China's meteoric economic transformation has brought billions of workers out of poverty and into the global labour market. But recent discussion has raised the possibility that China’s “migrant miracle” (fuelled by the influx of people from the countryside to work in the cities) could now be over as the so-called “Lewis point” is reached – the moment when excess rural labour runs out and pricing power returns to workers. Such a development could have profoundly negative implications for asset prices across the globe, and also put an end to the debates over “Secular Stagnation”.
The rise of the Asian Tigers, collapse of the Iron Curtain, the reduction of barriers to trade and capital achieved by, first, the General Agreement on Tariffs and Trade (GATT) and then the World Trade Organisation (WTO), and finally China’s accession to the world trading system have coincided with a collapse in pricing power among the bottom 80 per cent of working populations in the West, falling interest rates and soaring asset prices. We see more than coincidence – we see causation.
During the 1960s and 1970s, labour became increasingly powerful, incentivising companies to substitute workers (labour) for machines (capital). This had the effect of driving up what economists call the Wicksellian neutral rate of interest (the interest rate that is neither too high nor too low for an economy that is growing at its potential).
Unhelpfully, the Wicksellian neutral rate is unobservable and central banks spend much time trying to discern where it truly lies. Having built an estimate of the neutral rate, they can then adjust (observable) nominal interest rates around this unobserved variable.
But since 1980, as the labour market globalised, so the marginal cost of Western labour pricing ebbed away. And with a low marginal cost of labour, it made sense for companies to substitute capital for labour – building factories that employ large numbers of cheap workers in emerging markets. In doing so, the price of capital – the neutral real rate – was brought down.
Central banks, finding that the Wicksellian neutral rate was falling, had to cut interest rates to stop monetary policy tightening. And despite cyclical ups and downs, this secular trend of diminishing Western labour pricing power and associated reductions in the neutral rate has continued now for 35 years. Recently, some academics and policy-makers have mislabelled this phenomenon as Secular Stagnation. And at the same time, central banks have been blamed for pumping up asset prices and causing the collapse of bond yields.
But as deputy Bank of England governor Ben Broadbent argued powerfully in a speech last October, central banks have been only the proximate agencies through which the neutral real rate can be observed by society at large; it is the economy that sets the neutral real rate and the central bank which responds to changes in that real rate. Central bankers can no more control the neutral real rate than King Canute could command the tide.
As the neutral real rate and the observed central bank rate fell, so the value of long-dated cash flows (bond coupons, equity dividends, property rents) has soared, and the result has been significant asset price inflation. This has been a story of excess labour finding its way into a globalised economy. We now need to look at likely labour market developments to understand how asset prices will fare for the next 35 years.
Given the importance of labour markets to the formation of the neutral real rate in the West, a change in the marginal cost of global labour – that would go with a Chinese Lewis point – would represent a secular shift that could have profound effects for asset prices around the world and pose a real challenge to the “new normal” of low rates, off of which assets have been priced. Indeed, the long period during which assets have enjoyed the tailwinds of falling rates may be replaced with a long period during which headwinds of a secularly rising neutral rate is more the norm.
What could upset this forecast? Structural reforms that saw India industrialise and its population join the world labour market, and the development of Africa spring immediately to mind. Both would be boons to the global economy and to the liberal mission to eradicate poverty via trade.