The Continued Economic Decline of The West PDF

The continued economic decline of the West
Diagnosis and prognosis

Jon Moynihan 23 February 2012
The challenge
Potential actions
Likely outcomes
PA Knowledge Limited 2012
Page 2
How has the Wests economic decline happened? Will it continue?

Real GDP per capita Change from 2007 to 2012 (forecast), % United Kingdom United States Japan France Germany Russia Brazil India China -20 Source: IMF.
Real GDP per capita (1992 = 100) 550 520 490 460 430 400 370 340 310 280 250 220 190 160 130 100 70
China India United Kingdom United States Germany Japan Brazil
1992
1994
1996
1998
2000
2002
2004
2006
2008
Page 3
2010
20
40
60
There are many competing explanations, some more persuasive than others:
5-Year CDS of Eurozone countries vs. percentage of men living with parents
3500
5Y CDS of founding Eurozone countries
Greece 3000 2500 2000 1500 Portugal 1000 500 0 0 Finland Ireland Italy France Belgium Germany Netherlands 10 20 30 Austria 40 50 60 R2 = 0.75282 Spain
% of men aged 25-34 living with parents Source: EuroStat, Bloomberg, via Boaz Weinstein, Saba Capital.
Page 4
The central dilemma facing Western economies:
The paradigm for the 1900s

Average annual growth in number of jobs: Average annual growth in real wages:
The paradigm for the 2000s
2%
Negative
3%
Negative
Page 5
The challenge
Potential actions
Likely outcomes
Global wage disparity
Ineffectual governments and credulous voters
Entitled groups
Poor allocation of tax monies
Page 6
A global wage disparity
The global wage disparity, potentiated by the global adoption of capitalism, is driving an unprecedented loss of wealth and growth for the Western economies.
Wage disparities between OECD and emerging countries result in an almost insuperable competitive advantage for the East*.
As a result, a job drain continues and is indeed accelerating.
The jobs drained are not returning; rather, more will be lost.
With no job supply, i.e. less demand for labour, wages in the OECD must inevitably fall.
* Includes Brazil etc.

Page 7
This jobs drain is taking place, driven by the wage disparities that exist between West and East:
Advanced Economies1 Developing Economies (urban)2 1.1 billion
Waiting to urbanise (rural)2 1.3 billion
Labour pool
500 million
Average daily wage
$135 (OECD, 2010)
$12 (China, 2008)
$1-2?
Alarmist worries about this were dismissed as overblown, even as many millions of jobs migrated (indeed continue to migrate) from OECD to Third World 1995-2011.
Sources: 1 OECD; 2 Estimated: UN World Urbanization Prospects, 15-64 year olds, assuming 65% LFPR.
Page 8
Wage disparities between OECD and emerging countries result in an almost insuperable competitive advantage for the East.
Page 9
Since globalisation began in earnest in the 1990s, OECD economies have, despite government stimulus policies, been unable to sustain rates of job growth:
Total employment (1983=100) Europe
160 150 140 130 120 110 160 150 140 130 120 110
A jobs drain continues
USA
100 100 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 Source: OECD
Page 10
The last decade was the first decade since the Great Depression to see no net job creation in the US:
US job growth by decade, 1940s 2000s
% change in non-farm payroll employment (%) 45 40
1940s, 37.7%
Compound annual jobs growth by decade (%)

3.5
35 30 25 20 15 10
1
1960s, 31.1% 1970s, 27.6% 1950s, 24.7% 1980s, 20.2% 1990s, 19.8%
2.5
1.5
5 0 -5 0 1 2 3 4 5 6 Year in decade 7 8 9
2000s, -1.1%
0.5
10
0 40s 50s 60s 70s 80s 90s 00s -0.5
Page 11
Wages have increased for those with the most education, while falling for those with the least:
Changes in wages for full-time, full-year male U.S. workers 1963-2008

190 180 170 160 150 140 130 120 110 100 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 90
Graduate school
College graduate
Some college High school graduate High school dropout
Source: Acemoglu and Autor (MIT), Skills, Tasks and Technologies: Implications for Employment and Earnings (2010).
Page 12
In 1955, the biggest company in the world by value was GM (revenues: $105bn).* Today it is Apple (revenues: $108bn). Employment patterns have, however, changed somewhat:
US employees 800000 700000 600000 500000 400000 300000 200000 100000 0 GM 1955
* At 2011 prices. At 1955 prices, revenues were $12.5bn.
Overseas employees
Overseas contractors
Apple 2012
Page 13
The US labour market is the most flexible in the world. Unlike in previous recessions, it looks as if lots of these jobs are not coming back:
Percent job losses in US recessions 1 0 -1 -2 -3 -4 -5 -6 -7 9 million jobs lost
1 2 3
1974
1980
1981
1990
2001
2007
6 million jobs lost

4
Number of years after peak employment

Page 14
Whole industries the ones the West was built on are disappearing to the East:
Crude steel production (megatons)
China 800000 700000 600000 500000 400000 300000 200000 100000 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 USA Europe
2008
2009
Source: World Steel Association.

