The Bear’s Lair: A nation without productivity growth

As I have discussed recently in this column, the world’s adoption of ultra-low “funny money” interest rate policies over a number of years has caused productivity growth to slow markedly, and in the most extreme case of Japan, to go into reverse. Since we appear unlikely to change interest rate policies in the near future, residents of “funny money” countries had better get used to a world in which productivity has ceased to grow. It does not look likely to be a happy one.

Robert J. Gordon, in his “The Rise and Fall of American Growth” postulates that technological change is slowing, so that productivity growth will slow to zero over the reminder of this century. That doesn’t seem to be what’s happening; the disappearance of productivity growth has happened far too quickly to be the result of technological senescence, and in any case technological change itself seems to be continuing at a brisk clip.

Since hyper-stimulative monetary policies, with interest rates far below the inflation rate (and mostly below zero) are common to the United States, Britain, the Eurozone and Japan and productivity growth has been far below its norms in all four monetary areas, below zero in Japan, I think we should accept that the adverse effect of “funny money” on productivity is universal.

We can now write a new economic law, validated in four separate experiments, that if you persist in negative real interest rates for an extended period of time, you will eventually get very poor productivity growth. From the Japanese example, where productivity growth was minus 3% in 2015, it would appear that if you push “funny money” policies too far or keep them in place for too long, your productivity growth will eventually turn negative.

I have discussed previously the mechanism by which “funny money” affects productivity, but the Austrian economic theory of “malinvestment” seems the likeliest explanation. When interest rates are far below their natural level, then excess investment in bad but fashionable ideas is encouraged. Governments abandon any pretense of fiscal discipline and run ever-enlarging budget deficits, often funding them through central banks, since the money is both available and cheap. The idea of fiscal “stimulus” goosing the economy by pouring money down politically favored rat-holes, appears pretty well irresistible – after all, conventional GDP accounting says that any government spending, however foolish, increases output, so if it can be easily financed, why not indulge?

Businesses devise crazy expansion plans like that of Valeant (NYSE:VRX) by which they buy drug companies at inflated prices and hope to recoup their excess investment by driving up the prices of the drugs they control – at the expense of consumers and Medicare, both of which are expected to accept 100% or even 500% price increases without complaint. Hedge funds and venture capital funds proliferate, the one indulging in zero-sum speculation and charging excessive fees to investors, the other financing ever more chimerical new companies at ever more over-inflated valuations.

Real estate projects of enormous size proliferate. If the housing market crashes, we see a boom in overpriced rental apartments in major population centers. Enormous hotel projects managed by obscure speculators and constructed by inexperienced Asian contractors spring up, that often go bankrupt before completion. If they make it to opening, for the next several years they greet their very occasional guests with the eerie stillness of an empty Pharaonic mausoleum — the only sound being hotel staff quietly sobbing.

Since the 2016 election is down to a choice between Hillary Clinton and “low interest rate man” Donald Trump, current monetary policy is not going to change until it is forced to do so. That could take some considerable time. If we get a recession without evidence that is completely clear even to Congress and the proletariat that that the Fed’s policies are to blame, it will simply produce a doubling-down on stimulus and an attempt at negative nominal interest rates in a U.S. context. Thus we are condemned to several years of zero productivity growth, and should consider what such a society would look like.

In certain respects, such a world would be similar to that of the 18th Century before about 1760 or so, when the only factors causing economic growth were population increase (which reduced GDP per capita, producing the famous Malthusian limit) and conquest. Corporate profits would decline, as competition increased and genuine productivity innovation disappeared. In such an environment., research and development expenditure would be wasted and therefore quickly eliminated, while venture capital investment would produce no new companies of any value.

There would be the occasional South Sea Bubble, in which chimerical projects were awarded fantastic valuations in the private equity market, as institutional investors sold small stakes to each other. However, the vast majority of such companies would be new applications of well-understood technology. The genuinely novel would find it very difficult to get funding, because the Facebooks and Ubers would be swallowing up all the available capital.

