Unemployment in the economic stagnation scenario spikes upwards and stays abnormally high for long periods, leading to very high levels of long-term unemployment – or structural unemployment, as economists often call it....

Welcome to the economic stagnation, 21st-century style

October 3, 2011

Posted in Sunday Business Post by David McWilliams

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The other night, in Cork, I was chatting to a woman from Mayfield. Let’s call her May. She works in a clothes shop on Patrick Street, Cork’s main shopping street. Last Sunday, she worked all day on this prime retail thoroughfare, and guess how much she took in the till during the whole day? Well, a shop like this should be – and was in the recent past – taking about €1,800-€2,000 on Sundays, around €6,000 on Saturdays and anywhere between €1,200 and €1,500 on weekdays. Last Sunday, May took in €60 for the entire day!

Although this example might be a tad extreme, the reality for retailers all over Ireland is one of collapsing demand. Strolling down Patrick Street last Friday morning, it was clear that everyone was struggling. Every shop I counted, from the top of Washington Street to the English market, had either ‘for sale ‘or ‘massive discounts’ signs on the window. This is what happens when the economy slumps.

The question that worries May is: what happens next? When we discuss where the economy could go over the next five years, much of the discussion focuses on one of two possible outcomes: the economy will either grower it will contract. But there is another possible outcome. The economy might not grower contract; it might well stagnate. With the financial markets in turmoil everywhere and growth slowing massively all around the world, economists are mentioning the stagnation experience of Japan between 1990 and 2010 as a possible blueprint for the western world in the year ahead.

Having grown dramatically since the Second World War, Japan went on a credit binge in the 1980s and then, following a dramatic property crash and asset price crash that destroyed its banks and its national balance sheet, Japan stagnated for a generation. The economy flatlined and the national debt exploded. One of the interesting things about the discourse among economists is the sense that what happened in Japan was unique. It was not. In fact, economies stagnate all the time. There is nothing unprecedented about stagnation. Think about Ireland in the 1980s.

One of the most extraordinary things about the 1980s is that the Irish economy grew in nine out of the ten years of that decade.GNP fell only in one year -1986 – and even then, the fall was modest. However, for people living through it, the 1980s felt like a recession. Around 480,000 emigrated from Ireland, and this was in a decade when the economy actually grew 90 per cent of the time. That is what stagnation feels like, and it happens all the time all over the world.

Recent research by Goldman Sachs shows that long periods of stagnation – as happened in Ireland from the late 1970s to 1990 – are not so unusual. There have been 20 such episodes in the past century. Interestingly, stagnation often occurred in developed countries, rich countries, countries like Ireland. In all cases, these periods of stagnation are preceded by one of four types of crisis. The probability of stagnation increases dramatically if the country experiences either (1) a banking crisis, (2) a financial crash with stock and asset prices falling significantly, (3) a currency crisis or (4) a war.

The stagnation is characterised by modest growth in the economy of around 1 per cent per annum. Inflation is low, and so are interest rates. However, because the economy has just experienced a crash of some sort, the balance sheet is destroyed by debt and actually needs jaunty levels of inflation to wipe out the debt. Low interest rates don’t spur growth because there is too much debt. Unemployment in this scenario spikes upwards and stays abnormally high for long periods, leading to very high levels of long-term unemployment – or structural unemployment, as economists often call it.

And, as anyone who has been looking for work knows, it is much easier to get a new job when you have one. The longer you are out of the game, the harder it is to convince someone to take you on. House prices fall dramatically and don’t recover in the stagnating economy. They remain low for prolonged periods and, of course, the stock market gets hammered, which affects pensions. The reason pensions take a battering is that with very low interest rates, it is impossible to guarantee an easy yield. Think about it.

Take an example where the yield curve is upward sloping (as it is when an economy is growing and there is a bit of inflation in the system), short-term interest rates are 1 per cent, but long-term interest rates are 6 per cent. Then it is easy for even a dozy fund manager to generate 5 per cent for the pension fund by simply investing the pension at the long end. But if the economy is stagnant, interest rates will be very low and there will be no yield to generate the returns for pensions. This has massive ramifications for the unfunded pensions of huge semi-states and the public sector. If the economy hits a period of stagnation, how will it throw off the necessary cash to generate the money for pensions? The question is then, how likely is it that Ireland will go into a period of stagnation? It is highly likely, as we have experienced two of the four conditions for stagnation: the banking and asset price crises.

We are also in a dreadfully overvalued currency compared to our major trading partners, Britain and the US, and this means that to get competitive, we have to go through the stupidity of this ‘internal devaluation’. This means that we will grind down wages and prices over years, practically guaranteeing the stagnation that we are trying to avoid. We are entering a period that could come to be termed the ‘Great Stagnation in Ireland’. Like the 1980s, we may achieve the statistical feat of GNP growth, but it will feel like a recession characterised by high unemployment and emigration. It can be reversed by applying normal Leaving Cert economic solutions to an economy, such as a managed default and a profound change in the value of the currency. If we are not prepared to do this, welcome to stagnation, 21st-century style.

What does a 21st-century version of stagnation look like? It looks like a till with €60 in it at the end of a full trading day