What if the economists are all wrong on productivity?
Deflation may be hiding big gains from technological improvements
Glenn Hutchins
Productivity gains, which allow an economy to grow faster than its population, determine increases in national wealth © Tolga Akmen/AFP/Getty
A few years ago, pundits were confidently forecasting that the US Federal Reserve would soon “normalise” monetary policy by gradually raising interest rates and paring back its holdings of Treasuries and mortgage-backed securities. This would give it the freedom to reduce rates in a future crisis.
Two years on, monetary policy seems anything but normal. As rates began to trend up and the balance sheet down, the markets and the underlying real economy could not digest the change. Instead, central banks around the world have had to apply yet another dose of unconventional monetary policy — ultra-low interest rates and quantitative easing — to keep growth going.
There has been considerable hand-wringing about why productivity growth is anaemic and inflation is stubbornly low. This is important because productivity gains, which allow an economy to grow faster than its population, determine increases in national wealth. Similarly, inflation erodes wealth, so we must adjust output for it to be certain that gains are real rather than simply reflecting higher prices.
Yet there is today a “dialogue of the deaf” between Silicon Valley and the economics profession on this critical issue. Economists point to longitudinal data that shows productivity has been rising at a lethargic pace and say it shows the lack of true technology breakthroughs such as flying cars. But the tech industry looks at a world economy that is rapidly transforming from industrial to digital and argues that the changes must be causing productivity to hurtle forward at warp speed, creating widespread financial benefits.
Tech leaders also point out that they are on a mission to eradicate costs from everything everywhere. Rapidly doubling processing speeds and the use of algorithms have combined to let us use software to replace many physical activities at vastly lower expense to producers and consumers alike. Meanwhile, smartphones, ecommerce and global supply chains are driving prices down.
Digital disruption, the tech industry argues, with its ruthless efficiencies, improved price transparency and “creative destruction” of existing business models, is obvious and natural. In their eyes, what can possibly be wrong with delivering ever more value at continually lower cost? Any data that suggests otherwise must be indicative of yet another flaw of the old economy.
With that in mind, let’s go back to the question of why the global economy proved allergic to a modest tightening of interest rates. If the traditional economists are right, and real interest rates (actual levels minus inflation) are in fact hovering near zero, history would suggest that rates could have increased materially without a hitch.
Now consider the view of the techies that we do not live in an economy characterised by little productivity growth, low inflation and modest increases in gross domestic product. What if they are right that we live in an economy with rapid productivity growth, burgeoning output and relentless price drops? If such deflation was running at around 2 per cent today, real interest rates would be roughly equal to historic levels and the stubborn resistance of economic activity to increases would be unsurprising. Does this alternative view fit reality better?
Moderate deflation is not necessarily pernicious. The US economy endured bouts of deflation in the 19th century partly due to two economic shifts — the mechanisation of farms and transport, and later as industry displaced farming. In both cases, the transition substantially raised both output and living standards. But the 19th century was also afflicted by numerous severe recessions, pointing to the urgent need for a monetary policy toolkit and ultimately the creation of the US Federal Reserve.
What would we do differently in a deflating economy? First, we would prepare — operationally and psychologically — for the topsy-turvy world of negative rates in which lenders pay borrowers. The Fed’s current mandate of targeting specific inflation rates would be replaced with new measurements of purchasing power that take into account “better, faster, cheaper” technology. We would probe markets to discern the levels of nominal interest rates at which activity stalls. And we would talk about real rather than nominal rates.
Paradigm shifts require radical rethinking. Today’s economy is undergoing an epochal shock driven by technological change and globalisation. That suggests that the negative nominal rates now common in much of the world may be normal and could be with us for a long time. Policymakers must adapt their world view and tools accordingly.
The writer, a private equity investor, is chairman of North Island
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