Sandy McGregor
The victory of Donald Trump in the US presidential election took the market by surprise. Market behaviour subsequent to the event suggests that while Trump’s victory was unexpected by investors, it was not unwelcome. After a brief hesitation on the evening the last election results were announced, US share prices and the dollar appreciated.
Trump won despite having insulted at one time or another almost every constituency in the US, including women, blacks, Hispanics, Mexicans, Muslims, the Wall Street elite, war heroes and even the obese. Repeatedly he expressed opinions which conventional wisdom judged to be fatal to his cause. Perhaps he won because Hillary Clinton offered nothing more than another four or even eight years of the same policies, which many judge to have failed. Trump offered change. Voters may not know the solutions to their grievances but they are increasingly of the view that, where current policies are not working, something different should be tried.
A common characteristic of any ruling political elite is an inability to contemplate, let alone implement, radical change. If you want change you must replace the entire incumbent leadership. This is what happened in the UK and the US between 1979 and 1981 when Margaret Thatcher and Ronald Reagan came to power espousing an economic philosophy totally different from the then-prevailing consensus. More dramatically, in 1989 communist regimes in Eastern Europe were overthrown by a popular uprising and replaced by market economies. The election of Trump is following a trend we are seeing in other democracies, where incumbent political leaders, who have been judged to have failed, are being voted out, regardless of their political persuasion. There is increasing pressure for change.
Secular stagnation
In developed economies the root cause of contemporary popular discontent is ‘secular stagnation’, a concept we discussed in detail in Quarterly Commentary 2, 2015. These countries have ageing populations and face rising costs of pensions and healthcare. Increasingly the surplus produced by a shrinking workforce is being redistributed as social benefits. Improved healthcare and healthier lifestyles are extending longevity and therefore the pension burden. The simple truth is that many countries have made commitments to pay retirement benefits which they cannot afford.
Economic growth requires increasing productivity. Ever-rising welfare payments crowd out productive investment required to grow the economy. The inevitable cost of adverse demographics is slower economic growth. The dilemma faced by a redistributive state is that it needs strong economic growth to be able to afford to make welfare payments but, because of them, it is not going to achieve the growth it requires.
The crisis of 2008 was triggered by imprudent borrowing and lending. The legacy of this crisis was a burden of excessive debt. Combined with the consequences of ageing populations, this has created a condition of secular stagnation in developed economies to which the incumbent political elite has few answers. Probably there is no sustainable long-term solution, but the pressure to do something, indeed anything, is growing.
The response to the crisis of 2008
There was a three-pronged response in developed countries to the crisis of 2008 and subsequent secular stagnation. The first was fiscal prudence, which was essential if excessive government debt was to be serviced. The second was aggressive monetary easing by central banks. Interest rates went to zero. They also embarked on programmes of quantitative easing, which is a euphemism for printing money. Thirdly, there was a plethora of new regulation of both the business sector and private individuals. These had varying degrees of success:
1. A positive outcome from fiscal discipline
Fiscal prudence has delivered positive results. The poster children of fiscal discipline are the Baltic States and Ireland, all of which aggressively balanced their budgets despite the severe contraction their economies suffered as a consequence. They accepted short-term hardship as a price for sustainable longer-term growth. Their economies rapidly adjusted and repriced, allowing growth to resume. The Conservative government in the UK cut its budget deficit aggressively, against the advice of the International Monetary Fund (IMF), and now is one of the better economic performers in Europe. Germany never had big deficits and its economy was only slightly damaged by the financial crisis.
The countries which imposed fiscal discipline have been rewarded with better growth. However, while they may be doing relatively well, in a world of secular stagnation they are growing at a much slower rate than they did in earlier, happier times.
2. Monetary policy fails
In contrast to fiscal discipline, the great monetary experiment of zero interest rates and printing money has been a total failure. It has not created growth because one cannot reverse the consequences of adverse demographics by manipulating interest rates. Rather it has had adverse consequences on the way people save and invest, creating asset price bubbles and a misallocation of resources, which has had a cost in declining productivity and therefore slower growth. In boosting asset prices it has led to the unpopular consequence of making the rich richer.
3. Increased regulation stifles growth
Greater regulation has also had a negative impact on growth. Unfortunately, regulatory structures are created by governments with sanctimonious claims of their virtuous intentions, but with little study of the huge costs that compliance imposes on business and ordinary citizens.
