Text on screen: Changing economic orders. Gareth Colesmith, Head of Global Macro Research
So Raman showed a slide, which you've probably seen before, that of the roadmap for the interregnum showing the limits of fiscal and monetary policy being reached, leading to a series of crises, and ultimately, a new economic order. I'm going to spend a little time now talking about what that new economic order might look like, and ultimately, what it might mean for investments.
But let's start with some history.
Capitalism has seen a number of swings between economic orders, from more state involvement in the economy to less, and then back again. State-sponsored monopolies, such as the East India Company, gave way to the classical laissez-faire liberalism of the Victorian period. That was replaced in turn by Keynesian fiscalism over the 1930s and '40s, before swinging back to neoliberalism around the 1980s. And today, we are partway through a swing back towards a new economic order with more state involvement in the economy, an economic order that we are calling neofiscalism.
But what do we really mean when we talk about these economic orders like Keynesian fiscalism or neoliberalism? Let's consider some of the things that changed during that shift.
There are a number of different elements that make up an economic order, how capitalism arranges itself.
First of all, there's the management of the business cycle, whether that is dominated by fiscal policy, that's government decisions on spending and taxation, or monetary policy, the supply and cost of borrowing money. The 1980s saw neoliberal governments come into power in the UK under Margaret Thatcher, and the United States under Ronald Reagan, and elsewhere, and they believed in less state involvement in the economy. That led to increased central bank independence and the dominance of monetary policy. Tony Blair's government, one of the first things they did upon coming to power was to make the Bank of England independent of the Treasury in terms of setting monetary
policy.
The shift in the monetary order happened quite a bit earlier, actually in 1971, when President Nixon of the United States abandoned the Bretton Woods arrangements that had been in place since World War II. So a system where the United States dollar had been fixed to gold and other currencies had been pegged to the United States dollar were abandoned and changed to the system that we've experienced for all of our working lives, that of fiat currencies, where central banks are basically free to print as much as they want and typically floating rate exchanges between currencies.
That shift in money and foreign exchange has had an effect on trade arrangements. To keep exchange rates stable ultimately needs some form of capital controls, and a lot more economic activity was domestic rather than internationally focused.
That has gradually shifted to a much more globalized trade system, particularly after the World Trade Organization came into force.
Looking at government involvement in industry. During the Keynesian era, we saw companies that were privatized and nationalized, sometimes repeatedly, as governments changed. But all those governments had a very strong industrial policy focusing on targeting key areas of the economy. Only after the neoliberal governments came into power did we see deregulation replace those industrial policies, as well as a final wave of privatizations.
Part of that industrial policy was aiming to maintain full employment, and that combined with high levels of unionization protected real wages.
Neoliberalism saw deregulation come to labor markets as well. Atomization took over from unionization. Individuals had to bargain for themselves rather than collectively.
It's also worth bearing in mind that there are some things that didn't change during this shift. Welfare systems, as well as state education and healthcare, they had been key innovations of the Keynesian era, but these elements were retained into neoliberal period because they were too politically difficult to remove.
Now let's consider those elements of the economic order in terms of what changes we're seeing in the current transition.
Since COVID, we've seen a return of fiscal dominance and the need for increased fiscal spending on areas such as healthcare and defense, and potentially going forward, adaptation to climate change or migration.
Independent central banks so far have still been involved in managing the business cycle, so we may end up seeing a hybrid model, but that independence might be under threat in some places.
The structure of money is probably going to remain as fiat floating currencies, although there are clearly some investors out there, including major central banks, who believe in that debasement risk given the price of gold. The more apparent change in the nature of money is around digital currencies.
The international trade order has clearly had some very large shocks over the last year, led by so-called Liberation Day in April, and that's accelerated the existing trend of reshoring and de-globalization as nations seek to prioritize resilience of supply chains over efficiency.We are also seeing a resurgence in targeted industrial policies, governments seeking to attract and protect the key industries of the future, whether that's energy systems, critical minerals, or of course, things like semiconductors and artificial intelligence.
