Tuesday, 31 January 2017

No ‘Project Fear’- economy is faltering post EU referendum

By Tom O’Leary

The UK economy has slowed since the Brexit vote. This is long before Brexit actually takes place, which will cause a further sharp deceleration in the economy and significantly lower living standards.

The latest GDP data have been widely hailed as confounding the authors of Project Fear, including the former Chancellor George Osborne. His talk of an immediate recession on a Leave vote was clearly a foolish exaggeration. By contrast, the Bank of England’s sober assessment focused on the long-term and argued that growth and living standards would be significantly lower as a result of Brexit. The BoE’s assessment may be an under-estimate as it probably takes insufficient account of the depressing effect on investment.

The GDP data show a slowdown. In 2014 GDP grew by 3.1%, which slowed to 2.2% in 2015 and slowed again to 2% in 2016. In the final quarter of 2016 the preliminary estimate is that agriculture, construction and production combined contributed just 0.2% to growth. Instead, the economy is running on services, especially retail sales growth.

As prices are rising, there is a widespread assessment that consumers are spending at a rate far higher than income growth in a pre-emptive move against rising inflation in 2017. If so, consumers are probably right. Chart 1 shows the effect of changes in the value of the pound (using the Bank of England’s Sterling Trade-Weighted Index) on consumer prices. In this chart the consumer price inflation rate is lagged by 18 months, as changes in the value of the currently take their time to work through the economy. The Bank of England’s projection is that Inflation will rise to 2.8%. This would probably mean stagnant or even falling real wages once more. However, the last time the pound fell as sharply as after the Brexit vote, inflation rose to 5%. This would certainly mean sharply falling real wages.

Chart 1. Consumer prices and the pound

The rise in prices without a corresponding increase in wages means that the rise in retail sales and more generally in household consumption cannot last. But this is the main prop for the economy currently (Chart 2). 
Chart 2. Largest and smallest quarter-on-quarter contributions of industries to headline GDP growth
Source: ONS

There is a widespread misconception that ‘demand’ can lead the economy, by which it is meant that rising Consumption will by itself lift Investment and so lead to rising GDP. The services sector ‘Distribution, hotels and restaurants’ grew by 5.4% in the 4th quarter of 2016 compared to the same period in 2015, while real wages are growing at little more than 1%. If the theory, widely supported by ‘keynesians’ although having little in common with Keynes, that Consumption could lead growth was correct, then this would be a positive development and we should expect growth to accelerate. The opposite is the case. Household savings are falling and growth will slow further. Notions of ‘consumption-led growth’ cannot explain the real world, where Consumption has been growing strongly and GDP growth has been slowing (chart 3).
Chart 3. Household Consumption and GDP Growth, Q4 2009 to Q4 2016
The previous Tory government introduced a series of measures to boost Consumption, ‘Help to Buy’ schemes and so on as part of its re-election campaign. The sharp slowdown in inflation also allowed real wages to rise very modestly from 2012 onwards. At this point, Consumption began to rise strongly, from around 0.5% annual growth to over 5%. However, GDP has not followed. Over the same period GDP growth has barely changed, rising from 1.5% to just over 2.2%.

Consumption-based services are among some of the lowest productivity sectors of the economy. The much weaker growth of manufacturing and industrial production at the same time means that employment patterns are changing in a negative way. In the 3 months following the referendum manufacturing and construction jobs combined have contracted by 60,000, having expanded by 136,000 in the 12 months prior to the referendum. Crucially, total hours worked for the whole economy have recorded the first fall since the stagnation of 2011.
Chart 4. Total Hours Worked (millions) January 2009 to October 2016
In the 12 months prior to the referendum total hours worked grew by 2%. In the 4 months’ data since then total hours have fallen by 0.2%. This should not be exaggerated. But it is widely understood that the crisis of the British economy is primarily expressed as a weakness of investment. This means that it is only possible for GDP to rise if there are more people in the workforce or if they are working longer hours, which is the recent experience. If hours worked stagnate or fall for a significant period, in an environment of weak investment then both GDP and living standards would fall.