In the US, Obamacare and the Dodd Frank Act – which regulates the financial sector – are administrative nightmares, imposing incredible complexity on business. The Basel accords to control international banking are an attempt to solve the 2008 crisis in retrospect. The consequences of regulation are higher costs to the consumer, who has to pay for compliance and a significant decrease in investment because regulation increases the cost of doing business. One of the biggest systemic risks facing the world economy is the unintended consequences of regulations which have become far too complex. The explosion in the scope and number of regulations is a significant contributor to the current economic malaise.
The push for more government spending
During the past year there has been growing popular discontent about the failure of the above-mentioned strategies to deliver an improving quality of life to any but the super-rich. Trump’s victory reinforces the pushback against what are increasingly regarded as failed policies.
Demands that governments spend more on infrastructure are increasing. Trump has promised to do just this and the deteriorating condition of America’s infrastructure, most of which is more than 50 years old, provides a strong argument which might persuade Congress to support such a programme. In Europe, Germany is being pressured by the EU to abandon its balanced budget and to spend more to boost growth on the continent as a whole. In July, when Theresa May became prime minister of the UK, she promised to ease up on the austerity imposed by the Cameron government. A fashionable consensus is developing that governments should spend more.
The lesson of history is that governments abandon prudent finance at their peril. In a world of rising commitments to fund retirement benefits, any state which adds significantly to public debt to pay for a temporary boost to growth faces ultimate financial disaster. Germany’s approach of balancing its budget is the only prudent way to go.
This orthodoxy is increasingly being questioned. Over the past eight years central banks in developed economies have abandoned all prudence and printed vast amounts of money in a failed attempt to stimulate demand. The expectation was that this would cause inflation. Indeed the central banks themselves expected and wanted inflation. However, they have been unable to reverse deflationary pressures, which have kept inflation close to zero. The prices of assets have gone up but not those of goods and services.
The proponents of fiscal imprudence argue that we are presented with a unique opportunity because governments can borrow cheaply and, if necessary, print the money required. Cheap money has become as an excuse for fiscal irresponsibility. The pressures for an imprudent spending spree are rising. Donald Trump’s victory reinforces these pressures.
The end of zero rates
The push to take advantage of zero interest rates coincides with the increasing recognition that they are unsustainable and must end soon. Central banks are being criticised for monetary policies which, far from stimulating growth, are actually a significant cause of economic stagnation. The critics argue that zero interest rates distort the pattern of saving and investment, promoting a misallocation of resources, which erodes economic efficiency and therefore growth.
The failure of unconventional monetary policy is giving credibility to its critics. It is noteworthy that Prime Minister May has publicly criticised extremely low interest rates in the UK – the first time that a head of government of a major economy has expressed such sentiments. In the US the Federal Reserve Board has finally reached the point where, with the economy operating at full capacity, it has to raise rates if it is to avoid significant inflation. The Trump victory, with its promise of more government spending, reinforces the need for higher interest rates and prompted a big sell-off of bonds. As the international monetary system is based on the dollar, ultimately all countries will have to follow the US in raising rates. The market will punish any country which persists with zero rates with a major depreciation in its exchange rate.
In recent months the dollar has been strengthening against all other currencies, a trend that has accelerated following the US election. There is a risk that the combination of a push for higher government spending and rising interest rates will cause major instability in the global financial system. A particular vulnerability is the large amount of corporate debt in the emerging economies, much of which is denominated in dollars.
Trump promises deregulation
The Obama administration was a major proponent of increasing regulation of business. Trump promises to reverse this trend. It is worth mentioning that such serious opponents of regulation as Margaret Thatcher and Ronald Reagan had limited success in reversing the inexorable increase in the number and scope of rules and regulations. However, their attitude did limit the growth in regulation. The same can be expected of Trump. International cooperation aimed at creating global regulatory systems is likely to suffer. The consequences will probably be positive for world growth. If entrepreneurs can attend to growing their businesses, rather than spend time filling in forms, the world will be more prosperous.
Change brings instability
There is a prevailing sense that things cannot carry on as they are. This will accelerate changes which were already starting to happen. The great experiment with unconventional monetary policy and excessive regulation has created a system which is inherently unstable and is unsustainable. We have entered a period of change. Change can happen with astonishing speed. It inevitably brings with it instability. In previous periods of profound change, such as the end of the post war expansion in the 1970s and early 1980s, financial markets were extremely volatile and exceptionally confusing. It is concerning that these difficult periods of transition can last for a decade or more. Getting things right will take time. The unknown unknowns which make planning for the future so difficult are compounding.
By Sandy McGregor, portfolio manager, Allan Gray