Andrew Jackson is an adjunct research professor in the Institute of Political Economy at Carleton University in Ottawa and senior policy adviser to the Broadbent Institute.
The recent stock market correction and resulting investor jitters are unlikely to lead to a new financial crisis. But they do suggest a justifiable lack of confidence that the economic stagnation of the past decade is safely behind us.
The dominant narrative is that the equity market correction reflects an increase in long-term bond rates and an anticipated further tightening of monetary policy in the United States, Canada and elsewhere as the economy closes in on capacity.
The expectation of higher risk-free interest rates makes equities look even more overvalued than they are already compared with corporate earnings. (U.S. equities are currently valued at more than 30 times earnings, a record high except for just before the 2000 crash.)
Higher interest rates not only lead to a shift of financial assets from equities to bonds, but will also lead to a reduction in corporate borrowing to finance share purchases. Low interest rates in recent years have juiced up the stock market as corporations have substituted debt for equity.
It is anybody’s guess if the stock-market correction will continue, but there is limited potential for a meltdown if real global economic growth continues at current levels, and if corporate profitability remains robust. In the short term, tax cuts in the United States will boost profit and growth.
As widely noted, rising interest rates are actually a good sign if they are the result of a pickup in growth and a strong economy.
That said, long-term interest rates on government bonds remain extremely low by historical standards. This reflects a lack of confidence on the part of many investors that real growth will indeed pick up in a meaningful way despite a modest synchronized recovery in North America, Europe and Japan.
The underlying key issue is whether we can successfully shift from an unstable growth model based on increasing financial debt, to a more normal growth model based on robust business investment in the real economy and rising real wages.
Recovery from the great recession of 2008 was mainly driven by low interest rates and a temporary fiscal stimulus which increased household, corporate and public debt relative to GDP (on top of increases in debt through the 1990s). Over this period, real business investment has been low, and this has been reflected in very low productivity growth.
A sustainable growth model, by contrast, is based upon robust business and public investment which increases productivity, which flow through to workers in real wage increases, which expands the market and justifies further investment. This set of linkages has been undercut by the big shift of bargaining power away from workers to employers dating back to the 1980s.
The recent upturn has not boosted real wages for most workers in the United States, Canada and more generally, undermining effective household demand, especially now that debt levels are high and interest rates are set to increase. Strong real wage growth for the bottom 90 per cent is unlikely to take place given the weakness of unions, which now represent less than 7 per cent of all private-sector workers in the United States (and less than 20 per cent in Canada).
The recent growth of average wages in the United States mainly reflects income gains for the top 10 per cent, and especially the top 1 per cent. High and rising inequality implies not just real income stagnation for the many, but also continued accumulation of financial assets in the hands of the very affluent who account for the great bulk of savings.
The flip side of the huge growth of debt in recent years has been the massive growth of financial assets. As a result, the cost of capital has been low.
But, as noted, real business investment has been very weak in the United States and even more so in Canada.
It is conceivable that investment in the digital economy, artificial intelligence, robots and the knowledge-based economy generally will set the stage for a broad revival of demand. But the new economy is not very capital intensive, its potential to drive a supply-side revolution is overhyped and the linkage from productivity gains to demand is uncertain.
The sustainability of the recovery ultimately depends on the demand side of the economy. If debts are high and economic inequality persists, we all have reason to be nervous.
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