Perhaps the question that provokes the most debate among economists is: what happened in 1950?
As Chart 1 shows, global GDP increased massively from that year until 2008, particularly when compared with the first half of the century.
Keynesian economists argue that it was a consensus among global governments around the ideas of John Maynard Keynes that led to the post-war boom.
Keynes advocated counter-cyclical economics: that if an economy were growing at persistently above its potential rate, the proper response of government would be to cut back its own spending. If an economy were growing significantly slower than its potential rate, the correct response would be for the government to increase spending until the economy reaches potential.
Central to the understanding of how politicians misjudge the true state of the economy is to grasp that there is a trend rate of growth and a cyclical rate of growth, with the latter represented by the GDP number covered in the media and quoted by politicians.
The trend growth rate doesn’t tend to change much over the short term, and is mostly only influenced by population and productivity growth. The cyclical GDP number is influenced much more by government policy and other shorter-term factors.
What drove growth?
Those who criticise the Keynesian consensus explanation of the sharp rise in global growth after 1950 contend the economy had plenty of room to grow after World War II, so the higher government spending was very productive because the world economy after 1950 essentially gathered all of the growth that didn’t happen during the war.
Critics go on to argue that policymakers persisted with this approach beyond the period when global developed market economies were operating at below potential, with the result that by the 1970s governments were pouring extra spending into economies that didn’t need it. Most economists agree that extra spending in an economy that is already at potential simply creates higher inflation, not higher growth.
This higher inflation then has the effect of slowing the economy to below trend levels, so policymakers are faced with a combination of slowing growth and rising inflation, a phenomenon known as stagflation.
Critics of the Keynesian consensus argue this is what the world looked like in the 1970s, and it took a shift away from the consensus by Ronald Reagan and Margaret Thatcher, who focused on reducing inflation and improving the trend growth rate rather than simply managing the cyclical growth rate.
This involved, according to its advocates, a policy of reforming the supply side of the economy to improve the structural growth rate, even if this leads to intermittent recessions. Advocates of this view contend that Keynesian economics will always end with inflationary bubbles, while improving the structural growth rate is not inflationary.
Boom and bust
At the turn of the millennium, the Keynesian consensus appeared to be dead, with global economies growing steadily and inflation not a serious problem, but that consensus was itself destroyed by the global financial crisis of 2008.
Many Keynesian economists argue that Thatcher and Reagan simply replaced what they saw as an unstable growth fuelled by government spending with a liberalisation of the financial system that meant the cash that governments had injected into the system was effectively replaced by liquidity from banks securitising debt.
Advocates of the monetarist economics of Thatcher and Reagan contend that increasing the supply of money in the economy would improve the structural growth rate of the economy because it would allow easier access to capital for businesses that could then challenge the incumbents.
This was supposed to boost the fortunes of the poorest by making credit cheaper, while allowing governments to maintain spending at a lower level and central banks to control inflation. Many critics of the Keynesian theory argue that governments are not efficient at allocating capital in a way that enhances growth, as they are beholden to political considerations.
Defenders of the Keynesian tradition contend that replacing the government as provider of capital with the market has also been proved by the global financial crisis to be inefficient, creating a housing bubble and debt bubble that would inevitably burst, and prove no more stable than what went before.
Structural versus cyclical
Fahad Kamal, global market strategist at Kleinwort Hambros, believes that structural changes in society from 1950 onwards were far more important than the actions of any government, and that the improved growth rate from 1950 onwards was the result of an increase in the working age population brought about by more women entering the workforce.
This stands in contrast to the period before 1950, when there were two world wars and millions of working age people died. Population growth was rapid in the years after 1950, meaning the structural rate of growth in the economy expanded. Mr Kamal argues it was this, rather than the policies of any particular government, that caused the growth rate to accelerate.
He believes the other major contributor to the heightened structural growth rate after 1950 was the liberalisation of the Chinese economy, which managed the rare economic feat of bringing many millions more consumers into the global economy while also being deflationary, as it sharply reduced the cost of production of many goods and services.
Mr Kamal also claims that the lunge into stagflation that occurred in the 1970s was the result of central bankers at that time having very limited experience of how to control inflation because for decades countries were part of the gold standard. Higher oil prices and a period of strong economic performance in the 1960s led to higher inflation, he argues, and the result was recessions in the 1980s. He believes central bankers have “learned” how to manage inflation since then.
The economic uncertainties of the 1970s and 1980s gave way to a period of far more settled and steady growth in the 1990s – growth that continued until the financial crisis of 2008.
Critics of the economic policies of Reagan and Thatcher argue that it was the removal from office of those politicians that led to the uptick in growth.
Those looking at the economy from a structural point of view argue that the collapse of the Soviet Union at the start of the 1990s provided a boost to the world, upping the number of working age people within the economy.
A new era
James Carrick, senior economist at Legal and General, says the boost that came in the 1990s was the result of economists finally working out how to measure the positive contribution to growth made by the personal computer. He believes similar upward revisions to growth rates will happen as economists work out the impact of the technology we are seeing today.
As the chart shows, economic growth since 2008 has been closer to the sluggish levels seen before 1950 than to the faster growth of the second half of that century.
Mr Kamal thinks this is because the factors he believes drove the higher growth rate are fading, with working age populations in many western countries stagnant or shrinking, and no economy as large as China about to enter the global system.
He says: “While there are other emerging market economies that are going through the same growth phase as China, there are none as large as China, or that will have that impact. India is, of course, a very large country, but each region is different , many are very highly developed already, and in the country there are a lot of local laws. It’s not like the way China was able to move in giant leaps.”
Guy Miller, head of macroeconomics at Zurich, argues that the demise of the various factors that led to much higher economic growth in the past vindicates the ideas of the US former Treasury Secretary Larry Summers, specifically that the world in entering a phase of “secular stagnation” where growth will be permanently much lower than in the past.
Mr Miller believes the problem is exacerbated by developed market central banks having a mandate to control inflation, rather than deliver growth. He argues those mandates were created due to memories of the high inflation of the 1970s or earlier, but in the present low inflation world these can be damaging, because central bankers stop inflation rising at the expense of also halting economic growth’s potential rise.
He said the logical conclusion of this for investors is to believe that interest rates will remain lower “forever”, and consequently so will bond yields.
David Thorpe is investment reporter at FTAdviser.com