Finally, labor markets may remain atomized. We're not seeing any shift from individualization back to unionization, but we are going to be seeing changes to labor markets as artificial intelligence and automation interact with declining workforces due to demographics.
So I'm going to talk about each of these elements in a little bit more detail, how they're changing, and we're going to start with management of the business cycle and central bank independence. There are some very obvious changes to central bank independence in the United States at the moment. President Trump has been calling for very large interest rate cuts, which the current Fed Chair, Jerome Powell, has been resisting.
Powell's term as chair ends in May.
However, he could potentially stay on the Fed Board of Governors for another two years. Conventionally, Fed Chairs step down from the Board of Governors when their term as chair ends, but convention's not really that fashionable in American politics anymore.
Kevin Warsh on the far right here is Trump's nominee to replace Powell as Fed Chair. That is subject to congressional oversight, but it's likely to go through eventually. Warsh is at the more sensible end of the potential candidates that Trump could have appointed. He was previously a Fed Governor.
Currently, he is calling for interest rate cuts, but he's against the Fed running a large balance sheet, and it's not entirely obvious that once appointed, he will necessarily simply follow orders from the White House.
I also wanted to talk about a couple of historical characters.
Marriner Eccles was the Fed Chair through World War II, and he was actually the last Fed Chair who didn't step down from the Board of Governors after his term as chair ended in 1948, and the reason he didn't do that is that he wanted to restore Federal Reserve independence. President Truman, American president at the time, wanted to maintain very low interest rates at 0.375%.
Eccles wanted to restore the ability to do something about inflation.
He was ultimately successful in that Fed independence was restored in 1951.
Arthur Burns is a historical figure some of you may have heard of. He was Fed Chair during the 1970s, and he's an example of how notional independence isn't always enough because he gave into pressure from President Nixon to cut interest rates before inflation was fully brought under control, which certainly contributed to the escalating inflation spiral of the 1970s.
The quote that you can see, "In a rapidly changing world, the opportunities for making mistakes are legion," that's a quote from Arthur Burns. The building at the bottom of the slide is the Federal Reserve Building in Washington, but its official name is the Marriner Eccles Building.
The historical lessons for Warsh are pretty clear.
That US financial repression in the '40s and '50s, keeping rates artificially low, that meant that the average coupon or the government funding rate, the government funding cost, was well below nominal GDP, the combination of real growth and inflation. That imbalance was very painful for bondholders, but it did mean that government debt to GDP levels were able to fall continuously from after the Second World War through to 1980, and that is despite continuous increase in government spending.
This chart shows G7 rather than just US average government spending as a proportion of GDP. You can see that during the laissez-faire liberalism period, that was pretty steady at around 10 to 15% of GDP, excluding periods such as the world wars.
Once Keynesian policies such as welfare spending were implemented, you can see a steady rise in government spending across the G7, up to around 50% of GDP by 1980, and neoliberal efforts to rein that in since have frankly mostly been rhetorical.
Going forward, we can see several pressures that are going to lead to renewed increases in government spending. Healthcare we've talked about. Defense is an obvious one. We're also dealing with increasing costs from climate change, the migration that comes from that, potential disruption to the labor markets from AI adoption.
That pressure towards even higher government spending is the core of our thinking about the next economic order, and that's why we are calling it neo-fiscalism.
Countries such as the United States and France are running large budget deficits even when they're not in crisis. Countries such as Germany and Japan are now increasing their budget deficits as they seek to expand spending on infrastructure or defense. Of the major economies, it's really only the UK where we have a government still aiming for fiscal consolidation, and frankly, we're not doing very well at that. It's not clear that the political will is really there to make that succeed.
