We stand on the brink of a technological revolution that will fundamentally alter the way we live, work and relate to one another. The Fourth Industrial Revolution, a concept launched by Professor Klaus Schwab, became the overall theme of the World Economic Forum's Annual Meeting in Davos.
Digesting the intensive discussions in Davos and based on my experience as minister of finance, central banker and investment banker, I would like to try to come to some tentative conclusions as to the effect of the Fourth Industrial Revolution on economic policy.
One point is that the technological changes we are seeing in the spheres of digital, connectivity, robotics and big data will have a broad impact on the labour market. The Fourth Industrial Revolution will be disruptive. According to estimates from Oxford University’s Carl Benedikt Frey and Michael Osborne, 40-50% of all jobs will be transformed or disappear in advanced economies.
Some tend to regard such calculations with scepticism. Let me give a concrete example. Over the past five years, banks in the Nordic region have reduced their headcount by approximately 5% per year. If that trend holds for the next five years, the total staff reduction will accumulate to close to 40%. One should note that during the same period, the Nordic banks delivered among the best returns on equity (ROE) of all the European banks.
The implication of increased turnover on the labour market is that the demand for flexibility will increase. The countries that are best adapted to transfer labour resources from old contracting sectors to new and expanding ones will have an advantage in terms of lower unemployment rates and higher potential growth.
There are other trends in the labour market reinforcing the same tendencies. During the recovery in the United States and United Kingdom after the Great Recession, a large number of the jobs that were added are not traditional full-time jobs with full social benefits. Self-employment, short-term contracts, seasonal work and part-time employment dominate. The implication is that job security has been undermined.
Fewer jobs, less tax
For fiscal policy, the implications of the Fourth Industrial Revolution are likely to be complicated. If robotics and digitalization are disrupting jobs, there will be an impact on tax revenues. If more and more jobs can be replaced by computers and machines, the ability to tax labour income will be reduced in the long run. It is also likely that the social costs of taxes in terms of lost employment and lower GDP will increase. Taxes are likely to yield lower revenues and be more costly in terms of negative side effects for society.
The negative implications for tax revenues can potentially be reinforced by digitalization of retail sales and VAT. Almost one-third of Sweden’s Christmas shopping took place online this year. Young people below the age of 25 are already spending between a quarter and a third of their incomes on the internet. Sweden is a forerunner (the digital market in Sweden is bigger than in France in absolute terms, even if France is six times more populous), but others are gradually following suit.
From the medium-term perspective, there is also a risk that revenues from value-added tax will be affected. Goods are moving freely, and many online services are acquiring rights to use a digital product (consumption of sports, porn, gambling seems not to be hampered my the moral norms or tax jurisdictions of the digital age). The risk for tax migration in a globalized world is obvious in the long run. The standard economic theory of taxation states that the tax wedge on labour is the combination of income tax, social fees and value-added taxes.
If the Fourth Industrial Revolution has implications for labour as a production factor, it also has implications for VAT revenues.
Technology v education
The problem for fiscal policy is that there is also an upwards pressure on government expenditures. The most obvious way for policy-makers to meet technological disruptions is to increase investments in education and re-education. The digital age is being characterized by a race between technology and education, as Nobel laureate Robert Solow has noted.
Technological change also has implications for income distribution, and this reinforces the upwards pressure on government expenditures. Job disruption can undermine earnings of low-income groups. The digital age also creates winners in terms of new tech millionaires. The fact that professionals and experts can work well into their seventies implies that pension incomes will become more unequal.
One way of countering inequality is to increase spending on pedagogical childcare and early education. To provide healthcare and elderly care regardless of economic strength is also mitigating inequality. Again, the pressure is on to increase public spending.
All of this is problematic: an erosion of taxes and a need for higher expenditure is undermining the long-term sustainability of fiscal policy.