It was a foolish exaggeration from the Tory leadership of the Remain campaign to suggest that the UK economy would immediately go into recession with a Leave vote. The negative effects of the Brexit vote provoked a sharp fall in the pound and interest rates were cut. These averted sharp slowdown, but the inflation effect will cut living standards.

The real effects of Brexit will be felt over the medium-term and will naturally be strongest only if and when Britain leaves the Single Market. Even so, it is clear that the economy is already faltering. 2016 GDP growth was weaker than in 2015 and in 2014. The economy is almost wholly reliant on services led by retail sales, which cannot be sustained.

Consumption cannot lead growth. The deepening imbalance in the economy is leading to job losses in manufacturing and construction, where there had been growth prior to the referendum. Worryingly, total hours worked have contracted in the near-term. If this persists in the continued absence of investment growth, a contraction in GDP and living standards would be almost unavoidable.

The Brexit vote is already leading to economic slowdown. Brexit itself will lead to job losses and lower living standards on a large scale.

Thursday, 26 January 2017

Trump's consequences for the US economy explained in 3 charts

By John Ross

There has been much discussion on the likely effect of Trump on the US economy. But some of this discussion fails to distinguish clearly between short term and long term effects of Trump. This can lead to wrong interpretations of events and trends as they unfold. The aim of this article is therefore to set out the fundamental parameters of the US economic situation as it confronts Trump. This can be clearly shown in three charts showing the fundamental features of the US economy which are given below. These show:
  • There should be a short-term acceleration of growth during the early period of the Trump presidency, for the simple statistical reason that in 2016 the US economy was growing significantly below its long-term average. A move of the US economy up towards its long-term average growth rate will therefore create the illusion that the US economy is improving during the early period of Trump’s administration – when it is in reality a predictable statistical effect.
  • Trump, however, cannot accelerate the long-term US growth rate without fundamental changes in the US economy which are very unlikely for reasons analysed below. Therefore, over the long-term Trump will not accelerate US economic growth.
Analysing these most fundamental trends in the US economy also identifies which key US data must be watched carefully to assess the success or failure of Trump’s economic policy in both the short and long term.

The long-term slowing of the US economy

To start with the most fundamental trend of US long term growth, Figure 1 shows US annual average GDP growth using a 20-year moving average to remove all purely short term fluctuations due to business cycles. This data shows clearly the most profound trend in US growth is a half century long economic slowing – the peaks of US growth progressively falling from 4.9% in 1969, to 4.1% in 1978, to 3.5% in 2003, to 2.3% by the latest data for the 3rd quarter of 2016.

Figure 1

 The cyclical situation of the US economy

Turning to short term developments, the trend of US growth shown in Figure 1 is a long-term average. This necessarily means that short term economic growth is sometimes above and sometimes below this average. Figure 2 therefore shows the short-term trend in US growth, the economy’s year by year growth rate, compared to the long-term average.

It may be seen from Figure 2 that the US economic growth in the year to the 3rd quarter of 2016 was only 1.7%. That is, the US economy in the recent period leading up to Trump’s election was growing at significantly below its long-term trend. For this reason, purely for statistical reasons, it is probable that the US economy may accelerate in the short term.

As this would coincide with the initial period of Trump’s presidency this would lead to the claim ‘Trump is improving the US economy’. But this is false, such acceleration would be expected purely for statistical reasons.

Figure 2

The determinants of US growth

Finally, if the reasons for the US long term economic slowdown are analysed these are simple. The most fundamental of all features of the US economy is that it is a capitalist economy. This means when there is a high rate of capital accumulation the US economy grows rapidly, when there is a low rate of capital accumulation the US grows slowly.

