“Something looks wrong.”
So begins Greg Ip’s most recent column in The Wall Street Journal.
What exactly “looks wrong?”
Well, the economy, stupid.
Specifically, as Ip points out, consumer spending has been rising strongly recently but business investment has been headed down for two straight quarters, which is supposed to happen only in recessions. (Ip is the Journal’s chief economics commentator, a post he’s held for about a year after being at The Economist for over a decade. Before that he was at the Journal for his first tour of duty, which lasted 8 years.)
Ip is hardly alone.
If you follow the business/financial/economics press as I do, you’ll have heard an increasing volume and intensity of commentary and analysis over the last, say, six to nine months, dwelling on themes such as:
- “secular stagnation” (more below)
- lagging productivity growth
- the exhaustion, and exhaustion, and exhaustion, of monetary policy
- accompanied by partisan political paralysis on fiscal policy
- declining labor force participation
- the threat of robots/automation/AI, in the nearish term, to unskilled and semiskilled workers
- stagnation in middle class standards of living
- zero real growth in household incomes
- and I could go on.
Obviously none of these are happy themes, but separately and together they reinforce the conviction that the economy isn’t responding to this post-recession period as it typically has in the wake of past recessions. Ip worries that our disappointing economic growth is worse than a hangover from the Great Recession and that it’s “part of a deeper malaise that predates, and indeed may have helped cause, the financial crisis.”
Evidence isn’t hard to find:
- From 1980—2007, annual economic growth averaged 3% in the US; since then the average is 1.2%. According to the Congressional Budget Office, the overall US economy is 11% smaller than where they thought it could and should be by now.
- Productivity growth has barely kept its head above zero in recent years: At +0.5%, it’s the lowest it’s been in decades. There’s no sign of its picking up.
- The historically unprecedented duration of exremely low interest rates “could lead to excessive risk taking and over time to unsustainably high asset prices and credit growth.” (Yes, folks, we’ve seen this movie before, in the housing bubble.)
This chart illustrates projected vs. actual GDP growth:
As I mentioned, Ip is far from alone in his thesis, and it’s buttressed by an IMF Working Paper recently published by Larry Summers (of Harvard fame), Olivier Blanchard (the IMF’s former chief economist), and Eugenio Cerutti (IMF), whose abstract begins as follows:
We explore two issues triggered by the crisis. First, in most advanced countries, output remains far below the pre-recession trend, suggesting hysteresis. Second, while inflation has decreased, it has decreased less than anticipated, suggesting a breakdown of the relation between inflation and activity. To examine the first, we look at 122 recessions over the past 50 years in 23 countries. We find that a high proportion of them have been followed by lower output or even lower growth.
We clearly seem to be in the “high proportion” of recessions (their paper calculates the number as about 70%) that turn into long-run drags on growth. Why?
The leading explanation is that the Great Meltdown caused such severe long-term unemployment that discourged workers dropped out of the labor force entirely, decreasing the US’ productive labor capacity. (The BLS draws the official line between “short–term” and “long-term” unemployment at six months, which is necessarily a somewhat arbitrary choice but perfectly rational.) It reached “historically high levels” in the wake of the Great Meltdown, as evidenced by this utterly depressing chart:
Meanwhile, on the capital front, businesses slashed investment because they were shut out of the borrowing markets, they had lost all faith in a prosperous future (no “animal spirits”), or onerous new regulations imposed new and higher costs and generally threw sand in the gears. Of course, if you have fewer available workers and you arm them with less capital equipment, no one should be surprised if output and productivity are impaired.
It gets worse.
Going back all the way to the post-dotcom meltdown, the “capital investment shutoff” thesis posits that most of the productivity gains from IT were in place by the early 2000s. Throwing more new hardware and software at workers didn’t generate the same bang for the buck, so businesses naturally dialed it back. Something was clearly going on here: The annual growth of business capital investment (net of inflation and depreciation) slowed from 3% to 2.2% from the 1990s to the 2000s.
Since the Great Meltdown (let’s date it to 2009), even though interest rates are at historic lows, business capital investment has fallen by almost half, to a mere 1.2% per year. Take a look for yourself:
Now we cross over into vicious circle territory:
- Lower business capital investment
- Makes productivity growth even more sluggish
- Leading to slower income growth
- Cutting consumer spending
- And discouraging businesses from investing even more.