Page 15
2010
2011
Whole industries the ones the West was built on are disappearing to the East:
The commodity car industry is going the same way. Luxury cars will take slightly longer:
Car production
USA 25,000,000 20,000,000 15,000,000 10,000,000 5,000,000 0 Japan Europe China
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Source: International Organization of Motor Vehicle Manufacturers.

Page 16
2010
With each stage of advancement up the industrial ladder in the East, there is a corresponding jobs drain from the West: The industrial development cycle: from delivery to creation
Low education Low capital investment Low know-how
Light manufacturing Assembly
Medium and high capital intensity

Steel Auto
Scientific and creative

Design Know-how Ecosystem growth
Professional services
Financial services Legal Accounting
Other high know-how

High-tech IP Entrepreneurialism Venture capital
Cash surpluses in developing countries
We are here Critical mass ecosystems
Time Western hostility to high earners
Enablers of advancement:
Education
Innovation centres (universities)
Page 17
Page 18
The jobs are not returning
At the same time, our own competitive advantages are steadily crumbling:
Competitive wage rates Existing physical and intellectual capital base Barriers that could prevent job loss from the West to the East Propensity to invest new capital Encouragement of VCs and entrepreneurs Existing IP Ability to generate IP
Unfeasible Half-life is some 10-15 years
Page 19
China has been investing almost half its GDP, while the West barely invests a fifth:
Gross capital formation (% of GDP)
60 50 40 30 20 10 0 1970 China 1975 1980 United Kingdom 1985 1990 1995 2000
2005
2010
United States
Page 20
Source: World Bank
Just catching up?

Wuhan Liverpool St
Hongqiao
Kings Cross
Page 21
Unfeasible Half-life is some 10-15 years Vanishing
Page 22
Western attitudes to high earners contrasts with some other countries:
We need to get tough on irresponsible and unjustified top remuneration

Nick Clegg, UK Deputy Prime Minister
To get rich is glorious
zhf gungrng Deng Xiaoping, Former Leader of the Peoples Republic of China
Page 23
Unfeasible Half-life is some 10-15 years Vanishing Western hostility to high earners
Page 24
The West has been haemorrhaging intellectual property, with little sign of abatement:
Global value of counterfeit and pirated goods (2015): $1.5 trillion Known jobs lost due to counterfeiting and piracy: 2.5 million.
Source: Frontier Economics, Estimating the global economic and social impacts of counterfeiting and piracy (Feb 2011)
The Chinese government has a national policy of economic espionage in cyberspace Although a rigorous assessment has not been done, we think it is safe to say [this] easily means billions of dollars and millions of jobs.
Source: Mike McConnell, Director of National Intelligence (2007-09), Michael Chertoff, Secretary of Homeland Security (2005-09), William Lynn, Deputy Secretary of Defense (2009-11), Wall Street Journal (Jan 27 2012)
Page 25
Unfeasible Half-life is some 10-15 years Vanishing Western hostility to high earners Cyber and physical theft
Page 26
A fifth of Western school leavers are functionally illiterate:
Percentage of students who do not attain the essential reading skills needed to participate productively in society
30 25 20 15 10 5 0
Source: OECD PISA 2009.

Page 27
The Chinese take advantage of the best education in the West: 1978 - 2007
Number of Chinese students studying abroad
160000 140000 120000 100000 80000 60000 40000 20000 1978 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 0
Number of Chinese students returning home
1978
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
Source: National Bureau of Statistics of China, 2009; Tina Hsieh and Ershad Ali, Auckland Institute of Studies.
When our thousands of Chinese students abroad return home, you will see how China will transform itself.
Deng Xiaoping, Former Leader of the Peoples Republic of China
Page 28
2007
50000 45000 40000 35000 30000 25000 20000 15000 10000 5000 0
And, indeed, they are innovating:

