SERIOUS MONEY: FAR TOO many investors continue to cling stubbornly to the belief that the recent economic slowdown is simply a typical mid-cycle pause and, that a self-sustaining expansion is set to take off any day now.
The view is naive and fails to recognise that the financial crisis marked a once-in-a-generation breakdown in the prevailing economic model.
It is time to get used to the reality that an era is at an end.
It is important to take a step back in time to appreciate the dynamics that characterised the development of the US economy from the early-1980s to the present day.
An important shift in power from labour to capital began more than three decades ago, as growing frustration with the stagflation of the 1970s precipitated a welcome sea change in economic ideology.
The resulting transformation from “big” to “small” government undermined union power and contributed to increased labour market flexibility, while greater shareholder activism led to a renewed focus on value creation and returns on equity. The process gathered pace through the 1990s and into the new millennium, as the twin forces of rapid technological change and globalisation, via increased trade flows and greater capital market integration, sparked a further reduction in labour’s bargaining power.
The shift in power to the owners of capital triggered a structural upturn in corporate profitability, as the labour share of output accounted for by employees’ compensation, dropped by roughly five percentage points from its 1947/82 average to less than 61 per cent by the middle of the first decade of the new millennium.
The owners of debt and equity securities benefited handsomely, as high returns on capital contributed to significant price appreciation, while interest income alongside dividend payments and share repurchases, provided an important boost to income.
Indeed, the share of total income captured by the top 5 per cent of the income distribution jumped from 22 per cent in 1983 to 34 per cent in 2007. The large increase in income inequality, however, brought with it greater financial fragility, as the typical US household had no option but to borrow in order to keep pace with rising living standards as measured by real GDP per capita.
To appreciate this development, it is important to recognise that while productivity is the primary determinant of a nation’s standard of living, real hourly compensation measures workers’ purchasing power. In this regard, the diminished power of labour meant increases in real hourly compensation failed to keep pace with accelerating productivity growth over the past three decades. The compensation/productivity gap has became ever more pronounced as the period unfolded.
The increase in workers’ purchasing power lagged productivity growth at a rate of less than one-quarter of a percentage point per annum from 1947 to 1979 but the gap began to widen as the power shift gathered momentum. Growth in real hourly compensation trailed improving productivity by three-quarters of a percentage point per annum through the 1980s and 1990s and, the gap widened to almost 1½ percentage points during the economic expansion that peaked at the end of 2007.
The shortfall in employee compensation relative to national output could have led to oversupply and a fall in corporate profitability but the savings of high-income earners alongside foreign capital was channelled to households via the financial sector to fill the shortfall in effective demand.
The result of this financialisation process however, was a surge in household indebtedness. As the share of total income captured by high-earning households jumped by 12 percentage points between 1983 and 2007 to the highest level since 1928, the household debt/GDP ratio increased from less than 50 per cent to nearly 100 per cent.
A tipping point duly arrived as the subprime segment of the residential mortgage market began to unravel.
The result was the deepest economic downturn since the 1930s. The diehard bulls on Wall Street applaud the surge in corporate profitability but fail to recognise that this has served only to exaggerate further the move away from labour towards capital.
Indeed, workers’ purchasing power has lagged productivity gains at such an extraordinary rate during the recovery so far that the aggregate compensation share of the increase in national income amounts to just 1 per cent versus an almost one-third share at a similar point during for previous recoveries.
Meanwhile, the corporate profits share has jumped from less than 30 per cent to almost 90 per cent. The bottom line is that corporate profits are improving at the expense of effective consumer demand. For now, consumer demand is being buoyed by government transfer payments rather than incremental borrowing but it’s plain to see that current trends are not sustainable. There is nothing typical about the current economic climate. Overleveraged household balance sheets combined with stagnant compensation virtually assures years of subdued growth.
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