pressure on wages.

It is possible that the structure of the economy is fundamentally changing in the G7 countries in a manner that is structurally containing inflation by constraining wages and prices. There is no incentive for corporations to raise wages which is, therefore, slowing price increases.

While wages in the financial and technology sectors are high relative to other sectors but not necessarily rising, wages in the rest of the economy are flat. Advancing technology is making every sector, including finance, ripe for disruption in a manner that brings goods and services to the masses at low prices.

Wages, the primary driver of inflation, are not rising and so is not inflation.

Exploiting the Inefficiencies in the Stock Market

Efficient market hypothesis has been widely accepted by academic financial economists while financial market participants have been trying to predict future prices of stocks from past stock data or from fundamental analysis, which is the analysis of financial information such as company earnings and asset values to pick “undervalued” stocks, for the investors to achieve returns greater than those that could be obtained by holding a randomly selected portfolio of individual stocks, at least not with comparable risk.

The idea of “random walk” is associated with the efficient market hypothesis. Random walk characterizes a price series where subsequent prices randomly depart from previous prices. The logic of random walk is that if the flow of information is unimpeded and the information is reflected in the stock prices without delay, past stock prices would be uncorrelated to future stock prices because new information is unpredictable. Therefore, because prices of stocks immediately incorporate all known information, uninformed investors buying a diversified portfolio will obtain a rate of return comparable to that obtained by experts.

The stock markets, however, are not perfectly efficient. If they were there would not be any incentive for professionals to uncover the information that gets so quickly reflected in market prices. Market participants make mistakes and are not perfectly rational in their judgments resulting in pricing irregularities and even predictable patterns in stock returns which could persist for short periods of time. Though such departures from efficiency of the stock markets should not be misunderstood as the abandonment of the efficient market hypothesis, increasingly sophisticated mathematical and statistical techniques are being used by experts to exploit the temporary market inefficiencies for financial gains that beat the market.

Despite the proliferation of quantitative analysts in the past two decades and the digital computing (DC) power that is being employed in the pursuit of returns, some problems in computational finance are intractable for digital computers. Examples of such problems are dynamic portfolio optimization, clustering, scenario analysis, and options pricing. Quantum Computing (QC) offers the promise of solving these problems in a matter of days rather than in years.

Every time a large asset manger rebalances his portfolio, investors lose considerable money in transaction costs and in price impact or slippage. QC could find a portfolio that is globally optimal over multiple investment horizons thus significantly reducing the need for rebalancing and its associated losses. Further, QC can starve high frequency algorithms that prey on rebalancing. QC can not only compute faster than DC, in fact, DC cannot solve, for example, the rebalancing problem.

QC will disrupt finance in a few years just as DC transformed finance decades ago.

Will a Recession Occur Under Extraordinary Monetary Accommodation? Lessons From the Case of Japan

The Japanese economy is once again skirting a recession despite the extraordinarily accommodative monetary policy from the Bank of Japan. Investors have preferred the flight to safety of Japanese Government Bonds (JGBs) even though the buyers of the bonds have to pay the Japanese government to hold them because of the current regime of negative nominal interest rates. On the demand side, consumers are not spending, depressing aggregate demand.

Japan is stuck in a liquidity trap where holding cash appears to be safer than investing it given, in particular, the external environment of the global economy which is weak to sustain an exporter such as Japan. Raising the value added tax (VAT) did not help because it amounted to contractionary fiscal policy and depressed growth.

A lack of wage increases is making inflation both too high and too low at the same time: it is high enough to eat into the purchasing power of workers’ wages which are not rising and it is low enough to push the economy back into deflation if consumers do not spend.

The case of Japan tells us that even an environment of extraordinary monetary expansion – in the overall economic context described above – cannot prevent an economy from slipping back into a recession. The three arrows of Abenomics – fiscal expansion, monetary easing and structural reform – can only take hold if they complement each other to achieve specific economic goals.

The macroeconomic policy experience of Japan applies to Europe as well which is in a similar situation with low inflation and low growth. Europe needs its own version of Abenomics led by Germany.

Absent external shocks, with oil prices being low, no bubble in financial asset prices, and little dependence of the US economy – unlike Germany, China or Japan – on exports, the highly accommodative monetary policy in the US should continue to enable the 83-month old expansion though there are some symptoms of the emergence of a liquidity trap in the US because of very high excess reserves of banks with the Fed.

To prevent a liquidity trap, while continuing to very gradually raise interest rates, the Fed must stop paying interest on excess reserves. It must also stop rolling over treasuries upon their maturity to begin, extremely gradually, shrinking its large balance sheet.

Japan’s experience shows that it is not sufficient to simply provide an extraordinarily accommodative monetary policy environment in a context of deflation or potential deflation. Without public investment it would not have been sufficient had the US Fed during the Great Depression provided monetary stimulus.

The only way to achieving economic recovery and the inflation target for any country is for monetary and fiscal policies to work in tandem to raise private and public investment in the economy while keeping the budget in check.