Stagnation Risks in Advanced Economies
Economic growth in advanced economies has slowed down during the last fifteen years. In part, this reflects the output declines after the global financial crisis of 2008 and the unusually slow recovery. However, in most cases the growth slowdown preceded the crisis.
The slower growth is largely driven by a combination of supply side factors. Potential employment growth has declined as population ageing accelerates. Labour productivity growth has also fallen, constrained by falling investment rates post-crisis, lower returns to innovation and an older workforce. While labour productivity growth is expected to improve in the next decade, it is unlikely to match that of the 1990‘s. The reduction in the available labour force due to population ageing will also remain a significant constraint on growth.
As a result, baseline forecasts for the next decade show a continuing mediocre GDP growth. Only the Eurozone is forecast to see a significant improvement, mainly due to the end of the Eurozone crisis recession in 2014. There is a significant likelihood of even lower growth rates. In this Advanced Economies Stagnation scenario, annual GDP growth in 2016-2025 would decline by a further 0.6-0.7 percentage points.
Looking at real GDP growth rates for the four main advanced economies (the US, the Eurozone, Japan and the UK) shows a significant slowdown since the 1990’s. The recent growth performance of the Eurozone and Japan has been particularly sluggish, but the slowdown is more general.
The financial crisis and demographic slowdown continue to limit output growth, but cannot be the only factors
Financial crises reduce capital accumulation, business entry and innovation. This leads to a permanent decline in the level of economic activity relative to previous trends (Queralto, 2015). The global financial crisis has also probably caused a longer-term reduction in the availability of external financing through stronger capital requirements, tighter regulation of financial institutions, and higher investor risk aversion. While these changes increase financial stability they also reduce investment, hurting labour productivity. Ongoing private sector deleveraging is still limiting growth in some countries, especially in the Eurozone. But the slowdown in GDP growth rates in advanced economies precedes the crisis, suggesting that other factors are also at play.
Population ageing and the resulting decline in working-age population growth has been one of the main causes of lower growth. The problem is particularly severe in Japan and the Eurozone, where the working age population is expected to shrink over the next decade.
However, the decline in output growth rates remains after taking into account the worsening demographics. Looking at GDP per working-age (15-64 year old) person reduces the gap between the economic performance of Japan or the Eurozone and the US. Japan’s economy outperformed other advanced economies in 2001-2015 in terms of GDP per working age person. The Eurozone’s economy outperformed the US in 2001-2007, before being hit by both the global financial crisis and the Eurozone crisis in 2008-2015. After adjusting for differences in the speed of population ageing, the key advanced economies are forecast to have similar annual growth rates of 1.5-1.7% in 2016-2025.
Slower output growth per working-age person can be due to a decline in employment rates or lower labour productivity growth. The global financial crisis reduced employment significantly in most advanced economies. In the US, the labour force participation rate was declining already before the crisis and has remained relatively low, with a large number of discouraged job seekers dropping out of the labour force. In the other key advanced economies the employment rate has returned close to or even exceeded its level in 2007, with notable exceptions in Southern Europe. Taking a longer term perspective, rising labour force participation rates since 2000 have contributed to a higher employment rate outside the US. Therefore, lower employment cannot explain the declining output growth rates after adjusting for demographics.
There is some scope for raising the employment rate of older workers, but increasing the pension age and other reforms to achieve this are likely to continue facing tough opposition from voters. Japan’s labour force would also get a strong boost from higher participation of women, but progress on the labour market reforms part of Abenomics has been slow (IMF, 2016).
Falling investment rates, diminishing returns to information technology and an ageing workforce reduce labour productivity growth
Slower increases in labour productivity after the 1990’s explain most of the remaining growth slowdown. The Eurozone’s productivity growth rate was already below 1% in 2001-2007, but after 2011 the slowdown became more general. The deceleration in labour productivity can be decomposed into slower increases in capital per worker and lower growth in total factor productivity (TFP), the efficiency of the economy in using a given amount of capital and workers.
The large drop in investment and lower capital accumulation during the global financial crisis has been an important contributor to low labour productivity growth in the recovery. US business investment was rebounding until 2016 (before the oil sector investment crash), and was already significantly above its 2007 level. Eurozone business investment in 2015 barely reached its 2007 level, reflecting the additional impact of the Eurozone crisis.
The information and communications technology (ICT) revolution led to large TFP gains in the 1990’s, boosting output growth in the US and the UK. Some of the productivity growth was specific to the ICT sector, but ICT also boosted TFP in other sectors through more efficient organisation of production (for example in retailing or financial services). However, the returns to ICT investment appear to have declined in the early 2000’s, leading to smaller efficiency gains (Fernald, 2016).
