Are Western economies running out of steam?

The West's economic recovery has come with two major caveats. Activity has picked up, but it is running below the levels that were the norm before the Great Recession. Meanwhile, in a sign of mounting pessimism about the growth potential of the Western world, economists are cutting their forecasts for long term growth.

Some economists think growth in the Western world actually started to slow at the turn of the century and that the financial crisis accelerated this process.

In the rich world we have become used to the idea of strong growth raising living standards from one year to another and from one generation to another. Slower growth in the long term would deal a heavy blow to the western idea of material progress.

It is indicative of the concern that one of America's leading economists, Larry Summers, has revived the term 'secular stagnation', coined during the Great Depression, to describe the current phenomenon. The International Monetary Fund believes that the rich economies will see subdued growth for at least another five years.

Although there are numerous differences of opinion, four factors are often cited as the cause of slowing growth in the West.

Demographics have undoubtedly become a growing headwind. Most advanced economies have ageing populations. The UK's working age population, as a percentage of the overall population, is now at its lowest since 1999, and is projected to keep falling. The IMF predicts that working-age population growth is likely to slow significantly in most advanced economies, and that Germany and Japan will start to see working-age populations fall by 2020. Labour force participation rates are also much lower than they were before the crisis in most European economies, and have fallen sharply in the US.

These trends imply a continued decline in the human capital western economies put to productive use and, therefore, slower growth.

Adverse demographics could, however, be offset by increasing productivity growth. Rising productivity makes workers more efficient and allows economies to produce more for the same amount of human input.

But for many developed nations, especially the UK and the US, weak productivity growth has slowed in the wake of the financial crisis. Output per worker in the UK is still 4% below its pre-crisis peak, and many other advanced nations have fared worse in this respect. The US Conference Board thinks that the UK and US will experience lower productivity growth in the years to 2030 than they did in the decade to the financial crisis.

Some economists see diminishing gains from innovation and technology as being a key factor behind 'secular stagnation'. Propounded by well-known American economist Robert Gordon, this theory suggests that technologies of today, such as the smartphone and the internet, are not as revolutionary as those of the past. Gordon argues that following a period of rapid technological growth in the post-war decades up to the 1980s, the pace of technological progress has slowed. He claims that electricity, the internal combustion engine and indoor plumbing all did far more to boost growth and living standards than anything since the dot.com boom. Personal consumables, such as tablets and smartphones, while great for consumers, are not so good for an economy's productive capacity or growth. US data seem to lend some weight to this theory, by showing that productivity growth has been slower in the four decades since the 1970s than in the century before.

Finally, many economists believe low levels of investment have hampered growth. Across advanced economies, investment-to-capital ratios remain below pre-crisis levels, and business investment has only recently started to bounce back in the UK and some other developed economies.

Depressed investment means lower productivity growth and lower potential output. Research by the IMF suggests that investment tends to remain subdued for long-periods after financial crises and that, for advanced economies, a "full reversal of the decline in investment-to-capital ratio is unlikely" in this decade.

Yet the 'secular stagnation' theorists have critics.

While most economists agree on the effects on demographic change, some wonder if slow but stable growth supporting an unprecedented level of prosperity would be an entirely bad thing. Given the slowing growth in working-age population, fewer new resources, such as houses, roads or cars, would be required to maintain standards of living. Slower output growth does not necessarily imply a worsening lifestyle. This is borne out by Japan's experience of rising per-capita GDP despite a prolonged slowdown in growth.

We think it is too early to say that technology has become less transformational. The last 300 years of technological change show that it takes a lot more than a decade or two to realise the full value from a general purpose technology such as the internet. We have only begun to realise the productive potential of the latest innovations in robotics and genomics. As for the current weakness in productivity, history shows that productivity has slowed in the past in periods before revolutionary new technologies had been fully applied. The period of electrification which started in the 1890s is one such episode.

On productivity and investment, some critics argue the current weakness is cyclical, not structural. They see the West in a sluggish recovery characteristic of those after financial crises and expect things to start improving as growth and demand pick up. Recent developments in the UK and US labour markets and a pick up in business investment offer some support to this argument.

The changing nature of developed economies also helps explains why investment may have slowed and why that may not be a bad thing. In the service-based economies of the West investment often entails buying new software or investing in employee skills or brands. Services tend to be less capital-intensive than setting up a new factory, building a national railway system or an electrical grid.

The official data may also overstate the problem. Current measures underestimate investment and, therefore, GDP and productivity. Businesses are increasingly investing in intangible, hard to measure assets such as brand, R&D, intellectual property and employee skills rather than in new factories and machines.

The scale of underestimation is significant, if we looked to financial markets. Recent estimates show that five-sixths of the S&P500's market capitalisation is now accounted for by intangible assets, up from just one-sixth forty years ago. In the UK, GDP and business investment both saw significant upgrades after the introduction of a new measurement technique that incorporates spending on several intangible assets.

Inadequate measurements also make it difficult to assess improvements in lifestyle brought about by new technology. Gains from free email and web searching are hard to calculate using traditional measures which rely on the prices of services. Indeed, much of the consumer surplus from the internet remains unmeasured.

The debate on stagnation shines harsh light on the inadequacy of many of the ways in which we measure the economy.

Yet ultimately this debate raises a simple question: are Western economies losing their wealth creating capacity? The answer will be provided by what happens to the incomes of the mass of households over the coming years.