“Demographics, education, debt and inequality are powerful enough to cut growth in half” … Robert Gordon in Feb 2013. Growth in real GDP per capita averaged 2% over the past 120 years. Gordon argues these four factors alone are enough to reduce future expectations to 0.8%. What would it take to reverse the 70 year trend in falling growth?
Robert Gordon’s book, “The Rise and Fall of American Growth” (see 12 minute TED version) tries to answer the “why” behind the chart above. What this graph shows is that prior to 1700, growth in real GDP per capita (or simply “growth”) was pretty much flat. Then it rose significantly starting around 1870, peaking at 2.5% in 1945, and has been generally falling during the past 70 years. This troubling trend has perplexed economists for many years. Understanding why growth fell is critical because growth determines the size of the pie. Ultimately, returns on investments are not determined by P/E ratio, dividends, or coupons. They are determined by growth. And if the pie stops expanding as rapidly it means there is less “income” to go around. Just about every pension fund and earnings forecast assumes growth will “mean revert” back to the average post WWII period. These forecasts are wildly optimistic in my view.
Gordon’s thesis is that we will never again be able to match the growth rates of the past 120 years. His argument comes in two steps. First, headwinds from demographics, education, debt and inequality are reasons enough to adjust expectations of future growth from 2% to 0.8%. This much of his thesis is very difficult to refute. He goes a step further, suggesting that growth will fall to near zero because technological innovations of the future cannot match those of the 1870 – 1945 period such as the light bulb, internal combustion engine, and nuclear fusion. However, you don’t need to believe in such a pessimistic view in order to recognize that growth will almost certainly not reverse its 70 year trend simply because of “mean reversion”. Hours worked per person is almost certain to decline as the global population gets older. Barriers to quality education, record high levels of debt and income inequality are unlikely to reverse without significant political reforms.
Aging populations hurt growth because it means fewer hours will be worked per person. As more and more women entered the workforce the total output of the economy per person increased. Now the opposite is happening as baby boomers retire and retirees are living longer. There is also some evidence to suggest that as the pace of technological progress quickens the average age of “peak productivity” falls, just as the average age overall is getting higher.
Income inequality hurts growth when it prevents regular folks who don’t have enough money from investing in their own productivity. Someone living in poverty lacks the money to invest in healthy food. A single parent working two jobs doesn’t have time to invest in their own health via regular exercise. A capable adult who can’t afford to go to college will have trouble improving their job prospects. When this happens society loses out in two ways; we fail to help everyone achieve their potential and we fail to produce goods and services that would have helped them achieve their potential. Income inequality also hurts growth when an excessive portion of the society becomes so wealthy that they chose not to contribute to the economy and simply live off the income from their investments. Excessive production in luxuries can also hurts growth by diverting resources away from useful goods and services. The challenge is to come up with the right balance of transfer payments and support to help those in need while still maintaining incentives to work efficiently. The optimal balance is up for debate but if ever we have had too much income inequality, it is today.
Debt hurts growth when it prevents productive capital investment. Government debt levels over 90% appear to “crowd out” debt markets preventing businesses from borrowing. This makes it harder for businesses to pay for capital investments that make employees more productive. The average G20 country now has a Debt to GDP of over 100%! Artificially cheap corporate debt created by quantitative easing (see prior observation on “Investment Price Fundamentals”) also prevents productive capital investment. Companies that are fundamentally insolvent but avoid bankruptcy through borrowing are known as “zombie companies”. The number of zombie companies today is unknown, but near zero interest rates make it likely the number is growing. Zombie companies hurt growth by preventing labor and capital from moving to more productive businesses. Too much household and corporate borrowing also hurts growth because it reduces how much they can spend on future goods, services and capital investment.
There are numerous other theories for why growth has been falling for 70 years, but like theories for “Why Interest Rates Fell”, they necessarily point to longer term trends that by their nature do not reverse course without cause. Here are a few more that I find particularly compelling:
We simply don’t need as much. Much of what we consider a “need” today was a “want” yesterday. A growing body of research suggests that the most reliable source of happiness comes from meditation and exercise (both perpetually on sale for the unbeatable price of free). If that’s not your thing then The Platform Revolution has provided a wide range of free (or very cheap) entertainment. Meanwhile, the cost of producing durable goods like computers, cars, bicycles, and clothes continues to drop. Costs for services are rising but that is mostly due to education and housing. More and more education is moving online (which could actually help growth). Housing could get smaller. Companies like Uber make it easier not to own a car. In short, we can achieve a high quality of life without growing GDP.
Regulations are easier to create than destroy. Laws are generally created with good intention, but eventually become obsolete or require reform. Inevitably, some special interest benefits tremendously from the existing law even if the net cost to society is greater. This reality makes it economical for special interests to hire lobbyists, but not so for the rest of us. This unfortunate reality allows a buildup of laws that should be reformed, but the cost to politicians for pushing the reform is often greater than the benefits because only the special interests care enough. This phenomenon hurts growth because it protects older and larger companies from newer more nimble startups. The complexity of the regulations act as a barrier to entry, preventing new companies from entering or succeeding in a marketplace, even if they have a superior product or business model.
We have largely reaped the rewards of diversity in the work place. Warren Buffett likes to quip that it was easier for him to be a success because he only had to compete against half the population. He is right! We still have work to do to improve the role of women and minorities in the work place. However, we are a far cry from the world of 1920 or 1960. The benefits of having more women and minorities in the workplace, particularly in places of power, were no doubt tremendous. This contributed to growth during the past century. We will continue to gain from more diversity in the workplace, but at a slower pace for the simple reason that we have already reaped much of these gains.
What about technology?
Growth optimists point to computers, robotics and AI as evidence that growth will pick up in the near future. Unfortunately, these innovations have already been improving for decades. As Robert Solow once said, “You can see the computer age everywhere but in the productivity statistics”. The trouble with assuming that technology will reverse the 70 year downward trend in growth is that it would take more than some fantastically powerful new smartphone, AI or robot. You also need the technology to translate into higher growth.
The technological forces shaping our future are not fundamentally different than those of the past. What technology does is allow us to produce better “stuff” (cyber or physical) using fewer people. This inevitably hurts some people who lose their jobs and have to retrain. For example, manufacturing jobs in the United States have been falling pretty much non-stop since WWII in part because these jobs were largely manual and thus easier to automate using robots.
When some people inevitably lose their jobs to technological improvements they need to retrain. In 1920 this process took a few weeks because most jobs were pretty simple. Back then, one man working a labor intensive job could raise a family and pay off a mortgage. Not so today. Ironically, the technology that growth optimists point to as their savior may actually be contributing to the fall in growth. More jobs than ever require a bachelor’s degree. The result is that those most likely to be replaced by technology, such as “Predictable physical work” (ex. Manufacturing) are required to work harder than ever to retrain. This may explain why a growing number of men between the ages of 25-55 are choosing to leave the labor force altogether rather than even try to find another job. The takeaway here is that new technology only translates into growth if people misplaced by that technology can retrain into better paying jobs. What this illustrates is that this process may not happen without structural reforms to help retrain those displaced by technology.
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Disclaimer: These are our personal views. This article is not, and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action. Our hope is that these observations will merely help you to more critically examine your own beliefs about finance and stimulate dialogue.