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posted on 23 July 2016

Simple Math Goes Global

from Lakshman Achuthan, Co-Founder and Chief Operations Officer of ECRI

The risk of a global recession is edging up, as the global slowdown we first noted last fall continues (ICO Essentials, September 2015). This danger is heightened because longer-term trend growth is slowing in every Group of Seven (G7) economy, as dictated by simple math: growth in output per hour, i.e., labor productivity - plus growth in the potential labor force - a proxy for hours worked - adding up to real GDP growth.

As we laid out over a year ago (USCO Essentials, June 2015), this simple combination of productivity and demographic trends reveals that U.S. trend GDP growth is converging toward 1%. This is reminiscent of Japan during its "lost decades," where average annual real GDP growth registered just ¾%, which is why we have cautioned that the U.S. is "becoming Japan" (USCO Essentials, February 2016)and (ICO, July 2013).

Expanding this analysis to the rest of the G7, we find that every economy is effectively becoming Japan, and the sharpest slowdowns are happening outside North America. Thus, as trend growth falls in the world's largest advanced economies amid the ongoing global slowdown, the threat of a global recession is growing.

In the face of slowing U.S. trend growth, the Fed had hoped that the U.S. economy would recover to earlier levels of trend growth, provided they could find the right size and mix of quantitative easing and low interest rate policies. We dubbed this effort, a "Grand Experiment," which has served only to pull demand forward, ultimately depleting future demand and failing to achieve the Fed's objective. Other G7 central banks have arguably made even greater attempts at ginning up growth, but with even less to show for it.

To make our simple math analysis consistent internationally, we used comparable annual data for productivity, labor force, and potential labor force for each G7 country. Then, we examined the data for the half-century preceding the Global Financial Crisis (GFC). Separately, we examined labor productivity growth in the 2010-15 period and potential labor force growth in the 2015-20 period to estimate trend growth in the latter period. As productivity is notoriously difficult to predict, and there is no compelling reason to expect it to change significantly in the near term, we used the last five years' average productivity growth as the best available estimate for the next few years. The results for the U.S. were quite consistent with our original findings.

Outside of North America, trend growth will likely be even worse. Indeed, the German outlook is substantially weaker than that of the major developed English-speaking economies. While average productivity growth was relatively high at 0.8% from 2010-15, as shown in the chart (upper panel, red line), withnegative 0.4% annualized potential labor force growth for 2015-20 (lower panel, red line), trend GDP growth is expected to be only 0.4% over the second half of this decade. To what extent Brexit will change the growth trajectory remains to be seen, but it is unlikely to help.

In Germany productivity growth averaged nearly 4% a year in the 1957-2007 period - being a bit higher in the 1960s and a little lower in the 1990s - (upper panel, gold line), while labor force growth was reasonably steady around 0.3% (lower panel, gold line). Thus, the growth rates of both productivity and the labor force have downshifted substantially in Germany in recent years - a major problem, since Germany is the Eurozone's growth locomotive.

Still, no G7 economy has as dire an outlook as Japan, where trend GDP growth is converging to zero over the next five years. Indeed, with the potential labor force set to average -0.4% annual growth and productivity growth having averaged 0.4% for 2010-15 (not shown), they effectively offset each other, netting zero trend GDP growth. Unlike the rest of the G7, Japan has annualized growth stair-stepping down for both productivity and the labor force.

All of this highlights the degree to which the G7 economies are "becoming Japan." In the 1957-2007 period, all of the economies except Japan were in the three-to - four-percent trend growth range. But, in the 2015-20 period, while Japan is on a zero-percent trend growth trajectory, Germany is on track for just 0.4% trend GDP growth. As productivity and labor force growth slow, all of the G7 economies are converging to lower levels of trend growth, with Japan leading the race to zero.

Of course, this lower trend growth problem is a hallmark of our "yo-yo years" thesis (ICO, March 2012), which posits that lower trend growth and higher cycle volatility lead to more frequent recessions. This is because, when trend growth is close to zero, it is relatively easy during growth rate cycle (GRC) downturns for actual growth to fall below zero for a sustained period, triggering a business cycle recession.

Another result of lower trend growth has been competitive devaluation (ICO Essentials, March 2015). As domestic demand fails to deliver sufficient growth, countries attempt to stoke growth through exports by devaluing their currency. However, as export volume growth hovers around zero for advanced economies and export price growth is negative, these countries are fighting over a shrinking trade pie (ICO Essentials, April 2016).

At the moment, all of the G7 economies are either in, or on the cusp of, GRC downturns, and therefore recession remains on the table, to some extent, in all cases. Given the ongoing global slowdown, this means that a global recession, while not at hand, is a distinct possibility in the relative near term. This is precisely the situation where the global economy can ill-afford major negative shocks, especially if some of these G7 economies enter windows of cyclical vulnerability defined by pronounced, pervasive and persistent downturns in the levels of their respective long leading indexes. With central banks around the world essentially out of ammunition and unable to reach any consensus on how to get growth back on track, a global recession would be particularly problematic.

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