Wall Street's Best Minds


The Hole in the Middle of the U.S. Economy


BlackRock's chief investment strategist explains why this economic recovery is so lackluster.

Despite the encouraging jobs report in November and the upward revisions to third-quarter's gross domestic product, the economic recovery continues to feel uninspiring. Indeed, by most measures, the recovery that began in 2009 has been a disappointment. And one area in particular stands out as a letdown: household spending.

Much has been written dissecting this recovery, but less noticed is the fact that four years into the recovery, household spending is still weak. In third quarter, consumption fell to an annualized rate of 1.4%, a four-year low and less than half the long-term average. Why is it so lackluster – and is it a short-term event, or does this represent a longer-term trend? And why is this so important?

Consumer spending has long been the lifeblood of the U.S. economy. It is fair to say that other countries like to shop, but the United States has long done consumption better than anyone. For most of the post-WWII period, spending rose faster in boom times and dipped in recessions, but the overall trend was always higher. 

Initially, rising consumption following WWII was fueled by rising incomes, but even during periods of stagnant income growth consumers usually found a way to spend. And during the late 1990s and the first seven years of the 2000s, consumers were able to juice their consumption through borrowing.

But since the recession ended, spending has never rebounded as expected. U.S. real personal consumption has grown annually at around 2% since the end of the recession, well below the long-term average of nearly 3.5%. We have even seen more evidence of this with the holiday shopping season, when it was widely noted that sales on Black Friday were actually down this year.

The persistent weakness in consumption is somewhat puzzling. After all, consumer debt is slowly normalizing, household wealth recently hit a peak and the housing market is roaring back to life.

In fact, behind the weak spending is a troubling, longer-term trend: stagnant income growth. Personal income, adjusted for inflation, grew at an annualized rate of less than 1% during the first eight months of 2013. Not only is this below the 50-year average of 3.25%, it also compares poorly with the already anemic levels of the post-recession environment

But income growth has been moving in the wrong direction for some time. For most households, real income peaked somewhere between 1998 and 2000. Once you adjust for inflation, the vast majority of U.S. households have been contending with stagnant or declining incomes for well over a decade.

While consumers can, and often do, spend more than they make, ultimately, income drives consumption. In short, without faster income growth, it will be difficult for household spending, and hence the broader economy, to match its long-term growth rate.

Unfortunately, there are a number of longer-term trends that are, not all of them cyclical, impeding income growth. Four in particular are worth discussing:

Declining productivity. U.S. productivity growth is slower than it used to be. While there was a temporary surge in productivity in the mid-1990s, U.S. productivity growth has reverted to the levels of the 1970s and 1980s. Why this declinewhich predates the recession -- has occurred is not quite clear, but productivity gains are the ultimate driver of sustainable wage growth.

Global competition. Since the late 1990s, U.S. workers have faced a flood of competition from countries that had previously been cut off from the global economy. Recent developments, such as rising Chinese wages, may slow this trend, but it is unlikely to reverse and it will continue to exert downward pressure on U.S. incomes.

Technology. Improving technology has a beneficial impact on productivity and living standards, but it is also eliminating the demand for labor across many industries (think of factories that are increasingly staffed with robots).

Rising transfer payments. The long-term increase in government transfer payments – in other words, direct payments to individuals through social security, unemployment, disability and other benefits -- has coincided with the deceleration in income growth. Transfer payments automatically rise during a recession when income growth is weakest, but as transfer payments have risen, overall workforce participation has dropped. There are several factors contributing to this drop—changing demographics, more time spent in university and a poor labor market— but increasing generosity from Washington may also be driving down labor force participation. Fewer working Americans means that aggregate income will rise at a slower rate.

What does all this mean for the economy and investors? To begin, stagnant income growth is likely to be a headwind for consumption and overall U.S. economic growth for some time. In addition, modestly weaker income growth and spending suggests that consumer spending is likely to continue to shrink relative to other sectors of the economy, such as energy or manufacturing.

Finally, apart from the level of income growth, how it gets distributed is important. To the extent that more income accrues to the top, this trend will actually exacerbate the slowdown in spending, because the marginal propensity to consume actually decreases with income levels. And should the majority of the income continue to go to the top 1% or 10%, this could have, and arguably already is having, significant political and social ramifications – including the likelihood of policy makers pursuing well-intended but unwise economic policies. Ultimately, this could be the biggest impact of the long-term trend of weak income growth.

Koesterich is chief investment strategist with BlackRock (ticker: BLK), the largest asset-management firm in the world.

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Renminbi Rising?

Wing Thye Woo

DEC 12, 2013

Newsart for Renminbi Rising?

