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The world economy

A lump of growth?

Jan 12th 2012, 21:20 by R.A. | WASHINGTON

BACK in June, the Bank for International Settlements (which journalists are required to call the central bank for central banks) suggested that, globally, monetary policy would need to tighten in order to slow growth and rein in inflation. At the time, this struck me as foolishness. It still does. But I've been thinking. And I wonder: what is global growth potential?

Let's back up. Think for a moment about an economy like America's. Much of the time it operates near potential, which is to say that it's producing as much output as it can given current technologies and available inputs. In any given year, it can grow by obtaining new labour or capital inputs, and over the long term the rate of growth will be governed by the pace of innovation and productivity growth. If the American economy is running at close to potential, then efforts to try and make it grow faster will just produce inflation. If the Fed throws more money at the economy, then people will go out and spend it, which will bid up prices. Firms would like to increase production in the face of higher prices, but they're already running flat out, and so you get no new output, just higher prices.

The economy will occasionally fall into recession, however, which is a sustained contraction in output. This can occur because of a fall in demand (thanks, perhaps, to a round of deleveraging). But it can also occur because of supply-side factors. An asteroid might blow up a bunch of factories, leaving the country less able to produce than before. Or if the economy's production relies on a certain, inflexible ratio of oil to output and the supply of oil suddenly drops, then output must also fall until oil supply recovers or firms and households adjust such that the ratio of oil to output changes.

Now, what if we extend this model to the world as a whole? Our intuition tells us that the world is operating well below potential, because billions of people are much poorer than residents of the developed world. We observe that when residents of very poor countries move from those countries to America their incomes increase substantially. And we conclude, correctly in my view, that if those countries were able to duplicate America's institutions and adopt America's existing technology, then they'd be able to grow very rapidly and converge on advanced-country income levels. As evidence for this proposition, we can cite the record of the last 60 years, in which many poor countries have sequentially passed through a "catch-up" growth phase. 

The world has lots of underemployed labour, much of it highly skilled. It has lots of underemployed capital. And the knowledge that underlies the world's high technology is generally speaking non-rivalrous; once an idea is born, anyone can exploit it. It's tempting to conclude, then, that global growth is limited only by the pace of improvement in emerging market institutions. Once the entire world is at the production possibility frontier, the pace of technological innovation will again set the speed limit. Until then, extremely rapid global growth is possible. Or should be.

But consider this graph:

The black line is the average world growth rate over the preceding decade. So in the ten years to 2011, global growth averaged about 3.8%. The blue and red lines are the average contributions to global growth over those ten year periods by advanced and emerging economies, respectively. The data are from the IMF; I realise PPP calculations are questionable and that the figures aren't perfect. The constitution of the groups is held constant; advanced countries are America and Canada, Australia and New Zealand, Western Europe, Japan, and the Asian Tigers. The emerging world is everyone else. As of last year, output was just about equal in the two groups. In 1992, advanced-economy output was twice that of the emerging world.

Global growth ticks down in the 1990s and rises again in the 2000s, but there's a general, if muted upward trend across the 30-year period as a whole; growth isn't quite flat. The distribution of growth changes quite a bit, however. In the 1980s, advanced economies were responsible for most global growth. The gap narrowed in the 1990s, and in the 10 years from 1994 through 2003, the emerging and advanced world contributed roughly equally to global growth. The last individual year in which the advanced world contributed more to global growth than the emerging world was 2000; in every year since, the emerging world has accounted for more. 

On the one hand, the chart seems to indicate that since the early 1990s growth in emerging markets has led to an acceleration in the pace of global growth, from about 3% per year to above 3.5%. But the emerging market's share of global growth has increased by more than that. In other words, the chart creates the appearance that since the early 1990s, and especially since 2000, some emerging market growth has come at the expense of advanced economies.

