Economic Growths False Paradigm
Economics / Economic Theory Jan 27, 2014 - 12:24 PM GMTBy: Submissions
Raymond Matison writes: With pressing economic, banking, and systemic financial problems the world over, leaders of advanced nations both in Europe and in America are calling for programs to resume growth. President Obama in a recent State of the Union message proposed to reinvigorate growth in the US by doubling exports over the next several years. Prime minister Abe of Japan was a keynote speaker at the World Economic Forum in Davos his January outlining the need to rejuvenate growth. Japan has been vigorously increasing its money supply and depressing interest rates in order to promote the growth of its exports and GDP. Government leaders seek growth as the universal answer for maintaining government solvency as well as citizen prosperity, and it seems that no government leader anywhere in the world seeks less growth. Yet few have really considered recently whether growth is the promised panacea of nations and its citizens. This article raises reasonable questions regarding such policy and its desirability.
Most investors identify growth as a highly desirable or even a necessary trait in a company to be considered for a possible investment. We are all vaguely familiar with the historical growth in the revenues and profits of companies such as Amazon, Google, Microsoft, EBay, among many others, and understand the immense investment return that such a growth company may provide. So “growth” becomes imbedded in our minds as the primary driver of increased financial benefits, improved prosperity and an improved quality of life. As a consequence, economists, money managers, bankers, treasury and government officials all tell us that growth is good – and contrariwise, a slowdown or decline in growth is to be avoided.
Growth companies generally increase their revenues dramatically because they provide innovative or desirable products to consumers that have not existed before, or previously existing products which have new innovative and important features, together with a continuing new generation of products that consumers are eager to purchase. Thus, the stock market reacts positively when Apple Inc. reports that the number of phones sold in short time frame has increased dramatically. This kind of growth is easy to understand and accept. And, of course, it is good for everyone.
A normally functioning stock market values such companies on their perceived rate of revenue and earnings growth. When a company’s products sell rapidly, the contribution to revenues from an increase in the number of units sold is dramatic, whereas revenue increases due to inflation are inconsequential. Investors are really interested in the growth of the number of products sold, not so much their price. Indeed, as the number of units sold increases, the price per unit is likely to decrease. However, when a company’s product has saturated its market and the growth in the number of products recedes, the component to revenues from inflation can become important, and in periods of recession - dominant. The history of companies that evolve from their initial faster growth stage to a slower-growing more mature stage has been well established and confirmed. Growth in revenues and earnings from highly inflationary periods such as that of the early 1980’s demonstrates also that inflation can be the primary driver of financial results. Thus long term generated money expansion, which promotes inflation, creates a false measure of real growth.
The more sophisticated discounted cash flow model for company valuation also requires assumptions for revenue and earnings growth. However, if for a specific company the projected growth in revenues and earnings are zero, does the company still have value? Just ask Warren Buffett who likes to make acquisitions of mature companies where the expected growth in revenues and earnings is low - but very predictable. Yes, growth in revenues and earnings does affect valuation, but at the right price low or no-growth companies are valuable and good investments, and contribute to a country’s Gross National Product (GDP).
But contrary to companies, what happens when government reports a certain rate of growth in the economy as measured by GDP? What is the impact when your government suggests that the economy as measured by GDP has been reduced from the previous quarter, or the trend in growth has declined for several quarters, or the increase in GDP growth is simply continuously below historically accepted levels? How do we compute GDP anyway, and what are the factors that influence its measure? Gross National Product is the sum of consumer spending, government spending, investment, and the difference between exports and imports. Recently, GDP approximately is comprised 70% on consumer spending, and consumer and government spending combined comprise approximately 90% of GDP.
What influences the direction, size, and growth of GDP? Clearly, consumer confidence in the economy, and people’s collective financial capability to consume is a very important factor. In addition, a continuing dramatic influence can come from the level of inflation. A growth rate in the economy as measured by an increase of GDP in the range of 4% would be laudable to economists and government leaders alike. If that growth came from increased consumer spending in the absence of any inflation, that would be construed as being very positive. But if that year experienced a rate of inflation greater than 4%, that GDP growth would not be construed so positively, and the quality of life for the average citizen would not have improved.
This begs the question as to whether consumers can live comfortably in an economy that is not expanding, as measured by the nominal change in GDP. Must we continually strive for growth – at least at the national level? Will the effect of inflation on the growth of GDP, without attendant real growth in production and exports, provide improved economic lives for its citizens? Currently, the FED is trying to instill a 2% rate of inflation in the U.S. economy. In a no-growth economy the attainment of the FED’s inflation target would increase GDP by 2%. Does this translate into a 2% improvement in living standards? To test these dynamics let us consider a simplistic thought experiment.
