There are number of things that make the global economic recession of 2020 different to any other we’ve seen, and while you’d never wish to go through an experience like it, there are definitely some silver linings.
The government forced the economy into recession
This was the first time in living memory that governments deliberately threw economies into recession. If you close down all but a few sectors and tell workers to stay home, obviously economic activity is going to crash.
Previous recessions have been attributable to the business cycle: typically there is a speculative build up which causes an imbalance that eventually tips over, and the worst recessions are those fueled by debt.
The standout example of this is, of course, the GFC. Building activity reached frenziewd levels in the US because buyers were able to access debt way too easily. The adjustment process was long and painful because credit, which is the lifeblood of a modern economy, all but seized up.
This time there were no baddies
When a recession is caused by excess building in some part of the economy, there is normally going to be a culprit you can point to. It might be banks, or it might be investors, but there’s a group that cops the blame and derision for crashing the economy.
That’s when the philosophy of ‘moral hazard’ argues if the culprits just get bailed out there’s no lessons learned to stop the same thing from happening again. Politicians and the media will often argue the responsible group should somehow be punished, perhaps with tighter regulations or even criminal charges.
This time (ignoring arguments about how COVID started and who or what is responsible), there is no real culprit to punish.
No holds barred support program
Because the government was responsible for switching off the economy and there was no concern about moral hazard, both they and central banks were able to throw the proverbial kitchen sink at supporting the economy.
Central bankers learned valuable lessons from the GFC that they had to make sure credit could continue to flow. The range of measures undertaken was unlike anything we’d seen before, and while things were ugly for a short time, markets were once again reminded how powerful central banks can be.
Remarkably, US financial markets have clearly recovered strongly despite the Federal Reserve barely tapping a range of the programs they announced – see chart 1 below.
Chart 1: US financial markets have recovered despite many of the Fed’s announced measures barely being utilized
By far the most important support measures were from governments. One after another, governments wre throwing massive amounts of newly created money into their economies. Programs like JobKeeper in Australia and its equivalents overseas were critical in supporting families that otherwise would have been in dire financial circumstances.
The critical part is that it was newly created money, which governments can do directly, but central banks can’t. The central bank programs can help create new money by encouraging people to borrow (loans also create money) but that was going to be tough when the media was full of stories about the global economy crashing.
This is the opposite to what happened after the GFC, where, especially in Europe, governments preached from the gospel of austerity. Spending cutbacks sucked money out of economies and saw them slow to a grinding crawl.
Economies are on fire
Some of the data showing how sharply economies are bouncing back is remarkable. Here in Australia, we’re seeing restaurant bookings up to 50-80% compared with the same time last year, new car sales leaped 12% from last year and Commonwealth Bank credit card sales were up 11%. They are huge numbers and it’s not just because lockdown restrictions were eased.
The Australian government’s COVID support programs amounted to 13% of GDP. It’s hard to overstate how massive that is. In the wake of the GFC, the Chinese government ‘rescued’ much of the developed world by announcing a spending package equivalent to 12% GDP (clearly the absolute amounts are hugely different, it’s the proportion that’s significant). The early withdrawal of superannuation adds anotehr 2% to that. The household savings ratio hit almost 20% in the June quarter, only a fraction less than the highest it’s been in the past 60 years.
That’s an awful lot of pent-up spending power.
The silver lining
Ever since the end of the GFC, central banks have pleaded with governments to raise fiscal spending to help increase economic growth. But most governments, including Australia’s, were obsessive about balancing budgets and instead were more intent on reducing spending (the obvious exception to that was $1.2 trillion Trump tax cuts, which helps explain why the US economy was doing so much better than most others).
It’s taken the unique circumstances of the pandemic to show the power of fiscal spending to drive economic activity: low income families suddenly had enough money to go to the dentist and get the car fixed, and the money they spent doing that got spent again and again.
If governments take the lessons on board, it’s possible it could be the first step toward abandoning the flawed dictums of neoliberalism and addressing the massive wealth inequalities that lie at the heart of so many other problems we face. That would be a great silver lining.
Want to take advantage of the expected economic growth?
