The sun is shining over the global economy | Martin Wolf

From Martin Wolf at FT.com:

The world economy is enjoying a synchronised recovery. But it will prove unsustainable if investment does not pick up, especially in high-income economies. Debt mountains also threaten the recovery’s sustainability, as the OECD, the Paris-based group of mostly rich nations, argues in its latest Economic Outlook.

…..Low investment and high indebtedness are not the only constraints the world economy faces. Political risks are also high, as are threats to liberal trade. But raising investment and lowering debt are high priorities. As President John F Kennedy said in 1962, “the time to repair the roof is when the sun is shining”. It is essential to hack off the overhangs of unproductive private debt bequeathed by the crisis and its aftermath. The transformation will not happen overnight. But we should eliminate the incentives for such risky behaviour.

An excellent summary of the global economy’s strengths and weaknesses. I agree with Martin that low rates of capital investment (which leads to low productivity growth) and high levels of both private and public debt are the major threats to continued growth. And that the time to address it is now.

Click here to read the full article: The sun is shining over the global economy | Martin Wolf

How Will Tax Cuts Affect the US Economy and Corporate America?

Bob Doll at Nuveen Investments discusses the likely impact of tax cuts in the US:

Is it even a good idea to enact tax cuts at this point in the economic cycle? After all, growth has picked up, unemployment is at a 17-year low and capacity utilization is high. It’s reasonable to wonder whether tax cuts spur inflation higher rather than boost economic growth. We agree that inflation is likely to move modestly higher next year (more so if tax rates are reduced), but lower tax rates will likely improve productivity and benefit the economy.

Tax cuts are unlikely to have a significant impact on inflation or productivity other than through indirect stimulation of new investment and job creation.

…..If the corporate tax rate is reduced from 35% to 20%, we estimate this would increase S&P 500 earnings-per-share between $12 and $15 annually. Companies could also see an additional boost in the form of earnings repatriation. It’s possible (and even likely) that some companies would use these earnings benefits to lower prices to increase market share, so some gains may be “competed away.” But we think an overall boost in profits and earnings is likely.

That would amount to an annual increase of between 10 and 13 percent in S&P 500 earnings per share (based on a forecast $114.45 EPS for calendar 2017). Companies that invest in building market share would expect a return on that investment by way of increased growth which would still benefit future earnings streams.

Furthermore, if U.S. companies finally bring their overseas earnings home in a tax-effective manner, it’s fair to wonder what they would do with their cash windfalls. Should this happen, we expect increases in balance sheet improvements, more hiring, a rise in capital expenditures, dividend increases, higher levels of share buybacks and an increase in merger and acquisition activity. All of these actions would be a positive for corporate health and equity prices.

I would expect a big increase in stock buybacks as that will boost stock prices and have a direct impact on executive bonuses. Mergers and acquisitions have less certain outcomes and are likely to be secondary, while new investment and job creation will most likely get the short straw.

Michael Gove on Brexit, productivity and innovation

Interesting viewpoint on Brexit.  How the EU became anti-innovation, erecting barriers to entry which favor incumbents.

Corporate profits and employee compensation

Employee compensation as a percentage of net value added by nonfinancial corporations has been falling since its Dotcom peak in 2000 and is now approaching lows last witnessed in the 1960s. Both rising productivity, through technological advances, and offshoring of blue-collar jobs have contributed to the fall.

Net Value Added: Employee Compensation & Corporate Profits

Corporate profits (as a percentage of net value added by nonfinancial corporations) have shown a corresponding rise for the same period, demonstrating an inverse relationship over the last half-century. Rises and falls in both employment costs and corporate profits (as a percentage of net value added) are most likely attributable to fluctuations in output per employee (productivity) rather than fluctuating wage rates.

The question is: are rises in corporate profits and corresponding falls in employee compensation, as a percentage of net value added, sustainable? Is this time different, or are we likely to witness a peak followed by a sharp fall as in the 1960s? Productivity improvements through offshoring jobs are likely to continue for as long as the Dollar remains strong relative to Asian exporters. In other words, a very long time. Technological advances such as automation may also reduce employment costs per unit of output. But there is no clear answer as to how far profit margins will be eroded by increased competition from Europe and Asia. All we can do is monitor the relationship between employee compensation and net value added for nonfinancial corporations for clues. So far, there is no indication that the decline is reversing.

