Expect neither a recovery nor a recession
The challenge for Western economies is not achieving a soft landing to stave off recession but a sustained, solid expansion to avoid declining wages and rising inequality.
In a nutshell
- The overall economic picture in the West is not bleak but hardly exciting
- Policymakers seeking to avoid recessions are ignoring the stagnation threat
- Without robust private investment and strong growth, problems will endure
It took central bankers about a year to grasp that exceedingly easy money and credit eventually lead to sustained inflation. Yet, when it arrived, their response remained remarkably restrained. Rather than freeze the nominal money supply and stop manipulating the credit market, the United States Federal Reserve and the European Central Bank focused on trying not to upset the apple cart. They merely slowed down the creation of new money, confirmed their easy-credit policy by keeping key real interest rates negative and financing government expenditure and waited for inflation to erode the money supply in real terms, hoping for the best.
Of course, central bankers had two legitimate concerns. They did not want to trigger a public finance catastrophe by rapidly increasing the cost of debt servicing, (particularly public debt) and upsetting the balance sheets of many banks burdened by long-term bonds. Also, they wanted to avoid a sharp recession: unemployment and double-digit inflation would have hit vast layers of the population and created deep social unrest with unpredictable political consequences. For example, think of how the Russian invasion of Ukraine would evolve if the West were enfeebled by prolonged high inflation, rising unemployment and plummeting real incomes.
Where are we now?
During the past 12 months, the economic situation in the Western world has beaten expectations. Real wage rates declined, but unemployment is currently at its lowest level in over 50 years in the U.S., below 3 percent in Germany and the lowest in the euro area since the introduction of the common currency. Economic growth rates are far from vibrant, but no major crisis is in sight. In contrast with gloomier earlier predictions, the U.S. and the eurozone economies are expected to stagnate in 2023 and move into positive territory in 2024.
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One may conclude that even though the overall scenario is not overly exciting, it is far from alarming. While recovery is out of the question, global or continental recessions have been averted. Recovery is not arriving because it already took place in 2020. Instead, the real question is whether Western economies can engage in sustained expansion and avoid stagnation.
At present, this question does not seem to bother Western policymakers much, though; they prefer to focus on how to ensure a “soft landing” (slowdown in economic growth that avoids recession) and gather enough resources to finance grand public projects such as limiting climate change and promoting the clean-energy transition. The remaining part of this report analyses these two issues – the recovery that could morph into long-term stagnation and the outlook for a soft landing.
Why do investors not engage?
Let us first consider the grand picture. The current rhetoric emphasizes consumer demand. When it rises, consumer demand is usually regarded as good news for growth and bad news for inflation – and the opposite when it drops. Central bankers typically refer to these two indicators to fine-tune interest rates and, more generally, monetary policy.
The banking world has preferred to finance governments rather than private businesses, and investors have refrained from expanding their capacities.
Indeed, central bankers do not give up their hopes of waking up one day and discovering that consumer demand expands without generating pressure on prices. That is the ideal suggested by the now-disgraced Modern Monetary Theory (MMT), in which money- and credit-market manipulation meets no limits. Many believed the MMT promises during the 2008-2021 period. That partly explains why some find it difficult to understand what happened during the past three years and only now seem to appreciate the consequences.
Yet, the theory is relatively simple. Over the long run, consumers can increase their demand if they have the necessary purchasing power, which, in turn, depends on what they produce. Production has stagnated in recent years: technological evolution has failed to translate quickly and smoothly enough into new and more efficient production. Regulatory barriers and uncertainty have slowed down such a transition. The banking world has preferred to finance governments rather than private businesses, and investors have refrained from expanding their capacities.
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Therefore, rather than celebrating their ability to promote public expenditure through negative real interest rates, policymakers should wonder why private investors fail to engage in ambitious and long-term projects even when the actual cost of financing is about zero. For example, gross fixed capital formation (investments) in the U.S. today is nearly the same as two years ago and significantly lower if one considers inflation. The same variable for the eurozone has yet to reach its early 2020 level (in nominal terms). The data about labor productivity is also disappointing, although the long-run trend for the U.S. shows some encouraging signs.
The current policymakers’ view seems to ignore that if private investments are not satisfactory, growth will suffer, and governments will not have the additional tax revenues required to finance grand projects or defuse social tensions.
More trouble is coming
Policymakers also seem unable to acknowledge the coming challenges, an additional source of uncertainty that further depresses entrepreneurial spirits and does not bode well for the future. During the next decade, increasingly more intelligent machines will likely replace the existing capital stock and a considerable portion of the labor force.
In the past, such prospects encouraged labor to move from manufacturing into private services and the government sector. Over the next few years, however, governments will not be able to absorb the workforce as much as in the past, and the private sector is complaining about the competence mismatch between the required and the available new entrants. This phenomenon may not affect the employment figures but will significantly impact the wage rates.
Western educational systems are misguided. Public policies that favor more years spent in the classrooms and award ever higher degrees will only make things worse: more hidden youth unemployment and lower educationa standards.
Declining wages, growing inequality
Growth can still occur thanks to introducing more AI machines operated and developed by highly qualified technicians. However, it is not evident that all Western countries can accept declining real wages for unskilled workers and, consequently, higher inequalities. In this light, the U.S. may be more flexible and accommodating than Europe. If so, growth in the Old Continent will remain problematic, and recession could be in the cards for several countries.
Regarding recession, once again, labor markets will play a significant role. Central bankers are betting on the ongoing drop in real wages and widespread optimism in the business world. If so, they assume there will be no further inflationary pressures. Low unemployment will ensure that social tensions and demands on the welfare system are contained and that “animal spirits” drive investments.
Stalling investments, social tensions
In contrast with the current narrative, however, central bankers aim at the wrong target: tight labor markets do not fuel inflation. After all, the nominal money supply has stopped growing and is dropping in real terms. Unless the monetary authorities reverse course, inflation will gradually die out, although at a slower pace than central bankers had anticipated. But if labor costs eventually catch up with inflation and the money supply remains practically frozen, profits will be squeezed, and debt financing will become more expensive. In other words, investments will stall, and some businesses might face heavy losses.
It is unclear how the world of politics – including central bankers – will react to a scenario characterized by troubled public accounts, rising inequalities and social tensions or to the alternative picture featuring lower profits, modest investments, business troubles and zero growth. The latter would still allow a soft landing, possibly followed by prolonged stagnation. However, the West would be heading toward big problems instead if the former scenario materializes and social policies – that is, more public spending and compassionate monetary policies – are the result.