February 14, 2018 / 3:38 PM / in 6 months

Breakingviews - Hadas: Renewed growth tests old economic theories

LONDON (Reuters Breakingviews) - The recent correction in global equity markets may turn out to be merely temporary indigestion involving algorithms. Nonetheless, it was the increase in the annual rate of U.S. wage growth to 2.9 percent in January that set the trading programmes in motion. The unexpected 0.5 percent monthly jump in American consumer prices adds to the excitement. This might be significant, if it indicates the arrival of an era when the economy once again follows some long-suspended basic rules.

People are reflected on an index board inside the Athens stock exchange September 9, 2011. Investors in Greek government debt from around the world tell regulators on Friday whether and how they will participate in a bond swap aimed at giving Athens more time to emerge from a debt crisis, with officials expecting a take-up of about 70 percent. REUTERS/John Kolesidis (GREECE - Tags: POLITICS BUSINESS) - GM1E7991K8X01

Basic economic theory states that when GDP growth picks up, businesses are selling all they can make, so they can raise prices without cutting into demand. Companies see more opportunities for profitable investment and have – or can easily raise – the money they need to expand.

Expansion leads to companies hiring more workers, and paying up to get them if necessary. More out-of-work people are tempted to look for jobs. Higher wages and higher prices feed each other, and the rate of inflation increases. Expectations of even higher future prices also pick up, pushing up bond yields.

There is also a political rule. Increased prosperity and employment soothes voter discontent. Isolationist nationalism, which rises along with unemployment, is supposed to fall with growth.

In this simple model, the behaviour of share prices is a bit of a puzzle. Corporate earnings benefit from the upward movement of prices and the expectation of improved revenue growth, but are squeezed by higher wages and the increase in financing costs that comes with rising yields. More expensive borrowing also pushes down share valuations, since the cost of holding leveraged positions increases. Given all those cross-currents, the recent market gyrations are hardly surprising.

Even factoring in stock market uncertainty, the economic model is admirably clear and easy to understand. Portfolio strategists and economists have relied on it for decades. Unfortunately, reality has been getting in the way. The economy has been breaking these rules for a long time.

Global inflation rates and bond yields have been heading steadily downward since the early 1980s, through good and bad times. And all the rules have all been pretty much out of commission in the recovery that followed the 2008 financial crisis. Falling unemployment rates have not put upward pressure on wages, while political populism has been rising in countries even as economies strengthened.

No one denies that the standard model is in conflict with the facts. However, economists have not come up with anything to replace it. So they, along with investors and the computers they program, have generally treated the theory’s failures as an aberration – a problem with the measurements or a long but ultimately temporary delay to the expected reaction functions.

The desire for reality to once again conform to theory is almost palpable. No wonder many experts and speculators pounced on the U.S. wage data, announced on Feb. 2, as a harbinger of higher inflation, higher yields and tighter monetary policy – a short-term sell signal for equities which might just bring a long-term sigh of relief for economists.

That interpretation may be right. Certainly, it would be presumptuous to say that the old relationships have broken down forever. However, the lack of a persuasive alternative leaves model-failure as the default option. In that case, the tentative signs of increasing wage pressure could soon dissipate, even if the recent run of strong employment growth continues in most developed economies.

Even if the traditional growth-inflation-employment model can be revived, its long failure leaves it critically wounded. Rethinking is in order, starting with the addition of more variables. Economists are already working on taking into account the availability and cost of consumer and business loans. They are less advanced on demographic factors – the shifting balance of old and young workers, disappearing population growth, shrinking family sizes and increased migration.

They have hardly started with the subtle shifts in such social-economic factors as welfare programmes, labour regulations and taxes, plus changes in workers’ habits and desires. For financial markets, internal factors – new bank regulations and the unpredictable psychology of bankers and investors – may be as important as anything in the real economy.

The inclusion of all those variables will turn simple rules of thumb into a hugely complicated system. Indeed, it could well be so complex that no economic model can explain much of anything for very long.

In that case, economists will need to summon some professional modesty. They might start by abandoning the belief that simple economic hopes and grievances determine political developments. Political factors may well influence the economy more than the economy drives politics. Economists could also admit that the direction of financial markets is even harder to predict than the behaviour of economies.

Investors may be irritated if the old rule-book has to be thrown away. However, after so many years of suspension, the practical changes may not be that large. At worst, they might have to learn to get used to even more sudden and violent oscillations between fear and greed.

Breakingviews

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