How weak productivity can neuter monetary policy

What was seen as a cyclical problem has morphed into a supply-side constraint, writes Stephen King
Throughout the developed world, productivity growth has been remarkably weak. Even though we are faced daily with new technological gizmos, growth in output per hour has been dismal.
Admittedly, some countries have done better than others. Between 2007 and 2014, the latest year for which comparable data are available, output per hour rose more than 7 per cent across the US economy while in the UK it was broadly unchanged and in Italy it fell 2 per cent.

Yet even the “successes” are failures judged by their own history. Other than during the dark days of the early 1980s, when two recessions led to a serious, albeit temporary, loss of output, the US has never before experienced such a fallow period of productivity growth.

There are many explanations for this, including Lawrence Summers’ revival of secular stagnation, Robert Gordon’s claim that the biggest technological impacts on living standards are in the past and, for what it is worth, my own view that we are returning to economic “normality” after an extended postwar period of economic catch-up.

The Summers view is, in many ways, the most optimistic. Offer fiscal stimulus, particularly focused on infrastructure projects, in the hope that higher demand will create higher supply.

Yet the risk is that stimulus will raise government debt with no lasting benefit for the economy.

Think of Japan over the past two decades, and US stimulus after the dotcom bubble burst that triggered only a housing boom and bust with no lasting benefit for productivity growth.

Weak productivity has a corrosive impact on living standards. Should the post-financial crisis trend continue, in the US by 2021 average incomes would be 16 per cent lower than had the 2 per cent per annum postwar productivity trend been maintained. Tax revenues, healthcare, pensions, wage growth and other contributors to a nation’s welfare would be lower. Promises made across the political spectrum would have to be abandoned.

To date, attempts to boost productivity have failed. What was seen as a cyclical economic problem has morphed into a biting supply-side constraint. Worse, the stimulus aimed at boosting economic growth and limiting unemployment may have inadvertently damaged productivity performance.

Exceptionally low interest rates and quantitative easing may have lifted asset prices indiscriminately, crimping capital markets’ abilities to separate productive wheat from unproductive chaff.

Further, persistently low productivity growth may be neutering monetary policy. In a world in which growth and inflation are structurally low, interest rates will be dragged down to incredibly low levels — precisely the conditions we see today. If, however, interest rates are low on a structural basis, there is nowhere for them to go in the event of a deep recession.

In these circumstances, the entire monetary policy framework is up for grabs. Shibboleths will have to be dispensed with. At zero rates, central banks may have to work increasingly closely with finance ministries, prioritising the need for co-ordinated action over the desire for independence. Inflation targeting may have to be ditched, perhaps replaced by nominal gross domestic product targeting: a slowdown in real growth would then be countered by a commitment to higher inflation, boosting nominal GDP and limiting the risk of ever more indigestible debt.

Yet nominal GDP targeting will work only if central banks can credibly demonstrate not just their desire for higher inflation but also their ability to deliver it. To date, they have not been particularly successful. And if productivity growth is permanently lower, expectations of a life of ever-rising prosperity will have to be abandoned. If the economics are already difficult, the politics will be considerably harder.

The writer is HSBC’s senior economic adviser and author of ‘When the Money Runs Out’

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