A positive position against economic reluctance

Despite irritations like the trade conflict between China and the U.S., Swiss macroeconomist Guido Cozzi is positive about the global economy for the next few months. The professor at the School of Economics and Political Science at the University of St. Gallen (CH) shared his views at the latest meeting of Kaiser Partner Privatbank AG’s asset management committee. Later on, Adrian Schneider (Head Investment Solutions) and Senior Investment Advisor Michael Stiefel took the opportunity to interview Prof. Cozzi for the Investment Blog. 

Question: How likely is a recession in the US, now that the bond markets are showing an inverted yield curve?

The current yield curve shows that returns on investments of between 1 year and 7 years are expected to be lower than short-term returns. In past experience, this used to be a good predictor of recessions in the US. However, in the past there was no quantitative easing. Now, central banks buy medium and long-term bonds on a massive scale, inflating their prices and dragging down their returns. This greatly undermines the value of yield curve inversion as a recession predictor.

We cannot rule out the possibility that negative expectations may discourage investment and consumption, thereby stagnating aggregate demand. However, I think that the worst recessions are usually the result of a crisis that happens unexpectedly at the end of a boom period inflated by relatively long-lasting bubbles, which does not seem to be the case now.

The current pessimism seems to be fueled more by political tensions triggered mainly by nervous and unpredictable political leadership, rather than by market fundamentals.

In my opinion, in fact, there is little in the fundamental growth variables that merits overly pessimistic predictions. The US has great potential, not only in high-tech industries, but also in more mature industries such as the energy sector. Of course we shouldn’t forget that in reality markets do not just rationally respond to fundamentals, but also to self-fulfilling prophecies.

Question: Are we going to see a low interest rate environment in the developed world “forever”?

There is no “forever”, and no “this time is different” in economics. The labor market in the developed world has lots of untapped resources: double-digit unemployment in the weakest parts of Europe and masked unemployment in the US. For example, the US probably has about 7,000,000 relatively young workers out of the labor force, not recorded as unemployed. These people were discouraged after the 2008-2009 crisis and gradually stopped applying for jobs. The good news is that if the economy recovers, employment may expand without leading to escalating labor costs. All this has already been noticed by the Fed and the ECB, and in fact it led to their decision to leave expansionary monetary policy unchanged.

Question: Do developed countries have a chance in their race against demographics?

Demographics have to digest the aging of the baby boomers in all advanced countries. While this will not last forever, because eventually the baby boomers will exit the scene, it will last a long time. But we can also view this demographic transformation as a major spur to innovation in industry and services. In fact, automation is replacing more and more tasks that until now used low-skill labor. Similarly, artificial intelligence, while supporting intermediate-skill workers in many tasks, is potentially leading to relatively high-skill labor exuberance. Hence we are probably witnessing an aging process that encourages research and development (R&D) in labor-saving innovation, targeting widespread automation and advanced digitalization. These are certainly sectors worth considering for investment.

Question: What are the biggest challenges to your models in the present economic environment?

The biggest challenge is the lack of reliable political leadership in a period of intense technological transformation. In several countries, voters seem more influenced by social media whims than by authoritative experts with a long-term view of the economy and society. Constituencies lacking reliable guidance are easily manipulated into voting incompetent politicians to power. I think the most important institutional challenge in the next decade will be that of re-establishing healthy democratic processes that guarantee stability and fairness.

Question: In which direction do you see the trade talks between the US and China going? And what are the possible consequences for their economic models?

China is growing fast, so it is no surprise that the international balance of power is being challenged and needs to start moving towards new equilibria. The US is trying to force the new superpower China to adopt a more compliant stance on intellectual policy rights, currency, and trade. While this certainly makes sense, the tone of the debate seems more provocative than it needs to be. For example, by raising tariffs from 10% to 25%, the US has effectively been forcing a retaliation on China’s part. This would certainly be damaging to trade, and it will contribute to isolating the US internationally. These tensions are leading to appreciations of the Japanese yen, helping to slow down the already weak pace of the Japanese economy, on top of the potential slowdown of China’s demand for Japan’s exports. Being a safe haven, the Swiss franc is subject to appreciation tensions, carrying unnecessary deflationary stress into our economy.

Question: Do you see China’s economy entering a Japan-like scenario?

There are several similarities between China and Japan, which may suggest the scenario you are mentioning. Yet there are big differences.  For example, the sheer size of China’s labor force and potential markets. Endogenous growth theory – heralded by recent Nobel Prize winner Paul Romer – teaches us that innovation is hugely affected by market size. In fact, a successful idea can be incorporated in an unbounded number of goods, and the larger the market the larger the returns on idea production. This means that China could likely become an unprecedented innovation furnace in the future, which should be reflected in persistent technological success and growth.

