Introduction
Discussions over the likelihood of a regime change in both the global economy and financial markets have intensified. Commentators speculate that we are likely to shift from a regime dominated by subdued growth/inflation to an environment characterized by higher growth and inflation. This reflects the recent change in macroeconomic orthodoxies (change in policy preference and frameworks), especially in AEs, towards more liberal use of fiscal tools, coupled with accommodative monetary policies. These are happening amidst shifting domestic political paradigms and rising global geopolitical tensions. Covid-related disruptions too led to expectations of a re-configuration of global production organization (de-globalization; on-shoring; supply-chain fragmentation/re-organization), supporting the narrative.
Most, however, fail to explicitly identify conditions critical for the global economy to achieve escape velocity. Rather, discussions have been bogged down by shifting narratives reflecting episodic events, uncertainties over macroeconomic variables, and, worst, recent market moves (essentially circular reasoning). Arguments at times also fail to distinguish between cyclical and structural elements, even though implications for a regime change, by definition, must be structural.
We seek in this article to elucidate the key conditions, deemed necessary, for the global economy to achieve “Lift-off”.
Where We Left Off
Recall that Part 1 of the ‘Contemplating Investment Regimes’ series discussed at length the underlying fragilities of the previous low growth/inflation regime, and how they have been further amplified by the pandemic. Such fragilities include socio-political imbalances in major economies, the increasingly binding side-effects of accommodative global monetary policies, and the broadening of economic stagnation globally (economic pains broadens to surplus countries via the global shortfall of demand). We highlighted, back in 2H20, that prior fragilities were being brought to the extremes, rendering the regime unsustainable. Further, policymakers are forced to re-think economic/political ideals/constructs (central themes includes the importance of generating domestic demand, prioritizing resilience vs. efficiency, navigating geopolitical multipolarity, and technological competition etc.), accelerating the shift away from what was already a fragile regime near its breaking point.
However, and more importantly, the dislodgment of the low growth/inflation regime does not necessarily entail either a shift towards or the entrenchment of a higher growth/inflation regime (“Lift-off”); rather it simply suggests that the global economy is now in a state of flux. Indeed, the world may remain in a constant state of flux – vacillating among the various plausible “states”. Key elements of the various plausible regimes can co-exists, reflecting the circumstantial ebb and flow in major policy frameworks and policies – unless structural conditions underpinning the previous regime are, at least partially, meaningfully altered.
Conditions critical for “Lift-off”
In earlier posts, we have regularly highlighted strictures that are currently binding the economy to the low growth/inflation regime; they include macro ‘super-structures’ which limits “inherent wealth velocities” of economies (see this) and other inter-related elements such as the income/wealth disparities, elevated debt levels, an over-reliance on monetary policies, and inadequacies of the global financial architecture (see this).
Correspondingly, we believe conditions required to achieve “Lift-off’ depends crucially on i) the change in wealth/income distribution; ii) the quality, magnitude and permanence of fiscal policy, iii) global leverage, and the credit and investment cycle, and iv) global re-balancing.
Four unifying themes encapsulate these inter-related conditions, they:
1) entail changes to the macroeconomic ‘superstructures’, such that drivers become self-reinforcing and long-lasting,
2) drive sustainable demand generation,
3) help permanently increase the rate of change in “wealth stock” & its “wealth velocity”,
4) bring about reduced fragility for the global economy.
I. Wealth/Income Disparity – Reforms and Redistribution
We believe a central condition for a higher growth/inflation regime is the need, globally, to narrow income/wealth disparity. This is less borne out by any specific political/philosophical leaning, but reflects more a diagnosis that the world simply suffers from a lack of sustainable aggregate demand (i.e. circumstantial argument). The lack of sustainable global aggregate demand remains the key constraint of the global economy as opposed to supply-side impediments (such as the lack of savings/capital, cost of financing, structural availability of production inputs – labour/capital/technology) at this juncture. This is not to say that supply-side improvements are not important (policies should always consider its implications on potential growth) nor all economies suffer from demand-side deficiencies (importance of idiosyncrasies). Nor the less, this diagnosis, we strongly believe, is accurate globally in aggregate.
Under such a context, widening income/wealth disparity contributes to the problem. High disparity shifts income/wealth away from the consuming classes (debtors, labour, median and lower income households) with higher propensity-to-consume towards capital owners, rentiers, and higher-income groups who save a high proportion of their income/wealth, effectively constraining and dampening aggregate demand. We have clarified before how extreme wealth disparity leads to the prevalence of ‘hoarders’ which reduces the wealth velocity of economies – with further side effects such as ‘indebted demand’ (characterized by an entrenched environment of low interest rates and high levels of debt) and imbalanced financial asset cycles. In terms of global re-balancing, skewed income distribution further distorts the global current account imbalances, putting even more onus on structural deficit economies to absorb “excess savings”. Income/wealth disparity in a low growth environment also contributes to socio-political and geopolitical frictions.
