Friday, July 3, 2009

Trend growth can not defy gravity

Trend growth promises to drop in the years ahead. For one, the credit-financed housing and consumption boom of the past years has increased trend growth during that time period. This, however, is unlikely to be repeated and in turn trend growth should fall as credit creation eases (or even reverts). In fact, this is what happened in Japan during the 1990s and in Germany once the re-unification-led construction boom faded. However, the lack of credit creation is not the only thing which will limit trend growth. The credit-financed construction and consumption boom has rendered several industrial sectors too large (for example: finance or any housing related activities such as construction but also real estate agents). These sectors are likely to shrink on a trend basis vs. the rest of the economy. In turn, a lot of capital which has been used in these industries (be it physical capital or human capital) becomes unproductive. It takes time to redeploy the physical capital (if possible) or for employees to retrain in order to secure a job in another industry (if there are any available on cyclical grounds). Therefore, during this period structural unemployment/NAIRU (non accelerating inflation rate of unemployment) raises and trend growth will be reduced as well. Finally, the lack of demand in general will lead companies to lower their investment and therefore the capital deployed in an economy will be growing at a lower rate than before.
In turn, trend growth across a number of economies (most significantly in those countries exhibiting large imbalances, high indebtdedness, having 'enjoyed' the most pronounced housing boom) such as the US, the UK, large parts of the Eurozone, CEE etc. will fall significantly. It is very difficult to quantify by how much trend growth will be falling but the severity of the imbalances suggest it might be very substantial and prolonged.
Still, the Directorate-General for Economic and Financial Affairs of the European Commission in its latest quarterly report on the Euro area tries to quantify a likely trajectory of trend growth (see here, page 27ff.). They estimate Eurozone potential growth to have been at 1.8% during 2000-2006 but falling to 1.6% in 2007, 1.3% in 2008, 0.7% in 2009 and 2010. in turn, NAIRU will increase from 8.5% to 10.2%!

Personally, I find it very spurious to calculate a yearly trend growth rate but the drop of roughly 1% in trend growth sounds about right. This would clearly not be good for the development of real assets and is hardly in the price already.

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