Secular stagnation?

Economic recovery after the Great Recession has been disappointing.

Employment levels remain low. Official unemployment figures ignore the declining participation rate. Employment levels, in the 25 to 54 age group, for males remain roughly 6%, and females 5%, below their previous peaks. Using the 25 to 54 age group eliminates distortions from student levels and from baby boomers postponing retirement.

Employment levels

Manufacturing earnings, as would be expected, are also weak.

Manufacturing earnings

Sales growth remains poor.

Sales growth

And real GDP growth is slow.

Real GDP

US Headwinds

Stanley Fischer, Vice Chairman at the Fed, in his address to a conference in Sweden, attributed slow recovery in the US to three major aggregate demand headwinds:

The housing sector

The housing sector was at the epicenter of the U.S. financial crisis and recession and it continues to weigh on the recovery. After previous recessions, vigorous rebounds in housing activity have typically helped spur recoveries. In this episode, however, residential construction was held back by a large inventory of foreclosed and distressed properties and by tight credit conditions for construction loans and mortgages. Moreover, the wealth effect from the decline in housing prices, as well as the inability of many underwater households to take advantage of low interest rates to refinance their mortgages, may have reduced household demand for non-housing goods and services. Indeed, some researchers have argued that the failure to deal decisively with the housing problem seriously prolonged and deepened the crisis.

A slow housing recovery is unfortunately the price you pay for protecting the banks. By supporting house prices through artificial low interest rates, you prevent markets from clearing excess inventories.

Fiscal policy

The stance of U.S. fiscal policy in recent years constituted a significant drag on growth as the large budget deficit was reduced. Historically, fiscal policy has been a support during both recessions and recoveries. In part, this reflects the operation of automatic stabilizers, such as declines in tax revenues and increases in unemployment benefits, that tend to accompany a downturn in activity. In addition, discretionary fiscal policy actions typically boost growth in the years just after a recession. In the U.S., as well as in other countries — especially in Europe — fiscal policy was typically expansionary during the recent recession and early in the recovery, but discretionary fiscal policy shifted relatively fast from expansionary to contractionary as the recovery progressed.

Anemic exports

A third headwind slowing the U.S. recovery has been unexpectedly slow global growth, which reduced export demand. Over the past several years, a number of our key trading partners have suffered negative shocks. Some have been relatively short lived, including the collapse in Japanese growth following the tragic earthquake in 2011. Others look to be more structural, such as the stepdown in Chinese growth compared to its double digit pre-crisis pace. Most salient, not least for Sweden, has been the impact of the fiscal and financial situation in the euro area over the past few years.

Supply-side

Fischer also cites the weak labor market, declining investment and disappointing productivity growth as inhibiting aggregate production.

While I agree with his view of the labor market, we should not use the heady days of the Dotcom bubble as a benchmark for investment. Private nonresidential investment is recovering.

ASX 200 Corrections

Productivity is also growing.

Productivity

Other factors

There are two factors, however, that Fischer did not mention which, I believe, go a long way to explaining slow US growth.

Crude oil prices

In the last 4 decades, sharp rises in real crude oil prices have coincided with falling GDP growth and, in most cases, recessions. Crude prices remain elevated since the Great Recession and, I believe, are retarding economic growth. The blue line on the graph below plots crude oil (WTI) over the consumer price index (CPI).

WTI Crude

Currency manipulation

China continues its aggressive purchase of US Treasuries in order to maintain a competitive advantage of the Yuan against the Dollar. Inflows on capital account — not only from China — include roughly $5 trillion of federal debt purchased since 2001. This keeps the US uncompetitive in export markets and places domestic manufacturers at a disadvantage when competing against imports.

Foreign Holdings of US Federal Securities

Recent purchases of federal debt are sufficient to drive 10-Year Treasury yields through support at 2.40%/2.50%.

10-Year Treasury Yields

Glass half empty or half full?