Patents granted to China 90,000 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 0 10 9 8 7 6 5 4 3 2 1 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 0 Global percentage of patents granted to China
Chinas universities graduate more than 10,000 science PhDs each year.
Source: World Intellectual Property Organization, McKinsey Quarterly.
Page 29
Unfeasible Half-life is some 10-15 years Vanishing Western hostility to high earners Cyber and physical theft Collapsing education set-up
Page 30
Page 31
In the West, average wages have plummeted - from 3% real annual increases to 3% real annual declines:
Average annual growth rates of real average wages 4 3 2 1 0 -1 -2 -3 -4
United States United Kingdom
Page 32
OECD wages must fall
1995-2000
2001-07
2008-10
2011
Source: OECD; 2011: BLS and ONS.
Precisely as one would expect, it is the low- and medium-skilled workers who are losing out, while the most skilled retain their comparative advantage:
Annual percentage change in nominal weekly pay in UK by pay percentile
2010
2.5 2 1.5 1 0.5 0 -0.5 -1 -1.5 10 20 30 40 50 60 70 80 90 2.5 2 1.5 1 0.5 0 -0.5 -1 -1.5 10 20 30 40 50 60 70 80 90
2011
Note that inflation in the UK has been 5%, so wages are in fact plummeting.
Source: Annual Survey of Hours and Earnings (2009, 2010, 2011) UK Office for National Statistics.
Page 33
We have every reason to think the trend will continue, leading to enormous downward adjustment, disruption and dislocation for Western workers:
2010 2020? Equilibrium price 2025*
Beyond that?
OECD daily wage
$135 $100 $60
? ?
China/India daily wage
$2-12 $20
Inflation and currency collapse seem to be the most likely ways by which this process will be managed in the medium term
* Assumes annual world GDP growth rate of 5%; constant prices.
Page 34
The challenge
Potential actions
Likely outcomes
Entitled groups
Starting with the Greenspan Put (1987), governments, corporates and individuals have sought to borrow to fund the maintenance of an unmaintainable lifestyle.
This has been elevated to a religion by the neoKeynesians.
Continued indefinitely, this will destroy our economies.
Page 35
Ineffectual governments
Since 1987, the response to any economic downturn has been to flood the system with cheap money:
Fed Rate
25
20
15
10
Page 36
36
For todays Keynesians, there seems never to be a good time to run a surplus:
Surpluses and deficits (% GDP)
6 4 2 0 -2 -4 -6 -8 -10 -12 -14
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Japan United Kingdom United States
Page 37
Euro area
Source: OECD.
The result of low interest rates (easy money) and government deficits is staggering levels of debt:
Total debt in selected countries around the world as percent of GDP
Households Ireland Japan Portugal United Kingdom Spain Greece France United States Italy Germany 0% Nonfinancial business Government Financial Institutions
100%
200%
300%
400%
500%
600%
700%
Source: McKinsey Global Institute (MGI), "Debt and deleveraging: Uneven progress on the path to growth," January 2012.
The relationship between government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90 percent of GDP. Above 90 percent, median growth rates fall by one percent, and average growth falls considerably more.
Reinhart and Rogoff, Growth in a Time of Debt, American Economic Review (May 2010)
Page 38
All are agreed: we should spend our way out of this.

Unfortunately, with savings going up to 5, 6, 7 percent, aggregate demand is going to be weak. The only thing to fill it is government. Joseph Stiglitz, Aug 4 2010 Standard macroeconomic analysis, applied in a standard way, says that aggressive tightening of fiscal policy, of the kind we are seeing now, is inappropriate and unnecessary. Jonathan Portes, New Statesman Aug 24 2011 The idea, amazingly widely accepted, that the UK cannot borrow any more seems quite absurd. Martin Wolf, Financial Times Nov 24 2011 Isn't the truth of the matter, Mr Alexander, that you are collaborating in a doctrinaire Conservative experiment which is not working? Jeremy Paxman, Newsnight Jan 25 2012
That which cannot go on forever won't.

Herb Stein's Law
Page 39
Indebtedness becomes a vicious downward spiral, Keynes la grecque

Consumer borrowing Corporate borrowing Banking borrowing Credit market rebellion leads to financial crisis Starts with normal counter-cyclical deficit spending Spending proves sticky (civil servants, benefits culture, etc.) Debt-to-GDP levels begin to rise, but below Reinhart/Rogoff levels Deficit spending distorts economy Borrowing masks the problem Calamity exposes those without swimming costumes Deficits suddenly massive Judgment day can be put off by devices such as QE (lowering the rate of interest) Keynesian voices warn against any pullback in spending as per prior point The pain of restructuring becomes increasingly impossible with every iteration The doom loop accelerates Voila! Greece goes to Argentina
Government deficit spending Greater funding need Increase in stock of debt
Keynesian monetary tactics (e.g. QE) temporarily lower interest rates
Higher level of interest payments

Higher rate of interest Worsened credit rating
Page 40
The problems are exacerbated by the claims made on shrinking Western economies by an oddly disparate set of entitled groups:
Entitled groups
The challenge
Potential actions
Likely outcomes
Entitled groups
Bankers
CEOs
Public sector
Benefit claimants
Page 41
Bankers sources of excess profits (that also lead to massive socialised losses)
Cheap funding from government stimulus Oligopoly in many markets (corporate lending, mortgages, credit cards) Foolish acceptance of high prices by customers where oligopoly does not exist Excessive leverage Inside trading knowledge Big bet culture Willingness of boards and shareholders to countenance excessive rewards, in particular, because the previous points create excessive profits
Page 42
Bankers
The financial sector has claimed a growing share of Western economies:

Financial sector compensation and profits as share of GDP 1929 - 2010
8 7 Share of overall GDP (%) 6 5 4 3 2 1 0 3.7% 7.6% $547 billion in 2010 dollars 3.8% 6.9%
Source: Bureau of Economic Analysis (BEA) data on National Income and Product Accounts (NIPA), tables 1.1.5 and 1.1.4.
Page 43
Bankers
The excess profits in turn lead to excessive remuneration:

Historical excess wage in the financial sector
relative to nonfarm private sector, accounting for education level, skill premium and unemployment risk 40%
1933 Glass-Steagall Act 1933 Securities Act 1934 Securities Exchange Act 1939 Trust Indenture Act 1940 Investment Advisers Act 1940 Investment Company Act 1956 Banking Holding Company Act 1980-84 Removed interest-rate ceilings (from Glass-Steagall Act) 1994 Riegle-Neal Interstate Banking & branching efficiency act (repeals parts of Bank Holding Co. Act) 1996 Investment Advisers Act amended 1999 Graham-Leach-Bliley Act (repealed Glass-Steagall & parts of Bank Holding Co. Act) 2002 Sarbanes-Oxley Act
30%
20%
10%
0% 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Source: Philippon and Reshef, Wages and Human Capital in the U.S. Financial Industry: 1909-2006 (2008).
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Entitled groups
The challenge
Potential actions
Likely outcomes
Entitled groups
Bankers
CEOs
Public sector
Benefit claimants
Page 45
CEOs in the US and the UK have also captured their companies remuneration processes:
CEOs
Ratio of average annual CEO compensation to average worker compensation, 1965-2010

350 300 250 200 150 100 50 0
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
299-to-1
277-to-1 243-to-1
126-to-1 100-to-1 24-to-1 35-to-1
185-to-1
Rectifying this would be important to ensure a cohesive society, but the impact will be limited (too few CEOs).
Source: Adapted from Lawrence Mishel and Josh Bivens, Economic Policy Institute Briefing Paper #331 (2011).
Page 46
Entitled groups
The challenge
Potential actions
Likely outcomes
Entitled groups
Bankers
CEOs
Public sector
Benefit claimants
Page 47
With the exception of the highest skilled, public sector workers are significantly overpaid:
Average public/private sector pay gap by qualification
% Pay gap (public minus private sector) UK US (excluding pensions) (including pensions) 40 30 20 10 0 -10 -20 -30
No qual. Other qual. GCSE A-C A-Level Higher ed. Degree High School Diploma Some college Bachelor's degree Master's degree Prof. degree or PhD
Public sector
The governments own conclusion: Allowing for [job] differences as far as possible, in April 2010, public sector employees were paid on average 7.8 per cent more than private sector employees. Source: ONS.
8 6 4 2 0 -2 -4 -6 -8
NB: UK analysis excludes pension contributions, so greatly understates the already large pay gap (private sector companies mostly no longer have DB schemes).
Source: ONS, Estimating differences in public and private sector pay (July 2011); CBO, Comparing the compensation of federal and private-sector employees (Jan 2012).
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Public sector workers are also getting less productive, while the private sector company necessarily finds improvements, or closes down. Thus the public sector is becoming a heavier and heavier drag on the public purse: Annual growth in productivity in the UK (1997 = 100)
Private Sector 130 125 120 115 110 105 100 95 90 1997 1998 1999 2000 2001 2002 2003 2004 2005 Public Sector
Public sector
2006
2007
Source: ONS, Estimating differences in public and private sector pay (July 2011).
Page 49
Entitled groups
The challenge
Potential actions
Likely outcomes
Entitled groups
Bankers
CEOs
Public sector
Benefit claimants
Page 50
Benefit claimants
Real spending on welfare continues to outstrip GDP growth:

Growth rates in GDP and welfare spending
1200 CAG: 3.87% 1000 800 600 CAG: 2.39% 400 200 0
Source: HMT, IFS

Social Security
Page 51
GDP
Under Blair and Brown, spending on benefits should have fallen as the economy boomed. It didnt becoming a redistribution rather than a safety net.
UK welfare spending and unemployment 1974 - 2011
14.5 13.5 12.5 11.5
Benefit claimants
Welfare spending (% GDP, LHS)
12.0 10.0 8.0
10.5 9.5 8.5 7.5 6.5 5.5 6.0 Unemployment rate 4.0 (%, RHS) 2.0 0.0
Source: HMT, IFS.