For fear of sounding like a real nerd, anyone even remotely interested in financial markets will appreciate how exciting it is to have an audience with three international central bankers. I got that opportunity, amongst other things, this week at the twentieth anniversary of UBS’s Greater China Conference, held in Shanghai over Monday and Tuesday.
It was my first time in China, and while suggesting Shanghai is representative of China is like saying the same thing about Sydney and Australia, I did come away with a changed impression and understanding of the country; but I’ll come back to that, first the exciting stuff.
‘The new normal for the global economy’
Full credit to UBS that they were able to get three rock star central bankers for this presentation: Dr Bill Dudley is the President of the New York Federal Reserve, Dr Raghuram Rajan was the 23rd Governor of the Reserve Bank of India and the former Chief Economist and Director of Research at the IMF, and Dr Min Zhu is a former Deputy Governor of the People’s Bank of China. One thing to bear in mind, however, while these guys are super smart and extraordinarily well connected, they don’t possess a working crystal ball and what they say is still a (very well informed) best guess.
Their respective views of the ‘new normal’ were extremely close to each other: an ongoing environment of slow growth, low unemployment and low inflation – in other words, no meaningful change from what we’ve experienced over much of the past 10 years. Given the similarity of their outlooks, I can only presume that, for now at least, they don’t see anything on the horizon that’s going to cause things to change much.
To me, the most interesting part of Dr Dudley’s message was his candid acknowledgement that if interest rates are as low as they are now when the next recession hits, there’s obviously not much room to cut them in order to support a recovery. While he acknowledged central banks do have other (read unconventional) tools at their disposal, such as quantitative easing, he argued monetary policy alone will not be sufficient to pull the economy out of recession and reiterated several times they will definitely need fiscal policy, so changes in government spending, to do some, if not a lot, of the heavy lifting.
That is an identical position to most central bankers, including Australia’s Dr Philip Lowe, who have collectively been saying that monetary policy is reaching the limits of what it can do and have been pleading with governments to open their wallets and spend. Dr Rajan also said that while unemployment is very low across the world, job dissatisfaction is relatively high because the quality of a lot of those jobs is poor, and this is something fiscal policy is far better placed to address than monetary policy.
Importantly, and as you’d expect, Dr Dudley also stuck with the Fed’s current script that they are in no hurry at all to raise rates, and will be happy to let inflation in the US run above its 2% target level before they increase from the current 1.75%. That sits well with the market’s current view of where interest rates are headed and is considerably more optimistic than UBS’s US Chief Economist, who spent 14 years at the Fed, and is forecasting three rate cuts this year in response to a weakening economy.
Dr Rajan gave his rundown of what he considers to be the five major influences on economies, none of which will surprise anyone:
Technological innovation, which is increasing productivity but is also changing the nature of jobs that are available to those without higher education
Demographics, which he sees as presenting threats and opportunities
The rise of emerging nations and the need to find ways of accommodating their growth and aspirations
Inequality, which underpins the rise of populist politics
Climate change, which he also sees as presenting threats and opportunities.
Dr Min commented that all technological change is disruptive to the extent that it usually means an existing system is changed in favour of the new, and he pointed to the possibilities that 5G brings with the ‘internet of things’. It took China five years to reach some 3.7 billion 4G devices and it’s targeting all of those to be switched to 5G within 2.5 years, bringing with it the benefits of bigger, faster, fatter pipes of data.
He also believes that ageing demographics and the gradual reduction in the proportion of working age people across the developed world, which is baked in and cannot be changed quickly given it takes 18 years to make a worker, has helped to usher in an era of lower growth (the formula for growth is very simple, it’s the number of workers times how much they produce. If the number of workers goes down, you have to improve productivity if growth is to be sustained). While most commentators refer disparagingly to Japan’s decades of low growth as an example of what must be avoided, he argued it’s a miracle Japan has managed to grow at all give its demographic challenges, and the fact it has is testimony to what fiscal spending can achieve.
As to whether China can sustain its growth rate, he reckons the key is to improve the productivity of the services sector, which is now 52% of GDP. China’s industrial sector’s productivity is world class, but services productivity is about 30% below world’s best practice. In his view the solution is simple: open China’s market to more international service companies so they can learn from them. Interestingly, we heard from Dr Weng Mingbo, the Deputy Secretary General of the Shanghai Municipal Government, that Shanghai had issued 1600 new licences to financial services firms in 2019.