In terms of economic statistics net capital accumulation is equal to net savings. Figure 3 therefore shows the long-term trend in the US savings rate/capital accumulation rate since 1929. The curve of long term development of the US economy can be seen to be clear:
  • During the crisis creating the beginning of the Great Depression in 1929-33 US capital accumulation was negative – that is the US economy was creating no capital. This necessarily produced a deep crisis of the US economy. After this the rate of US savings/capital creation rose, with a powerful acceleration during World War II, to reach a long-term peak as a percentage of the economy in 1965.
  • After 1965 US net savings/capital creation steadily fell as a percentage of GDP until it once again became negative during the ‘Great Recession’ in 2008-2009. This declining trend of US capital creation of course explains the long-term growth slowdown that was shown in Figure 1.
This trend therefore shows the fundamental issue confronting Trump which he would have to overcome to accelerate the long-term growth of the US economy. He would have to increase the percentage of capital creation in the US economy. Without this, while a short-term speed up in the US economy is to be expected for the statistical reasons given earlier, no long term acceleration of US economic growth will take place. Without such a sharp increase in the level of capital accumulation claims by Trump that he will accelerate the US rate of growth are purely ‘hot air’.

Figure 3

It is clear that the first effect of Trump’s policies will not be to increase but to reduce US savings/capital accumulation. This is due to the fact that an economy’s savings are not only household savings but company savings plus household savings plus and government savings – government savings in most economies being negative because the government runs a budget deficit.

Trump has announced policies that will clearly increase the US budget deficit – tax cuts focussed on the rich and increased military spending. This increased budget deficit will necessarily reduce the US savings level.

In the purely short term Trump could lessen the effect of low US savings/capital creation by borrowing from abroad. But historical experience shows that over the medium/long term in major economies it is domestic capital creation which is decisive. Therefore, Trump has so far announced no policies which will increase the long-term US growth rate. Therefore, in summary:
  • A short-term speed up of the US economy is likely for the statistical reasons already given – but does not indicate any increase in long term economic growth.
  • Trump has no put forward policies that will accelerate US long term economic growth.
Finally, these trends show which data must be closely watched to see success or failure in Trumps economic policies. The short term shifts in the growth rate must not be seen in themselves but compared to the long term trend of US growth: the key variable for judging long term US growth is whether the level of capital formation in the US economy is rising or falling.

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This article was originally published in Chinese by New Finance.

Monday, 16 January 2017

The world will be listening to Xi Jinping at Davos

By John Ross

Xi Jinping is the first Chinese president to speak at the Davos World Economic Forum. This visit has attracted even greater international media attention than the normally high levels of interest in a trip by China's leader. As the Financial Times chief foreign affairs columnist Gideon Rachman put it, "The big star of this year's forum is certain to be Xi Jinping."

The reason for this is well understood. China's unequivocal support for open economies and globalization is now clearly in contrast to the protectionism embraced by U.S. President-elect Trump and that was manifested on a smaller scale in the U.K. Brexit referendum.

In terms of declared positions on globalisation, a definitive turning point has already been made. Every U.S. president since World War II has at least verbally committed to free trade and globalisation. Trump explicitly broke with this historical U.S. position with threats to impose a 35 percent tariff on Mexico, a 45 percent tariff on China, to impose a U.S. "border tax", to renegotiate the North American Free Trade Agreement (NAFTA), by his pressure for U.S. companies not to invest in Mexico despite it being a NAFTA partner and by his clear overall policy statements. In parallel, while the reality of the Trans Pacific Partnership (TPP) was not a move for freer trade - being in reality an anti-China bloc - nevertheless its unilateral abandonment by Trump made the U.S. appear an unreliable negotiating partner.

Whatever happens in the future, there can never again be 100 percent certainty that the U.S. remains committed to globalisation. This fundamental pillar on which the post-World War II global order was built is no longer solid. It is widely understood that of the world's two largest economies, only China remains unequivocally committed to globalisation.

This directly and powerfully affects other countries in addition to China - hence the wide international interest in Xi Jinping's Davos visit. Other countries well understand, both factually and theoretically, the decisive importance of the international trade and globalisation.

Factually, numerous studies demonstrate the positive correlation of an economy's international openness and its development speed. Growing internationalisation by almost all countries was a decisive trend during the long period of relative global international economic stability and growth after World War II - a marked contrast to 1929-39 global economic fragmentation, marked by the infamous U.S. Smoot-Hawley protectionist tariff, which led to the greatest economic crisis in modern history.

