The Bear’s Lair: Back to the economics of 1792

When William Pitt the younger made his great and optimistic Budget speech of 1792, he attributed Britain’s increased prosperity not to technological improvement but to the wealth-enhancing effect of the compounding increase in the country’s capital stock. Only a generation later, in the administration of Robert, Earl of Liverpool, was technological change given credit for the country’s growth and prosperity. Today, as productivity growth slows or even halts, we may be returning to the economics of 1792, in which only capital increase brings greater wealth. This has uncomfortable implications.

Pitt’s 1792 speech was groundbreaking in several respects. It began with a tribute to Adam Smith, then recently deceased, and to the power of economic analysis. It then claimed correctly that the country was making economic progress and was richer than it had ever been before – this was a marked change to the traditional view that the modern era had yet to catch up to the glories of Ancient Rome. However, since there was as yet little use of steam power and the rapid expansion of the textile sector was based largely on water mills, Pitt did not attribute the country’s economic improvement to technology or productivity growth, but simply to the increasing capital intensity of industry, services and agriculture, with a greater quantity of capital employed leading to higher output.

A generation later, Liverpool’s equally impressive speeches on the economy gave full credit to the technological change that was sweeping through the British economy and the productivity gains that were resulting from the application of steam power in textiles and other sectors. The qualitative change was important: whereas in 1792 almost all the modest productivity gains in the British economy resulted from capital deepening, by 1815-25 technological productivity growth was in full swing. This resulted in faster economic growth than had ever been seen before, albeit still slow by the standards of the later Industrial Revolution and the mid-twentieth century.

Liverpool was aware of the difference between the two eras, as was the great French economist Jean Baptiste Say, who visited Britain before and after the Napoleonic Wars and noted the contrast. Liverpool highlighted the change in his speeches and adjusted policies accordingly, removing economic restrictions such as the 1563 Statute of Artificers that had assumed a generally static economy. We have been living with the joys of technological productivity growth ever since, forming our policies on the assumption that it will continue.

However, recent productivity data over the last decade suggest that the assumption of continued brisk productivity growth may no longer be valid. In the United States, productivity growth averaged only 0.6% annually between 2011 and 2016, before ticking up for a couple of years; in the latest quarter it has relapsed to minus 0.3%. In the Eurozone, annual productivity growth since 2009 has averaged only 0.4%, in Britain only 0.5% since 2010 and in Japan only 0.2% since 2009. All these figures are far below the healthy productivity growth levels seen before the 2007-08 financial crisis.

The common factor is interest rates, which have been held artificially low in all rich countries since the financial crisis. Only in the United States was there a modest rate increase in 2017-18, which was partially reversed in 2019, doubtless causing the productivity relapse in the latest quarter. In all these countries, interest rates have been below zero in real terms (i.e. lower than the inflation rate) and far below the level at which they would stand if governments ceased meddling with the market. The result has been a tsunami of misguided investment, into real estate, fly-by-night startups and junk bonds, all of which would not have happened in a free market, That tsunami has diverted rich countries’ economies a long way from their optimal states, eliminating productivity growth by doing so.

Budget deficits in rich countries have also been artificially high, another productivity-suppressing factor, since the public sector is less efficient than private business. The true damage to productivity from recent policies is substantially understated since GDP figures arbitrarily take the value of government output as equaling its inputs in wages etc. Since almost all government output is worth less than its cost (otherwise the output would arise naturally in the private sector) this artificially inflates output, growth and productivity figures.

This column has now been complaining about this state of affairs for several years; we must thus face the possibility that it may not change for a long period into the future. During this period, with interest rates artificially low, there will be little or no productivity growth, indeed productivity will probably decline as rich country economies become less and less efficient. We will thus be back in the economics of 1792, having left the healthier economics of 1820-2007. This has several unpleasant implications.

First, if we are to go back to the zero-productivity-growth world of 1792, we must return to its budgeting methods. Liverpool after 1815 brought down the largest public debt in British history (in terms of GDP) not through inflation (as the post-1945 governments did) but through relying on the productivity growth of the British economy to grow GDP at a sufficient rate to reduce the burden of debt on taxpayers and on the British economy.