SHANGHAIChina is increasingly debating whether or not the renminbi should be internationalized, possibly joining the US dollar and the euro as an international vehicle currency (IVC) – that is, a currency that other countries use to denominate the prices of their traded goods and international loans. Related to this is a debate about whether Shanghai can become a first-tier international financial center (1-IFC) like London and New York.

Financial history can help to answer these questions. First, a city can become a 1-IFC only if its national currency is an IVC. But, as London’s status shows, a longtime 1-IFC can retain its position in the international financial system even if its currency is no longer an IVC.

Second, the transaction cost of using a foreign currency as a medium of exchange is inversely proportional to the extent to which that currency is used globally. Similar economies of scale characterize foreign investors’ use of a particular international financial center. As a result, there cannot be more than three or four IVCs and 1-IFCs.

Third, a country’s financial sector must be both open, with no capital-flow restrictions, and sophisticated, with a wide range of instruments and institutions. It must also be safe, with a central bank maintaining economic stability, prudential regulators keeping fraud and speculation in check, macro-prudential authorities displaying adequate financial fire-fighting capabilities, and a legal system that is predictable, transparent, and fair.

Last – and most importantsuccessful convergence to IVC and 1-IFC status requires the national economy to be strong relative to other economies for a substantial period of time. The United Kingdom occupied a position of global economic leadership for more than a century. In 1914, the US/UK GDP ratio was 2.1, but the US dollar was not an IVC, suggesting that America’s relative economic strength was inadequate. A decade later, in 1924, the ratio was 3.2 and rising – and the US dollar had eclipsed the British pound as the most important IVC.

Relative economic strength explains why the Japanese yen failed to develop into an IVC, and why Tokyowhose financial markets satisfied the relevant requirementsfailed to become a 1-IFC. With its GDP reaching only about 60% of America’s at its peak in 1991, Japan never attained the critical mass required to induce foreigners to use the yen to lower transaction costs.

Determining the future international status of the renminbi and Shanghai must begin with a calculation of China’s expected relative economic strength vis-à-vis the US under two plausible scenarios.

In the first scenario, China becomes caught in a middle-income trap, with per capita GDP stuck at 30% of America’s – an outcome that has characterized Latin America’s five largest economies since at least 1960, and Malaysia since 1994. This would put China’s economic strength relative to the US at 1.1well below the necessary ratio.

In the second, more favorable scenario, China’s per capita GDP would reach 80% of America’shigher than the 70% average rate for the five largest Western European countries since 1960 – and its economic strength relative to the US would amount to roughly 2.8. This would make the renminbi eligible for IVC status and enable Shanghai to choose whether to become a 1-IFC. But China’s economy still would not be strong enough relative to the US for natural market forces to ensure the renminbi’s international success.

Given this, the Chinese government would have to implement decisive measures to encourage international traders and creditors to price their transactions in renminbi. Specifically, China would have to use its market power to promote pricing in renminbi for relevant manufactured exports and raw-material imports, and encourage renminbi denomination of foreign financial assets that China purchases (which the country’s status as a net creditor should facilitate).

But there are serious pitfalls to avoid in this process. As the Asian financial crisis of 1997-1998 demonstrated, capital-account liberalization could lead to financial meltdowns – a danger that opponents of internationalizing the renminbi often cite. But these risks do not outweigh the potential benefits of financial openness, and they can be minimized with effective monitoring and regulation, including requirements for large capital buffers and low leverage ratios, together with strong crisis-response mechanisms, like a resolution trust corporation.

In fact, effective financial-monitoring and prudential-regulation systems do not have to precede opening the capital account. On the contrary, developing and enacting financial regulation must be a gradual process, shaped by both existing knowledge and firsthand experience. After all, no financial market is either completely open or completely closed forever; the degree of openness at a given moment depends on policy choices.

The recent establishment of the Shanghai Free Trade Zone will allow for the emergence of an offshore international financial center that offers real-world training to China’s regulators. This will give them the tools they need to recognize the signs of a developing crisis, defuse the threat, and efficiently handle the recapitalization and reorganization of failed financial institutions.

China’s pursuit of an IVC and a 1-IFC city would serve not only its own interests. Allowing the renminbi to help meet global demand for international reserves and risk diversification would also strengthen global financial stability.

There is little time to waste in internationalizing the renminbi. Given the limited number of currencies that can serve as IVCs, the failure of the renminbi to achieve IVC status before, say, the Indian rupee, the Russian ruble, or the Brazilian real could mean that the renminbi is denied IVC status – and that Shanghai fails to achieve 1-IFC status – for generations, if not forever.

Wing Thye Woo is Professor of Economics at the University of California, Davis, and at Fudan University, Shanghai, and Central University of Finance and Economics, Beijing. He is also Executive Director of the Penang Institute in Georgetown, Malaysia.

