The Economic Consequences of the Peace

by Andrew Milligan, September 07, 2021

In his famous book ‘The Economic Consequences of the Peace’, JM Keynes looked through the widespread relief at the end of the horrendous First World War and offered prescient and sober warnings about how the peace imposed on Germany would lead to its economic collapse. Sadly, his fears proved all too true in the widespread instability and horrors that followed.

Today, as investors celebrate the US stock market reaching successive record highs, as well-informed bodies such as the IMF forecast rapid growth amid falling unemployment, and as rising vaccination rates allow consumers to travel, entertain and party once again, should we be worried about the stability of ‘the peace’ that will follow?

The pandemic is the largest shock facing the world since the 1940s. It has dramatically exposed multiple fragilities in economies and societies — in health programmes, business models, supply chains, labour markets and political institutions. It has worsened, not ameliorated, inequalities in health, income, wealth, and employment. A sharp cyclical recovery does not obscure the fact that deep-seated problems, such as slowing productivity growth or massive debt burdens, were in place before Covid-19 struck.

Health systems were already under serious pressure from ageing populations, the diseases of the affluent and endemic poverty before Covid surfaced. Massive investment is needed to create resilient systems which can deal with future pandemics. Scientists have long warned that globalisation and greater human interaction and interference with the natural world creates multiple possibilities for zoonotic disease transfer.

Social security and other public and private retirement systems were similarly under pressure before the pandemic. Falling share of labour income has accompanied the ‘GIG economy’. Jerome Powell may be correct that the US is making “substantial progress toward the maximum employment goal”, but labour market economists warn about mis-match problems. The pandemic has caused many workers to reassess where, when, and how they will work, whilst many businesses are finding it difficult to attract the labour they require. There is a strong likelihood that economies will suffer a higher level of structural unemployment in coming years.

Governments will need to spend larger amounts on health, education, and welfare, as has become apparent this year in budgetary discussions taking place in the US and Europe. Politicians face a major hurdle, however. Debt levels have surged to multi-decade highs because of the pandemic’s disastrous effects on income and expenditure. The US Congressional Budget Office, for example, is warning that US national debt will broadly double from 100% of GDP now to 200% by 2050, with public sector deficits ranging between 4–8% of GDP per year through the middle of the century.

Governments are not alone in piling up debt. Many businesses have borrowed heavily, taking advantage of record low interest rates. So-called zombie companies are finding it easier to stay afloat. Household mortgage debt has risen in most countries, with significant pockets elsewhere related to education and auto purchases. The IMF was already concerned when global public and private debt reached $200 trillion in 2019, warning that ‘when we have seen private debt accumulate at a rate far exceeding GDP growth, so this phenomenon can be a sign of rising vulnerability’. A Federal Reserve Bank of St. Louis study found older millennials’ debt-to-income ratios to be 23% higher than expected based on previous generations at similar ages. Such debt often means that homeownership and family formation are delayed.

How should governments deal with elevated debt levels? Politicians can choose from an unenviable mixture of policies. Unless productivity and hence GDP growth surges, then in alphabetical order we face austerity, currency depreciation, default, financial repression, or inflation as the options to bring debt burdens under control. At present, a mixture of negative real interest rates and financial repression appear top of the agenda, but other outcomes are possible. Tax officials and bank robbers know where the money is — today it is the corporate sector. Company earnings and margins are at record highs. It is little surprise that proposals for a global minimum corporate income tax have gained widespread support.

Financial markets are pricing in lower interest rates for longer to help deal with such debt mountains. In most OECD countries, nominal bond yields are at historical lows, while real (inflation adjusted) bond yields are negative. It is no longer shocking news that roughly $16 trillion of government bonds is negative yielding. Such a backdrop raises legitimate questions about stock market valuations or future correlations between bond and equity holdings in a portfolio. The notion of a risk-free asset appears quaint.

There are further reasons to be concerned about future GDP growth. The proliferation of zombie companies, stranded assets, or misaligned groups of labour does not bode well for productivity. Labour supply appears to have fallen in OECD economies, an outcome reflecting a complex mixture of Covid-19 health concerns, expanded benefits and transfers, early retirement for those at higher income brackets, disruptions to migration, and altered attitudes towards work-life balance. At the same time, many small businesses are struggling, in some cases kept afloat only by government guaranteed loans. In the household sector job growth is picking up, but wages are generally only keeping pace with hefty rates of inflation.

Such cyclical effects come on top of long-term trends in the labour force. The US prime-age population has remained flat for over a decade. China’s population of working age is already in decline. On top of this must be considered the serious damage to human capital in the form of the disrupted education of many pupils and students.

Taken at face value the bond markets imply negligible global economic growth over the next decade. Central banks are not that downbeat, but it is notable that the estimates of trend US and UK GDP growth have been reduced by mainstream forecasters to only 1.5–2.0% a year. The UK’s OBR estimates the pandemic will lower the level of GDP by 3% compared to what would have been the case otherwise.

So, we have a slower growing economy than before the crisis, with higher levels of public and private debt, relying on a slower growing tax base to fund ever larger commitments to government spending. Yet, as Larry Hatheway noted in a recent Jackson Hole Economics article, ‘Markets behave today as though normality will persist’.

If that were not enough, societies and governments are confronted by massive environmental challenges, above all climate change and biodiversity. Even if we assume that investment in renewable energy can contain the rise in global temperatures to 1.5–2.0C, the costs of doing so are staggeringly high. In 2006, the Stern report suggested a cost of 1–2% of GDP a year, whilst more recently Morgan Stanley report concluded that the world would need to spend $50 trillion by 2050 on technologies such as renewables, electric vehicles, biofuels, hydrogen, and carbon capture & storage.

Carbon taxes are being widely mooted as an essential means to raise such sums. Stiglitz and Stern suggest that the social cost of carbon should be $100 a ton, compared with single digit figures currently in many countries. That appears politically difficult, with resistance already mounting in the US. Burden sharing, to lessen the impact on the poor and vulnerable, is fertile ground for political bickering, as already shown in the run up to COP26.

Against these massive secular economic, social, public health, environmental and political challenges, financial markets act in Panglossian fashion. Equity markets make successive record highs, bond yields show limited reaction to economic data, and currency markets meander about in narrow ranges. The disconnect between asset prices and long-term fundamentals is startling.

Which returns us to Mr. Keynes. It is in the euphoria of the moment that we lose perspective. A century ago, the end of a ruinous war, and an accompanying pandemic, drove a deprived world willingly into a state of suspended disbelief — the roaring 20’s. The fundamentals did not warrant the social, economic of financial excesses of that decade, as Keynes presciently foretold and as everyone subsequently found out to their horror.

It pays to not be swept up in the moment, either in euphoria or despair. Sobriety is the foundation for careful thinking, a commodity seemingly in scarce supply in financial markets these days.

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