Page 52
Benefit claimants
The system really has broken:

Caseload (1,000s) of working age clients by type of claim and duration (May 2011)
3000 2500 2000 1500 1000 500 0
Job Seeker
ESA and incapacity benefits
Lone Parent
Carer
Others on income related benefit 1-2 years 2-5 years
Disabled
Bereaved
Up to 3 months Source: DWP.

3-6 months
6-12 months
5 years and over
Page 53
The cost is exacerbated by the large amount of money spent on those not in need, as the state seeks to develop a dependency mentality in its clients:
Benefit claimants
Percentage of benefit expenditure going to middle class households

90 80 70 60 50 40 30 20 10 0 Maternity pay 1998-99
With universal suffrage, it becomes impossibly expensive to bribe all of the electorate.
Child benefit 2008-09
Disability living allowance
Retirement pension
Housing benefit
Student support
Source: Reform, The money-go-round (Oct 2010).

Page 54
Benefit claimants
Managing the welfare state is, in itself, a very expensive operation:

Employees by Government Department (2011)
140,000 120,000 100,000 80,000 60,000 40,000 20,000 0 HMRC Department for Work and Pensions Home Office Department Department DEFRA Department HM for of Health for Treasury Education Transport DECC Manage the economy Stop climate change Take your money Give it back to you
Source: ONS, DWP.

DWP salaries in 2011: 3.5bn

Page 55
The challenge
Potential actions
Likely outcomes
Entitled groups
Page 56
Since 1992, spending on health has ballooned (mostly on salaries), while growth in education spending has fallen behind:
UK public spending (real bn)
140.0 NHS
Poor allocation
Education
CAG: 4.89%
120.0 100.0 80.0 60.0 40.0 20.0 0.0 1953-54 1958-59 1963-64 1968-69 1973-74 1978-79 1983-84 1988-89 1993-94 1998-99 2003-04 2008-09 Source: ONS. Compound annual growth calculated from crossover point (1993).
CAG: 3.14%
Page 57
The challenge
Potential actions
Likely outcomes
Reorient government spending
Reform the banks
Tax properly
Develop new technologies
Accept immediate cuts in living standards
Page 58
Potential actions
Reform the banks
Tax properly
Education Infrastructure
Page 59
Reallocating public spending towards infrastructure and education has a large and highly statistically significant effect on the long-run growth rate.
Effect of public spending mix on the long-run growth rate
0.14 0.12 0.1 0.08 0.06 0.04 0.02 0 -0.02 -0.04 -0.06 Transp & Comms Education Health Defence Econ services Housing Gen. pub. services Education and infrastructure the key
Reorient spending
Welfare
Source: Gemmell, N., Kneller, R. and I. Sanz, The Composition of Government Expenditure and Economic Growth: Some Evidence from OECD Countries, European Economy (2008).
Page 60
Reorient spending
The importance the West assigns to good teachers has plummeted:
Percentage of new American teachers who graduated in the upper third of their classes 100 90 80 70 60 50 40 30 20 10 0 1930
Source: McKinsey & Company, Closing the talent gap (2010); Milken Institute.
2012
Page 61
The strongest performers among high-income countries tend to invest more in teachers:
545 540 535 Mean reading scores 530 525 520 515 510 505 500 495 0 R = 0.61227
Reorient spending
Korea Finland
OECD analysis
In general, the countries that perform well in PISA attract the best students into the teaching profession by offering them higher salaries and greater professional status. High-performing countries tend to prioritise investment in teachers over smaller classes.
2.5 Source: OECD Does Money Buy Strong Performance in PISA?
Japan Australia Netherlands Belgium Norway Poland Estonia Iceland United States 0.5 1 1.5 2 Ratio of teacher salaries to GDP per capita
Page 62
Reorient spending
Quality of teaching matters above all:

Impact on student lifetime incomes by class size and teacher effectiveness (compared to average teacher)
$1,000,000 Impact on student lifetime earnings 90th percentile teacher $500,000
75th percentile teacher 60th percentile teacher
$0 40th percentile teacher -$500,000 25th percentile teacher 10th percentile teacher -$1,000,000 Class size
Source: Raj Chetty (Harvard), John N. Friedman (HKS), and Jonah E. Rockoff (Columbia), The Long-Term Impacts of Teachers: Teacher Value-Added and Student Outcomes in Adulthood, NBER Working Paper No. 17699 (Jan 2012).
Page 63
Reorient spending
A teacher one standard deviation above the mean effectiveness annually generates marginal gains of over $400,000 in present value of student future earnings with a class size of 20 and proportionately higher with larger class sizes. Alternatively, replacing the bottom 5-8 percent of teachers with average teachers could move the U.S. near the top of international math and science rankings with a present value of $100 trillion.
Source: Eric A. Hanushek (Stanford), The Economic Value of Higher Teacher Quality, NBER Working Paper No. 16606 (Dec 2010).
Page 64
Reorient spending
Replacing a teacher whose value added is in the bottom 5% with an average teacher would increase the present value of students lifetime income by more than $250,000 for the average classroom.
Page 65
Reorient spending
With an annual discount rate of 5%, the parents of a classroom of average size should be willing to pool resources and pay an 84th percentile teacher considering quitting approximately $130,000 ($4,600 per parent) to stay and teach their children during the next school year.
Page 66
Potential actions
Reform the banks
Tax properly
Education Infrastructure
Page 67
Reorient spending
Opportunities for high-return infrastructure investment abound:
Infrastructure needs in the US US infrastructure GPA
Exemplary infrastructure needs in the UK

