Ending the Era of Ponzi Finance

Ending the Era of Ponzi Finance

          
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Ending the Era of Ponzi Finance

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  • A Broken Growth Formula

    Addressing these challenges at any time would be difficult. To make matters even worse, however, they come at a moment when the developed world’s traditional model of economic growth appears to be broken. This is partly a consequence of the Ponzi scheme itself. Economic growth is negatively affected by high levels of debt. In this respect, the tendency of the developed economies to fund today’s living with future income has not only created the global Ponzi scheme—it has also severely undermined the ability to resolve it. But the broken growth model is also due to long-term demographic trends and other changes.

    Debt’s Drag on Growth. Economists Carmen Reinhart and Kenneth Rogoff have demonstrated that as soon as government debt crosses the threshold of roughly 90 percent of GDP, it begins to have a negative impact on an economy’s growth rate. In addition, the BIS has shown that the impact is similar for nonfinancial corporate debt and household debt, and that at least two of these three sectors have crossed the 90 percent threshold in most of the developed economies. (See Collateral Damage: What Next? Where Next?—What to Expect and How to Prepare, BCG Focus, January 2012.)

    Oversized Public Sectors. The government’s share in the economy, measured by government spending as a share of GDP, has a negative impact on economic growth as well. A recent study found that an increase in government size of 10 percentage points is associated with a lower growth rate of between 0.5 percent and 1 percent. In most European countries, government spending is currently about 40 percent of GDP or more, and in some countries, such as France and Denmark, it accounts for nearly 60 percent. (See Exhibit 3.) Even in the U.S., government spending’s share of GDP is 40 percent. By contrast, the share of government spending in developing countries is between 20 and 40 percent. Oversized public sectors create an additional drag on future growth, amplifying the impact of too much debt.

    exhibit

    A Shrinking Workforce. A critical problem in the decades to come will be labor scarcity. This may seem strange given that many advanced economies are currently suffering from high unemployment. But according to projections by the United Nations, between 2012 and 2050, the working-age population between the ages of 15 and 64 in Western Europe will shrink by about 13 percent (by 15.8 million people). In Japan, it will drop by 30 percent (by 23.8 million people). The U.S. working-age population will grow slightly, at 0.4 percent per year, but that is slower than the annual growth rate of 1.1 percent over the past 20 years. The fewer people in the workforce, the less GDP generated and, therefore, the less income available to pay down existing debt.

    This trend is not limited to the developed world. China and Russia will also see their workforce shrink by 2020. Meanwhile, the workforce in India, the rest of Asia, Latin America, and Africa will grow at least until 2040 and perhaps even beyond. (See Exhibit 4.)

    exhibit

    Slower Productivity Growth. Just as important as the number of available people in an economy’s workforce is the productivity of that workforce. Consistent increases in productivity have made possible the economic transformation of the developed world over the past 200 years and of emerging markets today. There are signs, however, that the rate of improvement in productivity is in decline. In a provocative paper, the renowned growth researcher Robert Gordon, of Northwestern University, makes a compelling case that growth in GDP per capita has been slowing since the middle of the twentieth century. He argues that “the rapid progress made over the last 250 years could well turn out to be a unique episode in human history.”

    Diminishing Returns from Innovation. Of the factors Gordon cites for this phenomenon, the most important is diminishing returns from innovation. In the 1920s, the Russian economist Nikolai Kondratiev identified a pattern of economic growth consisting of successive “long waves” of economic development, in which periods of rapid growth were interspersed with periods of slower growth and financial crisis before a new cycle of growth began. Later, the Austrian economist Joseph Schumpeter showed how these long waves were associated with major advances in basic innovation—for example, the steam engine, electricity, and the automobile.

    According to Gordon, the problem today is not merely that the incremental productivity impact of the most recent wave of innovation, associated with information technology and communications, has diminished in recent decades. Rather, he argues that the space for truly fundamental innovations that result in step-change improvements in living standards is getting smaller and smaller. As he puts it, the invention of indoor plumbing was orders of magnitude more important than the invention of the iPad, Twitter, and Facebook. (See Exhibit 5.)

    exhibit

    Of course, Gordon’s view may underestimate the creative power of entrepreneurship to identify and bring to market productivity-enhancing innovations, as The Economist has recently argued. Nevertheless, his view needs to be taken seriously. Innovation may continue to have a positive impact on GDP and living standards, but the marginal effect may very well be less significant in the future than it was in the past.