Once this set of expectations gets baked in to how people anticipate the world will continue to work, it’s even harder to dig out.
Well, that’s not 100% true. As Mervyn King, former governor of the Bank of England, explains in his new book The End of Alchemy (I’m relying on reviews here since I haven’t read it yet), if income is insufficient to support a family or a firm’s desired spending level, you can always…borrow! Eddie George, King’s predecessor at the BoE, even said in 2002, “unbalanced growth…is better than no growth.” Lords of Finance, indeed. But that’s exactly what central banks were encouraging people to do. This all hit a wall when households and firms came face to face with the degree of leverage they’d put onto their balance sheets, and of course opaque and even fraudulent loan terms, and an incomprehensibly rickety shadow banking system made matters far worse.
Getting back to today: Theoretically, there’s nothing wrong with the US economy that a little healthy labor market growth wouldn’t solve—in particular, by enticing more of those potentially productive workers who have dropped out of the labor force entirely back into the ranks of productive workers.
Maybe we shouldn’t be holding our breath on this one, however.
A couple of years ago Fed economists dreamed up a new data series composed of 19 different labor market indicators and named it the “Labor Market Conditions Index.” (I don’t blame them; our historic measures all have deep intrinsic flaws.) They were able to extrapolate it backwards to 1976 and the intrepid Justin Fox of Bloomberg View was courteous enough to publish the series back to the official end of the Great Recession in June 2009. Here it is:
This shows it down 5 months in a row, at an accelerating rate, its worst showing since the end of the last official recession. Worse, two of the LMCI’s more important leading components, labor force participation and temporary worker demand, are also down markedly in the last half year.
Yes, I did mention that Summers/Blanchard IMF paper. Without going into the log-extrapolated statistical details, here are the “main takeaways,” as the authors put it (see pg. 17 of the paper I cited above):
- Two thirds of recessions are followed by lower output vis-a-vis the pre-recession trend.
- Almost half are also followed by lower output growth vs. pre-recession.
- Recessions caused by shocks (supply shocks and financial crises) are even more likely to be followed by output shortfalls, implying that the shocks help explain the recession itself as well as subsequent lower output.
To complete the visuals for this tour of the latest sobering economic analysis, here’s the most visually compelling chart from the IMF paper. You don’t need to know precisely how each data series was calculated to get the gist.
From 1960 to today, recessions (vertical lines) cause subsequent real output (the solid blue line) to fall below pre-recession extrapolated straight line output (the dotted black lines). And this past Great Recession saw the greatest decrease in the slope of the post-recession output line of all. (The geeks in the audience will be happy to explain how that’s reflected in terms of the second derivative, but for the civilians the message, as we’ve written before, is that this was a really bad recession.)
Back to Law Land, shall we? So what does this mean for you? A few thoughts:
- In the long run, law firms cannot grow faster than our clients.
- You may have heard of a book published a few years ago on this topic titled Growth Is Dead: Now What? May I submit that we have positive confirmation of that hypothesis and that our attention has to turn now, if it hasn’t already, to the “Now What?” part of the title.
- I’ve argued before that we’re in a battle for market share. We’re in a battle for market share.
- You can speculate—I’ve heard the arguments and actually tend to concur—that in straitened times corporations will become more discriminating about whether they pursue litigation and the scale at which they wage litigation war if they do. We’ve already seen evidence of this in the declining share of litigation vs. transactional work across the Thomson Reuters PeerMonitor database of firms. It would be logical to believe this trend will stay constant or accelerate.
Finally: The market for “law firms” is a subset of the market for legal services. Not only are firms facing a battle for market share with other law firms, you’re now competing with non-law firms.
This all has implications for your long-term strategic planning, meaning, in the Cliffs’ Notes version, (a) what practice areas you focus on and (b) where you perform them (the geographic footprint of your offices).
Among today’s increasingly sophisticated, choosy, and discerning clients, the gravest mistake you can make is to have your firm be a full service, general practice, not-elite and not-economical, destination for nothing in particular. Be a destination for something. Stake a claim to a calling-card practice and stick to it. Does this mean making choices, and saying no to some things? Well, it’s called strategy for a reason.
If you doubt me, you might want to add a dose of business/financial/economic reporting to your daily media feed. Or invest in a business intelligence analyst.
You’re doing those things already, right?