When asked about inflation, they tacitly acknowledged that, the thing is, we don’t really know what causes inflation to rise and fall; all the old models have had to be rethought, so it could very well return at any time, though each indicated they don’t see that being the case. Dr Dudley said he’d been surprised that US wages growth hadn’t been stronger given unemployment is at 50-year lows (there goes the Phillips Curve?), but he expects it will happen at some point and that could underwrite higher inflation. Dr Rajan responded that for a long time many economists argued inflation was led by expectations, that is, if people expect prices will rise it becomes a kind of self-fulfilling prophecy. But, once again, Japan was referenced as dispelling that myth and could serve as a leading indicator.
Again, all three of the central bankers agreed that inflation is more of a mystery than we’d thought, and Dr Dudley said the Fed is giving thought to changing to targeting a range of, say, 1.5-2% per annum, or an average of 2% over the a cycle. Both would be subtle but significant changes, quietly admitting central banks cannot control inflation with any level of precision (again, the Japanese example was raised where the Bank of Japan has failed to reach every inflation target it’s set itself over the past 20 years despite throwing everything but the proverbial kitchen sink at it).
One final interesting point from Dr Dudley, he reminded us that everyone tends to presume the next recession will look just like the last one, but it rarely ever does.
The trade war
Frankly, there was less focus on the current trade war between China and the US than I’d expected. That’s not to say people were dismissive, but it certainly didn’t dominate conversations and my sense was it’s been going long enough that we’ve probably reached the point of fatigue. Several speakers, including the central bankers, mentioned the level of uncertainty created by President Trump’s unpredictability, where a random tweet could change the course of things without warning, and while we all know markets don’t like uncertainty, there comes a point where it becomes the status quo.
Those who attended last year’s conference said the Chinese message then was ‘we’ve got to work this trade war out’, whereas this year the only dedicated session, which included Madam Fu Ying, a former Vice Minister of Foreign Affairs, saw a more assertive Chinese stance. Madam Fu more or less said it’s pleasing the two governments are finding areas of agreement, as evidenced by the ‘Phase 1’ deal that’s just been signed, but if the US wants the benefits of leadership then it has to lead.
Dr Barry Naughton, Chair of Chinese Studies at the School of Global Policy and Strategy at UCLA, all but admitted the US had underestimated the ramifications of China’s rise when he used the analogy that when China was admitted into the World Trade Organization in 2001 it was like they had a pet baby tiger they could leave the kids to play with, and they’ve come back almost 20 years later to find they have a full grown tiger on their hands.
Madam Fu said the Chinese feel the US doesn’t want China to grow and the US needs to find ways to reassure them that’s not the case, meanwhile, Dr Naughton said the US feels confused because it appears China wants to supplant the US rather than work with them.
It was Dr Rajan that raised some interesting potential consequences that could arise if a resolution or compromise isn’t found: it’s conceivable there could be a split in key areas of technology where two distinct standards develop, one Chinese sponsored the other US. That potentially means countries could be forced to choose, which then becomes a question that carries both political and commercial significance, and if that’s about something as important as, say, 5G, there could be far reaching consequences. What if the US 5G standards are inferior to China’s or years behind, where does that leave a country like Australia?
Every presentation I listened to included references to climate change and explicit acknowledgement of the effects it’s already having, but also the necessity of addressing it and what the consequences might be from doing so. It was clear the Chinese government sees it as a really big deal, or at least they talk like they do, with climate change strategies incorporated into the government’s five-year plans.
One panel discussion included Dr Li Junfeng, the First Director General of the National Centre for Climate Change Strategy and International Cooperation, who took a reasonably pragmatic approach saying China appreciates the economic challenge of transitioning away from fossil fuels, nevertheless it has set a goal of 75% renewable energy by 2050, from about 24% currently (much of which is hydro).