Bears will no doubt seize on the headwinds to support their prediction of another market crash. I am reassured, however, that the economy has recovered as well as it has, given the difficulties it faces. None of the headwinds are likely to disappear any time soon, but progress in addressing these last two issues would go a long way to solving many of them.

Secular stagnation?

Economic recovery after the Great Recession has been disappointing.

Employment levels remain low. Official unemployment figures ignore the declining participation rate. Employment levels, in the 25 to 54 age group, for males remain roughly 6%, and females 5%, below their previous peaks. Using the 25 to 54 age group eliminates distortions from student levels and from baby boomers postponing retirement.

Employment levels

Manufacturing earnings, as would be expected, are also weak.

Manufacturing earnings

Sales growth remains poor.

Sales growth

And real GDP growth is slow.

Real GDP

US Headwinds

Stanley Fischer, Vice Chairman at the Fed, in his address to a conference in Sweden, attributed slow recovery in the US to three major aggregate demand headwinds:

The housing sector

The housing sector was at the epicenter of the U.S. financial crisis and recession and it continues to weigh on the recovery. After previous recessions, vigorous rebounds in housing activity have typically helped spur recoveries. In this episode, however, residential construction was held back by a large inventory of foreclosed and distressed properties and by tight credit conditions for construction loans and mortgages. Moreover, the wealth effect from the decline in housing prices, as well as the inability of many underwater households to take advantage of low interest rates to refinance their mortgages, may have reduced household demand for non-housing goods and services. Indeed, some researchers have argued that the failure to deal decisively with the housing problem seriously prolonged and deepened the crisis.

A slow housing recovery is unfortunately the price you pay for protecting the banks. By supporting house prices through artificial low interest rates, you prevent markets from clearing excess inventories.

Fiscal policy

The stance of U.S. fiscal policy in recent years constituted a significant drag on growth as the large budget deficit was reduced. Historically, fiscal policy has been a support during both recessions and recoveries. In part, this reflects the operation of automatic stabilizers, such as declines in tax revenues and increases in unemployment benefits, that tend to accompany a downturn in activity. In addition, discretionary fiscal policy actions typically boost growth in the years just after a recession. In the U.S., as well as in other countries — especially in Europe — fiscal policy was typically expansionary during the recent recession and early in the recovery, but discretionary fiscal policy shifted relatively fast from expansionary to contractionary as the recovery progressed.

Anemic exports

A third headwind slowing the U.S. recovery has been unexpectedly slow global growth, which reduced export demand. Over the past several years, a number of our key trading partners have suffered negative shocks. Some have been relatively short lived, including the collapse in Japanese growth following the tragic earthquake in 2011. Others look to be more structural, such as the stepdown in Chinese growth compared to its double digit pre-crisis pace. Most salient, not least for Sweden, has been the impact of the fiscal and financial situation in the euro area over the past few years.

Supply-side

Fischer also cites the weak labor market, declining investment and disappointing productivity growth as inhibiting aggregate production.

While I agree with his view of the labor market, we should not use the heady days of the Dotcom bubble as a benchmark for investment. Private nonresidential investment is recovering.

ASX 200 Corrections

Productivity is also growing.

Productivity

Other factors

There are two factors, however, that Fischer did not mention which, I believe, go a long way to explaining slow US growth.

Crude oil prices

In the last 4 decades, sharp rises in real crude oil prices have coincided with falling GDP growth and, in most cases, recessions. Crude prices remain elevated since the Great Recession and, I believe, are retarding economic growth. The blue line on the graph below plots crude oil (WTI) over the consumer price index (CPI).

WTI Crude

Currency manipulation

China continues its aggressive purchase of US Treasuries in order to maintain a competitive advantage of the Yuan against the Dollar. Inflows on capital account — not only from China — include roughly $5 trillion of federal debt purchased since 2001. This keeps the US uncompetitive in export markets and places domestic manufacturers at a disadvantage when competing against imports.

Foreign Holdings of US Federal Securities

Recent purchases of federal debt are sufficient to drive 10-Year Treasury yields through support at 2.40%/2.50%.

10-Year Treasury Yields

Glass half empty or half full?