In 1792, that would not have been possible. Pitt therefore instituted a rigorous Sinking Fund in 1786 to deal with the smaller debt he had inherited after the American War. Not only could the governments of 1792 not run deficits in peacetime, but they had to make Sinking Fund payments over and above normal interest payments, to reduce the public debt and its burden on taxpayers.

Today, if we are to have no productivity growth, we must follow Pitt’s budget policies. Not only must we run a budget surplus year by year, but we must institute a Sinking Fund to reduce the burden of public debt, forcing us to run a substantial budget surplus every year except in wartime or in deep recessions. Current budgetary policy, with large deficits year after year, will not only lead to bankruptcy, it will also produce a situation in which governments can no longer borrow, because investors will no longer have confidence in their ability to repay.

With the help of productivity growth, as has been the situation since 1820, governments can indulge themselves in Keynesian deficit financing, relying on productivity growth expanding the economy enough to keep the resulting debt under control. Without productivity growth they can’t do this; they must revert to pre-Keynes rigor in their budgeting. Needless to say, this will be exceptionally painful, especially to politicians.

The budgetary effect of zero productivity growth takes us back to 1792, but the capital compounding effect that brought wealth increases in 1792 will be much weaker today. Pitt in 1792 rejoiced in the capital deepening that was taking place in the British economy, which benefited from high real interest rates and profitability. With the Gold Standard preventing inflation and government bonds yielding just above 3%, the overall capital stock yielded as much as 5%, even after the excess consumption of the landed and rentier rich had subtracted from the amount to be reinvested. Hence capital accumulation proceeded at a rapid pace, and the society grew richer even without significant technological change.

In today’s economy however, decades of foolish monetary policy have left real interest rates generally negative and overall returns on capital at appallingly low levels. High share prices have left the earnings yield on stocks far below historic levels, and dividend yields barely ahead of inflation. Consequently, instead of a stream of 5% of outstanding capital flowing back into the economy, today hardly any new capital is being created. The problem is exacerbated by such corporate finance abominations as stock buybacks, which reduce the capital in the economy, leaving some huge companies without any capital at all, and others very poorly positioned against the next downturn.

Without productivity growth or growth in the capital stock, there is no driver for economic growth other than population increase. In the short term, this has been hidden by an epidemic of leverage, a technique little used in business in 1792 (though landowners took extensive advantage of mortgages). With debt costs so low, it is often possible to borrow at an effectively zero real cost and invest the proceeds in a project yielding a real 1% or 2% and thereby increase the output of the economy. That is why analysts who use historic “hurdle rates” of 8% or 10% to assess projects or takeovers so often get it wrong; in business today there is no need for a return anywhere near that high, though of course projections can always be falsified to make the numbers look pretty. Through the private equity business, this has been extended across the entire economy, although in Silicon Valley private equity has an unfortunate tendency to invest in projects with a negative long-term return, destroying economic value by their investment.

Even though through leverage an artificial impression of economic growth can be given, in an era of ultra-low returns on capital and zero productivity growth there is no reality to it. Once the business cycle turns, the mountains of leverage throughout the global economy will exert their usual malignly compounded effect on output, making the next downturn far deeper than it needs to be. Only then perhaps will the Keynesian madmen who run the world economy today realize that their entire lives have been a ghastly mistake.

The solution, once the downturn hits, will not be to indulge in further monetary easing – that will only perpetuate the cycle at still higher levels of leverage and still lower, indeed negative levels of productivity growth. Instead, interest rates must be returned to their historic level of about 2% above inflation in real terms. We will then find out whether productivity growth can return once productive investments are properly rewarded and unproductive ones weeded out, or whether decades of abominable policy have killed the 200-year Industrial Revolution and forced us to live forever in a world without productivity growth.

Either way, a huge amount of belt-tightening, ashes and repentance will be necessary in the world’s public sectors and economics departments.

(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.)