Managing Stagnation

A book that framed our past

Karl Marx’s bestseller from 1867, das Kapital, was an influential piece of work for its time. Apart from Marx’s personal views, the two production factors, capital and labour, resulted in a framework that has helped us make sense of the new economic and social situation in the wake of the industrial revolution and perpetual economic growth. Those to the left argued for a larger share of the growth to go the workers and those to the right argued for a larger share of the growth to go to the capital owners. Still today, most political parties define themselves along these two dimensions.

The idea of having perpetual growth, irrespective of the political debate on how to redistribute it, is still the foundation for how our societies are managed. Most mainstream economics assumes that we will have real growth of the economy and that is reflected by most countries welfare models, fiscal policies and central bank policies. Many of the public services that we take for granted today are financed by a pay-as-you-go system built on the assumption that there will be more tax-revenue in the future. Funded pensions are based on the assumption that the pension savings will earn a real investment return of 3 to 4 percent annually. Finally, no matter how bad policy decisions were made in the past, economic growth made it relatively painless to rectify those.

But looking ahead, is it reasonable to assume that we will experience perpetual economic growth? Through innovation and redistribution we might experience growth, but what happens if we instead face a long period of low, or even no, growth? A worrying example is Japan, that has had a period of more than three decades with low or no growth.

A complex world that is slowly changing

We have an aging society since fertility rates are way below the replacement rate in the developed world and for most emerging markets. There are many drivers behind this, but urbanisation is probably the most important one. Today, 56% of the world’s population is living in cities according to the World Bank and that is expected to increase to 70% in 2050 according to the UN. It has become increasingly expensive to raise kids in a large city so it is perfectly understandable that fertility rates are falling. Just to be clear, I am not making comments on the life choices made by individuals, I am just commenting on the consequences and how we, as societies, need to deal with this ‘new’ reality.

The economic impact of demographics is a bit tricky. Initially falling birth rates had a positive economic effect for several decades; it reduces the public expenditures on childcare and education. The maturing workforce increased productivity as the proportion of skilled workers increased. Finally there were relatively few retirees that needed to be supported. Economists are referring to these positive effects as a demographic dividend. But as time goes by, many of the skilled workers retire and there are fewer workers around that need to support a growing number of retirees. Many countries, and regions, are now facing a demographic deficit. The underlying mechanics of this is not that different from a company that cuts their investing in R&D: short-term revenues are boosted but long-term it loses its completive edge.

In addition, we need to address the existential threats such as climate change. In practice that means moving towards a circular economy with more durable products and recycling to reduce our pressure on the planet. From a climate change perspective, it is good news that we are approaching the global peak population and that birth rates are falling. The bad news is that this positive development for our planet is likely to impact future growth in a negative way.

The biggest Ponzi scheme on earth

After World War II, most social reforms were financed on a pay-as-you-go model. Paul Samuelsson provided evidence for the efficiency of the pay-as-you-go model, but acknowledged that it requires a growing nation. Milton Friedman went one step further and called the American social security model for “the biggest Ponzi scheme on earth.” With a shrinking population and low growth rates, we need to reconsider how we finance our society as we already have banked on future growth by building up a large public debt. Faced with the demographic deficit, that means we are effectively footing the bill to future generations which will consist of fewer individuals.

In a conversation with the economist Zvi Bodie, I expressed my concerns about growing public debt. Zvi said that he was not that worried about the debt, since many bondholders will realise that they are owning equity. So even if the debt issue can be resolved, we need to make our society fiscally sustainable across generations of different sizes. The economist, Larry Kotlikoff, suggested that we should introduce a generational accounting framework when making policies.

If I were you, I wouldn’t start from here

This punchline from the old joke about a tourist in Ireland asking for the direction to Dublin conveys the message that we might need to rethink our way forward and instead start afresh, rather than tinkering with Karl Marx’s old framework.

Personally, I find the current political arena a bit confusing. Both the traditional left and right are shrinking in the polls as their ideological framework do not provide much direction to solve today’s challenges, such as climate migration. At the same time populist parties are busy filling this political void since there are no credible alternatives solutions around.

What I lack is a fierce academic and philosophical debate on how to navigate a low growth economy. For an economist, this must be one of the most exciting challenges in our lifetime. Who will emerge as thought leaders of the 21st century providing us with the framework around which we organise our arguments? With a framework in place, we can have the democratic debate of how to address the key question; what is an acceptable way to get from here to there?

PS. I hope that I did not depress you and I do hope that I am wrong, but what if I am not?