The numbers game

The most important macroeconomic development of the last three decades has been the extraordinary growth of the Chinese economy. In 1990, it was largely a subsistence peasant economy with a negligible footprint in world trade. China now provides the largest share of world exports, and by some standards has already become the world’s largest economy. In 1990, the wage of an average Chinese worker was perhaps 1/40th of that of an American worker. By 2020, it was just about a quarter: a tenfold gain in just 30 years.

Before the 18th century, all societies were basically subsistence peasant agricultural societies with a small upper layer of landowning nobles and clerics. Then the Industrial Revolution began. The West, primarily Europe and North America, surged ahead, leaving the more populous societies of Asia far behind. Globally, inequality increased steadily from 1800 to 2010. But now the rise of Asia has so sharply reversed between-country inequality that global inequality has actually begun to decline. China is the most populous country in the world, and other parts of Asia, such as India, are growing at a rate comfortably outpacing the West.

The sharp reduction in inequality between countries has, however, been partially offset by an almost worldwide increase in inequality inside countries. The two trends are closely associated. The rise of China was partly brought about by a massive surge in the availability of labor there. Some of this reflected a rise in the proportion of women entering the workforce; the birth rate had plummeted under the influence of the ‘one-child’ policy, and there was internal migration to the coastal manufacturing cities. This labor was then employed in part by western employers offshoring their production to newly available regions offering cheap labor and efficient administration, not only in Asia but also in Eastern Europe after the fall of the Iron Curtain.

Much the same was happening outside China in the late 20th century: fertility rates were declining and many more women were working. As a result, the available labor supply in the world’s trading system more than doubled in the space of about 30 years. This was a massive positive supply shock on a scale never previously witnessed. What happens when you get such a supply shock? Prices go down, as we’ve notably seen in the West, and output goes up, with the latter especially marked in China.

This offshoring reinforced an existing western tendency to shift production from manufacturing to services. Labor is relatively well organized in private-sector manufacturing, but it is much less so in service industries. The membership and power of trade unions, and labor bargaining power in general, collapsed from the 1980s onwards. With it, there was a steady fall in the equilibrium level of unemployment (the level just high enough to prevent a rise in inflation). Meanwhile, those who had access to capital flourished: not only in real and financial assets, such as equities, equipment and housing, but also in human capital, such as technical skills.

Perhaps surprisingly, the Chinese Communist party provides a much less extensive welfare system than the capitalist West does. In particular, the Chinese government gives far less in the form of pensions or healthcare than the US government does. So Chinese workers must save massively for their prospective retirement. Even though the investment ratio in China was historically very high, their savings ratio rose even higher, to a level unparalleled in recent decades. It accounted for much of the ‘savings glut’ and the flow of foreign money into US Treasury bonds described by Ben Bernanke, chairman of the Federal Reserve between 2006 and 2014.

The effect of this was that China was disinflating the world, even including its near-neighbor, Japan. Not only were Chinese goods cheaper to import, Japanese manufacturers switched much of their production to mainland Asia, so labor in Japan moved from secure and well-paid manufacturing jobs to part-time, lower-paid jobs in services. The stronger these disinflationary forces became, notably after the global financial crisis of 2007-08, the more central banks turned to expansionary policies. But these have had some adverse side effects.

The main instrument of monetary policy lies in its command over interest rates. This has an immediate and direct effect on bond prices, and a quick pass-through onto mortgage interest rates, and thereby onto house prices and equity valuations. So expansionary policies make the rich even richer. And the rich have a lower propensity to consume. All this has added to perceived inequality within countries.

Most macroeconomic forecasts, however fancy in terms of mathematical technique, are in essence simply extrapolations of past trends. So, naturally, most current forecasts assume that the economic system we have known over the last 30 years will continue, and inflation and nominal interest rates will remain at rock-bottom levels.

The message in The Great Demographic Reversal, the book Manoj Pradhan and I have written, is that the future will be nothing like the recent past. The positive supply shock caused by the demographic expansion of China’s workforce is now reversing. Globalization is also reversing, not only in the wake of the COVID-19 epidemic but as a result of the geopolitical confrontation between China and the United States. The working-age population is now absolutely declining in China and much of Europe. The working-age populations of the US and the UK are still growing, though much more slowly than before, especially when populist politics such as Brexit and President Trump’s policies cause declines in rates of immigration.

Meanwhile, the serried and sere ranks of the old grow apace. Many of the aged become incapacitated and need care and state support, but the old still vote. Attempts to raise the retirement age or to reduce pensions and Medicare are not vote-winners. Neither is raising taxes on younger workers to pay for the benefits of the old. So fiscal policy is not about to rein in the prospective rise in inflationary pressures. But, we might ask, isn’t achieving price stability the job of independent central banks? And don’t their officials still trumpet their confidence in their ability to halt inflation in its tracks? In the 1960s and 1970s, their predecessors bemoaned the difficulty of checking inflation, but expressed supreme confidence in their capacity to halt deflation. Now the boot is on the other foot. The challenge now faced by monetary policy, partly self-imposed by prior policy decisions, is that debt ratios in both the public and private sectors have gotten so extraordinarily high (and will get much higher), and that financial and property prices, in particular of equities, bonds and houses, are so elevated.

The effect of a rise in interest rates on the public sector deficit would now be some three or four times worse than it was in the early Eighties, when Paul Volcker tamed inflation with President Reagan’s support. Since then, secretaries of the treasury and European chancellors have found central bankers to be their best friends. Will governments continue to be supportive when the same central bankers start to make their lives much more difficult?

Meanwhile, the private sector is so highly levered, with a massive increase in debt based on a thin layer of equity, and asset prices are so raised, that an interest rate rise high enough to halt the growth of inflation could easily metamorphose into a major financial crisis. This nearly happened in 1981-82, and our system is much more fragile now than it was then. My guess is that increases in interest rates will be glacially slow, due to a combination of external political pressures and central bankers’ belief that earlier attempts to push interest rates back toward their usual historical level of somewhere between 3 and 5 percent were ill-advised and erroneous.

I expect increases to be so slow, in fact, that tightening labor markets will lead to the rate of inflation continuing to rise at an above-target rate — 3 to 5 percent per annum, say — while aggregate growth slows down. Even at these moderate levels, inflation would become a political issue. If it were to rise much higher than 5 percent, central banks and politicians would be faced with a horrible dilemma: either allow the rise to continue, or raise interest rates so high that a serious recession would become almost inevitable.

Economists and politicians tend to focus almost exclusively on shocks to demand, perhaps because they feel they have some control over them. But they almost entirely ignore shocks to supply, except in very rare situations like the present pandemic-affected one. Yet the sharp changes in the long-term trends in labor supply are entirely independent of COVID: what the pandemic has done is not to alter our long-term projections, but to change the timing of the switch from an underlying disinflationary structural background to a more inflationary one. Prior to COVID, the bargaining power of labor in general, and of trade unions in particular, had been so diminished that we thought it would take quite a long time for the growing shortage of labor to translate into higher wages and labor costs. But the supply disruptions caused by the pandemic have already led to severe labor shortages in several sectors across many countries, for instance among truck drivers, cooks and caregivers. This has brought the effects of changing labor availability forward in time, much faster than we had originally expected.

Still, our basic scenario for the medium and longer terms is not all doom and gloom. Rising labor costs are likely to bring with them more domestic investment and higher productivity. Similarly, the shortage of labor, rising real wages and some fallback in asset prices and profit will reduce within-country inequality. We may be heading into a more inflationary economy, but we are also quite possibly heading for a happier society.

This article was originally published in The Spectator’s November 2021 World edition.