In their first walk, Olga and Hugo explore the nature and durability of post-COVID economic recovery. They unpack post-GFC growth challenges and discuss the impact of massive fiscal deficits on debt sustainability. They conclude that economic growth is the magic elixir, and we may just get on a faster growth trajectory this time.
Hugo Scott-Gall: OK, Olga. You and I both like acronyms, and you’ve come up with a new one—MOFAR. What does it mean? And why is it justified?
Olga Bitel: In this instance, the credit for MOFAR must go to one of our excellent industrials analysts, Anil Daka. MOFAR stands for the Mother of All Recoveries. By that, we mean that we are about to see the U.S. and much of the rest of the DM economies expand at rates that we have not experienced since at least the early 1980s. We are talking about real GDP growth of at least 5%-6%, driven primarily by private consumption and investment.
Hugo: But isn’t this high growth just math? In 2020, economic growth plummeted, so now it is going to look optically high relative to last year’s depressed levels. What about beyond 2021? How will growth rates compare to what was being achieved in 2018 and 2019?
Olga: That’s a valid observation, to an extent. For annual GDP growth to reach 5%-plus this year, we may see double-digit YoY growth rates, especially for Q2. This is largely arithmetic, as you rightly say, and this episodic growth is fleeting.
What is more exciting about MOFAR is that economic growth is likely to be domestically generated and sustained beyond a one-year rebound. Insofar as COVID precipitated a medical recession, underlying economic activity was less disrupted than at first appears. For example, private investment usually falls off a cliff when there is no prospect of demand growth, but we actually saw a sharp increase in private sector investment last year. To the extent that last year’s moratorium on face-to-face human interaction has helped convince businesses of the need to digitize their operations, we expect private sector investment growth to continue well beyond this year and next.
We expect private sector investment growth to continue well beyond this year and next.
The consumer side of the economic growth story may prove to be even more potent. Significant financial savings—fiscal support, inability to spend—together with pent-up demand suggest that consumption spending may grow by nearly double digits this year. In mid-March, Berlin theatres began to open. People expected the initial demand on reopening to be high. But how high? One theatre sold out of all tickets within only four minutes! The bottom line is that this is likely to be a sharp recovery, and we expect it to be sustained beyond a few quarters of rebound.
Hugo: We both lived through the GFC, the great financial crisis. Once it looked like it was going to be over, everyone expected a huge recovery. As if by magic, we were going to be back to where we were pre-2007, to a really strong global economy. But the 2010s turned out to be a pretty ropey decade for global growth, lower almost everywhere, even in China.
Why did the post-GFC recovery peter out? Why do we not think the post-COVID recovery will prove just as short-lived? What makes us believe economic growth can be sustained this time?
Olga: Wow, you packed a lot in here. I’ll try to be laconic so that we don’t get half a mile away from where we are now by the time we’re done discussing this point. The GFC exacerbated what was already a substantial economic recession and greatly aggravated the debt overhang that accumulated as a result of the housing market frenzy and the surrounding financial speculation. It is easy to overlook, but the U.S. economy was in recession since at least December 2007, before Bear Stearns in March 2008 and long before the Lehman Brothers collapse in September of the same year. Normally, a recovery from a deep economic recession followed by a financial crisis would be U-shaped; that is to say, long and gradual, as the underlying economy works off the debt overhang and gains traction again.
Instead, China brought forward loads of infrastructure projects—USD 0.6–1.5 trillion worth—and de facto bailed out the global economy into a sharp V-shaped recovery in 2009-2010. Much to its credit, China’s government did not let the infrastructure party run indefinitely. They unwound it pretty decisively, such that between 2011 and 2015, China’s industrial production growth decelerated from 15% per annum growth to just 6%. Given that by the early 2010s, China’s industrial production already accounted for close to one-third of the global total, such massive deceleration effectively put a lid on everyone else’s growth.