In the Eurozone, TFP growth has been lagging significantly behind that in the US for more than 20 years. The growing productivity gap relative to the US since the 1990’s is mainly caused by difficulties in exploiting the ICT revolution. In part this is due to a lower proportion of skilled workers in the Eurozone. Stronger product and labour market regulation, as well as lower competitive pressures on firms, have also discouraged changes in business organisation and procedures that are required to fully benefit from ICT. For Eurozone periphery countries like Spain and Italy, the credit booms after joining the Euro led to significant misallocation of capital and workers across firms and sectors, further reducing the overall efficiency of these economies (Cette et al, 2015).
The ageing of the workforce can also reduce overall productivity growth in the economy. Individual worker productivity tends to peak around ages 40-49, stagnating or declining afterwards. Therefore, a larger proportion of older workers can significantly reduce the average productivity growth across all workers. Recent research estimates that this effect can reduce the annual labour productivity growth of the US in 2010-2030 by 0.4-0.8 percentage points (Maestas et al., 2016, Rich et al., 2016).
Baseline forecast subject to significant stagnation risks
The baseline GDP growth forecasts assume that in 2016-2025 annual labour productivity growth in the main advanced economies returns towards 1.0-1.5%.This represents a view that recent ICT innovations will still provide a modest boost to productivity. However, it is easy to imagine a more pessimistic forecast in which labour productivity growth returns to its lower levels during the 1970s and 1980s. This would reduce annual potential GDP growth forecasts by 0.5 percentage points (Fernald, 2016).
Our advanced economies stagnation scenario captures this risk. In this scenario, annual labour productivity growth in advanced economies over the next ten years declines significantly below the baseline forecast. Lower expected output growth reduces the returns to capital and labour. Firms respond by cutting down investment and employment. The falling investment rates amplify the initial decline in potential output growth over several years, depressing private sector expectations even more. Lower income growth and more pessimistic expectations about future income reduce consumer spending, reinforcing the initial slowdown.
Central banks are constrained in their ability to cut interest rates that are already close to zero. However, they delay planned interest rate increases in 2017-2021. Fiscal policy responses are limited due to concerns about excessive government debt to GDP ratios. The combination of slower labour productivity growth, reduced private sector confidence and modest government stimulus policies causes annual GDP growth rates in advanced economies over the next decade to decline by 0.6-0.7 percentage points relative to the baseline forecast.
Overall, demographic and technological constraints are likely to lead to a continuation of the sluggish economic growth of the last 4-5 years. On the upside, greater use of technologies such as machine learning, robots or artificial intelligence could boost productivity growth closer to the 1990’s levels. But this is countered by a strong downside risk of even slower growth.
Japan Article 4 Consultation. IMF staff report, 2016.
Gilbert Cette, John G. Fernald and Benoit Mojon, The Pre-Great Recession Slowdown in Productivity.Working paper, 2015. http://www.frbsf.org/economic-research/files/wp2016-08.pdf
John G. Fernald, Reassessing Longer Run US Growth: How Low? Working paper, 2016. http://www.frbsf.org/economic-research/files/wp2016-18.pdf
Nicole Maestas, Kathleen J. Mullen and David Powell. The Effect of Population Ageing on Economic Growth, the Labor Force and Productivity. Working paper, 2016. http://www.nber.org/papers/w22452
Albert Queralto. A Model of Slow Recoveries from Financial Crises. Working paper, 2015. https://29c677c4-a-62cb3a1a-s-sites.googlegroups.com/site/albertqueralto/home/research—albert-queralto/SlowRecoveriesMarch2015.pdf?attachauth=ANoY7cowMR7Ouj7tjdIFWWtRDOs2DSv-WuPceuu3Vndj5KUy7qwjfiLBHRGng3YBrNUM9I2TWS9DW4GRqwKDl6aXcnYZUO2yyIm8V-7Ycdg5U-cMBJ9RNOD8fPaIjv2OPH2OdNnhMiLS-6C0l4UGK7zQR2NQ3B–y8qFW0goK8Nb7CDG99CVW3xvpDo1FfrdnEp8r7kYzfewhYzLxnBleMXGDqsHAyxiOm0tJMrOISfImwttHRoDj5Z-v6r-791714CL-xzEoxEGZj-sB3MHjGDOwih6Sf6qGQ%3D%3D&attredirects=0
Robert Rich, Joseph Tracy and Ellen Fu. US Real Wage Growth: Slowing Down with Age. NY Fed blog post, 2016. http://libertystreeteconomics.newyorkfed.org/2016/09/us-real-wage-growth-slowing-down-with-age.html