Wolfsons Brain Belt Oxford-Cambridge motorway/science ecosystem Other university/science/business ecosystem infrastructure
A nil
B nil
C Solid waste (+) Bridges Public parks and recreation (-) Rail (-)
D Energy (+) Aviation Dams Hazardous waste Schools Transit Drinking water (-) Inland waterways (-) Levees (-) Roads (-) Wastewater (-)
Manchester-Sheffield motorway Other removal of congestion through building new roads and improving efficiency of existing roads Local bypasses
Boris Island
Source: American Society of Civil Engineers.
Universal WiMAX or fibre broadband
Page 68
Potential actions
Reform the banks
Tax properly
Page 69
The multiple ways in which banks make excess profits, and how that might be reversed:
Cheap funding from government stimulus Oligopoly in many markets (corporate lending, mortgages, credit cards) Foolish acceptance of high prices and risk by customers even where oligopoly does not exist Get customers to behave better and think harder (for retail) Educate the populace and force far more, and better disclosure
Reform the banks
Excessive leverage*
Inside trading knowledge
Big bet culture
Excessive remuneration
Make them pay for that through tax, levies, ringfencing bonuses
Break them up
Require more capital Ban abuse of derivatives: better regulation Prevent concealment of true size of assets; punish auditors for allowing OBS vehicles Prevent other arbitrage of capital regulation Manage ratings agencies better Eliminate politically biased decision making Manage auditors better
Ban front running
Require more capital
Pressure the banks
Manage regulators better Split commercial from trading; dont subsidise trading/ investment banking Remove profit element of subsidies Remove too big to fail
Throttle or tax flash trading
Better transparency on daily exposures
Reform board behaviour
Pass duty of care legislation
Enforce insider trading laws
Pressure investing institutions
Ban exploitative behaviour
Possible progress Only slow progress Essentially no progress

* Traditional high beta in trading business.
Page 70
Potential actions
Reform the banks
Tax properly
Page 71
Tax properly
Taxes affect the determinants of growth:
Labour utilisation
Employment
Taxes
Consumption Property Income Corporate
Hours worked
GDP per capita Labour productivity

Physical capital Human capital Total factor productivity
Page 72
Tax properly
A significant reorientation of tax policy to less populist methods is needed:

Effects of the tax mix on long-run GDP per capita
Corporate income taxes 2 1.5 1 0.5 0 -0.5 -1 -1.5 -2 -2.5 Source: OECD * Note that punitive taxes on the richest dont help much as the base is always relatively small.
Personal income taxes
Consumption taxes
Property taxes
Page 73
Potential actions
Reform the banks
Tax properly
Support manufacturing
Help industry ecosystems to flourish
Encourage development of new technologies
Page 74
Consensus states that manufacturing is no more important than any other sector of the economy:
Manufacturing
Obamas surrender to the manufacturing fetish is a disaster.

Jagdish Bhagwati, Professor of Economics, Columbia University
Financial Times, 6 Feb 2012
A persuasive case for a manufacturing policy remains to be made.

Christina D. Romer, Professor of Economics, UC Berkeley
New York Times, 5 Feb 2012
Page 75
Manufacturing
But in fact, manufacturing is crucial to economic growth:
Economies of scale more likely to be realised
Substantial and disproportionate role in innovation
Primary source of middle-class jobs (especially for workers without a college degree - 75% of UK workforce)
Its also vital that we rebalance growth away from consumption and imports financed by foreign borrowing toward exports.
Page 76
Manufacturing
The proof: employment multipliers