At this point, some readers (and perhaps a lot of you) may shout that this is what non-economists have been complaining about for years: cheap foreign workers stealing American jobs and leaving the emerging world's industrial core to rot. I want to make it clear that just because the chart seems to suggest this dynamic doesn't mean that's actually what's going on.

Let's discuss what's taking place as emerging markets grow rapidly. As they catch up, they're matching underused labour and capital with a technology we might shorthand the Modern Economy Machine. Now, the Modern Economy Machine can be implemented flexibly up to a certain extent. You can vary inputs and outputs and run it at vastly different efficiencies. It does require some set of raw material inputs, however, including all the substances humans use to produce energy to power the world's economic machine. Energy intensities vary a lot across countries, but generally speaking the half of the world that uses an above average amount of fossil fuel per person is primarily occupied by rich countries and the half that uses a below average amount is exclusively made up of emerging economies.

One might then argue that there is a limit on global growth determined by the supply of and demand for critical resources. As the use of the Modern Economy Machine spreads around the world, demand for critical resources rises. If MEM operation involves a fairly inelastic demand for something like oil and oil supplies are constrained in the short-run, then there may be a fairly rigid limit on the growth in global economic potential. The battle over the limited amount of growth that may occur in a given year may then turn a little nasty. Global growth can rise as MEM efficiency slowly improves and oil supplies and substitutes are slowly developed. In the meantime, emerging markets can only grow rapidly if advanced countries grow more slowly, and vice versa. Price movements might mechanically force down advanced-country growth as emerging markets grow faster. Or I suppose that rich country central banks might preemptively react to expected price growth, creating the room for emerging markets to grow more rapidly.

I'm not at all sure that this is actually occurring. I'm not saying that oil is the bottleneck, rather than some other resource or resources generally. And I'm not at all suggesting that against such a longer-term backdrop we wouldn't see important cyclical moves in economies, which might well require aggressive countercyclical policies. Indeed, I very much think that America and Europe are both in situations like that.

Just taking in the past generation of growth, however, it does sort of seem as though the world can only digest a certain amount of growth each year, and over the past decade part of the rich-world's problem may have been that it was "crowded out" of that available growth. I suppose we'll have a better sense of the dynamic when and if the rich world returns to something like "trend" growth.

Readers' comments

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moon79

Is the author trying to suggest that the growth in the emerging market is an outcome of slowed growth in the developing nations when he says " emerging markets can only grow rapidly if advanced countries grow more slowly, and vice versa". Is he trying to take away the credit from these emerging markets who have worked on their shortcomings to gain pace in their economy. I do not think that this assumption is valid when you look around some countries who only rely upon knowledge industry and therefore their input is only education and good schooling systems and their output is producing the world class enterpreneurs or IT experts. I disagree that oil is the bottle neck, it might be temporarily. I think that emerging markets have realized that if they lay emphasis on education then that could be a permanent solution to their economic problems. With increasing education come intellectual labor which can either work domestically or work abroad thereby pouring money into their nation. This is one of the secret to the rising economy in the third world countries. I really believe that the Advanced nations should not rest on their oars and invest more money on education than weapons and sincerely create nations where the backbone of economy is intellectual property and not non renewable resources.

Lester Burnham

Excellent to see the questions that we had needed to solve since decades ago. The answer can be right or wrong, but what is important in this post is to post some questions like, which should be the world's growth potential, and related to that actual and potential growth, which should be the amount of money that keeps prices stable? And from then, a lot more of extremely interesting questions: ¿money? What is the amount of money in the whole world? Does it change with exchange rates? ¿Product? What is the world product, the PPP or the current one? If the last, then it changes with the prices and the exchange rates. And then, we are in face of the really interisting questions we have to solve.

Lester Burnham

Excellent to see the questions that we had needed to solve since decades ago. The answer can be right or wrong, but what is important in this post is to post some questions like, which should be the world's growth potential, and related to that actual and potential growth, which should be the amount of money that keeps prices stable? And from then, a lot more of extremely interesting questions: ¿money? What is the amount of money in the whole world? Does it change with exchange rates? ¿Product? What is the world product, the PPP or the current one? If the last, then it changes with the prices and the exchange rates. And so on...