Hence, our probability under-lying the ‘Lift-off’ scenario will be higher if we see signs that policies shift towards tackling such disparity globally. Such policies include higher public spending on improving the welfare of the lower income class (discussed below), removing policies which suppress the labour share of income in surplus economies (see this), proactively encouraging tight labor markets, and progressive tax systems amongst others. While much discussed, we see limited structural policies that will help re-balance income in a growth enhancing manner globally for now. Meanwhile, the pandemic has only served to widen both income/wealth disparity domestically in major economies and income gaps between AEs and EMs.
II. Fiscal Policy – Quality, Magnitude, and Permanence of Spending
The willingness of fiscal authorities to enact sizeable fiscal stimulus (at least in the AEs) during the Covid pandemic is a clear change in fiscal policy orthodoxy (compared to the preference of monetary over fiscal policy and political resistance to government spending in the past).
However, simply expanding fiscal spending (on our view on monetized fiscal expansion, see this), on its own, will not help the global economy achieve escape velocity. In our view, nuances and context matter greatly, with the i) quality, ii) magnitude, and iii) permanence of fiscal spending being far more important.
The quality of fiscal spending reflects its impact on the long-run productivity of the economy and the sustainability of demand, considering both the domestic and global context. Fiscal policy of sufficient quality must lead to higher real income growth (income growth must be higher than inflation by definition) and not higher inflation or a wage-price spiral (which usually impacts lower-income groups the most, considering their limited scope for asset diversification, coupled with less labour wage bargaining power). This can be achieved via either a) higher productivity growth and/or b) an increase in the labour share of income (note that lower corporate profit margins do not necessarily equate to lower profits, it depends on whether economic growth – top line – improves; also, efforts to appropriate corporate income without offsetting growth elements may be self-defeating, as it leads to a weaker economy instead).
Public investments with high returns to society can lead to higher future productivity and economic growth, considering prior under-investments and its high multipliers, while helping crowd in private investments. Such investment opportunities certainly exist in infrastructure and green investments. Further, such investments should not lead to rising indebtedness since the debt taken should be paid off with time even as debt levels may rise in the interim (productive investments/debt are self-liquidating by definition).
If the policy intent is to generate higher growth/inflation, fiscal expenditure will be better-targeted if it rebalances income towards entities with higher marginal propensity to consume while limiting its impact on labour supply (size of handouts for unemployed vis-à-vis minimum living requirements/market wages; income tax rebates; job credit schemes/subsidized apprenticeships; subsidized social, health and education schemes; pro-labour/low-income class taxation regime). Such fiscal programs – should they be made permanent – are likely to lead to a rebalancing of income, and a change in growth/income expectations.
On the contrary, one-off, reactive, tail-risk type fiscal responses will not help the economy achieve escape velocity. We believe most of the pandemic related fiscal stimulus measures globally are of such nature – one-off, temporary programs of limited size with mixed quality, and which have probably already reached a peak (uncertainty in the ebb and flow of politics; US mid-terms; elections in Europe; limited – either real/perceived – fiscal space in RoW).
Direct income payments made thus far are largely untargeted, temporary, and in some countries, too small, and designed, at least for now, with limited considerations for the future (essentially reactive response to the Covid pandemic rather than a clear rethink of the role of the state). The fiscal impulse will see a sharp falloff in coming years, even assuming a passing of an infrastructure bill in the US.
The prior build-up in private savings in economies with generous income replacement programs (private sector surpluses being the flipside of the public sector deficit) should help cushion the economy in the near term. However, as consumption picks up, the post-pandemic level increase in savings will likely normalize in due course (one-off fiscal support programs taper off). The savings rate will likely settle at a higher level since the untargeted nature of income support means that higher income entities – with low propensity to consume – will save such income permanently.
Further, public spending on investments remains limited in size and ambition in some (US’s AJP and Europe’s NGEU), while, reflecting limited fiscal/monetary space, totally lacking in others (EM).
We remain watchful of future developments (American Families Plan; political events and reforms in Europe; policies in China; Asia’s reforms), considering the importance that politics, and subsequently changes in policy frameworks, will play. It remains to be seen if the pandemic ends up as a catalyst for a seismic change in fiscal activism in major economies. As of now, we find it tough to argue that fiscal measures enacted thus far are sufficient for the global economy to achieve a lift-off.