Hugo: Fair enough, what is happening this time is quite different. This time, the U.S. is pumping unprecedented, some would argue reckless, amount of fiscal support into its economy. Although we can debate the true benefits to the economy of sending stimulus checks that might find their way into financial markets, the post-COVID economic recovery hinges on the size of U.S. fiscal deficits, and this leaves the recovery highly sensitive to the U.S. yield curve. How do you think about that? Can a rapidly steepening yield curve derail the economic recovery, or will the U.S. Fed attempt to control the yield curve?
For strong domestic demand to drive economic growth, it has to be accompanied by robust employment gains.
Olga: For strong domestic demand to drive economic growth, it has to be accompanied by robust employment gains. This time, the U.S. and European policymakers are almost singularly focused on preserving employment, and rightly so. The loss of employment and, by extension, output that occurs in recessions is quite detrimental, and we see its disastrous effects in rising populism, for example.
In a sense, the U.S. economy never recovered from the GFC. Instead, the U.S. economy evolved on a trajectory parallel to the path it followed pre-GFC. In practice, this means that all those folks that were employed before 2007 have either lost their jobs and income entirely or moved to lower quality, lower-paying employment. The consequence of this is that a lot of potential demand and, by extension, output is forgone. Fiscal support during COVID lockdowns was designed to avoid precisely this kind of adverse development, especially since this was not an economic but a medical recession.
To be sure, the U.S. fiscal policy, as it currently stands, is deeply flawed: there are no investment plans, as yet, only short-term consumption support measures. However, strong economic recovery need not be impeded by rising interest rates so long as rates rise slower than the pace of economic growth. Specifically—and this goes directly to the level of interest rates and the question of debt sustainability—if your interest rate is lower than your real growth rate, your stock of debt will decline exponentially. That’s exactly what happened in the U.S. and Europe in the 1950s.
Both the U.S. Fed and the ECB would love nothing more than to see economic growth strong enough to actually raise nominal rates.
I would even take it a step further and say this is any central bank’s ideal scenario. Both the U.S. Fed and the ECB would love nothing more than to see economic growth strong enough to actually raise nominal rates.
Hugo: If you asked 100 investment professionals why growth underwhelmed during the 2010s, I bet debt overhang, disruption from the diffusion of technology, and demographics would top the list. And, of course, following last year’s experience, disease would make an appearance. Don’t these four powerful Ds—debt, disruption, demographics, and disease—pose enough headwinds for us to realize that the episode of rapid growth this year is likely going to fade fast?
Olga: You know, economic growth, what you and I affectionately dubbed our “perpetual growth machine,” revs up when resources are allocated toward improving or creating tools to solve human needs. In times of existential “needs”—during wars and pandemics—resources are directed in vast quantities to address these needs. That’s why we actually see innovation accelerating during such calamities, and COVID is likely to prove no different.
Already we have seen COVID vaccines moving from conception to people’s arms in under a year—a record by any measure. Last summer, we hoped for the best vaccines to be 30%-50% effective: our current shots posit rates in the mid-90s.
We see innovation accelerating during wars and pandemics, and COVID is likely to prove no different.
In the mid-1600s, the Great Plague forced then undistinguished Cambridge student Isaac Newton to quarantine at his parents’ country estate. He spent his newly available time—a valuable resource—to produce seminal theories on gravity, laws of motion, and optics. I am not suggesting that every person stuck at home last year will prove to have been as productive, but there were undoubtedly some whose innovations will come to light in the 2020s.
So, I am actually quite optimistic. I see the dreaded Ds as needs to meet and challenges to solve. We already touched on debt today, as it is largely a function of economic growth. If we invest the resources productively, debt stock will decay. We can take up each of the others in more detail on our future walks, but I am of the view that the latest pandemic has already served to channel the resources to produce tools, aka innovations, to meet the challenges posed by demographics, disease, and technological disruption.
I hope the four dreaded Ds are not going to drag us down, certainly in so far as we have the means and the resources not to allow them to do so. And I think allowing any one of them to do so would be a massive opportunity missed.
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