Clear theoretical understanding of economic openness's advantages has existed for over two hundred years. The first sentence of the founding work of modern economics, Adam Smith's The Wealth of Nations, is, "The greatest improvement in the productive powers of labour… have been the effect of the division of labour." But division of labour in a modern economy has reached a point where it is necessarily international in scale. International supply chains, which alone ensure the cost efficiency of modern production, flow from the reality that different countries have different advantages in different parts of production. Attempts to create self-contained national economies necessarily make economies less efficient. Therefore, every strategy of "import substitution" or attempt to create an efficient national self-contained economy necessarily fails.

U.S. protectionism's negative effects, with its inevitable international reciprocal retaliation, would hit even the U.S., the world's largest economy - increasing prices of imported goods for consumers and costs for U.S. producers while restricting export markets. Even for the U.S., three quarters of the world market in economic terms and 95 percent of the world's customers in population terms lie outside its borders. A protectionist U.S. economy cannot match the advantages of orientation to a global economy.

But for Germany, 95 percent of its potential market is outside its borders, for Brazil 97 percent, for Australia 98 percent, for Thailand over 99 percent. Protectionism would be more damaging for them than the U.S. Such countries therefore applaud Xi Jinping's unequivocal defence of globalisation - not because of deference to China, but out of national self-interest because globalisation really is "win-win."

Sometimes in the media there is loose talk of a "rise of protectionism and populism." But this imprecise expression conceals a precise reality. In some European countries, there certainly is an increase in support for protectionist populist parties - for example, in France Marine Le Pen's National Front or the Alternative in Germany. But these are minority parties who are not in power and who in most cases have no realistic prospect whatsoever of forming governments. Only in the Anglo-Saxon economies have protectionist forces actually come to office or been able to determine government policy.

The overwhelming majority of countries, including traditionally firm U.S. allies such as Germany or Australia, have expressed opposition to Trump's protectionist policies. When Germany's Chancellor Merkel recently said, "We see protectionist tendencies," she was naturally discreet enough not to mention the U.S. But most people were well aware that the U.S. was included in the countries she was speaking of. A large majority of other countries listening will strongly agree either publicly or silently with Xi Jinping's clear statements in support of open economies and globalisation at Davos.

Maintaining an internationally open economy is vital not only for governments but for the world's population. Globalisation has brought immense benefits to the majority of the world's people, strongly confirming economic theory. Certainly, socialist countries were most able to take advantage of globalisation's benefits. The world's four fastest growing economies in the last 30 years have been socialist - China, Laos and Vietnam, together with a Cambodia whose economic policies are decisively influenced by China. China experienced the world's most rapid rise in living standards. Eighty-three percent of the people in the world lifted out of internationally defined poverty were in China, and a further 2 percent were in Vietnam - only 15 percent were in capitalist countries.

But while socialist countries made the most efficient use of globalisation, other countries also strongly benefitted. India under Modi has consciously moved closer to China's economic model, and India is now the world's other major rapidly growing economy. Several African countries, basing themselves on globalisation, have achieved growth rates of 6-8 percent a year.

Certainly the political crisis in the Anglo-Saxon countries, which has produced support for the protectionist dead ends, was created by a failure to improve their population's living standards. U.S. median household incomes are lower than 16 years ago, U.S. inequality has soared. In the U.K., real incomes in the last eight years experienced their most prolonged decline for a century. But this was not inherent in globalisation, as demonstrated by the dramatic improvements achieved by most countries, but a result of the specifically neo-liberal paths launched by Reagan and Thatcher. It is for this reason, not globalisation, that a protectionist political dead end has become strongest in the Anglo-Saxon economies.

China's support of globalisation, symbolised in Xi Jinping's Davos visit, corresponds to China's national self-interest. But it also corresponds to the national self-interest of other countries and peoples. Mutual self-interest is the firmest of all foundations for cooperation.

It is for this reason Xi Jinping's visit to Davos has attracted such intense international interest.

