Mar 2017 GMO White Paper
In a companion paper, “Six Impossible Things Before Breakfast,” we present evidence that asset markets are generally priced for “secular stagnation,” and argue that this requires a number of extreme assumptions on the part of investors. However, we didn’t really explore the root causes and consequences of secular stagnation in that paper. We remedy that with this paper, which is a deep dive into the murky world of secular stagnation, its sources, and its impact.
The rise of populism has been one of the broad themes to emerge over the last few years. This has left many within the establishment scratching their heads as to the cause of their fall from grace. From our perspective, the rise of populism has its roots in the same sources that have given rise to so- called “secular stagnation.” That is, a broken system of economic governance. This system – which we will hereafter refer to as “neoliberalism” – arose in the mid-1970s and was characterised by four significant economic policies: the abandonment of full employment as a desirable policy goal and its replacement with inflation targeting; an increase in the globalisation of the flows of people, capital, and trade; a focus at a firm level on shareholder value maximisation rather than reinvestment and growth; and the pursuit of flexible labour markets and the disruption of trade unions and workers’ organisation.
The orthodox view on secular stagnation seems to adopt one of two perspectives: either that secular stagnation is caused by a situation where the real interest rate has to be negative in order to generate a return to growth (a demand-side explanation), or that something has gone very wrong with the nature of productivity in the economy (a supply-side explanation). We have been outspoken critics of this framework1 of thinking. Rather than being the result of some unobservable figment of economists’ imaginations (as we believe the natural rate of interest to be), or some strange exogenous productivity event,2 we argue that it is the policies that have been pursued that have led to the observed “stylized facts” of secular stagnation (Exhibit 2). The neoliberal regime has given rise to: lower inflation; lower growth rates; lower investment rates; lower productivity growth; increasing income and wealth inequality; diminished job security; and a serious deflationary bias in the world economy that was only temporarily “plugged” by dangerously high levels of private sector debt accumulation. These are long-term trends that have been visible for decades, but they were severely exacerbated by the collapse of the global debt bubble in 2008-09.
As the citizens of various countries around the world gradually woke up to the fact that the quick-fix solutions put in place after the crisis merely kept a lopsided and increasingly dysfunctional system ticking over, they rebelled. It was then that they started to cast votes for various populist political candidates in an apparent effort to shake up the system. Without such a splash of cold water to the face, there is every chance that the system would march on regardless of its dysfunction until it decayed to such an extent that it simply collapsed – not unlike what happened in the non-democratic Soviet Union. If we are to prevent our own sickly Brezhnev era from slipping into a terminal state, we must understand clearly the causes of our current morass.
1See, for example, “The Idolatry of Interest Rates, Part I: Chasing Will-’o-the-Wisp,” May 2015. This white paper is available with registration at www.gmo.com.
2We argue that the slowdown in productivity largely reflects the slowdown in growth, rather than causing it. This hypothesis is explored in the appendix to this paper.
The Four Pillars of Neoliberalism
Inflation targeting and the NAIRU
The first of the four key pillars of neoliberalism is the abandonment of full employment policy and its replacement with inflation targeting. After the Second World War governments around the world realised that they could easily generate full employment through spending and taxation policies. This realisation came because of the economic experiments undertaken during the war – experiments that were necessitated by the war but that were consciously structured in line with the economic approach outlined in Keynes’ 1936 book The General Theory of Employment, Money and Interest . As Nicholas Kaldor wrote, “The formal obligation to maintain high and stable levels of employment... emerged as a joint impact of the Keynesian revolution in economic thought and the Second World War.”3...MUCH MORE (22 page PDF)
These policies were remarkably effective, and the decades after the war are generally known today as capitalism’s Golden Age. The Golden Age was characterised by high rates of employment, economic growth, and an equitable distribution of income and wealth. In the mid-1970s, however, these policies were abandoned because they were thought to be causing inflation. This was an incorrect assessment, as the inflation was actually generated by oil shocks imposed by the OPEC cartel in response to US foreign policy in the Middle East combined with poor labour relations in the English-speaking countries that led to class conflict and strikes over who should bear the brunt of these higher oil prices.
But the economics profession at the time did not realise this. Their theories told them that it was the full employment policies that were generating the inflation, and so they encouraged policymakers to abandon these policies and instead have the central bank attempt to control inflation through the use of monetary policy. The impact of these policies in the US could not be clearer, as shown in Exhibit 3.