The most obvious remedy would be to reduce expenditure on social security. In Europe, early retirement, sickness benefits, unemployment benefits and labour-market programmes often account for between a quarter and a third of the public expenditures. In many European countries, large groups, particularly among young people, are not in employment, education or training. In Italy, 20% of the population between 15-24 years are socially excluded; in Spain the equivalent is 18%; in the UK, 15%
Streamlining social security
In the aftermath of the refugee crises in Europe, welfare traps are even more unsustainable. Between 2014 and 2020, Sweden, with a workforce of 5.5 million, is likely to receive around half a million refugees and migrants. Today, the combination of courses for language training, adult high school (komvux), maternity leave for children migrating with their parents, welfare assistants, housing benefits and labour-market programmes makes it possible for many to get stuck circulating between public programmes for more than a decade. The unemployed are asked to search for jobs in all occupations and across the whole country, while immigrants are often stuck in rural areas with a weak labour market, while criss-crossing between different welfare programmes.
Streamlining social security systems and increasing spending on education, childcare and training, not to mention reducing taxation on labour, is one of the policy implications from the Fourth Industrial Revolution.
The Fourth Industrial Revolution and central banks
Technological disruption also has implications for monetary policy. To uphold price stability means to ensure that the price of an average basket of consumption goods is gradually increasing, at least enough to compensate for an underlying trend of a higher quality of goods. Central banks tend to approximate this to an average increase of the consumer prices in the vicinity of of 1-4% per year (with a slightly higher rate of inflation for emerging markets).
Consumer prices will be affected by the digitalization of retail sales. In some areas – bookshops, travel agencies, music companies and news print – this has already happened. In a forerunner country such as Sweden, this is now happening to consumer electronics and other sectors. Delivery hero, Mathem, Stayfresh, Linas Matkasse and other online retailers are eating into the domain of traditional grocery outlets in Sweden and elsewhere.
Operational costs for online retailers are substantially lower than for traditional businesses, and increased competition from low-cost alternatives are undermining pricing power.
My conclusion is that inflation propensity most likely has been dramatically reduced, with implications for central banks. It will take a longer time for resource utilization to feed through to consumer prices. When low unemployment and wage increases are putting pressure on prices, consumers are likely to respond by accelerating the migration to online shopping.
One implication is that the feed-through from exchange-rate depreciations might be less than the historical pattern. The theoretical starting point is that a permanent depreciation should be fully absorbed by consumer prices. In a digital world, currency depreciation could imply that the profit-margin squeeze is accelerating. If we look at the limited impact of the recent dollar appreciation on inflation in some of the emerging markets, this could be at least one underlying factor.
The outlook for productivity
It’s possible that the Fourth Industrial Revolution will increase productivity. If the relationship between capital and labour is shifted so that we are using more capital per worker, then productivity should increase. This is counter-intuitive to the low productivity growth we have seen over the last few years. To some extent, however, low productivity growth could be due to low resource utilization. Normally there is a strong correlation between resource utilization and productivity (machines are more effective when they are used). Advanced economies have been in an exceptional period, with large negative output gaps. This is now changing, and making it seem more likely that technological development and low productivity can go hand in hand.
The most important conclusion for monetary policy is that interest rates could remain very low for very long. Backward-looking central banks and macro-economists are apt to overestimate the inflation risks. If central banks, again and again, see actual CPI coming out lower than forecasted, soul-searching will ensue.
Against this backdrop it might be that the Federal Reserve will not follow through with quarterly rate hikes during 2016. Again, from a Swedish experience, there is a risk of too low inflation. The Riksbank, on the back drop of high growth, a strong labour market and increasing asset prices, landed in the natural conclusion that it was time to gradually raise interest rates. The stubbornly low inflation and deflationary risks that we have seen in Sweden thereafter is, at least partly, due to the fact that inflation propensity has been overestimated.
Even if the Fed had good reasons to raise rates in December, they now have good reason to exercise caution and wait for some actual inflation before they move forward. It is better to change the communication than to commit a serious policy mistake.
The Fourth Industrial Revolution is coming, and we are only just beginning to understand the implications for economic policy. Finance ministers and central bank governors alike are on a steep learning curve.