Death of Demand
World Economics Research Group
1 September 2010
Governments throughout the developed world are examining ways to cut the giant public-sector budget deficits that have opened up following the financial crisis. It is widely hoped that a combination of budget cuts and re-emerging economic growth will reduce the problem to manageable dimensions.
This paper suggests that policies dependent on a re-emergence of economic growth to manage deficit situations may in many cases be over-optimistic, as economic growth is likely to be very low in many OECD countries over the next decade. Government forecasts are frequently optimistic, but in the current situation realism is more than usually important. The average rate of real economic growth has been following a largely unrecognised falling trend for many years. Every successive decade since the 1950s has seen a lower rate of real growth than the preceding one. There are few reasons to believe this trend will reverse, but many reasons to believe it may worsen. We believe therefore that corporate and government plans should realistically expect economic growth in the developed countries as a whole of perhaps on third of the 2–3% range commonly
found in government projections. the long-term decline in demand seen over the postwar period is illustrated in Figures 1–4.
There are many plausible explanations for this apparently continuous decline, for which a combination of factors, rather than any single one, is likely to be the cause.
One possible explanation is the near continuous rise in most OECD countries in the proportion of GDP spent by government, and (in a variant of the argument) in the proportion of that expenditure used for purposes other than potentially growth-enhancing investment in health, education, law and other mainstream areas of state involvement. For example, in some countries the proportion of people who have become dependent on state welfare payments has grown steadily over the last half century to levels far above anything seen previously. A second possibility is that the growth of debt, including personal, corporate and sovereign debt, has been so large and continuous that western economies have been, little by little, reaching the limits of debt, where debt itself becomes a drag on economic activity as opposed to a facilitator of growth.
Irrespective of the reasons for the decline in the rate of growth of demand over the last 50 years, the simple fact is that it is many years since output in western countries grew rapidly over long periods of time, and difficult, in the face of this fact, to argue that growth is likely to recover quickly to the higher level that many corporate managements and governments seem to regard as normal and achievable.
In addition to the sheer unlikelihood of significant rises in output emerging, there are of course very special conditions in play at the moment. First and foremost is the explosion of public debt that has arisen in many advanced economies as a result of the financial crisis that erupted in mid2008. According to the OECD, total industrialised public-sector country debt is now expected to exceed 100% of GDP in 2011, something that has never happened before in peacetime.
But this is far from the end of the story. As a Bank for International Settlements (BIS) paper noted recently,‘As frightening as it is to consider public debt increasing to more than 100% of GDP, an even greater danger arises from a rapidly ageing population.’ In most industrialised countries, rapidly ageing populations present governments with the prospect of enormous future costs that are unfunded and simply left out of country balance sheet calculations. The BIS estimates that, once these unfunded costs are added to the equation, public-sector debt/GDP ratios could exceed 300% in Japan, 200% in the United Kingdom and 150% in many other developed countries, including the United States, within the next decade.
Even this doesn’t encompass the totality of western country debt, as it excludes consumer and corporate debt. A recent McKinsey Global Institute survey found that average total debt (private and public sectors combined) in ten mature economies rose from 200% of GDP in 1995 to 300% in 2008. And this without the unfunded costs referred to above.
A recent Economist Special Report summed up the situation well: ‘[The developed countries] have accumulated a mountain of [debt] at every level, from the personal to the corporate and the sovereign.’ This debt mountain is only partly a result of the recent banking crisis, and stems also from much longer-term trends in the increasing use of credit by individuals prompted by increasingly lax lending standards, by increasing use of credit by corporations spurred by the favourable tax treatment of debt, and by governments increasingly hooked on deficit spending to please electorates.
Individuals and companies have been attempting to cut levels of indebtedness for some time, but governments are only now attempting to reduce levels of debt, having been made painfully aware by the recession and the adverse reactions of bond markets to extreme cases such as Greece, that the costs of many welfare and other policies have outrun the ability to pay for them. Crucially, all such attempts to reform personal, corporate and government balance sheets will also initially create further unemployment, and inevitably depress demand.
Analysis by the BIS, McKinsey and others has shown how great the debt burden is today, and how difficult it will be to reduce to manageable levels in coming years. The debt burden can only be reduced by a period of inflation, by debt default, by government cost saving (inevitably largely reductions in employment), or by paying
the debt down from future income streams. Inflation and default both tend to hurt political reputations and so will be avoided until there is little alternative, and default is perhaps unlikely outside Greece. The third course (cutting government spending) is being implemented in most countries with lesser or greater severity, but, at least in the short term, it can lead only to further unemployment and further reductions in demand. The latter case – paying off the debt – is difficult in the absence of economic growth – the main theme of this paper.
As many commentators have noted, the best solution for rich countries is to work off their debts through economic growth. But outgrowing debt is not easy. The McKinsey debt study found that, out of 32 cases of deleveraging following a financial crisis that it examined, only one was driven by growth. The fact is that even in easier times with less debt, developed countries have managed only very modest and declining rates of growth for many years. The factors causing this decline in growth are unlikely to melt away. In addition, the giant debts that hang around the necks of most developed countries will be present for many years, and the even more gigantic unfunded future age-related costs remain somehow to be financed. These costs themselves will further increase the pressure on public finances. Cuts in public-sector workforces will reduce tax revenues and increase unemployment benefit payments. Large public debts have caused a significant rise in risk premia, which increase the cost of funding the debt. And, as the BIS report noted, there is a significant risk that continuing high levels of public debt will drive down capital accumulation, productivity growth and long-term potential growth. Finally, as Reinhart and Rogoff have shown, adverse output effects tend to rise as debt/GDP ratios approach the 100% level.
In these conditions it is difficult to imagine that most developed countries face anything other than a lengthy period of retrenchment, while publicand private-sector debts are reduced. It is likely that the next decade will be one of austerity, with very low average economic growth levels similar to those seen over Japan’s ‘lost decade’. It is time to mark down all those economic growth projections envisaging a return to happier times.