The Dow is setting a record high — and that is rational for two reasons. First, the global middle class is growing fast and will add $3 trillion in new consumption over the next forty years. Second, corporate profits continue to rise as productivity gains and little or no wage increases push ever greater slices of economic growth into corporate pockets.
Still, in the near term all of this growth is being pushed by debt-financed consumption NOT by self-sustaining increases in demand. Here is a virtuous cycle: Productivity goes up; workers get higher real pay; since higher productivity makes existing products cheaper, workers now have more disposable income to buy additional and new goods; demand drives increases in production and further gains in productivity. As real pay grows, government revenues increase as well without increases in taxation, and deficits stabilize or decline.
Here is a vicious cycle: Productivity goes up; workers do not get higher real pay; since government grows with demand for more health and pension care, taxes have to increase; this barely allows workers to maintain consumption at constant levels. Growth stalls to near zero while corporate profits grow but leave companies sitting on piles of cash as they have no need to expand capacity. To keep government debt from expanding, governments have to slash spending; but then to keep demand from collapsing, they have to pursue aggressive monetary policy, financing ever-larger deficits by printing money and buying bonds.
It is pretty clear the entire world is in the second cycle. Does it justify a record stock market? In the short term, yes. As long as monetary policy is easy and expansionary, and corporate profits are growing, stocks justify expectations for higher returns. But how long can the short-term last? Can countries print money indefinitely?
We know the answer for the US and Europe is no; one cannot manufacture paper growth from monetary policy indefinitely without eventually undermining the currency and inviting rapid inflation (see the 1997-98 Asian currency crisis). The world had thought that China’s rapid growth would be REAL growth and pull the world forward. Yet for the last decade, China’s growth has been overly driven by government investment in infrastructure and urban construction; that too cannot go on indefinitely.
I am very worried that China announced today that it would meet its target of 7.5% annual growth by raising government deficit spending. Government borrowing may be useful for many things, even advantageous if you want something that only government can provide (better roads, public education). But government borrowing just to reach growth targets is curious; it suggests shortfalls in the economy’s inherent ability to generate growth and jobs — that the virtuous circle is broken.
Pump-priming has a long and distinguished history. Smart government investments — bridges and ports to link areas for trade; agricultural extension and education to raise agricultural output; basic research; improvements to power grids — that raise future productivity and overcome barriers to expansion are valuable. But growth for the sake of growth, especially after China has spent a decade with more than half of all GDP growth coming from investment and led by state spending, seems to invite new inefficiencies.
Corporate profits will start to flat-line without expansion of consumption markets. And that hoped-for expansion of the global middle class and its consumption may not materialize unless it is underwritten by increases in jobs and wages in Africa, south Asia, and China. Those gains, however, have to date been too dependent on commodity exports to growing economies abroad, rather than on local demand. This is changing, but it remains to be seen whether domestic economic growth alone can cope with rising populations and demands for food, housing, and employment.
We need to ensure we get on a virtuous circle, soon, and out of the vicious one that haunts Europe, the US and China today.