The shell game

An interesting discussion with Prof. Percy Allan from University of Technology, Sydney regarding what caused declining economic growth in recent decades. The chart below shows how real GDP growth in the US declined over the past sixty years — from a 10-year average above 4.0% to a low of 2.2% over the most recent decade.

The primary cause is the decline in capital investment, with 10-year average capital formation declining from between 3.5% and 3.6% in the 1970s and early 1980s to between 2.2% and 2.3% in the past decade. You need new investment in capital equipment in order to improve the efficiency of labor (productivity) — increasing output (GDP) at a faster rate than labor input.

One possible argument for the decline is that productivity (blue) has grown at a faster rate than average hourly earnings (red) since the mid-1980s. This means that workers receive a smaller share of output (GDP) and are likely to consume less. Lower consumption will in turn lead to lower investment as there is no domestic market for the additional output¹.

But that argument does not hold true for the US, where personal consumption has grown as a percentage of GDP since the mid-1960s.

The increase in consumption was funded by an increase in debt. The ratio of non-financial debt to GDP doubled from 1.32 in 1960 to 2.64 in Q3 of last year.

The increase in debt occurred in three steps: 1980-1990; 2000-2009; and 2019 -2020. These steps coincide with three massive surges in the current account deficit below, when Japan, Germany and China (the largest three exporters to the US since the 1980s) exported surplus output to the US by manipulating their capital account.

If China, for example, exports goods to the US and does not import a corresponding amount of goods and services, it will have a current account surplus. The flow of Dollars to China in payment will drive up the Yuan exchange rate, making Chinese goods more expensive and restoring the trade balance. But exporters like Japan, China and Germany manipulate their exchange rate by investing in US Dollar securities and assets. The outflow on their capital account then offsets the inflow on current account² and prevents their exchange rate from rising to restore the balance in trade.

Conclusion

US workers share of GDP has fallen since the mid-1980s, causing rising inequality and political tensions. But the impact on their standard of living was cushioned by the shell game run by US political leaders and foreign trading partners. Personal consumption climbed despite workers’ smaller share of output, enabled through increased availability of cheap debt — funded by foreign trade partners through a growing current account deficit.

The result was a strong Dollar as foreign capital flowed into the US. Wall Street were big cheerleaders of the policy because it gave them access to huge volumes of cheap debt.

The combination of cheap debt and inflation also exacerbated rising inequality between workers and owners of capital. The wealthy were able to to profit from inflation, using their balance sheets to borrow at cheap rates and buy real assets as a hedge against inflation. Workers — with weak balance sheets and no access to leverage — bore the brunt of rising prices.

The downside to the strong Dollar policy is that it made US manufacturers uncompetitive, both in export markets and against imports in domestic markets. The result was an erosion of US  manufacturing jobs (below) and increased reliance on foreign imports which both the Trump and Biden administrations have tried to reverse.

Efforts to weaken the US Dollar and reduce the current account deficit are laudable. They may well spur an increase in capital investment over time which could revive economic growth. But the days of cheap debt, funded by US trading partners, are likely over.

Long-term interest rates are expected to rise in 2025. So are wage rates. Workers — emboldened by a tight labor market and facing higher interest rates — are expected to demand a larger share of productivity gains than in the past. Inflation is likely to prove persistent.

Acknowledgements

• Prof. Percy Allan, The Conversation: There are 4 economic scenarios for the rest of the decade – I’ve reluctantly picked one

Notes

1. 1. The growth model used by Japan, Germany and China is an exception to this, where additional output is exported via a surplus on current account.
   2. The sum of flows on capital account and current account is always equal to zero, with inflows on one account offset by outflows on the other.