In the developed world, neither the real economy nor the financial system is working as it should. On one side, GDP growth is generally judged to be too slow and, outside Japan, unemployment too high. On the other, fiscal deficits are too large, central banks' policies are too experimental and banks are not lending enough. But which direction does the arrow of causality go? Is messed-up finance holding the economy back, or are long-term economic issues responsible for the financial morass?
Conventional wisdom, as exemplified by the International Monetary Fund's latest World Economic Outlook, primarily blames finance. It assumes that financial rearrangement can bring back the real economy's former momentum. But the causality may mostly flow the other way. In that case, today's financial woes are primarily symptoms of long-term trends in the real economy.
Demographics: Demographics are a good place to start, especially the fall of young families. The number of people in their 20s is declining by more than 1 percent each year in Japan and most of Europe. Though the figure is increasing in the United States, it is doing so at a much slower pace than a decade ago.
When it comes to economic output, the effect of shrinking youth is magnified. Since each additional new household requires extra housing, cables, cars and all the other infrastructure of a prosperous economy, the current trend creates a disproportionately large drag on GDP.
Meanwhile, the old are proliferating. The number of people over 60 is increasing by 2-3 percent each year in almost all rich countries. Though the effect on GDP is not as clearly negative as the dwindling number of young people, it's reasonable to surmise that both energy and the desire to spend decline with age, even if pension income is ample.
True, old people spend more on healthcare, but that does not compensate for smaller houses, less ambitious holidays and cars that can no longer be driven. Indeed, since much of elderly care is done by relatives who receive no payment, ageing may weigh on GDP without changing the quality of life.
The officials who guide banks, regulators, monetary authorities and governments may underestimate the effect of these trends on GDP. If so, the financial system - including tax rates and pension promises -may be calibrated for faster growth rates than ageing economies can sustain. Excessive credit might push up activity for a while, but that effect will eventually fade. Viewed this way, the slow recovery from a sharp recession may be less a failure of finance than an unavoidable reversion to economic reality.
The global shift: The rapid growth of emerging economies may be causing additional collateral financial damage in the developed world. First, the exchange of labour-intensive goods from poorer countries for capital-intensive goods from rich ones tends to push up unemployment in the latter. Fewer workers lead to lower tax revenues and increased welfare payments. The result is a worryingly durable increase in fiscal deficits in the developed world.
Second, developing countries have overall been running trade surpluses. That makes economic sense, since exports bring jobs and skills to countries which need them. However, the resulting current-account surpluses have been recycled into developed-world capital markets. Before 2008, rising surpluses helped fund financial excesses. They have subsequently waned, perhaps squeezing cashflows and economic activity in rich countries.
What is to be done? Conventional wisdom suggests the solutions to most of today's economic problems are financial - higher or lower fiscal deficits, looser or tighter monetary policy, stricter or more lenient bank regulation. Get the finances right, the logic dictates, and growth will once again pick up.
But if longer-term economic trends are to blame, then such efforts are almost irrelevant. Little can or should be done to counter the effects of changing demography, and the rise of emerging economies is basically benign for the world. The appropriate response to higher unemployment is not to try to stimulate GDP growth, but to adopt policies that make hiring easier and benefits more affordable.
The problem is that the financial system is still a mess, with excess leverage and extraordinary policies that distort markets. If fundamental economic shifts rather than finance are to blame, then it's pointless to try to push up GDP growth to bring back financial balance. No financial strategy can push the growth rate high enough for long enough.
Something more dramatic may be required - perhaps a global resetting of the financial system to realign balance sheets and interest rates to more realistic long-term economic prospects. That would be fiendishly difficult. But if the financial mess is an effect rather than a cause of economic woe, it may be unavoidable.
