FEATURE | REFUTING SECUlar StAGNATion in The GlOBal EcONOMY Refuting Secular Stagnation in the Global Economy By Paul Ehrlichman hen I read about a particular Most attempts to mathematically explain point of view about the future, markets and the economy fail miserably because they W I want to understand the philo- “ sophical framework that guides the writer’s ignore this distinctly human dynamic of anticipation, thinking. So here I define the key idea upon adaptation, imitation, and reflection. which my outlook on the global economy is built: ” Humans appear to be the only species with The Panic of 1873: A Better Parallel by real business conditions. Cheap U.S. foresight. The ability to abstractly ponder Ben Bernanke is a student of the Great goods flooded European markets in an consequences of our actions is both a bless- Depression of the 1930s. Because he was American commercial invasion that sent ing and a curse. Our foresight drives the chairman of the Federal Reserve during the thousands of European farmers, merchants, construct that predicting the future must 2008–2009 global financial crisis (GFC), and manufacturers into bankruptcy. change the future, and this construct tends the Great Depression has defined both pol- European banks became worried about sol- to result in a constant series of unexpected icy and the prevailing view of the global vency and began calling in overseas railroad outcomes. economy. It also has led to the expectation loans, choking the boom in U.S. rail con- of a long period of below-trend growth and struction. On September 18, 1873, the Most attempts to mathematically explain the risk of a deflationary spiral popularly investment bank Jay Cooke & Company markets and the economy fail miserably known as “secular stagnation.” declared insolvency. The New York Stock because they ignore this distinctly human Exchange then closed for 10 days. Over the dynamic of anticipation, adaptation, imita- But the Panic of 1873 might be a better guide next two years 18,000 businesses failed and tion, and reflection. Therefore, many of the for thinking about long-term developments the unemployment rate hit 8.8 percent. ideas I present below have been formed by in today’s global economy. Scott Reynolds Falling commodity prices and monetary- accounting for the complexity of human Nelson, a professor of history at the College policy blunders led to a period of deflation. behavior and the belief that the world is of William and Mary, draws similarities Populist-based laws also extended the shaped by our often-flawed expectations of between the two crises (Nelson 2008). By downturn with increased tariffs, taxes, regu- the future. 1871, the world was focused on U.S. post- lations, and transfer payments. The contrac- Civil War reconstruction and the founding of tion lasted until 1879 in the United States From this standpoint, I believe that we are the German Empire. New financial institu- and two years later in Europe and Britain, experiencing a sluggish recovery from a tions and liberalization of incorporation laws but the economic landscape had shifted deep cyclical recession rather than secular led to a credit-fueled real estate and invest- structurally. A new superpower had stagnation. The global economy is in a ment boom in Europe. Capital flowed across emerged and the period of recessionary painful period of adjustment and rebalanc- the Atlantic Ocean to fund massive spending adjustment had laid the groundwork for the ing as unsustainable drivers of economic in the emerging U.S. economy, particularly Gilded Age and the empires of Morgan, growth give way to new ideas, new leader- the railroad industry. The beginning of the Carnegie, and Rockefeller. ship, and innovation that will lead to sus- industrial revolution along with an expan- tainable growth. As part of this transition, sion of global trade led to expectations of a Post-panic, the United States became the the locus of beneficial economic reform golden age of peace and prosperity. locus of global economic growth and trans- and global growth is shifting to the East. formed into a manufacturing and mercantile Taken together, I believe these factors place Increasing leverage, however, allowed asset powerhouse. U.S.-centric technological the global economy on the path to renewed prices and the expansion of industrial innovations fueled the subsequent industrial and long-term prosperity. capacity to move beyond what was justified revolution. The cost of goods plunged as SEPTEMBER / OCTOBER 2015 21 © 2015 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved. IWM SepOct15 Composite.indd 21 9/28/15 10:13 AM FEATURE | REFUTING SECUlar StAGNATion in The GlOBal EcONOMY productivity levels jumped, leading to better ment directly and indirectly supported Continental Europe faced a banking-led living standards for millions. Nelson (2008) automakers, homebuilders, mortgage lend- crisis and the end of a debt-fueled economic summed up the parallels between the Panic ers, banks, and renewable energy firms, bubble in many of the peripheral