Imagine a large island with a population which has grown dramatically over the last century. This island’s economy had grown concomitant with its population. However, its location is so distant from other countries that exports have been relatively unimportant. Most everything that this island country produces is utilized domestically. Everyone had been employed in agriculture, but with scientific advances more of its people have moved to cities are their jobs have become more diverse. Their form of money is based on pearls which were in the waters around the island, but some unknown water disease has killed of these shells, and as a consequence the supply of pearl-based money has been relatively fixed.
In this thought experiment model, the government does not collect taxes for the purpose of providing pensions or health care for its citizens as they are responsible for themselves. Because this island community is surround by and ocean measured in thousands of miles, the possibility of any foreign nation to launch an army to conquer its people and land mass is negligible. Accordingly, expenditures for military spending do not add much to GDP. As a result, total government expenditures are limited, and it does not need to borrow money – and as a consequence, there is little government debt, and commensurately, the individual savings rate is high.
As this island community evolves, women develop an interest to pursue careers outside the home. As a result, the national birth rate drops off to a level where it is foreseeable that the total population growth of this island will soon stabilize and then possibly start to decline. So our imagined island community now has a fixed money supply, and a static number of inhabitants. What possibility is there that this island country’s citizens could experience a continually improved standard of living?
Assume that for a while one of the important components of this island’s economy was agriculture. However, as people moved to the city for more interesting jobs, the crops that were grown previously by families for their own consumption, now became a part of their expenditures and GDP. Part of their GDP was also based on the production of furniture. But when everyone had purchased their furnishings, which maintained their utility for many years, the growth of such manufacture declined, as did its contribution to their GDP. To store their food, ice was sold to consumers, which interestingly also added to GDP growth. The cost of ice on this island was considerable, but as refrigeration was discovered, the production of refrigerators grew dramatically, but of course it reduced the contribution of ice sales to GDP. As someone on the island discovered how to make radios, this became the new growth industry. In a few years television was discovered and the sale of radios fell dramatically, as everyone already owned a radio and desired to purchase a TV. So the contribution of these products to GDP became somewhat offsetting, even as TV’s were more expensive than radios. Over a period of years everyone had managed to purchase these products from their savings, and since these products lasted for a number of years, their production eventually started to decline. Fortunately, someone discovered how to make a portable phone as opposed to the old fashioned wired home phone, and the growth of this product grew even as the growth of TV manufacture started to decline.
It appears that in our thought experiment economy, people over long periods of time are able to save and purchase new appliances and other products which improve living convenience. These new products add to an economy’s GDP growth, but as they last for a long time, their contribution to GDP gets supplanted by newer products and inventions. Accordingly, it is entirely possible that given a no growth population, in the absence of inflation which would drive nominal values of GDP growth, substitution of new consumer conveniences is the marginal stimulant to this thought-experiment economy. Thus innovation is the real stimulant to improved living standards. These are simplistic examples to characterize a whole economy, and of course can be refuted. However, if we are asked to visualize whether the quality of life for citizens in this island community can improve over time, even as the GDP magically just seemed to stay at the same level, and the amount of inflation on this island remained zero – we may suspect that eventually all of the island’s citizens got new products that improve living convenience, and therefore, would probably agree or conclude that over time the islander’s quality of life improved – in what appeared to be overall a stagnant no-growth economy. And of course life in the real United States (the island) did improve over two centuries when GDP grew with population, and when the pearl-based monetary system (gold) constrained government spending and inflation.
Neither the lack of monetary growth nor the absence of inflation has a negative effect on the continually improved lives of its citizens. The improvement in their citizen’s lives came from innovation of products, which created growth products and growth industries, but did not require for the total GDP to grow dramatically. In fact there seems to be a rotation of products that consumers buy which add to GDP, but when a new more desirable product is invented it tends to reduce demand for more outdated products. What we also can envision is that if the rate of inflation is zero – meaning that the currency remains sound, and citizen earnings and savings are not debauched through money devaluation, people can afford to buy new innovative products over time and thereby improve their living standards.
However, over the last several centuries dramatic actual growth in global population has driven real global growth in production and growth in demand. Yet presently, in the economically developed part of the world, birth rates have fallen to below population replacement. This means that the growth rate of population in Europe and America is slowing, with the expectation that total population in many advanced countries will stabilize or decline over the next fifty years.
