For more than two years, the global economic debate has revolved around rising prices, rising interest rates, and the likelihood of recession and rising unemployment. At the end of 2023, this long debate will be over.
In both Australia and the United States, underlying inflation peaked more than a year ago. Since then the trend has been declining. If the trend continues, and there are good reasons to believe that it will, current inflation figures will remain within central banks' target ranges by the second half of 2024.
Far from recession, unemployment in Australia and the United States remains below four percent. As inflation fell and output growth slowed, most central banks have stopped raising interest rates. It will take a while for interest rates to come down, but the tightening phase is most likely over in the US, Australia and Europe.
Both Covid-19 and the post-epidemic inflationary episodes are now behind us. It's time to think about what happens next.
We know that several important trends that have shaped our economic experience over the past three or four decades are less important today.
Over the decades, economists have not been good at predicting when productivity spurts will begin or end, or why.
China's economy has increased tenfold in the last 30 years and accounts for more than a quarter of global economic growth. With China's working-age population declining since 2010 and productivity gains becoming harder to find, China's manufacturing growth will likely slow from around 5% this year to 4.5% next year. In ten years the growth rate could be 3% or less. Living standards in China will continue to rise and more Chinese industries will advance to the global technology frontier. As the world's first or second-largest economy, China's economy will be as important to the world as America's. But China's outsized contribution to global economic growth and to the export growth rate of commodity producers like Australia will steadily decline.
Trade growth was the driving force behind the first two-thirds of the global economic recovery of the last 30 years. This is unlikely to be the case in the next few decades. Thirty years ago, exports were less than a fifth of global GDP. In 2008 it was almost a third. The share of exports in GDP is largely the same today as it was in 2008, meaning that overall exports have slowed relative to GDP growth. Rich economies tend to produce services that do not cross borders as easily as goods. Globalization, measured by the share of trade in production, is not a step backwards, but has long since stabilized. This eliminates another driver of global economic growth.
Most rich economies have not seen a productivity recovery for some time (Andreas Arnold via Getty Images)
Long-term interest rates began falling 40 years ago, driven first by lower inflation and then by central bank rate cuts to combat the 2008 financial crisis and later the Covid pandemic. In 1984, the interest rate on US 10-year bonds was 14%. In mid-2020 it was just over half a percent. Australian bond interest rates largely followed the US pattern. Lower interest rates contributed to an eightfold increase in U.S. stock prices and a tenfold increase in nominal U.S. wealth. The long decline in interest rates is also over. US bond interest rates are back to where they were at the beginning of this century.
Given the dangers of inflation, central banks will not reduce short-term interest rates back to the very low levels of the last 15 years. Most governments have accumulated significant debt in response to the 2008 and Covid crises. They continue to have to restructure their debts, which is compounded by the deficits of most governments. Meanwhile, central banks are reducing their accumulated holdings of government bonds, increasing the amount of debt that governments must sell to the market. It's hard to see how Treasury interest rates, the benchmark for most other interest rates, can fall sharply. It is true that a decline in opportunities could reduce expected returns on capital, but it is also true that the aging populations of China and most rich countries could reduce the growth of household savings. After all, a large portion of household savings is used to prepare for retirement.
We must expect worse battles over the distribution of income and wealth.
Finally, there is also productivity in an inventory of absences. Over the decades, economists have not been good at predicting when productivity spurts will begin or end, or why. But there is no doubt that most rich economies – including Australia, the United States and those in Europe – have not seen a productivity boost for some time. The growth of an economy can be roughly imagined as the growth in hours worked plus the growth rate of production per hour worked, i.e. labor productivity. At various times over the past 40 years, productivity growth has strongly supported overall economic growth. Not now – or at least not yet. When slow labor force growth is accompanied by slow productivity growth, this leads to slow growth in income and output.
So what about the hustle and bustle of technological change, the possibilities of artificial intelligence, quantum computing, etc. etc.? And what about the big transition to green technologies? Won't these changes lead to large increases in productivity? Maybe they could. But in fact, the long period of weak productivity growth coincided with the rapid technological change of the last decade. Some technologies increase output per hour of work. Others just make our lives more entertaining or complicated. And remember, electric vehicles are replacing gasoline vehicles and new forms of energy production are replacing existing forms of energy production. These are changes we need to make to save the planet – but they promise no particular increase in productivity compared to the things they replace.
After a deep downturn, growth tends to be above average as the economy recovers. But we are not coming out of a deep downturn. Therefore, we should not expect a recovery. At best, we should expect a sustained period in which average output growth will be significantly lower than in the last 30 or 40 years and the value of financial assets will grow at a much more modest rate. This won't be such a bad path once we come to terms with its inevitability. But we must expect worse battles over the distribution of income and wealth. When incomes rise sharply, even the poorest gain something. When incomes rise slowly, it is difficult to make one group better off without making another group worse off.
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