So much for managing the cycle. Now let's think about the next element of economic order, that of money.Just over 1,000 years ago, during the Chinese Song dynasty, there were some merchants in Sichuan, and they had a problem, because coins at the time were made of copper. They were very heavy, relatively low value, and it was very expensive to transfer chests of them from town to town in order to trade.
So they came up with a solution. They took woodblock printing technology, and they started to print deposit receipts. It's a much easier thing to carry, simply a piece of paper. You can take it to the next town, you then cash that in for the money there, and you do your trade.
These jiaozi, as they are called, an example of which is on the right, became the world's first paper money, an innovative monetary technology that enabled easier trading.
What happened next? Well, after several merchant companies went bankrupt, the government nationalized the money printing.
And that's the key point. Governments take over monetary innovations. Money is ultimately too important to an economy for them not to do so.
Six centuries after the invention of paper money in China, essentially the same process happened in Sweden, introducing paper money to Europe. Now, ultimately, this tends to lead to overprinting of money, runaway inflation. Couple of centuries later, the regime or the dynasty collapses, but that's not necessarily the key point. The key point I want you to bear in mind is that governments take over monetary innovations.
And that brings us to today, because we've seen significant monetary innovation in the invention of blockchain technology for cryptocurrencies, such as Bitcoin.
And that's very much analogous to the introduction of paper money.
The first users of this are private sector cryptocurrencies, but frankly, these are not stable stores of value. They're not really useful for anybody apart from criminals and gamblers. So now we're starting to see governments get involved in blockchain-based currencies, but they're all doing it in slightly different ways.
The United States is leading the way in something called stable coins. These are still decentralized, but they're backed by assets such as T-bills. There could be other assets involved as well. There is a stable coin out there from Tether, which is backed by gold. And that might be good for funding of the US government deficit, but it's not necessarily totally clear that it's as stable as you might like. China have banned them, as well as cryptocurrencies more generally. China are focusing on something called central bank digital currencies. That is centralized, and that's extremely useful if you want to be able to monitor the payments that your citizens are making.
That integrates very well with China's authoritarian system of social credit. The United States don't like this. They've banned central bank digital currencies as a result.
The EU, Europe, and the ECB, they are actually also focusing on central bank digital currencies, but not to track payments. They're putting in place privacy safeguards against that. Instead, they're focusing on financial stability risks. They worry about the risk that stable coins might not always be as stable as hoped.
Finally, the UK is leading on tokenized bank deposits, and these are really the clearest blockchain descendant of those Chinese jiaozi deposit receipts we saw on the last slide. We actually think this might ultimately prove to be the most successful of the digital currencies, perhaps with central bank digital currencies as a wholesale clearing mechanism.
Money ultimately exists to facilitate trade, so let's turn to the next element of economic order, that of trade.
This chart shows the evolution in trade balances from the United States being the major trade partner for most of the world, shown in blue, through to China becoming the major trade partner for most of the world, shown in red, particularly after they joined the World Trade Organization in 2001.
This globalization has been extremely good for investments in internationally-focused United States companies who've been able to offshore production and sell cheaper goods to US consumers. But it's been very bad for Western workers in those industries that have seen production shift to China. That has led to increasing inequality and the political backlash that we've seen play out over the last decade.
It's worth bearing in mind that backlash is bipartisan. It's not just a Republican Trump thing. Democrats as well as Republicans want to reverse this. They simply disagree about methods. And it's also worth bearing in mind that this trade imbalance has led to deterioration in the US capital account, and that's now built up to more than 100% of US GDP is owed to foreigners in terms of financial assets, combination of equities and treasuries.
The last year has seen the most rapid increase in tariffs since the US Civil War. And bear in mind, back then, they didn't have income tax. Tariffs were the primary source of government revenue back then. So if you need to increase revenue to fund a war, you have to increase what you have. That's why tariffs went up so fast in the 1860s.
These higher tariff rates, they're not temporary. This is the new normal. The Supreme Court ruling against the use of the International Economic Emergency Powers ActThat's already been circumvented.