In terms of practical steps China is taking, it has the most electric vehicles in the world and accounts for some 90% of global production and it’s the biggest producer of PV panels and is embracing wind power too. There were signs of the commitment to its climate change strategy around Shanghai, with lots of EV’s on the road (they don’t have to pay annual licence fees) and electric Vespa-style scooters just everywhere (I saw one, admittedly far more utilitarian in its styling than a Vespa, selling for about $300 brand new).
Possibly the biggest thing that struck me was the ‘can do-ness’ of China, thanks largely to the benefit of having an autocratic government that doesn’t have to worry about being re-elected. For example, the area on the far side of the river in the photo below, which is the iconic shot of the Pudong area of Shanghai, was rice fields 30 years ago. One of the delegates, who used to work in Hong Kong, told me he’d been at a conference in Shanghai around 1990 and a government official discussed their plans to turn those rice fields into a city over the following five years. He said he laughed at the suggestion, only to find five years later the area was covered in plain, rectangular skyscrapers. What you see in the photo is, in fact, the second generation of buildings on the site, and it is now Shanghai’s financial district, boasting, amongst other things, the second highest tower in the world.
Shanghai’s Pudong financial district – it was all rice paddies 30 years ago
While the Australian government frets about ‘picking winners’ to back, and consequently resorts to ‘letting the market decide’, the Chinese government picks industries it wants to lead the world in and backs them with the full resources of the State. Thus, years ago a struggling IT company called Huawei was picked as the Chinese 5G champion and now leads the world (yes, with all the attendant controversy). While climate change was probably the single most mentioned topic at the conference, with possibly the trade war second, the advent of 5G and the implications for tech industries would have been next.
Dr Chen, of the Shanghai Municipal Government, explained they had installed 14,000 5G stations around Shanghai in a single year, with plans to accelerate that. They had also built Tesla’s new mega-factory in 12 months and the first cars have been rolling off it recently. The next target is to establish Shanghai as one of the world’s leading financial centres, thus the 1,600 new licences mentioned before. Already, Shanghai’s stock market is the fourth biggest in the world at US$4 trillion, but Hong Kong is number five at US$3.9 trillion and Shenzhen is eighth at US$2.5 trillion. If you add them together, the Chinese markets are worth a combined US$10.4 trillion, which would put it second behind the US (which admittedly dwarfs it, for now, at US$33.7 trillion for the NASDAQ and NYSE combined).
Obviously there are dark sides to the Chinese government as well. It’s confronting not to be able to pick up your phone and Google something at will and watching the BBC or CNN news involves any story on China simply disappearing from the screen. The surveillance is frightening, and what’s happening to the Uighurs is simply appalling, and the Wall Street Journal reported this week that it estimates the Chinese government has given Huawei some US$75 billion worth of subsidies, tax breaks and benefits.
Clearly there’s no way western democratic companies can compete without significant state support as well, which involves overcoming the established neo-liberal doctrine that governments should keep out of the way of the market. No doubt this will continue to be an issue for a long time to come.
One final thing I learned: I went on a guided walk of Old Shanghai, a feature of which was seeing the 400-year-old home of Madam Goh, which was on 2,300 square metres of land. The buildings are in ruins and the government has been negotiating with Madam Goh’s family for years to buy it off them. Bear in mind, this part of Shanghai is so crowded I saw an ad to rent out 4 square metres of space for about A$265 per month! I said to the guide I’d have thought the Chinese government would have just said ‘We’re taking your land’, but she looked quite shocked at the suggestion and explained the government recognises her family owns the land and they need to compensate her accordingly. Like everything though, it’s a matter of reaching agreement as to what it’s worth.
There was, of course, plenty more covered at the conference, including plenty on the financial outlook for China. Overall, I came away with a stronger conviction that China’s influence on the world is only going to grow and western companies and governments need to take notice of what can be achieved with proper government support. I’m far from starry-eyed about how that growth has been achieved in terms of the consequences for personal liberties and the environmental effects, but from a pragmatic point of view the China story is a long, long way from over.
Sometimes it’s easier to see things in pictures and the charts below give a basic but effective illustration of just what a purple patch most of the world’s major economies are in right now. After years of post-GFC stimulation, sweating over potential sovereign bond defaults, stressing about deflation and fretting about the risks of populist politics, basically all the charts are heading in the right direction at the moment… except maybe Australia’s.
