Intro: Economic distortions often only become visible after they have already caused some economic distress, but there are a number of things to look at to get a sense of whether growth is sustainable or at risk of coming to an abrupt end.
Negative Real Interest Rates: If policy rates are set below inflation this will tend to undermine the efficiency of investment and create speculative bubbles. Also, in a free market long-term government bond yields should generally be in line with nominal GDP growth, the reason being that if growth is faster there will be a tendency for investors to shift money into other areas to take advantage of growth opportunities, while if if growth is slower, investors will be incentives to buy bonds, putting downward pressure on yields. Therefore when bond yields are low relative to nominal GDP growth this may be a sign of excessively loose monetary policy, warning of capital misallocation and economic risks.
Excessive Government Spending: This can take many forms; high levels of government consumption, high levels of transfer payments, or excessive investment spending. Generally speaking, the lower redistributive transfer payments are, and the lower government consumption is beyond providing the essentials, the more positive this will be for economic growth. While there is no cut and dried level of government spending relative to GDP that suggests economic fragility, rapid increased beyond historical or peer group averages could be a signal that the government is controlling too large a share of a country’s resources and this will negatively impact economic growth.
Artificially Strong or Weak Currency: If a country’s currency is manipulated to be significantly stronger or weaker than the fundamentals would suggest, this can create economic distortions. Countries with currency pegs, currency blocks, or engaging in policies to weaken their currency with monetary policy are prime candidates for economic distortions. Typically, a currency which is manipulated to be artificially strong creates a more pressing immediate risk to growth as sudden weakness can wreak havoc on the profits of import-dependent sectors of the economy. In contrast, a currency which is artificially weak can remain in such a state for a long time, effecting only gradual headwind to growth.
Asset Market Bubbles: Excesses in asset prices such as property price to income levels and equity prices relative to sales and earnings are a sign that speculative investment may be taking place. While there are no magic numbers, asset prices significantly above long-term averages are a warning signal that an economy is at risk from an asset prices decline which could trigger a shock to the economy.
Excessive Construction Spending: Similarly, if construction spending as a share of GDP is very high it may reflect an unsustainable boom driven by loose monetary policy or government subsidies that can result in a subsequent bust. Typically, bubbly real estate prices tend to result in excessive construction spending.
Expenditure Imbalances: An extremely large or small share of one or more component of GDP by expenditure can be evidence of economic imbalances. China’s large share of investment reflects policies that suppress consumption; Germany’s extremely large share of net exports as a share of GDP reflects the undervalued nature of its currency; the UK’s extremely large share of private consumption reflects high levels of transfer payments and the impact of deeply negative real interest rates on savings decisions. While such imbalances can remain in place for a long time, they nonetheless often reflect policy-driven economic distortions that can undermine growth.
Debt: Debt levels can have a major impact on economic growth as high debt levels can make certain sectors of the economy susceptible to shocks, which can in turn trigger recessions.
Government Debt: High levels of government debt are negative for economic growth in two main ways:
Firstly, if a government has a large amount of debt, high interest rates will make debt servicing very difficult, eating into the government’s tax revenues. Therefore, central banks will be encouraged to keep real interest rates low in order to prevent this from occurring. Such ‘financial repression’ tends to undermine savings and the productivity of investment.
Secondly, attempts to reduce government debt will mean that tax rates must rise and/or government spending must fall. Even if this takes the form of the latter, which is economically less damaging, it may still act as a shock to the economy causing a painful rebalancing period and potentially recession. While there is no magic number, a 100% debt to GDP ratio or will likely mean that independent monetary policy is compromised and/or destabilising austerity measures are likely as the government seeks to pay down debt.
Consumer/Corporate Debt: High levels of corporate or consumer debt can make debt servicing difficult if real interest rates rise, potentially forcing businesses or consumers to default or sharply cut spending. This has the potential to create a sudden shift in corporate profitability, leading to a painful rebalancing period and potentially recession.
External Debt: High levels of external debt are the most economically damaging because if a country owes money to foreigners it will ultimately have to pay this money back, and in the meantime pay interest on it. As the money is paid back, this acts as a drag on the ability of the economy to grow as it must save more than it invests. A net international investment deficit in excess of 50% of GDP, or a double-digit current account deficit may signal that the economy is at risk of a shock as further external borrowing becomes difficult to obtain.