The chart is up to date for having that removed and other factors put in place on a temporary measure. Those temporary measures are going to be replaced with more permanent tariff measures aimed at sectors and countries.
Tariffs are a tax. There've been a number of studies out there, including one by the New York Fed, which did not please the White House, that between 85% and 95% of the cost of this is falling on US consumers and businesses.
It's not like we don't have good evidence that adding trade barriers can be bad for a country's growth. This chart shows real GDP per capita for the UK and a range of other advanced economies. Prior to 2016, UK growth was in line with the median.
Since the Brexit referendum, we've grown around the 10th percentile. That's a real per capita underperformance gap of around 14% in 10 years.
I think it's fair to say Brexit promises of renewal have not been fulfilled.
And that leads us to the next element, which is that of industrial policy.
Countries are increasingly returning to targeted industrial policies to protect and develop key strategic industries.
Different countries are doing different things here. So the US is approaching this using a poker metaphor. Each round is a transaction in itself. Who has a strong hand of cards? Can we raise the stakes? Is our opponent bluffing?
In contrast, China seems to be thinking about long-term industrial policy more using the metaphor of their national game, which is Weiqi, better known in the West as Go. This involves placing stones on a board using patient strategy, planning many moves ahead, and gradually encircling your opponents.
China has a lot of stones on its industrial strategy board, but one that's particularly dominant is that of rare earth metals. These are essential elements for producing high-performance magnets and hence critical for a wide range of products, everything from wind turbines to electric cars to defense equipment.
China has a natural advantage here. They control nearly 50% of global reserves. They're responsible for almost 70% of global mining of this basic ores, and they refine close to 90% of the finished product refined production.
But there's an interesting story here because back in 2010, China actually mined almost 100% of this stuff.
Chinese state subsidies had effectively put every other mine in the rest of the world out of business.
Then what happened? There was a territorial dispute between China and Japan over the Senkaku Islands. They're not even populated.
China restricted exports of rare earths to Japan. Now, Japan had a problem. They don't have any reserves of this stuff. They can't just mine it themselves. So what they did is they invested in reopening mine production in Australia, and they invested in setting up refinery production in Malaysia, creating an independent supply chain for Japanese industry. Other nations can learn from this. The Pentagon set up a similar system within the United States last year.
One more point to make on this slide. The left-hand pie chart here, you can see the Greenland. There are less reserves in Greenland under the ice than there are in the United States. Just something to think about.
Now, smelting metals isn't that technically difficult. Fundamentally, it's Bronze Age technology. If you're prepared to invest enough money and time and deal with the pollution that results, pretty much anybody can do it. At the other end of the scale of technical sophistication are semiconductors, which are vital for all sorts of electronic equipment. China is also building a dominant manufacturing base in older generation semiconductors, which are useful in things like cars and mobile phones.
But Western companies still are ahead in the cutting-edge semiconductors needed for things like artificial intelligence. This chart shows the performance of leading-edge semiconductors from Nvidia, the US national champion, in green, and Huawei in red, the Chinese. The vertical axis is total processing performance, and that's what you need for training an AI model. The horizontal axis is memory bandwidth, which is what you need for running an AI inference. China's two or three years behind the United States on this, and the US has organized export controls, not just over the semiconductors themselves, but also over the lithography machines, which allied countries such as the Netherlands and Japan
produce, and those are what you need to produce the finest quality semiconductor chips.
This gives the United States an edge in the race for AI.
AI has the potential to radically change labor markets, as Raman talked about earlier. So turning to labor markets, the last element of economic order, I'm going to talk to you briefly about the other side of that peak worker versus automation race, which is demographics. And the key big picture here you can see in these two chartsOn the left, we have total fertility rates, how many children women have. And you can see there's been a gradual decline, and in developed economies in China, that's now dropped below the replacement rate. China's now actually down to one child per woman. That is 10 years after they abandoned the one-child policy, but that's the way it goes.