In this context, we have to consider the likelihood that the GDP of these real countries will at first slow, reflecting the declining growth rate of population, and eventually may –absent inflation - fall in line with the decline in total population. If this conjecture has merit, then it will become necessary for many companies to learn how to manage steady or declining revenues and profits. The larger challenge will be for governments to manage their budgets – in as much as their tax revenues may decline even as their commitments for various politically motivated welfare programs and military spending remain in place. With either lower population growth or actual decline, the challenge to maintain nominal levels of GDP will be considerable. Indeed, company managers and government bureaucrats will need to learn new skills, and change objectives as dictated by reduced growth. The success of a governmental department or agency instead of being measured by its ability to increase its budget, may instead become measured by its ability to reduce its expenses and future budgets. And the most important challenge will be to go through this economic transition without reducing (substantially) the standard of living for millions of citizens both here and abroad.
The quality of life for citizens can improve even as national GDP is unchanged. However, this requires that governments maintain strict discipline and lower spending as a proportion of GDP. This implies adjustments, reducing levels of welfare and military spending on behalf of government – spending that reduces the real net income of working individuals. And it requires the currency representing the money of the system to maintain its value without erosion. In addition, consumer and government debt as well as its unfunded liabilities would need to be addressed without obfuscation – and reduced through pay-downs or write-downs. New methods for valuing investments would need to be considered, developed and accepted which are not based on long term growth of revenues or earnings.
There is one interesting possible life style change to consider as a result of this futuristic no-growth world. With continued improvements in productivity coming from robotically automated factories, industries will be able to produce ever more products with less labor and lower employment, even as demand for such products grows reaching a peak and then may decline. When combined with the irreversible trend of billions of workers around the world from emerging countries willing to work for a fraction of that demanded by workers in advanced nations – it is clear that unemployment rates in the advanced countries characterized by higher incomes will remain commensurately high for decades. This will bring increasing pressure on governments to find some means of employment for the unemployed. It is likely that when combined with the unintentional consequences of the Affordable Care Act, which has prompted many employers to reduce the work hours of employees to a part time status – that eventually with these forces at work, our advanced-economy countries will gradually evolve to embrace a four day work week for everyone.
There was a tremendous opportunity to embrace such a change before 2008 and before the economic decline. At that time it was possible for the nation to decide to go to a four day work week. If this had taken place before all of the layoffs, mathematically at least, it would have been possible to maintain nearly full employment by agreeing that no one gets fired, but everyone works only four days a week and collects four day’s pay. Probably this would have been an acceptable solution by many in the work force. This alternative seems better than having a real unemployment rate that approaches 20% nationally. This transition to the four day work week may take place over the next decades because of the unintended effect of Affordable Care Act, but once we experience and become accustomed to the three day weekend, there will likely be no turning back. Unfortunately, since our work force participation rate is low and unemployment high, there will also be considerable economic pain for all citizens to experience as these adjustments are made over the next decades. Even more unfortunately, the segment of population most affected by these changes will fall upon the largest segment of population, that which has the lowest skill, education, and income levels. Hopefully, these adjustments will be managed by corporations and governments with care, so as to avert social chaos as one of its potential consequences. Industries that would be dramatically affected include manufacturing, banking, financial, and investment areas. Banks would have to learn to finance companies that may not grow beyond some point, while investors, institutional and individual, would have to consider investments where profits may stabilize and not grow beyond some point. Importantly, bank earnings would not grow from continued rapid or cyclically manipulated expansion of credit. The utility of the Federal Reserve in consumer markets would be reduced, while its function for government financing accommodation would change.
So, can an economy function or prosper without money inflation, without growth in population, and without nominal or real growth in GDP? Is it possible to provide citizens new innovative products produced by ever more efficient production methods, and enjoy meaningful, happy and prosperous lives? Is adjusting and managing reduced growth, with more leisure time to all citizens the next evolutionary step in our civilization? Likely, it will take many years to confirm conclusively. But it is not too early to start this debate among our thinkers.
By Raymond Matison
Mr. Matison is a U.S. patriot who immigrated to this country in 1949. With a B.S. in engineering physics, an M.S. in Actuarial Science, work in the actuarial field, and as a financial analyst at Legg, Mason Inc., Lehman Brothers, and investment banking at Kidder Peabody, and Merrill Lynch provides a diverse background for experience. First-hand exposure to fascism, socialism, and communism as well as the completion of a U.S. Army military intelligence course in the 1960’s, have inspired a continuing interest in selected topics in science, military, and economics.
© Copyright Raymond Matison 2014
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