The Real Challenges to Growth

Soon after the near-collapse of the financial system, the consensus view in favor of a reasonably normal cyclical recovery faded as the extent of balance-sheet damage – and the effect of deleveraging on domestic demand – became evident. But, even with deleveraging now well under way, the positive effect on growth and employment has been disappointing. In the United States, GDP growth remains well below what, until recently, had been viewed as its potential rate, and growth in Europe is negligible.

Employment remains low and is lagging GDP growth, a pattern that began at least three recessions ago and that has become more pronounced with each recovery. In most advanced economies, the tradable sector has generated very limited job growth – a problem that, until 2008, domestic demand “solved” by employing lots of people in the non-tradable sector (government, health care, construction, and retail).

Meanwhile, the adverse trends in income distribution both preceded the crisis and have survived it. In the US, the gap between the mean (per capita) income and the median income has grown to more than $20,000. The income gains from GDP growth have been mostly concentrated in the upper quartile of the distribution. Prior to the crisis, the wealth effect produced by high asset prices mitigated downward pressure on consumption, just as low interest rates and quantitative easing since 2008 have produced substantial gains in asset prices that, given weak economic performance, probably will not last.

The growing concentration of wealth, together with highly uneven educational quality, is contributing to declines in intergenerational economic mobility, in turn threatening social and political cohesion. Though causality is elusive, there has historically been a high correlation between inequality and political polarization, which is one reason why successful developing-country growth strategies have relied heavily on inclusiveness.

Labor-saving technology and shifting employment patterns in the global economy’s tradable sector are important drivers of inequality. Routine white- and blue-collar jobs are disappearing, while lower-value-added employment in the tradable sector is moving to a growing set of developing economies. These powerful twin forces have upset the long-run equilibrium in advanced economies’ labor markets, with too much education and too many skills invested in an outmoded growth pattern.

All of this is causing distress, consternation, and confusion. But stagnation in the advanced countries is not inevitable – though avoiding it does require overcoming a daunting set of challenges.

First, expectations are or have been out of line with reality. It takes time for the full impact of deleveraging, structural rebalancing, and restoring shortfalls in tangible and intangible assets via investment to manifest itself. In the meantime, those who are bearing the brunt of the transition costs – the unemployed and the young – need support, and those of us who are more fortunate should bear the costs. Otherwise, the stated intention of restoring inclusive growth patterns will lack credibility, undercutting the ability to make difficult but important choices.

Second, achieving full potential growth requires that the widespread pattern of public-sector underinvestment be reversed. A shift from consumption-led to investment-led growth is crucial, and it has to start with the public sector.

The best way to use the advanced countries’ remaining fiscal capacity is to restore public investment in the context of a credible multi-year stabilization plan. This is a much better path than one that relies on leverage, low interest rates, and elevated asset prices to stimulate domestic demand beyond its natural recovery level. Not all demand is created equal. We need to get the level up and the composition right.

Third, in flexible economies like that of the US, an important structural shift toward external demand is already underway. Exports are growing rapidly (outpacing import growth), owing to lower energy costs, new technologies that favor re-localization, and a declining real effective exchange rate (nominal dollar deprecation combined with muted domestic wage and income growth and higher inflation in major developing-country trading partners). Eventually, these structural shifts will offset a lower (and more sustainable) level of consumption relative to income, unless inappropriate increases in domestic demand short-circuit the process.

Fourth, economies with structural rigidities need to take steps to remove them. All economies must be adaptable to structural change in order to support growth, and flexibility becomes more important in altering defective growth patterns, because it affects the speed of recovery.

Finally, leadership is required to build a consensus around a new growth model and the burden-sharing needed to implement it successfully. Many developing countries spend a lot of time in a stable, no-growth equilibrium, and then shift to a more positive one. There is nothing automatic about that. In all of the cases with which I am familiar, effective leadership was the catalyst.

So, while we can expect a multi-year process of rebalancing and closing the gap between actual and potential growth, exactly how long it will take depends on policy choices and the speed of structural adjustment. In southern Europe, for example, the process will take longer, because there are more missing components of recovery in these countries. But the lag in identifying the challenges, much less in responding to them, seems fairly long almost everywhere.

Of course, the technological and demographic factors that underpin potential growth ebb and flow over longer (multi-decade) timeframes; and, regardless of whether the US and other advanced countries have entered a long-run period of secular decline, there really is no way to influence these forces.

But the immediate issue confronting many economies is different: restoring a resilient and inclusive growth pattern that achieves whatever the trend in potential growth permits.