But even someone like India is now down to just below two children per woman. So less babies.
The right-hand side is about life expectancy. Now, I realize there are a lot of pension professionals in the audience who are used to thinking about longevity as a risk. But from a human development point of view, it's worth bearing in mind, this is actually good news. We do have a speaker on longevity this afternoon, so I'm going to instead focus on the people who are between these two charts, working age populations.
This chart shows the annual rate of change in working age populations over time. This is what really matters for trend growth, which is basically a function of working age population times participation rate times productivity gains. And you can see that high income countries and China have already seen slight declines in working age populations. We're already past peak worker. There are not enough young people to replace people retiring.
That slight decline looks set to continue or worsen for the high income countries as a whole, though there is some country divergence. Countries like South Korea, Japan, Germany, Italy, they don't actually look that different from China, where you're seeing more significant drops in working age population going forward. Over the next 20 years, even India's working age population is going to stabilize.
So to conclude, we are partway through a change from a neoliberal economic order to one of neofiscalism, driven by a series of crises. What is it that we're watching?
In terms of managing the business cycle, we are seeing a return to fiscal dominance. That doesn't automatically mean that central bank independence is impaired, but that's certainly a risk to watch given the implications for the inflation outlook.
We are seeing rapid development in digital currencies and also digital assets. That probably keeps fiat currency in place. After all, it's very easy to print money if you can literally create a whole new currency. But a rapid monetary expansion would risk further inflation, ultimately debasement, and potentially a shift back towards harder backing for money, a return to the gold standard. Probably some way off yet.
Globalization and trade have clearly gone into reverse, and that is not likely to change. Instead, we're seeing protectionist policies such as tariffs, and a focus on reshoring or friend-shoring supply chains. So far, international capital continues to flow freely, but the logical endpoint of de-globalization is capital controls, and that's a risk that international investors should be monitoring. Deregulation remains a touchstone phrase in some political circles, but the fact of the matter is targeted industrial policies are making a big comeback as governments feel the need to protect their economies. Macroprudential policies after the great
financial crisis have also reduced deregulation. And finally, labor markets and productivity are some of the key questions for this new economic order. We don't see a return to strong trade unions. We need to watch whether AI elevates productivity in a positive way to offset declining labor forces, or a negative disruption leading to lots of people losing their jobs. If that happens, we might need to see some more radical restructuring of the tax and welfare systems, something perhaps like universal basic income funded by taxes on robots.
This is all long-term generational shifts, although the changes can sometimes happen very quickly as a crisis hits.
It's easy to get distracted by shorter-term events, such as the latest earnings report or headlines from the Middle East, but it's also important to keep these longer-term changes in the back of your mind because they can have profound implications for investments. The return of fiscal dominance leads to a higher run rate for inflation. Generally, we should be expecting inflation to be slightly above central bank targets rather than below, as we've seen for the last 20 years. And that's going to mean there's also an ever-present risk of monetization that leads to spikes in inflation, as we saw in the 2022 period.
So we should generally have a preference for inflation-linked assets over nominal assets. So inflation-linked bonds, strategic national infrastructure, probably equities.
De-globalization is going to lead to divergences in countries, as will different levels of government competency in fiscal policy and industrial policy. The winners of the future are not necessarily going to be the winners of the past. If this goes wrong for countries with large capital account deficits and very large net international investment positions, such as the United States, and foreign investors try to pull their money out rapidly, that could lead very quickly to capital controls, which would have very profound implications for investors who are no longer able to convert their dollars back to their home currencies. Unlikely, but a serious risk.
And finally, the risk of disruption to labor markets means there's the potential for ongoing political and indeed geopolitical volatility. The best way to handle that is to aim to hedge all those risks that you can, and look for skilled asset management for the rest of your portfolios. Thank you.