They tell a reasonably consistent story of slow but positive GDP growth and strong consumer sentiment – what should be good conditions for financial markets.
One thing to remember about charts: they’re great for showing where we’ve been, but they don’t necessarily tell us where we’re going.
One of the enduring economic conundrums over the past few years has been declining real wages growth across developed nations, because if wages aren’t growing then it’s a serious headwind for an economy to grow. The strange thing is, it’s difficult to pin down a particular reason for the flat wages, and the ominous thing is, you can make an argument that the combination of technology and globalization will continue to keep the pressure on.
Weak wages growth is endemic across developed nations
The only country that’s shown strong positive wages growth across the G8 since the start of this century is, surprise! surprise!, China – see chart 1 – but even that has recently been on a downward trend.
Chart 1: Year on year real wages growth across the G8
And Australia’s wages growth started to weaken after the GFC – see chart 2.
Chart 2: Australian wage price index growth
It’s worth remembering from the outset that like all things economic, you can point to many plausible reasons to explain low wages growth; and any one of them, or combination of them, could be right – it could also easily be the subject of a book as opposed to an article.
A couple of the popular ones are:
1.Low productivity growth
This argument is essentially that companies will only pay workers more if they are actually more efficient. So if a mining company increases its profits because the iron ore price has gone up, as opposed to its workers digging more ore out of the ground, then the workers shouldn’t necessarily benefit from that increased profitability.
Chart 3 shows quite a close relationship between Australian wages growth and productivity over the past five years, but very little similarity before that. So it begs the question, why would there suddenly be a close relationship?
Chart 3: Australian unit labour costs growth
Also, while productivity growth has stagnated since the turn of the century in most developed nations – another of the great economic mysteries of our time – in Australia it’s risen about 25%. But chart 4 shows wages growth has been about half productivity growth over that time.
Chart 4: Australian real wages and productivity growth
2. Poor company profits
It makes sense that if companies aren’t making good profits they’re not going to pay higher wages. Chart 5 shows there is some relationship between company profits and wages, but it’s not a particularly close one.
Also, the wages growth line in the chart is lagged by nine months, to allow for a rise in profits to feed through to wages, but despite the sharp rise in pre-tax profits starting some 18 months ago, the latest data show Australian wages growth is, as Reserve Bank governor Philip Lowe recently noted, “the slowest since at least the mid-1960s”.
Chart 5: Australian pre-tax company profits and wages
And for a bit of longer-term perspective, chart 6 shows the share of the overall economic pie going to profits continues to trend up toward record levels, while the share going to wages is doing the opposite.
Chart 6: The share of Australian national income going to profits vs. wages
So arguments based on profits doesn’t seem to stand up either.
3. Regulatory changes
Once upon a time Australia, and much of the developed world, operated under ‘wage indexation’, but the inflationary ‘wages spiral’ of the late 1970s put an end to that.
Since the 1980s the combination of reduced union representation and successive governments on both sides of the political fence seeking to link wages growth to productivity has reshaped how wage rates are negotiated.
This actually strikes me as a more persuasive argument for the long-term reduction in labour’s bargaining power.
Technology and globalization
I have a slightly more convoluted theory on why wages growth is weak and it’s to do with the effects of technology and globalization combining to seriously undermine any bargaining leverage wage earners can wield.
About 25 years ago China set out to become the world’s factory, exploiting a vast workforce that was paid a fraction of their western counterparts. From that point the pressure on manufacturing wages grew as companies that compete against manufactured imports have to do the math: at what point does it no longer make sense to produce locally and you either have to send the work offshore or close down?
Currently about half of Australia’s manufactured imports come from low-wage countries, compared with less than 10%, 40 years ago. This is important given that 80% of the value of Australia’s imports comes from manufactured goods.
The only way developed world manufacturers could hope to compete was to increase efficiency, which has translated into replacing as many people with machines as possible and keeping down the wages of those workers that remained. Even today, with the inexorable rise in robotics and AI, the so-called ‘on-shoring’ of manufacturing back to developed countries is because those factories are largely automated and energy and logistics can be sourced cheaply enough to make it worthwhile.