Moreover, the geopolitical influence of China is getting more and more comparable to that of the United States, rather than that of Japan.  Having the world’s second largest GDP in nominal terms and the largest GDP in real terms, it is already important. The current popularity of its Asian Infrastructure Investment Bank and even more its very ambitious Belt and Road initiative is evidence that several countries are starting to view China as an international leader. But while its total GDP is now roughly comparable to that of the US, its much lower per capita GDP level prompts the obvious prediction that China’s GDP will likely get at least 3 to 4 times higher in the future. This will massively enhance its future importance worldwide, giving it unprecedented superpower status.

Question: How would you assess the debt level of the Chinese economy?

The currently very high debt level in China is the result of an attempt by the public sector to keep the growth rate from slowing down. This is partly due to wrong incentives for local leaders to make their provinces or municipalities grow as fast as possible, in order to avoid political stigma from the central government. However, I think that Beijing should eventually realize that a decline in the GDP growth rate is physiological and even a good sign of a country getting more similar to other advanced economies. It must therefore try to change leaders’ career incentives from fast growth to healthier and sustainable growth. This includes caring more about people’s happiness, social security, environmental safety, etc. Studies in the economics of happiness have shown that clean air could be more important for happiness than fast growth. And a happier population is more prone to socio-political consensus than an overly stressed population.

Question: What is your opinion of the transformation process of the Chinese economy?

China has huge innovation and growth potentials, but it is still suffering from highly unequal wealth distribution. Paradoxically, in spite of its Communist history – or partly because of it – it still lacks a wealth tax. In order to avoid a middle-income trap, it needs to rebalance incomes and wealth toward a larger middle class. This will allow it to depend less on foreign trade and more on domestic demand. This process is vital if the government wishes to maintain economic and political stability. Equally important, China is transforming itself from an imitative to an innovative economy. This is also having huge consequences for its innovation-related institutions. Since even before its WTO accession in 2001, China has been putting a lot of effort into strengthening its IPRs. It will certainly have to do more in the future, but this will come naturally as the country transforms from an imitator to an innovator.

The service sector is still undersized, and it will probably massively expand. Important transformations should eventually take place in the banking sector, which at the moment is dominated by big state-owned banks. It is well known that this is deflecting credit away from several  promising firms in the private sector, which is dragging down the dynamics of aggregate productivity and diverting some of China’s huge domestic savings pool abroad.

Question: What is your opinion of intellectual property rights as an asset class?

I think that the world is awash with cash, and with huge amounts of traditional factors of production, such as labor and physical capital. International competitiveness relies more and more on immaterial assets, such as new product blueprints and new production process ideas. In economic theory we say that ideas are “non-rival” goods, meaning that, once produced, they could be simultaneously used by an unbounded amount of individuals or firms. And they are also much more easily copied than produced. Hence ideas can generate enough profits for those who invent and develop them only if intellectual property rights (IPRs) protect them. IPRs are need for private innovation to prosper, and could even be useful to public innovators, like government laboratories or research universities in order to fund their innovative expenses. In a world in which innovations are the most important competitive assets, I think IPRs are an important asset class. Of course, they have special characteristics and special risks, not least their dependence on Schumpeterian competition: if rival firms undertake more R&D in a field, this challenges the current top-quality products, thereby contributing negatively to the value of the patents protecting them. And if IPR-granting institutions, like patent offices, do not require a sufficiently high standard, low quality IPR proliferation can lead to patent trolls eventually suffocating economic life. Hence quite a complex microeconomic and macroeconomic picture should be kept in mind when managing a portfolio of IPRs.

Question: What are the drivers of innovation?

Innovation can come from several sources, including adoption of ideas from abroad, investment in advanced machinery, marketing, etc. However, research and development is certainly the most important part of the innovation production process. Therefore, anything that directly or indirectly supports R&D will eventually favor innovation. This includes supply side elements, such as the presence of highly qualified researchers and support personnel, which clearly requires a well-functioning education system. The scale of researchers is important, because it is the absolute number of ideas created that matters for innovation. But demand also matters: since ideas are non-rival goods, the larger the market in which an innovative product could be sold, the higher the expected profits from investing in R&D and in IPRs. Hence favoring international trade and international IPR institutions would likely stimulate innovation: no wonder innovation and globalization have gone a long way together. At the opposite extreme, protectionism would reduce the market for innovations, thereby depressing the value of IPRs and R&D. Moreover, in a world of relatively closed economies, the larger countries, by relying on a larger market would end up innovating much faster than smaller economies.

Question: Which country will be the future growth champion?

Countries with large markets, such as China and the United States, are very likely long-term growth champions. India is potentially interesting, provided it manages to dampen its chronic propensity to internal inter-cultural and religious clashes. But even smaller countries like Switzerland and Lichtenstein, with their highly qualified education systems and stable and transparent institutions, are excellent candidates, especially if they manage to keep trading and exchanging highly skilled labor and ideas with larger markets.