Far too many investors continue to stubbornly cling to the belief that the recent economic slowdown is simply a typical mid-cycle pause and, that a self-sustaining expansion is set to take-off any day now. The view is naïve and fails to recognise that the financial crisis marked a once-in-a-generation breakdown in the prevailing economic model. It is time to get used to the reality that the age of financialisation is at an end.
In this regard, it is important to take a step back in time to appreciate the dynamics that characterised the development of the American economy from the early-1980s to the present day.
An important shift in power from labor to capital began more than three decades ago, as growing frustration with the stagflation of the 1970s, precipitated a welcome sea change in economic ideology.
The resulting transformation from ‘big’ to ‘small’ government undermined union power and contributed to increased labor market flexibility, while greater shareholder activism led to a renewed focus on value creation and returns on equity. The process gathered pace through the 1990s and into the new millennium, as the twin forces of rapid technological change and globalization, via increased trade flows and greater capital market integration, sparked a further reduction in labor’s bargaining power.
The shift in power to the owners of capital triggered a structural upturn in corporate profitability, as the labor share of output accounted for by employees’ compensation, dropped by roughly five percentage points from its 1947/82 average to less than 61 per cent by the middle of the first decade of the new millennium.
The owners of debt and equity securities benefitted handsomely, as high returns on capital contributed to significant price appreciation, while interest income alongside dividend payments and share repurchases, provided an important boost to income. Indeed, the share of total income captured by the top five per cent of the income distribution jumped from 22 per cent in 1983 to 34 per cent in 2007.
The large increase in income inequality however, brought with it greater financial fragility, as the typical American household had no option but to borrow in order to keep pace with rising living standards, as measured by real GDP per capita.
To appreciate this development, it is important to recognise that while productivity is the primary determinant of a nation’s standard of living, real hourly compensation measures workers’ purchasing power. In this regard, the diminished power of labor meant that increases in real hourly compensation failed to keep pace with accelerating productivity growth over the past three decades and, the compensation-productivity gap became ever more pronounced as the period unfolded.
The increase in workers’ purchasing power lagged productivity growth at a rate of less than one-quarter of a percentage point per annum from 1947 to 1979 but, the gap began to widen as the power shift gathered momentum. Growth in real hourly compensation trailed improving productivity by three-quarters of a percentage point per annum through the 1980s and 1990s and, the annualised gap widened to almost one-and-half percentage points during the economic expansion that peaked at the end of 2007.
The shortfall in employee compensation relative to national output could have led to oversupply and a fall in corporate profitability but, the savings of high-income earners alongside foreign capital was channelled to households via the financial sector to fill the shortfall in effective demand.
The result of this financialisation process however, was a surge in household indebtedness. As the share of total income captured by high-earning households jumped by twelve percentage points between 1983 and 2007 to the highest level since 1928, household debt-to-GDP increased from less than 50 per cent to near 100 per cent.
A tipping point was bound to be reached sooner or later and, that moment duly arrived as the subprime segment of the residential mortgage market began to unravel. The result was the deepest economic downturn since the 1930s, from which the economy has yet to recover. Indeed, the damage unleashed upon the employment market has seen the labor share of output fall to a new low of less than 58 per cent, which means that the all-too necessary deleveraging of household balance sheets will be difficult to accomplish, while a self-sustaining recovery is likely to remain elusive.
The diehard bulls on Wall Street applaud the recent surge in corporate profitability since the recession’s end but, fail to recognise that this development has served only to exaggerate further, the move away from labor towards capital. Indeed, workers’ purchasing power has lagged productivity gains at such an extraordinary rate during the recovery so far, such that the aggregate compensation share of the increase in national income amounts to just one per cent versus an almost one-third share at a similar point during the previous four economic recoveries. Meanwhile, the corporate profits share has jumped from less than 30 per cent to almost 90 per cent.
The bottom line is that corporate profits are improving at the expense of effective consumer demand, which is inevitably self-defeating. It is instructive to note that the increase in total private wages in real terms over the ten years to the end of 2010 has fallen well short of any ten-year period since the Second World War and, has even failed to match the disappointing increase from 1929 to 1939. For now, consumer demand is being buoyed by government transfer payments rather than incremental borrowing but, it’s plain to see that current trends are not sustainable.
Investors should dismiss commentary that views the current recovery through the narrow prism of previous post-war cycles. There is nothing typical about the current economic climate. Overleveraged household balance sheets combined with stagnant compensation virtually assures subdued growth for years.
Previously posted on www.charliefell.com