Indeed, Uber itself, a taxi service with a little software and a $50 billion valuation attached is the quintessential success story of a world without productivity improvement. It hollows out old businesses in traditional taxi companies and destroys millions of jobs and billions of dollars in valuation (in New York taxi medallions, for example) without replacing them with anything genuinely value-added. Essentially, Uber has used a modest amount of technology to transform a relatively well paid workforce in the taxi companies with a much poorer-paid army of freelancers, without providing any economically significant additional services. Its valuation will collapse, and new entries will flood into its barrier-free market, but it will form an inspiration to employers in many other industries.

The good news for workers is that few new jobs will be destroyed by innovation, since there are no innovations that genuinely enhance economic efficiency. However, the job-destroying functions performed by say electricity, the automobile and the computer will be performed by regulators instead. They will pass such legislation as a $15 per hour minimum wage law, which will drive fast food outlets and retailers to replace their staff with robot order takers. These, like automated checkouts, will transfer labor from employees to customers, thus replacing paid labor with unpaid labor by the customer, while not increasing productivity as a whole. Indeed, this will reduce productivity because customers will be inept at order entry compared with even lightly trained employees.

Productivity will continue to increase in emerging markets, which have avoided the sillier excrescences of “funny money” and will hence tend to become more efficient, approaching and in many cases surpassing Western levels. Emerging markets inhabitants will continue to get richer, and may indeed surpass the living standards of Westerners, sometimes by inventing new and genuinely useful products that Westerners have not thought of.

Meanwhile, multinational companies will exert every effort to reduce both their number and wage rates of Western employees. Normally they will be unable to do this by direct wage reductions, so they will continue to resort to massive outsourcing, transferring expensive Western manufacturing to emerging markets. Domestically, they will either adapt or face new competitors, who use Uber-like techniques to replace expensive full-time labor with cheap casual labor, preferably operating from “home offices” that they pay for themselves. Decently-paid jobs in large workforces will all be outsourced, Uberized, or replaced by robots. This combination of actions will not cause unemployment to soar, as has always been feared from robotization; it will simply cause wages to collapse.

The elites, who have so far benefited so much from “funny money” while retaining the earnings premiums that result from stiff job qualifications and an absence of cheap foreign competitors, will not be secure from losses in the zero-productivity-growth economy. While interest rates will remain low, stock valuations will collapse, because corporate earnings have benefited as much as they can from cheap money, will gain no further benefits from additional productivity, and will therefore decline sharply, as competition increases without limit – new Ubers, funded by private equity, can cannibalize corporate earnings as well as those of the semi-skilled workforce. High-yield bond markets will also collapse, as declining corporate profits and the collapse of foolish malinvestments decimate the bond finance that have built them. Pension funds will therefore default, wiping out the savings of well-stuffed baby-boomers, who will also see a decline in house prices due to an appalling dearth of solvent buyers.

Professional earnings will be last to collapse, but collapse they will. The newly impoverished workforce will not be able to afford the spiraling cost of medical insurance (which their Uberized employers will no longer provide). That will empty the hospitals, and cause the bankruptcy of Medicare/Medicaid, which will face the burdens of increased impoverished enrollments and government finances decimated by declining earnings and negative capital gains taxes.

To keep the system operating, and prevent a Lagos-like level of corpses in the streets, government and insurance companies will combine to force the only solution possible: a drastic reduction in medical fees and an even more drastic reduction in the opportunities for trial lawyers. Hospitals and law firms will in turn find that subcontracting tasks to robots, underpaid free-lancers and Bangladesh will be the only way of salvaging their positions.

This will almost certainly produce a reaction among the electorate in favor of even worse government policies, which will accelerate the downward spiral. Even with the decisions the electorate has already taken, there seems to be no way to end the spiral before 2021.

Only then, when voters can compare their own sorry lot with the relatively prosperous conditions in the still-productive China, Vietnam and Brazil, is it possible that leadership will appear which will apply the only possible solution to revive productivity growth: Raise interest rates to at least 4% above inflation and “Volckerize” the Fed by statute so that it can never again engage in disastrous monetary stimulus experiments.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)