    Deteriorating Education Systems. The deteriorating quality of education in most advanced countries also undermines future growth potential. Today, China produces more scientists every year than the U.S.—approximately 310,000 in 2010 compared with 255,000 in the U.S.—and about ten times the number of engineers (2.2 million). And the number of educated people is just one side of the coin. Asian countries regularly surpass developed nations in educational results. In 2009, when Chinese students (from Shanghai) were included for the first time in the OECD’s triannual PISA (Programme for International Student Assessment) tests, they immediately ranked first.

    Increasing differences in education within the countries of the developed world are an additional burden. In the U.S., the “achievement gap”—the performance difference between African Americans and Hispanics, on the one hand, and white and Asian Americans, on the other—has widened, leading to overall poorer results as the first two groups’ share of the population grows. The same holds true for most countries in Europe, where the descendants of immigrants from Turkey, Africa, and the Arab world tend to perform less well than nonimmigrants or the descendants of immigrants from other regions. Unless these performance differences are addressed, it will be increasingly difficult for members of the next generation to compete with the rest of the world and with each other—let alone pay for the retirement of the current generation of baby boomers.

    Systemic Underinvestment in the Asset Base. Any global traveler will have experienced how much progress the developing world has made in its investment in public and private infrastructure. At the same time, the public and private sectors in the developed world have underinvested in capital stock. This will have a negative impact as well, because capital investment is a key determinant of future productivity and income generation.

    Despite record-high profit margins, businesses in the developed economies have significantly reduced their investment in new machinery and equipment. A recent Goldman Sachs report argues that Europe has witnessed a decade of underinvestment, starting before the financial crisis and intensifying since then. The average asset age increased to 10.3 years in 2011 from 7.4 years a decade before, representing an investment backlog of some €800 billion. The same trend holds true for U.S. companies. Nonfinancial corporate businesses in the U.S. show significantly higher savings levels compared with investments in almost every year since 2000; there is also a clear downward trend in net domestic fixed investments relative to GDP. (See Exhibit 6.)

    exhibit

    The End of Cheap Resources. Ever since the 1972 publication of The Limits to Growth by the Club of Rome, there has been an ongoing debate about how long the easy (and relatively economical) availability of the world’s natural resources will last. Some observers are confident that long-term declines in the price of raw materials (real prices have fallen by half since the 1860s) will continue, citing the fact that new raw-material deposits have been regularly found or substitutes identified. Others, however, argue that the period of declining prices has come to an end.

    On balance, it makes sense to assume structurally higher raw-material prices, notwithstanding constant and high volatility in the economic cycle. The speed of economic development in the emerging markets and the sheer number of people aspiring to a developed-world lifestyle support this view. Efforts to reduce energy consumption and carbon-dioxide emissions in order to protect the environment will lead to higher costs as well. And if the scenarios predicted by researchers are correct, the costs of dealing with the implications of climate change will only increase in the coming decades.

    In conclusion, the availability of cheap natural resources, which for more than a century has been an enabler of productivity improvement, may be ending. Higher costs will lead to more global disputes over resources and fewer financial resources to pay down debt.

    Intensifying International Competition and Rising Inequality. Globalization has brought the promise of economic prosperity to billions of people around the world. But it has also contributed to tougher international competition and the creation of new inequalities of wealth and income in the developed world. The growth in the global labor force continues to put pressure on labor costs in developed economies. At the same time, globalization is leading to increasing inequalities in income and wealth within countries, as some groups (such as investors) benefit more from increased globalization than others (such as manufacturing workers).

    Income statistics highlight this development: between 1979 and 2007, the income of the average U.S. household grew by 62 percent. Over the same period, the income of the top 1 percent of households grew by an extraordinary 275 percent and the income of the rest of the top 20 percent grew by a slightly above-average 65 percent, while the income of the remaining U.S. households grew by less than 40 percent. The incomes of the lowest quintile grew by only 18 percent.

    Inequality increases the risk of social unrest and declining support for capitalism and a free society. As University of Chicago economist and former IMF chief economist Raghuram Rajan points out, “Ultimately, a capitalist system that does not enjoy popular support loses any vestige of either democracy or free enterprise.”