III. Global Debt Overhang – Debt Jubilee/Restructuring/Productivity of Debt/Financial Repression
The global debt overhang adds to the huge uncertainties over future demand, given the need to deleverage, and, for some, restructure stranded assets and obsolete business models. Leverage and balance sheets, for most, have been made worse by the pandemic. Further, the pandemic has enhanced market concentration and mono/oligopolistic structures, with larger firms getting bigger, and zombification worsening. Demand for credit will likely remain depressed, limiting the potential for a secular global credit expansionary cycle and, corresponding, a credit-fueled aggregate demand cycle.
At current debt levels and considering uncertainties over future demand, the urge to deleverage or to build up a precautionary buffer will be strong. This is especially so following the expiry of the fiscal support programs. Indeed, US bank credit, after a period of strong growth supported by government programs, have levelled off and is now seeing negative yoy growth. The credit impulse is now deeply negative, serving as a headwind to growth, going forward.
A “radical”, but also equally politically improbable idea suggested by Prof. S.Keen – which, we think, can theoretically lead to a positive reset of the global financial situation of the indebted class – is the Global Private Debt Jubilee. The design of this plan is technically sound, revisits the role of ‘credit’, focuses on the interaction between the sectoral balances (public vs. private vs. foreign), fulfills the criteria of Pareto improvement while also addressing concerns over fairness; although we think any legislative process will need to consider concerns surrounding moral hazard. However, we suspect the next major Overton window for such a policy (either direct/indirect debt forgiveness /restructuring) remains a distance away.
We are less concerned about overall debt levels compared to the more vulnerable problem of rising debt burdens. The persistent rise of debt vs. income globally points both to a skewness in debt accumulation (lower-income groups lacking the ability to repay), and the falling productivity of debt. These are related to both the lack of growth impetus (credit demand from the private sector rarely comes from real activities, but reflects financial engineering; credit demand is also far higher for entities with weak/mismatched balance sheets), and the distorted incentive structures of major institutions (such as the inefficiency of capital allocation, skewed lending policies, preference for financial engineering). The former requires credible growth strategies (addressing income/wealth disparity and proactiveness of well-designed fiscal policies), while the latter requires more institutional reforms (e.g. capital allocation reforms in important economies such as CN/IN, financial reforms in AEs etc).
Without a re-structuring of liabilities, debt forgiveness, and/or credible growth strategies, we suspect financial repression – in effect a long-drawn-out amortization of debt burdens through an implicit transfer of resources away from holders of monetary assets – is likely to be the central policy to address indebtedness. Such a strategy is unlikely to be successful considering the current context (high debt stock, lack of growth/inflation impetus, rising negative side effects). The side effects (zombification/inefficient capital allocation/inequality etc.) has already contributed to problems surrounding the previous regime.
IV. Global Re-balancing and Reforming the Global Financial Architecture
We have written extensively about the adverse impact of global imbalances on global aggregate demand and financial fragility in the past (see this, this and this). Simply stated, global imbalances – a large part reflecting domestic income imbalances in major economies – have led to a shortfall in aggregate demand, rising indebtedness, and financial fragility globally.
The persistence of global imbalances, as we have argued before, is enabled by the current global financial architecture which severely lacks a self-correction mechanism (creating a high degree of stasis for re-balancing – chronic imbalances therefore usually resolve via financial distresses instead). We believe the current global financial architecture provides a conduit through which surplus economies transmit their domestic imbalances (skewed labour-capital share of income; shortfall of demand; export-driven models) via trade and capital flows (see this) with limited consequences, if any, currently. While unlikely, proposals based upon J.M.Keynes’ bancor (see this) have the potential to address the architecture’s weakness by providing a functional adjustment mechanism. Without major reforms, which is only possible with global policy cooperation, the onus of adjustments continues to systemically fall on deficit economies (e.g. the build-up and the subsequent un-ravelling of levered demand in the US which led to the GFC).
Another way to re-balance the system in a growth-conducive manner is for surplus economies to lessen or reverse such imbalances by boosting domestic demand at the expense of external surpluses. There have been positive signs of such policies being enacted in the recent past. However, they remain largely reactive in nature – in response to domestic pressures, both through the inevitable slowdown in growth (as limits to importing demand have been reached) and correspondingly rising political instability – rather than an explicit recognition for the need to change their respective growth models. Nonetheless, it is clear that a critical mass of reforms have yet been reached. Asia and to a large extent core Europe, continue to rely on export-dependent growth models. We believe re-balancing has minimal chances to occur, unless the labour/domestic consumption share of income sustainably increase in these economies.
