The end of growth

‘The great classical economists all thought that economic growth would eventually cease. The prediction seems to be coming true’

Open Season

If you want to understand the politics of recent years — Brexit, the Trump presidency, the emergence of AfD in Germany and the gilets jaunes in France — one book is indispensable: Benjamin Friedman’s The Moral Consequences of Economic Growth (2005). He marshals evidence from around the world and throughout modern history to show that economic growth makes societies more open and tolerant, while stagnation begets intolerance and insularity. What we’re seeing today, with years of slow growth triggering anti-immigration attitudes, a backlash against free trade, and the rejection of “experts”,  continues the usual pattern.

Which poses the question: why has economic growth slowed so much? In the UK, for example, real GDP per person has risen only 0.3 per cent per year since 2008, compared to growth of 2.2 per cent per year in the previous 30 years.

Part of the story, of course, is that the financial crisis and subsequent fiscal austerity depressed the economy. But economies were faltering even before the 2008 crisis. The Institute of Fiscal Studies estimates that the real income of the typical UK household, after housing costs, rose only 1.6 per cent per year in the five years to 2007, well down from the 2.4 per cent growth of the previous thirty. And companies had become more reluctant to invest well before the crisis. In 2007, the volume of business investment accounted for only 9.4 per cent of UK GDP, compared to well over 12 per cent in the late 1990s. Such reluctance to invest was common to many developed economies. In 2005, Fed chairman Ben Bernanke complained that many Western economies faced a “dearth of domestic investment opportunities”.

As a reflection of this stagnation, real interest rates had fallen. At the end of 2007, long-dated index-linked gilts yielded just one per cent, compared to well over three per cent for much of the 1990s. Because interest rates are determined in large part by global forces, this downtrend signified a loss of worldwide economic dynamism.

If there had been ample opportunities for productive investment in the West, the glut of savings from Asian economies could have financed them and boosted growth. Without them, it inflated a housing bubble which led to the crash. The crisis, then, is not the cause of our troubles. It was “the symptom, not the disease”, as Ravi Jagannathan of Northwestern University has put it.

But why has there been such a longstanding lack of capital spending? It’s here that classical economists might at last be vindicated. Adam Smith, David Ricardo and John Stuart Mill all thought that economic growth would eventually cease. They saw growth as a race between technical progress and the diminishing returns that could be derived from it — a race they thought the latter would eventually win.

Mill believed we would reach a point at which “the rate of profit is habitually within, as it were, a hand’s breadth of the minimum, and the country therefore on the verge of the stationary state”. Of course, the idea that a falling rate of profit would lead to stagnation is usually associated with Karl Marx. But he merely elaborated the work of his predecessors. Paul Samuelson had a point when he called Marx a “minor post-Ricardian”.

Whoever deserves credit, the prediction seems to be coming true. Robert Gordon, another economist at Northwestern, has argued that recent innovations such as the internet just haven’t had the transformative effect of earlier ones, such as electricity.  And the returns to innovation and investment have been small for years. Nobel laureate William Nordhaus has shown that firms captured “only a minuscule fraction of the social returns from technological advances” between 1948 and 2001. And Charles Lee and Salman Arif have shown that from 1962 to 2009 new capital spending in the US led to disappointing profits.

This implies that economic growth during this period was powered by over-optimism. Firms overestimated future profits and so overexpanded, failing to anticipate that profits would get competed away. Steve Jobs’ genius at Apple consisted not so much in being a great technological innovator but in his ability to generate sufficient brand loyalty to give Apple some monopoly power. Few other innovators have been able to do this.

Wishful thinking has an upside: without it, there’s not much innovation. The tech crash of 2000-03 and crisis of 2008 have taught firms the hard way that wishful thinking doesn’t pay. This vindicates another economic forecast — this one by Joseph Schumpeter. Writing in 1942, he predicted that the heroic buccaneering entrepreneur would be supplanted by “rationalist and unheroic” bureaucrats — the buttoned-up types who make successful careers in large corporations. By taking a more cold-eyed and realistic view of potential projects, they invest less, giving us stagnation.

Rationality is usually good thing. But not always. Economic growth has been in part powered by irrationality, and the decline of this particular form of irrationality has contributed to stagnation. Which has, paradoxically, unleashed other forms of irrationality.