    Paralyzing Uncertainty: The Costs of Not Acting. No one knows how long the developed world’s Ponzi scheme can go on without causing major social and economic breakdowns. As long as it does, however, economic uncertainty will remain high. One indicator of growing uncertainty is an index developed by economists Scott Baker and Nicholas Bloom, of Stanford University, and Steven Davis, of the University of Chicago. (See Exhibit 7.) Their “economic policy uncertainty index” shows not only that overall levels of uncertainty have risen since the financial crisis, but also that this uncertainty is increasingly driven by political disputes over economic issues rather than by events such as 9/11, for example, or military conflicts such as the First Gulf War. To the degree that politicians and other leaders fail to address the structural challenges described in this paper, the odds of economic paralysis go up.

    exhibit

    The underlying issues cannot be ignored any longer. The developed world faces a day of reckoning. It is time to act.

    Carmen M. Reinhart and Kenneth S. Rogoff, “Growth in a Time of Debt,” National Bureau of Economic Research (NBER) Working Paper No. 15639, January 2010.
    Stephen G. Cecchetti et al., “The Real Effects of Debt.”
    Andreas Bergh and Magnus Henrekson, “Government Size and Growth: A Survey and Interpretation of the Evidence,” Journal of Economic Surveys, Social Science Research Network, January 2011.
    Indermit Gill and Martin Raiser, “Golden Growth: Restoring the Lustre of the European Economic Model,” World Bank, January 2012.
    United Nations, World Population Prospects, 2010 revision, June 2011.
    Robert J. Gordon, “Is U.S. Economic Growth Over? Faltering Innovation Confronts the Six Headwinds,” NBER Working Paper 18315, August 2012. The paper is also discussed in Marc Faber, “No Rational Thought Will Have a Rational Effect on a Man Who Has No Rational Attitude,” The Monthly Market Commentary Report, November 1, 2012.
    For a more detailed discussion of Kondratiev cycles, see Collateral Damage Part 5: Confronting the New Realities of a World in Crisis, BCG White Paper, March 2009.
    See also Martin Wolf, “Is Unlimited Growth a Thing of the Past?Financial Times, October 2, 2012
    Productivity and Growth: Was That It?The Economist, September 8, 2012.
    See European Commission, Eurostat (figures for Europe and the U.S.), and National Bureau of Statistics of China.
    OECD, “PISA 2009 at a Glance,” 2010.
    Gordon, “Is U.S. Economic Growth Over?”
    In Germany, for example, the overall performance of pupils is directly correlated with the number and origin of immigrants. A larger share of immigrants from Turkey, the Middle East, and Africa tend to be associated with significantly lower ability in reading and math. See Bertold Wigger and Georg-B. Fischer, “Die Zuwanderung macht die Differenz,” Frankfurter Allgemeine Zeitung, October 19, 2012.
    Corporate Margins Reaching Record Levels,” Financial Times, January 29, 2012.
    Goldman Sachs, “Spending the Way to Growth, Part 1: Capex,” March 2012.
    Dylan Grice, “Popular Delusions: Commodities for the Long Run? Not on Your Nellie—I’d Rather Eat Coal!!” Société Générale Global Strategy Alternative View, December 15, 2010.
    See Jeremy Grantham, “Time To Wake Up: Days of Abundant Resources and Falling Prices Are Over Forever,” Jeremy Grantham’s Quarterly Newsletter, April 2011, and “On the Road to Zero Growth,” GMO Quarterly Letter, November 2012.
    DARA, Climate Vulnerability Monitor: A Guide to the Cold Calculus of a Hot Planet, 2nd ed., Fundación DARA Internacional, 2012. The report estimates the carbon economy and climate-related net losses for 2010 at 1.6 percent of global GDP and forecasts an increase to 3.2 percent by 2030. See also Thomas C. Peterson, Peter A. Stott, and Stephanie Herring, “Explaining Extreme Events of 2011 from a Climate Perspective,” Bulletin of the American Meteorological Society, July 2012.
    Martin Wolf, “Romney Would Be a Backward Step,” Financial Times, October 30, 2012. The numbers can be found in U.S. Congressional Budget Office, Trends in the Distribution of Household Income Between 1979 and 2007, October 2007.
    Raghuram Rajan, “Legitimacy Rests on Restoring Opportunity,” Financial Times, October 17, 2012.
    Scott Baker, Nick Bloom, and Steven J. Davis, “Measuring Economic Policy Uncertainty,” Working Paper, June 4, 2012. The index is available at http://www.policyuncertainty.com/.
    The Japanese financial-services group Nomura recently estimated that additional uncertainty, defined as a one-standard-deviation increase in the dispersion of earnings forecasts for companies in the S&P 500 index, is associated with a 4.9 percent fall in fixed investments and a 0.5 percent fall in GDP over one year. See “Economics Must Heed Political Risk,” Financial Times, November 6, 2012.