The lack of global re-balancing is particularly stark when considering the effects of the pandemic. The US and UK, with arguably the most generous demand-side fiscal packages coupled with the most liberal capital markets (which allows ex-ante and ex-post current account and capital flows preferences to adjust with the most ease globally), saw their current account deficits widen (especially the US which saw a widening to -3.5% GDP; though still lower than the -5.2% seen during 2003-08), while key current account surplus economies (with support packages largely targeting the supply-side) kept their surpluses either largely unchanged or saw a positive widening. For instance, China saw its surplus widen to 1.8% GDP, an amount which in normal times will be tough for the rest of the world to absorb, considering its size. The US economy continues to play the role as the global demand provider of last resort. In our opinion, such demand is not sustainable (both economically and geo-politically) and following a cyclical boost, surplus economies will see demand weaken back closer to the pre-pandemic baseline (“pain re-distribution” – essentially a re-surfacing of underlying fragilities).
What if the necessary conditions are not achieved? No Permanent Regime Shift but Constant Oscillations in a State of Flux
We believe the conditions laid out above are all inter-connected, and addressing them is likely to help induce private investments, by convincing corporate executives that future demand will remain robust (a lack of future demand prospects, we believe, is a major contributing factor as to why investment spending has been lacklustre over the past decade — returns to financial engineering is far higher than real investment in an environment of limited growth prospects).
The failure to, at the minimum, meaningfully address some of the conditions stated above will mean that the increases in growth/inflation of the global economy (such as what we are witnessing currently) will likely be temporary bumps – the global economy is likely to gravitate back to its pre-pandemic trajectory eventually (“Stagnation” Regime) with both the fiscal and credit impulse turning negative and with limited secular productivity improvements. Even then, a reversion to “Stagnation” will likely have a short runway, considering both deepened fragilities and widening fault-lines (see this and this).
This brings us to the possibility of another alternative (“Global Friction & Disorder” regime) – one where rising domestic polarisation becomes increasingly a global phenomenon, accompanied by rising international fragmentation. We think isolationism and rising aggression internationally (dominance of realpolitik) is another distinct possibility (outside of “Stagnation” and “Lift-off”) not yet widely discussed, nor priced in by markets. This scenario may well occur should the transition from “Stagnation” to “Lift-off” fail to occur. Tell-tale signs include the rise of toxic nationalism (both political and economic), a return of populist figure-heads, and the dominance of realpolitik in international relations.
In such a scenario, outright growth/inflation beta bets become far more complicated and much less obvious, with the focus instead shifting towards sectoral/thematic alpha (e.g. economic nationalism can lead to either higher growth/stagflation/loss of competitiveness through the choice of policy – thoughtful nation building or impetuous, wasteful spending). Idiosyncratic factors such as the “sustainability” of government finances, the ability of the economy to generate sustainable domestic demand, possession of strategically important commodities/resources, the control over strategically important value chains (technological prowess, strategic resources, talents), and geopolitical leverage/optionality become far more important.
Parsing through the necessary conditions makes it clear that the challenges for a shift towards a more sustained/permanent ‘Lift-off’ are daunting. Most of the conditions require surmounting entrenched political constraints, profound geopolitical differences, and dominant mainstream economic ideologies. Hence, in the near term, we do not anticipate a rapid shift and permanent entrenchment of a new regime. Rather, the world is more likely to experience a prolonged period vacillating amongst the three regimes: “Lift-off”, “Stagnation”, and “Global Friction & Disorder”. As such, the probability over which regime will eventually be entrenched will ebb and flow depending on the choice of policies under-taken, now and into the future. Markets, thus, too will reprice the shifts in the odds of the various regimes, likely in steps rather than a smooth re-pricing, considering the significantly different implications on asset classes among the three regimes (Part III of this series will focus more on asset class implications).
Conclusion
The probability of such a regime shift towards a world with sustained higher growth/inflation will increase, in our opinion, if policies address: i) the lop-sidedness of income distribution, ii) the indebtedness of the system, iii) the lacklustre investment and credit cycle, and lastly, iv) the global financial architecture. Conditions need to address issues surrounding macroeconomic ‘super-structures’; other unifying themes behind these elements include the generation of sustained demand, a permanent increase in the “inherent wealth velocity” of the global economy, and reduced fragility of the global economy. Only through meaningfully addressing these key elements, at least partially, will conditions be more conducive for a more sustained/permanent “Lift-off”. The hurdles these conditions face, however, suggest a prolonged period of oscillation amongst alternative scenarios.