Manufacturing Services
7 6 5 4 3 2 1 0
Every job in manufacturing supports 2.91 jobs elsewhere in the economy, compared to only 1.54 in business services and 0.88 in retail trade: Supplier effects (e.g. car plant sustains jobs in steel industry); Respending effects (where workers spend their paycheques); Government effects (taxes that support jobs in government).
Almost every industry within manufacturing supports much more secondary employment than other sectors.
Source: Economic Policy Institute, Updated Employment Multipliers for the U.S. Economy (2003).
Page 77
Potential actions
Reform the banks
Tax properly
Page 78
Policies need developing to support existing ecosystems, and develop new ones:
Agglomeration economies
35 30 25 z-score 20 15 10 5 0 0 10 20 30 40 50 60 Radial distance 70 80 90 100 Skills pool peaks at c. 40 miles
Ecosystems
Physical encounters best at mile
Local micro-industry ecosystems drive innovation: Londons Square Mile: bankers, lawyers, accountants. Birminghams F1 ecosystem: a huge driver of innovation and economic success. China found concentration key for e.g. semiconductor success.
Source: Reserve Bank of Philadelphia Working Paper No. 11-42, 'The Agglomeration of R&D Labs.
Page 79
Potential actions
Reform the banks
Tax properly
Page 80
New technologies
Technology holds the promise of massive, early breakthroughs:
The accelerating pace of change

2045: Computer that surpasses brainpower equivalent to that of all human brains combined 2023: Computer that surpasses brainpower of human 2015: Computer that surpasses brainpower of mouse The Kurzweil prediction
1900
1920
1940
1960
1980
2000
2020
2045
Source: Adapted from Raymond Kurzweil, The Singularity Is Near: When Humans Transcend Biology.
Page 81
Technology is subsidised by every government. In Europe and the UK, the process seems to be ineffective and insufficient:
New technologies
Bio
Neuroceuticals Genetic engineering
Nano
Thin films Fine particles Chemical synthesis Advanced microlithography
Info
Networking Telecommunications
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Energy storage Electric cars Battery tech Renewables
Today, a car emits less pollution traveling at full speed than a parked car did in 1970 from leaks. Matt Ridley, The Rational Optimist State Capitalism is on the march, overflowing with cash and emboldened by the crisis in the West. The Economist, January 21st 2012 Our industrial policy was meant to be the government picking winners. Instead, the losers picked government. Peter Mandelson, Today, January 26th 2012
Page 82
A 20-50 year view, and a cross-party consensus that this is needed, is essential:
New technologies
An integrated industrial policy

Manufacturing policy
R&D support Innovation centres (universities)
Ecosystem support
Selected technologies
Page 83
Potential actions
Reform the banks
Tax properly
Page 84
Living standards
Accept lower living standards:

Potential actions
Increase the retirement age Lower entitlements Lower wages Act immediately
The bureaucrats own conclusion The relentless increase in the sustainability gaps suggests the urgency in considering in earnest profound reforms in social protection systems.
Source:
Reductions in primary spending or increases in revenues in various years needed to close the 25-year fiscal gap in the US
14 12 10 8 6 4 2 0
Actions begin in 2012 Actions begin in 2015 Actions begin in 2020 Actions begin in 2025
(% GDP)
12.5
8.1 4.9 5.9
Source: Congressional Budget Office.

European Commission, Sustainability Report 2009
Page 85
A decline in living standards of between 10 and 15% is needed to rebalance Western economies today. Tomorrow's continued job loss and wage pressure will mean more of that pain in the future
Reinhart-Rogoff threshold
Living standards
Governments
Japan Greece US
Households
Net borrowing (% disposable income) 2008* 15 10
Greece
Deficit (% expenditure) 2000-10 (weighted avg)
20 18 16 14 12
5 0 0 -5
Italy Germany France
UK
Ireland
10 8 6 4 2 0 0 30 60
UK Portugal France Italy Germany
Portugal
25
50
75
Japan
US
100
125
Ireland
150
-10 -15
90 120 150 180 210 240 270 Debt (% GDP) 2011
Household debt (% GDP) 2011
Size of bubble, non-proportional but directionally correct, represents (L) overall size of government expenditure 2011 (% GDP); (R) household final consumption expenditure 2010 (% GDP). Source: IMF, OECD, MGI, World Bank. * Greece 2006, Japan 2007 (latest available).
Page 86
Living standards
as will demographic challenges.

Workers per retiree
5 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050
Source: UN Population Projections.
US Japan UK
Page 87
In the short term, America is better positioned to recover:

America has successfully kicked the can down the road: It has the firepower It is more resilient Much less is nationalised The nationalisations are less political Debt restructuring (reduction) has been far more responsive and swift Much smaller government so less impact Europe (incl. the UK) has not: Less firepower Deeper and different problems More public ownership Germany unwilling to socialise the problem Less ability to restructure Less determination to restructure*
* Automatic stabilisers = big unrestructured government that continues to batten on the corpse.
Page 88
Living standards
The biggest challenge to transcend wanting and acquiring:
Economic growth and the future of the West: happiness studies
Neuroscience shows that wanting, striving and acquiring are major and fundamental drivers of human behaviour.
An equilibrated world would have few Western necessities (car s, flat screens, etc.) per capita [at current prices]
Continued growth means further strain on global resources.
Can insights from neuroscience, coupled with education, reengineer human behaviour towards less consumption?
Page 89
The Challenge
Potential actions
Likely outcomes
Short term Long term
Page 90
Potential actions
Likely outcomes
How it looks now How it may be (10-30+ year view) No sign in most countries of electability of Grinches
Reorient government spending Curb the banks Tax properly

