The global balance sheet is off-kilter. Central banks can't fix it.

With U.S. and global inflation lingering at above-average levels, interest rates continuing to rise in major markets, and financial turbulence surfacing, all eyes are on central banks. Their decisions matter. But improving productivity growth matters more, write Asutosh Padhi and Olivia White in Barron's.

These challenges are symptoms of a larger one: an unbalanced " global balance sheet." The global balance sheet takes stock of the assets and liabilities of all households, corporations, governments, and financial institutions. Before 2000, net worth in advanced economies grew at roughly the same rate as gross domestic product. Since then, net worth has ballooned, but economic growth has been tepid and inequality within countries rose. From 2000 to 2021, asset price inflation, chiefly from equities and real estate, created $160 trillion in paper wealth and every $1 in investment generated $1.90 in debt.

The pandemic tilted the global balance sheet even further out of kilter. As governments acted aggressively to support businesses and households, every $1 in investment generated $3.40 in debt. When inflation surged, household wealth plunged.

Rebalancing will be tricky. In terms of monetary and fiscal policy, failing to tighten enough would keep inflation high, potentially leading to 1970s-style "stagflation." But tighten too much and the economy and financial system suffer. This happened in Japan in the 1990s, when its real estate and equity bubble burst, triggering drawn-out deleveraging and a sharp contraction in asset prices. If a sharp rise in real interest rates, ensuing financial system stress, and rising perceptions of risk were to happen in the U.S., equities and real estate values would drop 30% or more by 2030 in our model.

But going back to the conditions that prevailed from 2000 on is not a great option, either. In the U.S. and many other countries, this era has been characterized by chronic underinvestment in the kinds of things that support labor productivity, such as infrastructure, plants, and equipment. That contributed to soft demand, rising inequality, and sluggish GDP growth.

The simple fact is that only faster productivity growth can combine strong growth in income, wealth, and balance-sheet health. But productivity growth has been sluggish. In the U.S., business sector labor productivity has grown an average of under 1.4% a year since 2005. Western Europe is in the same range (and some individual countries have done much worse); Japan has been faltering, too. The McKinsey Global Institute has estimated that U.S. GDP would be $10 trillion greater by 2030 if productivity returned to the postwar average of 2.2%.

The power of productivity is not news. What is new is that accelerating it may be the only way to restore the global balance sheet to health. In the U.S., $48 trillion of household wealth is at stake. To boost productivity, two priorities stand out.

First, more productive capital formation. Since 2000, a glut of savings has struggled to find investments offering sufficient economic returns. Fixed assets that can drive economic growth made up only about 20% of global wealth, while two-thirds is now stored in real estate. After the 2008 global financial crisis, the growth in capital stock per worker dropped to the lowest rate since the end of World War II. It has never fully recovered -- and that is a problem. Allocating more funding to areas such as clean tech and energy systems, infrastructure, and supply chains can help to both meet critical needs and accelerate growth.

Second, digital technologies must be adopted more widely -- and at speed. There is a strong correlation between sectoral productivity growth and level of digitization. Under the pressure of Covid-19, more companies and industries shifted aggressively to online channels and automated business and operating models. But not nearly enough. In the U.S., for example, high-potential, high-employment sectors like construction and health care have lagged in both digitization and productivity, with ripple effects throughout the economy. Importantly, companies should go beyond simply digitizing their processes, placing bets on complementary intangibles such as R&D, intellectual property, and the capabilities of their workforce.

A lopsided global balance sheet is not a vaguely interesting accounting fluke: It is a sign that capital is being misallocated to funding transactions and asset price rises rather than the investments needed to meet human needs, drive productivity, and build wealth.

In a turbulent geopolitical and economic landscape, and with new technologies like generative artificial intelligence sparking both interest and angst, policy makers may be tempted to hunker down and hope for a return to the simpler days of, say, 2019. That would be a mistake, setting economies up for decline while raising the risk of financial stress and future corrections.

Of course, if it was easy to boost productivity, everyone would have done it already. But remember, it has been done before, as recently as in the late 1990s in the U.S. and in many emerging economies since. We can do it again.

This article originally appeared in Barron's.

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