That has seen the gradual elimination of well paid but low skilled manufacturing jobs where unions used to play a role in helping secure wage rises. One upshot of this for Australia has been the hollowing out of the manufacturing sector, with services now representing more than 60% of GDP and 80% of employment.
Now the unskilled and displaced are often ending up in the growing low paid services sector, such as aged care services and hospitality, which is reflected in our unemployment data: while headline unemployment over the last three years has declined to 5.5%, the underemployment rate has been trending upwards since the GFC from 6% to now be 8.5% – see chart 7.
Chart 7: Australia’s labour market – underemployment continues to trend upwards
The long reach of globalization is now starting to touch the upper end of the services sector as well, with increasing numbers of accounting firms, engineering, software development, design and what-have-you ‘off-shoring’ work to the likes of Vietnam and India. If Australian accountants and designers want to compete they either have to stay ahead on the quality curve or reduce their costs (wages).
With the rise of AI it’s not just low skilled jobs that are being targeted, rather it’s any industry where wages form a high proportion of costs. For example, in the U.S. there’s a radiology ‘robot’ that is 50% better than its human counterparts at diagnosing particular tumors, and law firms are talking about cutting the human cost of litigation from 70% to 2% by using technology.
It’s reached the point now where if labor demands higher wages for a multitude of jobs they are battling an equation that has offshore workers or robots on the other side of it. Combine that with record levels of household debt, the risk of losing a job means for big chunks of the workforce there’s not much incentive to go in hard on your annual salary review.
The benefits go to capital
The big winner from the suppression of wages is, of course, the owners of the capital, that is, the companies. As we saw above profits are strong and getting stronger.
If that’s the case it makes it all the more critical that companies pay their fair share of tax. If wages are stagnant so too will be income tax revenue yet countries like Australia face a growing welfare and healthcare burden. And yet for now countries across the world are engaged in a race to the bottom for corporate taxes; a beggar thy neighbor strategy that risks impoverishing everybody.
Like I said, there’s a multitude of reasons to account for low wages growth, and just as with most economic arguments there’s almost no way of proving which one is right. Admittedly some of the trends have not existed long enough to make anything other than assertions and it may change on a dime. I’m by no means arguing we should try to fight a rising tide, but there are seriously important issues involved that will shape our economies and societies in the years ahead.
The entire world has benefited from the Chinese economic miracle and is praying it will continue. This article by US hedge fund Crescat Capital calls China the world’s biggest ever credit bubble, and argues, like all credit bubbles, it is bound to finish ugly, with serious knock on effects to those countries leveraged to Chinese growth – like Australia.
“The China growth story is not likely a miracle of communist government central planning; it’s a massive credit bubble, almost certainly the largest ever. China’s impressive growth has come overwhelmingly and almost exclusively from unsustainable credit expansion combined with extensive, largely unprofitable domestic infrastructure expansion. In the last two decades, China has seen the largest construction boom in any country ever.”
It’s worth pointing out the article ‘talks Crescat’s book’, that is, their funds are positioned to profit if China falls over. Nevertheless, on an objective view some of the numbers they quote give pause for thought:
Much of China’s economic growth has been founded on an enormous expansion of credit, with household and corporate debt rising from 110% of GDP in 2009 to 210% today.
They argue there has been an enormous misallocation of capital to often unprofitable Fixed Asset Investment, that is, infrastructure projects, to prop up growth, starting at 23% of GDP in 2000 to 87% in 2016.
Much of that capital allocation has been in the form of loans to inefficient State Owed Enterprises (SOE’s).
Between 2008 to 2017 the assets in China’s banking system (that is, loans made to customers that sit on their balance sheets), increased four-fold to US$35 trillion.
Based on banking assets as a proportion of GDP, China’s “banking bubble” is three times the size of the US’s just prior to the GFC.
Using what they consider to be conservative estimates, non-performing loans that have to be written off could be almost US$9 trillion. That would wipe out the Chinese banks’ capital base twice over, and government reserves are currently US$3 trillion. To recapitalize the banks through money printing would require the government to issue 37% of the total money supply.
As we’ve said in the past, China could carry on for years. But it pays to be vigilant.