Not happening 50/50 Little sign

10% - mob resistance more likely Promising signs (but only in some countries, e.g. UK)
50/50 Worsening: soak the rich

Cuts will happen only through inflation, currency depreciation
Educate better
Privatisation of education?
Page 91
The pressing short-term issue is whether the neo-Keynesian disaster can be avoided. Probably not
Page 92
Broad money falling
QE: What they understood

BoE buys gilts off private bondholders
HMT indemnifies Asset Purchase Facility
Alternative scenario
Eurozone Armageddon?
Severe risk of deflation
Assets Broad money soars BoE credits their reserves Commercial banks lend out a little of the money BoE owns 325bn gilts Money multiplier suspended
Liabilities BoE credits 325bn to commercial bank reserves
Mild inflation
Accelerating inflation
Money multiplier restored
Growth rebounds Capital flight from Western government bonds and currencies Gilts plunge in value HMT still on hook for 325bn
Growth does not rebound
BoE does not tighten monetary policy
BoE tightens monetary policy 2. BoE reverses QE
and what they (apparently) didnt.
Deflation Wage rises not enough to service debts Household debt accelerates rapidly
1. BoE raises interest rates
Gilt yields soar to e.g. 8% Broad money still bloated
Auctions gilts, gets ?175bn
3. Even higher interest rates
Households default
Households default Deflation-driven recession
Hyperinflation
Inflation-driven recession, Taxpayer loses 150bn In addition, government debt overhang permanently limits growth
Page 93
In summary: things dont look great.

Were teetering on a balance between: Inflation Growth Acceptance Short-term pain
* * * * *
V.
Deflation Recession Wilful disregard Long-term catastrophe
In the short term, the outcomes are unknowable. For the long term, as things stand, the continued economic decline of the West is highly predictable.
Page 94
Further reading
The Modern Industrial Revolution, Exit, and the Failure of Internal Control Systems, Presidential Address to the American Finance Association, originally published in the Journal of Finance (July, 1993) pp. 831-880 Michael C. Jensen Lost Victory Correlli Barnett
The Big Short Michael Lewis World on Fire Amy Chua Shall the Religious Inherit the Earth?: Demography and Politics in the Twenty-First Century Eric Kaufmann The Rational Optimist Matt Ridley
This Time is Different Carmen Reinhart, Ken Rogoff Once in Golconda John Brooks
Stumbling on Happiness Daniel Gilbert
Page 95

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The continued economic decline of the West

Diagnosis and prognosis

The continued economic decline of the West

PA Knowledge Limited 2012

How has the Wests economic decline happened? Will it continue?

China India United Kingdom United States Germany Japan Brazil

5Y CDS of founding Eurozone countries

The central dilemma facing Western economies:

The paradigm for the 1900s

The paradigm for the 2000s

PA Knowledge Limited 2012

The continued economic decline of the West

Global wage disparity

Ineffectual governments and credulous voters

Poor allocation of tax monies

PA Knowledge Limited 2012

A global wage disparity

As a result, a job drain continues and is indeed accelerating.

* Includes Brazil etc.

A global wage disparity

Waiting to urbanise (rural)2 1.3 billion

Average daily wage

$135 (OECD, 2010)

$12 (China, 2008)

A global wage disparity

As a result, a job drain continues and is indeed accelerating.

PA Knowledge Limited 2012

A jobs drain continues

A jobs drain continues

Compound annual jobs growth by decade (%)

0 40s 50s 60s 70s 80s 90s 00s -0.5

PA Knowledge Limited 2012

A jobs drain continues

Changes in wages for full-time, full-year male U.S. workers 1963-2008

Some college High school graduate High school dropout

A jobs drain continues

A jobs drain continues

6 million jobs lost

Number of years after peak employment

A jobs drain continues

Source: World Steel Association.

A jobs drain continues

Source: International Organization of Motor Vehicle Manufacturers.

A jobs drain continues

Medium and high capital intensity

Scientific and creative

Other high know-how

Cash surpluses in developing countries

We are here Critical mass ecosystems

Time Western hostility to high earners

Innovation centres (universities)

PA Knowledge Limited 2012

A global wage disparity

As a result, a job drain continues and is indeed accelerating.

PA Knowledge Limited 2012

The jobs are not returning

Unfeasible Half-life is some 10-15 years

PA Knowledge Limited 2012

The jobs are not returning

Source: World Bank

PA Knowledge Limited 2012

The jobs are not returning