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24 March 2012

The New Normal

Tag(s): People, Politics & Economics

A couple of years ago I had lunch with Andrew Sentance, then an external member of the Monetary Policy Committee of the Bank of England. He was forthright in his views that it was time for the Bank to take a more proactive line in monetary policy in the pursuit of its mission to control inflation by starting to move up interest rates. He has since stepped down from the Committee and is now Senior Economic Adviser at PwC. Last week I heard him address the Association for Investment Companies Annual Conference for Directors. He posed the question “What is the ‘New Normal’ for the economy and investors?”

His initial analysis was unexceptional: that UK economic growth has disappointed with a long term trend in slowing down of non-oil growth going back to 2000 when Gordon Brown moved away from Ken Clarke’s policies and started his own abolition of boom and bust. Inflation has been high and volatile with long term trends upwards again since 2000. Behind this is the more troublesome fact that UK consumer service inflation has been persistently around 4% since 1997. In the Labour years it was the very low inflation in consumer goods that apparently kept inflation under control, but of course this was largely imported, the so-called China effect. Consumers are therefore facing a prolonged squeeze and while their spending exceeded GDP in the years 1997-2007 since then it has been behind GDP growth, as no doubt the majority of consumers realised that their absolute levels of debt had gone too high.

World economic growth is below trend though the world economy only went into recession for a short time in 2008 as a result of the Lehman shock. But a slow start to recovery is not unusual. Andrew showed that in the 1980s and 1990s recessions the first three years of recovery were slow both in the UK and in other advanced economies. The next several years saw much stronger growth. By contrast in this latest period the growth rate in emerging and developing economies has been much faster than in the two previous periods reflecting the rise of Asia. The Asia-Pacific group of ten countries including Australia, China, India, Indonesia, Japan, Malaysia, Singapore, South Korea, Taiwan and Thailand now exceeds both the US and the EU in its share of World GDP for the first time. We can expect this two speed global recovery to continue.

So what is the “New Normal”?

We can see a number of forces shaping the New Normal: the rise of Asia and other emerging markets which has created price pressure from energy and other natural resources. There is the legacy of the financial crisis and a structural adjustment in western economies following the long expansion which ended in 2007. In addition the pre-2007 policy paradigm has broken down and there is little confidence in subsequent policy responses.

Andrew draws a parallel between the long period of expansion in the 25 years from 1948 to 1973 with average growth in GDP of 3% and consumer spending just behind followed by a much slower average growth rate of 1% in the decade from 1973 to 1982, and the similar long period of expansion from 1982 to 2007 with average GDP growth of around 3% and consumer spending even faster at 3.5%. This is now being followed by another period of slow growth and Andrew is probably not sticking his neck out very far by using current consensus forecasts for 2011/12 and assuming trend growth of 2.1% for 2013 to 2016 to project a decade of GDP growth averaging even lower than 1973-82.

The forces that underpinned the “Old Normal” of 1982 to 2007 included financial deregulation and liberalisation, broadening access to debt for consumers and businesses; new markets opening up as China, India, the former Soviet bloc, Brazil and others embraced the market economy; relatively low energy and commodity prices, at least for the period 1985-2005, were reinforced by the “China effect” on manufactured prices; the US remained the dominant economic power acting as an engine of growth for the rest of the world while there were positive effects from European countries reforming their economies to get access to closer European economic integration; there was confidence in the ability of policy-makers to support growth and of independent central banks to control inflation; and there was rapid innovation and technological advance, particularly in Information Technology and communications, perhaps one of the few of these factors which we can expect to continue.

To support the thesis Andrew draws salutary lessons from the 1970s experience. The 25-year long expansion came to an end, first when the international financial system was seriously disrupted with the end of the Bretton Woods system. Energy and commodity prices were high and volatile after OPEC applied an oil embargo on the US as a response to its supplies of military equipment to Israel in the Yom Kippur war. Consequent inflation in the UK led to a lost decade during which economic and financial conditions were volatile leading to IMF intervention. Other western economies also saw a slowdown in growth over this period, with rising unemployment and high inflation. This undermined the full employment policy consensus prevalent in the 1950s and ‘60s leading to a lack of confidence in policy makers and their errors compounded this volatility.

In the “New Normal” we can expect two phases. First, a continuation of the current pattern of disappointing growth in western economies, accompanied by financial volatility and high and fluctuating energy and commodity prices. Then a second phase will develop with a clearer and more sustained growth dynamic, perhaps starting in the second half of this decade. However, this is likely to be based on a different set of technological, regulatory, geopolitical and financial drivers from the forces driving the long expansion which ended in 2007. Businesses, policy-makers and investors therefore need strategies to manage and survive through Phase 1, while building potential opportunities for Phase 2.

