It’s interview season in investment banks. This is when students are grilled about why they want to work in finance and what they think is going on in the world. What can those students say when asked about recent global events? Helpfully, an enormous, neglected, pre-Trump study produced by Deutsche Bank in September provides the answers.
The ‘Long Term Asset Return Study’ is something Deutsche Bank’s economists write every year. Its purpose is to contextualize day-to-day events in global markets in economic and political themes. At 70 pages, it’s not short. It predates the election of Donald Trump and gets some things wrong (‘Government bonds will likely see a negative real return from this starting point over the next few decades.’) However, it also helps explain Trump and Brexit, and if you happen to be in an interview where someone asks you about the economic causes of recent political events, it equips you to answer them very comprehensively indeed.
We’ve pulled out the most relevant points and the most relevant charts (not in the order that Deutsche presented them) below.
1. We’re coming to the end of a 35 year economic cycle. What comes next is going to be very different
Deutsche says we’re at the end of an economic cycle. Previous cycles in recent history include the first wave of globalization, which happened between 1860-1914. This was followed by the inter-war period and ill-fated experiments with the gold standard. Post World War II, came Bretton Woods, and then the high inflation of the 1970s.
The cycle we’re emerging from now began in the late ’70s, says Deutsche. It dictated, “politics, policy and asset prices from around 1980 to the present day.”
2. The cycle that began in the late 1970s was defined by the addition of over a billion cheap workers to the global economy
Deutsche says the last cycle was defined by changes in the East. China’s emergence into the global economy, the collapse of the Iron Curtain, and ‘maybe the economic liberalisation of India in 1991 following the IMF bailout,’ were quietly cataclysmic to the old order. In combination, they added over a billion cheap workers to the global economy. This wave of cheap labour overseas coincided with an increase in workforce participation in the West as more women went to work. The result was, “a perfect storm and an abundance of workers.”
Demographic shifts in the West also had an effect: “The most productive, highest earning and highest spending 35-54 year olds were at their smallest portion of the key global economic powerhouses around 1980. They then surged in numbers but have been peaking out and declining from this decade,” notes Deutsche.
As the charts below show, these population effects are about to go into reverse. The demographic trends that drove the global economy between 1980 and 2015 will turn negative between 2015 and 2050.
3. The last cycle was defined by globalization. Mid-ranking earners in the West lost out
In 1960, around 25% of global GDP was generated through international trade. Now, it’s more like 65%.
As shown in the famous ‘elephant graph’ below (Figure 3 in Deutsche’s numbering…) the process of globalization benefited some groups more than others. The top global 1% (point C in Figure 3) enjoyed disproportionate benefits, but so did the people in the middle of the income distribution (point A). The losers were those at point B. Point A represents most of the population in developed countries like China and India. Point C represents the wealthiest in developed countries. Point B represents lower skilled workers on lower wages in the West. Deutsche notes that, ” 70% of people at point B are from developed countries. Although relatively affluent on a global scale they tend to make up the lower half of the income scale in their own country.”
Herein lies the problem: a population boom, combined with globalization (and technology, although Deutsche doesn’t mention this), pushed down the price of labour (especially lower skilled labour) in the developing world. In the EU, Deutsche says the free movement of people likely made matters worse. Notably, and as shown by Figure 17 below, wages in China rose at higher rate than elsewhere during the past 35 years; China was one of the main beneficiaries of the cycle that’s now coming to an end.
4. Before the financial crisis, borrowing helped palliate the pain of globalization’s losers
Deutsche Bank says these trends didn’t make themselves felt before the financial crisis because financial market deregulation allowed individuals borrow to offset their stagnant incomes. It’s only since the crisis that people in developed countries have faced the reality of stagnant real wages. “Workers suffered from a kind of money illusion by replacing lost real wages with cheaper and cheaper debt (fuelled by cheap labour and thus low inflation) which funded spending and also allowed them to make capital gains from interest rate and debt sensitive assets like property,” say the economists.
5. In Europe, the euro has made the problem worse
For countries in the eurozone, matters were made worse by the single currency. Deutsche notes that virtually every country in the block spent the five decades to the 1950s devaluing their currencies against the Deutschmark. Under the euro, this is no longer possible: real wages have to fall or unemployment has to rise to achieve the same effect.
6. Governments can’t counteract this because they already have huge deficits and it’s become harder to raise tax revenues in a global world
Increased government debt and deficits (themselves partly the result of bailing out the banking sector in the 1980s) make it difficult for governments to reflate economies by spending money. Instead, many have pursued austerity policies in an attempt to bring their deficits down – even though Deutsche says these accentuate the problem.
Deutsche argues that high government deficits in the developed world are partly a result of globalization: fear that corporates will move to a lower tax regime have made it hard to raise corporate tax rates. Instead, corporate taxation has fallen everywhere since the 1980s.
7. Now, it’s all about containing the pressures created by the past 35 years while the cycle turns
Over time, some of these problems will resolve themselves. As the population shrinks, Deutsche says labour will automatically become more a more important part of the global economy. However, economic growth is likely to remain low and debt levels are likely to increase.
Unfortunately, Deutsche thinks it’s unlikely the world will just “muddle through”: political and social pressures are too intense. “In our opinion we’re getting closer to a binary outcome for the global economy and financial markets,” wrote Deutsche’s economists in September. “Inequality surely can’t continue much further without a political backlash. Globalisation and perhaps free movement/immigration can’t continue in its current form without a similar such social/political response.”
8. Monetary policy is exhausted
From now on, Deutsche says it won’t be possible for governments to rely entirely upon monetary policy as way of boosting their economies: interest rates are already close to zero and if they turn negative, then there are serious second-order effects as negative bond yields hit banks’ profitability and limit their ability to led. Fiscal policy will therefore need to be used, but with governments already heavily indebted this will almost certainly be funded by further money printing – this time undiluted (so-called ‘helicopter money‘), which could be inflationary.
9. All things being equal, populism should wane naturally
As what Deutsche Bank describes as, the ‘huge surge in excess in working age population globally’ reverses, it predicts that real wages will rise along with labour’s share of GDP. However, as inflation rises, it says governments will need to introduce minimum wages or some form of universal basic income to minimize social problems. In future, corporates and the wealthy can expect to pay higher taxes. At the same, time, international trade and migration are likely to decline.
Sometime soon, Deutsche also thinks ‘financial repression’ is likely to increase. Governments will be unwilling to allow the unrestricted flow of capital across borders and that this is likely to be curtailed. Instead, they will, Wwant to make sure enough capital is directed to where it’s needed domestically (e.g. government bonds).”