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This article originally appeared at China.org.cn.

Thursday, 5 January 2017

British economic crisis is deepening

By Tom O’Leary

2017 has begun with some upbeat economic survey evidence although the majority of economic forecasters are cautious about whether this will be sustained. Leading stock market are also at or close to all-time highs. The reality is that the UK economic outlook is deteriorating. This will have both important economic and political effects over the course of the year.

Chart 1 below shows the nominal growth rate of profits for UK companies, quarter-on-quarter. Profits (more accurately the gross operating surplus) of firms have fallen marginally before inflation is taken into account. Once the effect of price rises is included, the fall in profits becomes more substantial.

Chart 1. Quarterly growth of UK companies, quarter-on-quarter
Source: ONS
Quarterly growth rates can be misleading, in part because they also reflect the impact of immediately preceding growth rates. If these were substantial, as in Q1 2016, then the effect is to depress subsequent quarterly growth. In a less erratic measure, the moving average of the last 5 quarters year-on-year growth rate in profits is 0.8%. This is extremely weak, and turns negative in real terms, once inflation is taken into account. It is much weaker than the long-run average growth in profits for the UK economy, which has effectively been slowing down since the early 1970s, with cyclical fluctuations.
Chart 2. UK companies’ year-on-year growth rate of profits, 1956 to 2016
Source: ONS
Profits matter. The creation of surplus value and accumulation as profit is the motor force of any capitalist economy. While every individual firm will continue to seek to maximise profits, if the total accumulation of profits is close to zero, then firms as a whole will primarily seek to maintain their capital rather than to expand it. Capital preservation is the priority.

This is exactly what has happened in the recent period. Firms have stopped investing, and are generally content to hire workers only as an alternative to capital investment or where they can enforce limited hours, low pay, zero hours or other increases in exploitation. In each of the first 3 quarters of 2016 the total level of business investment was below the equivalent period in 2015. In the quarter to October there was no growth in employment, while full-time employment fell by 50,000, made up by a similar rise in part-time work.

These trends represent the acceleration of longer-term tendencies in the UK economy. Chart 3 below shows the contribution of the different sectors of the UK economy to the total accumulation of the capital stock. From 1997 to 2015 UK companies increased their net capital stock by less than 1.5% per annum.
Chart 3. Net capital stock growth 1997 to 2015

Source: ONS
In absolute terms the company sector increased its capital stock by £390 billion over the period. But the combined increase in the capital stock from the household and government sectors significantly exceeds this total, rising by a combined £600 billion! The UK has not been able to rely on the private business sector to lead productive investment for a long time.

But this long-term trend has become more pronounced since the crisis. Private companies’ net capital stock has risen by little more than 1% on average per year since 2007. This profit-induced weakness of business investment is the primary cause of the Great Stagnation in the UK and in other advanced industrialised economies since the crisis.

Brexit effect

Since the Brexit vote profits have declined outright and so has business investment. Manufacturing has declined by 1% since June and industrial production has fallen by 2%. The trade gap has widened by £8 billion compared to the same period in 2015, an increase of almost 20%. The forecasts of sunny uplands by the Brexiteers are purely delusional.

There are many single markets in the world. The British economy is itself one, with minor exceptions there are common laws, freedom of movement for goods, capital firms and people, and a unitary currency and fiscal policy. The benefit of the EU Single Market in the making is that it is one of the world’s three largest single markets, alongside China and the US. This provides a powerful magnet for capital seeking profits. 

Of course it is possible for small amounts of capital to make very large profits investing in a small market, such as the UK would become with Brexit. But it is impossible for a large mass of capital to make large returns in a small market. And Britain needs large capital inflows simply in order to finance its external deficits.

British firms are struggling to realise profits. Ever since the crisis their level of investment has been abysmally low. This deepened the long-run negative trends in the UK economy. These have become sharply worse since the June 23 referendum. In any Brexit scenario, the less the access to the EU Single Market, the lower the attractiveness of the UK to international capital. Without a dramatic change in Brexit policy, there is little reason for optimism about UK economic prospects in 2017.