In the more benign scenario for Phase 2 of the “New Normal” we can expect the Asia-Pacific region to become the leading and dominant force in the global economy. Western economies will adjust their growth expectations downwards and will have to adjust public spending and tax structures to a lower growth world. The financial sector will be re-regulated with consequent restrictions on growth and exchange rates will be more managed. There will be continued development of IT and communications technologies to drive business efficiency and consumer spending. There will have to be investment in technologies which support energy and resource efficiency and aid transition to a lower carbon economy. And we should see the development of new international institutions and frameworks to manage global volatility and address major challenges such as climate change.

While I find much of this coherent I also find that it is still rooted in the stereotypical thinking of conventional economics. I think there is an argument that just as Andrew calls for new institutions and frameworks we should call for new thinking in economics to help policy makers and stimulate a more positive environment for businesses  and investors. For one thing most of Andrew’s analysis rests on conventional metrics such as GDP. All of us, perhaps led by the media and politicians, seem obsessed by GDP growth as a measure of economic prosperity and, by implication, happiness. GDP stands for Gross Domestic Product but it does not measure what we produce; in fact, it measures what we spend. I quote from a recent letter to The Sunday Times: “It isn’t generally understood that GDP goes up if our government spends more. It also goes up if we as individuals borrow to spend. So the past 25 years has seen growth achieved totally by personal and government borrowing.

If the natural laws of economics had been allowed to work, prices would have gone up to mop up the extra money in circulation and therefore keep supply and demand in balance. Inflation is not a disease; it’s the natural correction for too much money chasing too few goods. A better solution is reducing money in circulation or increasing supply of goods. This means GDP will go down but we’ll end up with a healthier economy.

The natural laws of economics haven’t worked because we import the shortfall in goods and borrow the money to pay for them. Our trade deficit is the best measure of our failing economy. It’s simple proof that we consume more than we produce. Rather than wanting a growing GDP through increased borrowing and more government waste, we should be working to reverse our trade deficit.”[i]I would agree with that. When I was young and first starting to follow the news the Balance of Payments was used by the media as the regular barometer of economic health, not GDP.

But I would go further. We are also obsessed with the concept of recession. A recession is defined as two successive quarters of economic contraction but this definition only emerged in the 1970s. In a 1974 New York Times article[ii]economic statistician Julius Shiskin suggested several rules of thumb for defining a recession but over time all the others faded away leaving the concept of two quarters of negative growth. This is crazy. The UK economy remains smaller that it was in 2008 at the time of the Lehman crisis and our own banking disasters. But we are not seen as in recession because we grew last quarter by less than 1%. First, our measures of statistics are not sufficiently accurate to measure such subtleties. Gus O’Donnell, then Cabinet Secretary, confirmed that to me when I had lunch with him a few years ago. Second, one could imagine a year in which we decline 10% in the first quarter, grow 1% in the second, decline 15% in the third and grow by 0.5% in the fourth. The economy would have declined by over 22% but would not officially be in recession!

In such circumstances I was disappointed with this week’s budget. Not because of any of the measures introduced. Most were insignificant and will make very little difference to the overall macroeconomic picture despite the extraordinary outburst of the newspapers. What was disappointing is the missed opportunity to reform the tax structures radically in a way that would make a difference. It is true that with the size of the deficit and with a coalition government the Chancellor is limited in what he can do in the way of fiscal measures. But he could reform fiscal policy.

Just consider this. I estimate that the budget document which you can download[iii]is over 100 pages with in excess of 50,000 words not counting the many tables and charts therein. It includes a huge section on simplification of taxation which itself only goes to complicate it further. Part of our problem today is the complexity of legislation. This week Her Majesty the Queen, visiting the Houses of Parliament in recognition of the 60 years she has spent as the Queen, referred to the 3,200 Acts she has had to sign into law. Complexity of legislation and regulation reveals paucity and impoverishment of thought. The best stuff is short and to the point. Here is a table to prove it.

Pythagoras' Theorem: ...........................................24 words.

Lord's Prayer: .................................... ………………….66 words.

Archimedes' Principle: ...........................................67 words.

Ten Commandments: ...........................................179 words.

Gettysburg address: .............................................286 words.

US Declaration of Independence: .......................1,300 words.

US Constitution with all 27 Amendments: ………….7,818 words.

EU regulations on the sale of CABBAGE…………….26,911 words.

UK 2012 Budget document………………………………..50,000 words (my estimate.)

And just a few more words from me. It is clear that the economic model of GDP growth based on government and consumer borrowing is bust. It is also clear that the economic model of ever more consumption when resources are finite is bust. We have to imagine a different world of prosperity without growth. Tim Jackson, who is economics commissioner on the UK government's Sustainable Development Commission, has tried to do just that in his book “Prosperity without Growth[iv].” He states the challenge starkly: “Questioning growth is deemed to be the act of lunatics, idealists and revolutionaries. But question it we must.”

Perhaps that should be the “New Normal.”

[i]Put focus on trade deficit, not GDP” John Elliott  letter to Sunday Times

[ii]Shiskin, Julius (1 December 1974). "The Changing Business Cycle". New York Times


[iv]Prosperity Without Growth: Economics for a Finite Planet. Tim Jackson. Earthscan Publications 2009

Copyright David C Pearson 2012 All rights reserved


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