Africa’s Structural Transformation Challenge

Dani Rodrik

DEC 12, 2013
Newsart for Africa’s Structural Transformation Challenge

PRINCETON Long viewed as an economic basket case, Sub-Saharan Africa is experiencing its best growth performance since the immediate post-independence years. Natural-resource windfalls have helped, but the good news extends beyond resource-rich countries. Countries such as Ethiopia, Rwanda, and Uganda, among others, have grown at East Asian rates since the mid-1990’s. And Africa’s business and political leaders are teeming with optimism about the continent’s future.

The question is whether this performance can be sustained. So far, growth has been driven by a combination of external resources (aid, debt relief, or commodity windfalls) and the removal of some of the worst policy distortions of the past. Domestic productivity has been given a boost by an increase in demand for domestic goods and services (mostly the latter) and more efficient use of resources. The trouble is that it is not clear from whence future productivity gains will come.

The underlying problem is the weakness of these economies’ structural transformation. East Asian countries grew rapidly by replicating, in a much shorter time frame, what today’s advanced countries did following the Industrial Revolution. They turned their farmers into manufacturing workers, diversified their economies, and exported a range of increasingly sophisticated goods.

Little of this process is taking place in Africa. As researchers at the African Center for Economic Transformation in Accra, Ghana, put it, the continent is “growing rapidly, transforming slowly.”

In principle, the region’s potential for labor-intensive industrialization is great. A Chinese shoe manufacturer, for example, pays its Ethiopian workers one-tenth what it pays its workers back home. It can raise Ethiopian workers’ productivity to half or more of Chinese levels through in-house training. The savings in labor costs more than offset other incremental costs of doing business in an African environment, such as poor infrastructure and bureaucratic red tape.

But the aggregate numbers tell a worrying story. Fewer than 10% of African workers find jobs in manufacturing, and among those only a tiny fractionas low as one-tenth – are employed in modern, formal firms with adequate technology. Distressingly, there has been very little improvement in this regard, despite high growth rates. In fact, Sub-Saharan Africa is less industrialized today than it was in the 1980’s. Private investment in modern industries, especially non-resource tradables, has not increased, and remains too low to sustain structural transformation.

As in all developing countries, farmers in Africa are flocking to the cities. And yet, as a recent study from the Groningen Growth and Development Center shows, rural migrants do not end up in modern manufacturing industries, as they did in East Asia, but in services such as retail trade and distribution. Though such services have higher productivity than much of agriculture, they are not technologically dynamic in Africa and have been falling behind the world frontier.

Consider Rwanda, a much-heralded success story where GDP has increased by a whopping 9.6% per year, on average, since 1995 (with per capita incomes rising at an annual rate of 5.2%). Xinshen Diao of the International Food Policy Research Institute has shown that this growth was led by non-tradable services, in particular construction, transport, and hotels and restaurants. The public sector dominates investment, and the bulk of public investment is financed by foreign grants. Foreign aid has caused the real exchange rate to appreciate, compounding the difficulties faced by manufacturing and other tradables.

None of this is to dismiss Rwanda’s progress in reducing poverty, which reflects reforms in health, education, and the general policy environment. Without question, these improvements have raised the country’s potential income. But improved governance and human capital do not necessarily translate into economic dynamism. What Rwanda and other African countries lack are the modern, tradable industries that can turn the potential into reality by acting as the domestic engine of productivity growth.

The African economic landscape’s dominant feature – an informal sector comprising microenterprises, household production, and unofficial activities – is absorbing the growing urban labor force and acting as a social safety net. But the evidence suggests that it cannot provide the missing productive dynamism. Studies show that very few microenterprises grow beyond informality, just as the bulk of successful established firms do not start out as small, informal enterprises.

Optimists say that the good news about African structural transformation has not yet shown up in macroeconomic data. They may well be right. But if they are wrong, Africa may confront some serious difficulties in the decades ahead.

Half of Sub-Saharan Africa’s population is under 25 years of age. According to the World Bank, each year an additional five million turn 15, “crossing the threshold from childhood to adulthood.” Given the slow pace of positive structural transformation, the Bank projects that over the next decade only one in four African youth will find regular employment as a salaried worker, and that only a small fraction of those will be in the formal sector of modern enterprises.

Two decades of economic expansion in Sub-Saharan Africa have raised a young population’s expectations of good jobs without greatly expanding the capacity to deliver them. These are the conditions that make social protest and political instability likely. 

Economic planning based on simple extrapolations of recent growth will exacerbate the discrepancy. Instead, African political leaders may have to manage expectations downward, while working to increase the rate of structural transformation and social inclusion.

Dani Rodrik is Professor of Social Science at the Institute for Advanced Study, Princeton, New Jersey. He is the author of One Economics, Many Recipes: Globalization, Institutions, and Economic Growth and, most recently, The Globalization Paradox: Democracy and the Future of the World Economy.