Bears will no doubt seize on the headwinds to support their prediction of another market crash. I am reassured, however, that the economy has recovered as well as it has, given the difficulties it faces. None of the headwinds are likely to disappear any time soon, but progress in addressing these last two issues would go a long way to solving many of them.

Ray Dalio: The Economic Machine and Beautiful Deleveraging

Ray Dalio, founder of Bridgewater Associates, released a 30 minute video in 2013, explaining his template of the economy and how central banks and government should manage a deleveraging like the Great Recession and its after-effects.

Ray proposes three simple rules to avoid future crises:

  1. Don’t let debt grow faster than income (GDP) otherwise it will eventually crush you;
  2. Don’t let income grow faster than productivity otherwise you will become uncompetitive in international markets; and
  3. Do all that you can to raise productivity because in the long run that’s what matters most.

What is productivity and how do we measure it?

Productivity is the result of hard work and innovation, both of these factors will increase the level of output (GDP) per unit of input.

We measure productivity by comparing GDP to units of input, either:

  • the population of a country;
  • the number of hours worked; or
  • the number of people employed.

Index

Each will give a different perspective, but there are a few general rules:

  • countries with high technology and innovation (e.g. Germany or USA) show high productivity;
  • as do resource-rich countries with big extraction industries (like Norway and Australia); and
  • countries with low tax regimes (Singapore and Ireland) which attract transient income.

Read more at Labor productivity can be misleading.

Australian Made | SBS Insight

This discussion on SBS Insight from April 24th, 2012 covers the Australian manufacturing dilemna:


SBS Insight

There are three major costs in manufacturing: material costs, labor costs and other operating expenses. Roughly equal in size. Material costs are roughly the same, whether you are in Australia or China. Labor costs are radically different, with labor costs of $15 compared to $1 in China. But Australia also can’t compete on other operating expenses, which are far higher because of the labor cost and related benefits…….I can’t see why Australia hasn’t got the sense to turn around. We have been on this path for 30 years…
~ Peter Rodeck, Australian manufacturer EnvironData.

The Magical World Where McDonald’s Pays $15 an Hour? It’s Australia | The Atlantic

Jordan Weissmann compares wages paid to McDonalds workers in Australia and the US, raising four interesting points.

Firstly, McDonalds (or “Maccas” if we use its colloquial name in Australia) is profitable in both low-wage and high-wage countries:

The land down under is, of course, not the only high-wage country in the world where McDonald’s does lucrative business. The company actually earns more revenue out of Europe than it does from the United States. France, with its roughly $12.00 hourly minimum, has more than 1,200 locations. Australia has about 900.

They achieve this partly through higher prices, but also through adjusting their staff structure in Australia.

The country allows lower pay for teenagers, and the labor deal McDonald’s struck with its employees currently pays 16-year-olds roughly US$8-an-hour, not altogether different from what they’d make in the states. In an email, Greg Bamber, a professor at Australia’s Monash University who has studied labor relations in the country’s fast food industry, told me that as a result, McDonald’s relies heavily on young workers in Australia. It’s a specific quirk of the country’s wage system. But it goes to show that even in generally high-pay countries, restaurants try to save on labor where they can.

They also focus on increased productivity.

It stands to reason that in places like Europe and Australia, managers have found ways to get more mileage out of their staff as well. Or if not, they’ve at least managed to replace a few of them with computers. As Michael Schaefer, an analyst with Euromonitor International, told me, fast food franchises in Europe have been some of the earliest adopters of touchscreen kiosks that let customers order without a cashier. As always, the peril of making employees more expensive is that machines become cheaper in comparison.

That is one of the primary dangers of high minimum wages: automation is used to improve employee productivity and shrink the required workforce. Shrinking the national wage bill might seem like good business sense, but if we look at this on a macro scale, reduced incomes lead to reduced consumption and falling sales.

Finally, McDonald’s have attempted to add value to their product range, moving slightly more up-market in order to capture higher prices.

McDonald’s has also helped its bottom line abroad by experimenting with higher margin menu items while trying to court more affluent customers. Way back in 1993, for instance, Australia became home to the first McCafe coffee shops, which sell highly profitable espresso drinks. During the last decade, meanwhile, the company gave its European restaurants a designer make-over and began offering more localized menus meant to draw a higher spending crowd.