nations. of 1873 and the GFC with the following: building the largest public debt in the The eurozone countries of Portugal, Ireland, nation’s history. The primary macroeco- Italy, Greece, and Spain began unsustainable In the end, the Panic of 1873 demon- nomic effect was to maintain a large spending binges fueled by low interest rates strated that the center of gravity had amount of inefficient capacity that delayed but without accompanying levels of produc- shifted west—from Central Europe to the a recovery in wages, business investment, tivity necessary to support their economies. United States. The current panic [the crisis and real consumer spending. These actions These sharp economic, political, and funda- of 2008–2009] suggests a further shift— may have softened the post-crisis recession mental differences within Europe delayed from the United States to China and India. but they also resulted in an extended and shaped government response to the period of sluggish growth. Economists, crisis. In coordination with the European 1873 Redux: The Global among them James K. Galbraith in his Central Bank (ECB), the weakest countries Financial Crisis 2014 book The End of Normal, generally were placed on a path of sharply reduced The resemblance of this period of boom, view this below-trend recovery pace as fiscal and current account deficits. The bust, and painful transformation to the structural in nature. Galbraith, former region’s financial institutions were required post-GFC world is startling. Excessive opti- Treasury Secretary Lawrence Summers, to significantly increase capital adequacy, mism and use of new credit instruments and economist Paul Krugman among which had the effect of shrinking lending fueled speculative bubbles in technology, others, contend that a combination of past capacity. The initial impact of these policies real estate, and commodity investment over excesses, policy errors, demographics, lag- was painful as unemployment rose and the 20 years pre-GFC. The United States ging innovation, and productivity will lead growth remained depressed, causing the played the role of 1870s Europe in leading to a period of secular stagnation. public to push back against austerity. The the financing of these booms as China ECB at first maintained too-tight a mone- played the role of the emerging superpower Policy Responses and Risks tary policy given the conditions, then that shifts global competitive dynamics. To avoid such stagnation, the U.S. Federal embarked on a powerful program of quanti- Belief in the super cycle of never-ending Reserve lowered interest rates to effectively tative easing by the end of 2014. developed-country demand for goods zero and began a program using the uncon- resulted in a massive oversupply of tradable ventional tool of quantitative easing (QE), Japan, suffering from nearly 20 years of slug- goods and commodities. Monetary and where the central bank buys up govern- gish growth, had few policy options given political blunders extended the duration of ment and/or other securities to lower inter- already-high public debt and near-zero the downturn. Nevertheless, this is also a est rates and increase the money supply. interest rates. After the election of Prime period of rebalancing and transition from This policy mix was adopted eventually by Minister Shinzo Abe to a second term in unsustainable to sustainable drivers of the central banks of Europe, Japan, and the December 2012, the government believed global growth. United Kingdom and led to weakness in that the country’s problems were structural the respective non-dollar currencies. The in nature and sought to change the behavior After a crisis, market dynamics relentlessly effectiveness of QE in boosting the real of institutions, companies, and society. shift capital from weak to strong hands as economy has been mixed; the suppression Businesses were incentivized to increase consumers and companies with adequate of interest rates led to a rise in financial profitability and growth. The Bank of Japan liquidity benefit from cheaper tradable asset prices. Central-bank policy supported shifted from a policy of high real rates that goods and productive asset prices. The bad debtors at the expense of savers and helped accepted deflation and a strong yen to a actors tend to retain significant political shift the burden of excessive leverage to the massive program of qualitative and quantita- and social power; they resist the process public sector. tive easing that explicitly supports an expan- and receive bailouts and other benefits sion of fiscal stimulus. With this the “three from targeted expansionary government China reacted to the global financial crisis arrows” of monetary, fiscal, and structural programs. The British fell into this trap with a massive program of government support for economic growth came to define during the 1873 recession and substantially spending on public infrastructure such the program called “Abenomics.” lagged the worldwide recovery well into as housing, roads, dams, schools, and the 1890s.