April 30, 2013
The Big Engine That Wouldn't
Signs of slowing economic growth are everywhere. China has slowed from decades of annual gains near 10% to a merely rapid growth rate of less than 8%. Europe has waded deeper into recession with already negative growth dropping further as Germany has chosen to join periphery countries in recession by balancing its budget a year ahead of schedule. In the US, for the third year in a row, there is concern over a spring swoon as retail sales dipped in March and worries increase over the self-inflicted wounds of cuts to Federal spending by the sequestration. The IMF has lowered its outlook for world growth for the second time in four months.
Of course economic growth always fluctuates, but the current slowdown comes amidst a recovery which has had the slowest growth of any recovery since World War II. Following ten previous recessions the economy has on average taken just over one year to return to normal. The current recession ended four years ago and high unemployment and sluggish income growth demonstrate the Great Recession has left far too many people and facilities unemployed.
The economic costs of a slow recovery are enormous. The short-term costs are straightforward to estimate: Each year the economy has the capacity to produce income and goods and services; however, during a recession, incomes are reduced as people are unemployed, and fewer goods and services are produced as business slows. The cost to the overall economy of having high levels of unemployed labor and capital is the difference between the income and goods and services that would have been produced if there had been no recession and the smaller level of what is actually produced due to the ongoing impact of the recession. So far the immediate cost to the US economy has been greater than $3 trillion in lost income and production.
The longer term costs are far greater: The capacity of the economy to produce income and goods and services is not a mysterious economic measure; rather it arises practically from education, work experience and investment. The US economy has accumulated its capacity to produce through decades of educating our population and decades of investing in roads, other infrastructure and businesses. The wealth income and GDP of today is possible because of this past investment. In the same way, the wealth income and potential GDP of our future will arise naturally from how much we invest in education, infrastructure and business today.
The more we invest today, the greater standard of living in the future, and by this measure the long-term costs of a lengthy recession are clear as well. If less is spent on education, less knowledge is accumulated through work experience. If less money is spent investing in infrastructure and less money is spent investing in business, because of the recession and the slow recovery, the long-term cost of the slow recovery will be large. It can be thought of as the difference between the smaller potential economy that will be supported by this lower investment and the larger economy that could have been possible with higher investment.
On this basis the outlook is bleak and the risk of large long-term costs is high. Businesses have not yet begun to invest at the same level they did in 2007 and the capacity of businesses to produce has grown at ever slowing rates, falling to just 1.2% over the past five years after having grown better than an average 2.5% per year for the 50 years before. Unemployment and underemployment is high and workers are accumulating less work experience. The US continues to slip in Global Competitive rankings for primary education and infrastructure with 24 and 36 other countries ahead of the US in each category respectively.
Standard practice in the developed world prior to the financial crisis was to increase government investment in a country’s infrastructure in years when businesses were reluctant, for whatever reason, to invest at levels high enough to provide jobs.
This practice was followed for sensible reasons. Government investment is complementary to private business investment. For example, private companies investing to build trucks depend on the highway systems built by the government for their trucks to be productive; a technology firm seeking to build new internet services depends on hiring skilled workers educated in our public schools, and so on. It made good sense for a government to take advantage of periods when business was slow to invest more heavily because labor and resources were available and less costly. And no less importantly, investment spending by either business or government has two benefits, not only does investment support a higher level of potential income for the future, but the money spent building infrastructure or increasing education increases incomes, employment and business activity today.
Indeed, the immediate response to the recession by governments around the world was to increase spending to offset collapsing economic activity. In April 2009, at the depths of the Global Financial Crisis, the leaders of the G20 announced that the 20 countries would undertake an unprecedented fiscal expansion of $5 trillion aimed at saving or creating millions of jobs and raising global output by 4%. This was something of a triumph for the academics and economic policy makers who had arrived at the common sense truth that governments had the ability to end recessions.
Yet the ink was barely dry on this announcement and the green shoots of recovery had hardly begun to sprout, when the concerted effort began to change the policy conversation from recovery and job growth to the danger of government debt. The result has been that, in the US, government spending has been falling for more than two years, and many people and resources have been left unnecessarily unemployed.
The fear of government debt is wrong, and completely misplaced. Public debt does not burden our children; rather the greatest burden we can pass on to the next generation is failing to properly invest today to support a more productive and wealthier economy in the future. The few efforts to offer theoretical or empirical support for the idea that high levels of government debt cause slow economic growth are contradicted by the evidence.
The mystery remains why policies like fiscal austerity and balanced budgets, that are known to be costly both in the short and long-term, are pursued by political and business policy makers. Even the wealthy and powerful fail to maximize their wealth when the economy is too small and under-investment risks a smaller future economy. One strong finding in behavioral economics may partly explain this seeming contradiction. People regularly make choices to increase their relative wealth rather than their absolute wealth. For example, people make choices such as preferring to earn $80,000 in a neighborhood where the average income is $50,000 over earning $100,000 in a neighborhood where the average income is $130,000.
Whether or not a focus on relative wealth explains fiscal austerity, current policy certainly has increased inequality and greatly increased the relative wealth of the privileged. Failing to invest and support necessary investment to provide adequate job opportunities, both now and in the future, comes at an often crushing personal cost to those who are unemployed. At the same time, low growth has been good for business owners. High unemployment results in low wage growth and this combined with low interest rates results in record margins and earnings for companies and disproportionately large rewards for the business owners.
Europe has aggressively pursued a policy of trying to reduce government debt while its economies are too weak. The result has been a return to recession and shockingly high unemployment, reaching Great Depression levels of 27% in Spain and Greece. For several years, due to concerns about the political and social risks of this policy, we had very little investment exposure in Europe. In recent weeks, however, there have been a number of indications - such as the formation of a new government in Italy that strongly rejects fiscal austerity, a retreat from austerity in Spain, and warnings against austerity from the European Union and the IMF - which suggest the ideological and political tide is turning against the very damaging austerity policies in Europe.
A change in European policy would likely be very positive for stocks in Europe much as Japanese Prime Minister Abe’s economic plans have been positive for Japanese stocks. We continue to hold healthcare, consumer discretionary and industrial stocks in Japan with the belief that the odds of Abe’s policies breaking Japan out of its long deflationary slump remain good. Although growth is slowing in the US, the risk of recession or worse outcomes are diminishing as the healthy rebound in the private economy remains stronger than the negative impact of federal fiscal policy. We are continuing to increase our weightings in stocks with a focus on the healthcare and technology sectors, which have attractive growth opportunities based on new technology, and on consumer companies that are focused on the rapidly growing consumption demand of households in emerging markets and strengthening consumption in the US and possibly soon in Europe.
Zevin Asset Management, LLC is a global top-down investment management firm whose philosophy is rooted in the idea of avoiding major losses rather than seeking big gains. Our disciplined approach removes the emotion from investing by indentifying attractive regions and sectors from around the world while experienced analysts concentrate on stock selection. For both social and investment reasons, we focus our stock selection on well-managed companies with sustainable business practices.