If we take McDonald’s as a microcosm of the entire economy, the trade-offs and benefits (or lack thereof) are evident. Funding wage hikes out of increased prices (for the same quality products) is futile. It adds no benefit: the increased wage is eroded by higher prices. Reduced wages for younger workers simply disadvantages older workers, excluding them from certain jobs. Increased productivity — higher sales per employee — on the other hand, can benefit the entire economy.

Improved training or increased automation may increase output, but run the risk of shrinking the jobs pool — unless new jobs created in training or manufacturing are sufficient to offset this. Product innovation, on the other hand, is an immediate win, raising sales while encouraging job growth in new support industries.

How do we encourage product innovation? Higher minimum wages is not the answer. Nor, on its own, is increased investment in research and education. What is needed is a focus on international competitiveness: reducing red tape, ensuring basic goods and services such as electricity, water, shipping and transport are competitively priced, lowering taxes and stabilizing exchange rates. That would encourage the establishment of new industry locally rather than exporting skills and know-how to foreign shores. We need a culture of innovation and entrepreneurship, rather than lip-service from politicians.

Read more at The Magical World Where McDonald's Pays $15 an Hour? It's Australia – Jordan Weissmann – The Atlantic.

Rude Awakening Awaits Western Economies | WSJ

Michael J. Casey at WSJ interviews HSBC group chief economist Stephen King, author of When the Money Runs Out: The End of Western Affluence:

Mr. King’s thesis….. is that we in the West are in line for a shock when we discover that the high-growth rates to which we’re accustomed aren’t coming back. In the U.S., we’ve been wrongly budgeting for a return to 3.5% average real growth rates that persisted through the second half of the 20th century — an affliction suffered by both policymakers and households that he calls an “optimism bias” — and yet even before the financial crisis destroyed trillions of dollars of wealth the economy was only clocking gains of 2.5% per year. Forget worrying about the post-crisis onset of a Japan-style “lost decade,” Mr. King says. “We have been through a lost decade already. ”Among the reasons for this long-term shift to a slower potential growth rate, he cites the exhaustion of a various one-off productivity gains that boosted growth after World War II: the entry of women into the workforce; the liberalization of world trade; a tripling in rates of consumer credit founded on an unsustainable increase in housing prices; and education. These gains are no longer to be had, he says, but policymakers are blind to that fact and so are burdening the economies of the U.S., Europe and Japan with long-term debts.

While I agree that we are unlikely to see a resumption of the rapid debt growth of the last 3 decades, this should contribute to lower inflation and greater stability, without a credit-fueled boom-bust cycle, that could partially offset the negative effects. I also question whether productivity gains are really exhausted, or if this is a temporary after-effect of low, post-GFC capital investment. There is ample evidence that the global economy is slowing and productivity gains will fall — if one is prepared to ignore evidence to the contrary such as the rise of automation, advances in genetics, nanotechnology, sustainable energy and slowing global population growth — which should alleviate the poverty trap that many countries are still in. The researcher has to beware of confirmation bias, where they gather data to support a preconceived opinion.

Read more at Horror Story: Rude Awakening Awaits Western Economies – Real Time Economics – WSJ.

Australia: Ford is the tip of the crisis

By Houses and Holes — cross-posted from Macrobusiness.com.au

It’s fascinating to watch the exit of Ford shake up commentary alliances and ideology.

The loon pond that dominates Australian business media is out in force with soothing words that Australian car manufacturing needs to be let go gently into that good night.

Bill Scales appears at the AFR to argue:

…..while it will be tempting to see this as a sign of the demise of Australian automotive manufacturing, it’s not. This decision is a direct result of the well-recognised, well-understood and deliberate decisions by Ford in Australia and the US.

However it does have important implications for public policy in Australia. This is a good example why governments should not provide company or industry- specific assistance. Governments and bureaucrats can never understand the strategic or commercial imperatives of individual businesses. So they cannot hope to successfully design company or industry-specific assistance programs that make any fundamental difference to the underlying economics of that company or industry. If the strategic direction or intent of a government policy for any company or any industry is not consistent with the strategic or operational direction of that company or industry, and it rarely is, then money provided to them by governments is likely to be wasted.

High priestess of the pond, Jennifer Hewitt, wants outright liquidation:

The national sympathy and attention given to 1200 Ford workers who will be out of a job in three years’ time shouldn’t obscure economic reality. Car manufacturing in Australia has been living on borrowed time – and permanently borrowed tax-payer money for far too long.

That can never be solved by additional government assistance or new industry plans or emotive rhetoric about how car manufacturing in Australia is so special. This only delays the inevitable.

But the response is part of the national semi-panic about the future of manufacturing in Australia. Both Julia Gillard and Tony Abbott stress the need for Australia to be a place that continues to “make” things. Just what new things should be made remains elusive. What is clear is it is will not be cars long term. That is despite the billions of dollars in government subsidies.

…the end of Ford manufacturing shouldn’t in itself be the sort of national crisis suggested by the massive reaction to the company’s announcement.

The Ford Falcon is an iconic loss rather than an economic one, a dream of the past rather than the future.

The AFR editorial and Judith Sloan at The Australian, card carrying members of the pond, are also happy to see Ford go. However, some of the more sane commentators are as well. Alan Mitchell at the AFR, John Durie at The Australian and Bernard Keane at Business Spectator are all for it.

What is missing, as usual, is the only thing that actually matters to the reader and the nation: context.

In 2009, the US faced an analogous decision about whether to let one of its big three auto-makers go to the wall (there were many differences as well). As the GFC tore its GDP to pieces, the government stepped into the breach and saved Chrysler, bankrupted the company, broke its union contracts, reorganised its cost base, sold much of it to FIAT and the company relaunched. Why did the global home of “free market capitalism” bother?

The cheap answer is to save jobs. But there is more to it than that. It is about productivity and not in the way you might think.

We all know that productivity is the key to national standards of living. Only through productivity growth do we sustainably increase our competitive advantage, capital formation, incomes and employment. But, I hear you ask, propping up dud car companies is bad for productivity, right?

Wrong, or at least, overly simplistic.

The issue is this. Manufacturing accounts for a huge slice of productivity potential in all economies. Without it, any economy will struggle to generate long term high productivity growth. Mechanisation, improved processes, innovation and technical progress are the bread and butter of productivity growth. They simply do not exist to the same extent in services, nor, for the most part, in mining (though the runoff in the boom will be good for the next few years). The following chart from McKinsey makes the point. Manufacturing contributes disproportionately to productivity, innovation and exports:
Productivity
This is the first question that Ford’s departure raises about Australia’s long term economic context. The car industry may or may not survive the shakeout but Australian manufacturing has already declined to only 7% of GDP and is clearly set to plunge further as capex expectations run at levels first seen in the 1980s.

Of the thirty developed economies in the world comprising the OECD, this level of contribution to GDP is last, tied with the tax haven of Luxembourg.

Our elite – the government, mining magnates and the media – have decided that manufacturing will be let go and we will instead rely entirely upon highly priced dirt and houses. Australia’s elite policy makers are engaged in a gigantic experiment that flies in the face of economic history.

The second question is more immediate. What our elite forget or ignore is that selling dirt is a highly cyclical business. Put simply, they never expected the current cycle to end. But it is. Right now. And is about to become a MASSIVE drag on the economy:
Mining Investment/GDP
Manufacturing is supposed to be one of those sectors picking up the slack along with other exports and more houses. Obviously the departure of Ford will damage any upside for a manufacturing bounce and it will also put a sizable dent in consumer confidence, making it harder for other sectors to rebound as well.

Short term and long, cyclically and structurally, this is a crisis, a crisis of our elite’s own making.

Cutting taxes is a largely ineffective strategy for attracting foreign investment | EUROPP

Aidan Regan writes:

The Irish have the second best trade surplus in the eurozone, and productivity per worker is three times higher than Germany….. The truth of this fairy-tale is that US multinational corporations are engaged in transfer pricing. They locate profits in Ireland to take advantage of the low corporate tax regime.

Read more at Cutting taxes is a largely ineffective strategy for attracting foreign investment. | EUROPP.