Greg P5n

Ryan,

you've just about convinced me of Tyler Cowen's 'Stagnation' hypothesis. We need to back up a bit further than the 1980s, though: back to the 1880s, give or take a decade or two.

On the long view of things, the story of the twentieth century is the story of the exploitation of five great innovations: the steam turbine, the internal combustion engine, the electric motor, the telegraph, and most importantly the Haber-Bosch process for producing fertilizer.

Without the Haber-Bosch process, Vaclav Smil tells us, there would only be half as many people in the world, so growth potential would be half. And indeed population growth is slowing.

The electricity-producing steam turbine and the electricity-using electric motor utterly transformed the nature of work, just as the internal combustion engine and the telegraph dramatically increased the speed and scope of transport and communication.

The 20th century was the period in which the World Economy Machine adapted to these five inventions. If you start your growth chart further back, you'll see that growth has been on a secular down-trend since WWII - and the down-trend would have started earlier, but for that great stimulus. This is because the big five innovations were applied first where they had the greatest benefit, in accordance with the law of diminishing marginal returns.

Apart from catch-up in the emerging economies, that adaptation is pretty much complete:

Population growth has run its course - proposals to multiply the world's population by six, as we did in the twentieth century, would bring predictions of catastrophe rather than prosperity.

We can still think of clever new ways of using electric motors, but they are all for very tiny niche applications - we would need hundreds of thousands of such clever ideas to equal the economic impact of the washing machine or the automatic lathe. And the returns to another quadrupling of transport and communication speeds are not thought worth the effort.

Looking to the future, there are areas where innovation to date seems limited, but they are only minor parts of the economy: education, financial services, perhaps healthcare. Because no new invention can utterly pervade the economy in the way that the big five have done, growth is much harder to come by. Growth is falling prey to the law of diminishing returns, in this case returns to innovation.

HighestandBest

In addition to the resource issues, their are structural and sectoral issues.

The way to think of it is, I believe, not that Chinese workers are taking our jobs, they're taking our robots jobs. Essentially the last twenty years can be modeled on two factors, a positive unskilled labor supply shock and a safe asset demand shock. As Noah Smith explains, endogenous growth theory predicts that such a labor shock would crowd out technological innovation:

"I've been critical in the past of Mike Mandel's thesis. After all, productivity gains from outsourcing are real. Suppose I am a guy who designs and builds widgets. Hiring cheap Chinese workers to make my widgets more cheaply boosts my productivity almost the same, in the short term, as inventing a robot to make my widgets more cheaply (minus the small amount I pay the Chinese workers).

BUT...productivity is not the same thing as technology. This is a fact that often gets ignored, since economists tend to treat the two as being equivalent. But they are not. In particular, trade can boost productivity without any new technology being invented. This is what Mandel claims has been responsible for the large productivity gains in the U.S. over the past 10 years. I tend to believe him.

So why should we care whether our productivity comes from robots (technology) or from cheap Chinese labor (trade)? One answer - and I feel like this is what Cowen and Mandel may have been getting at - is that one may crowd out the other. And this brings me to the theory of endogenous growth."

http://noahpinionblog.blogspot.com/2011/08/are-we-replacing-robots-with-...

On the other side is the increasing wealth by countries that lack a strong financial sector. This creates what I've called a 'Reserve Currency Dutch Disease,' and what Bred Setser referred to as our comparative advantage in creating debt. The reverse flow of capital does seem to share many traits with a resource boom cording out tradables and driving up home good production costs and real estate. Here's David Beckworth on the global shortage of safe assets:

http://macromarketmusings.blogspot.com/2011/12/why-global-shortage-of-sa...

Pacer

It may be a simple view, but for one thing we do know that capital assets (i.e. factories) have been dismantled in the developed world and reconstructed in developing countries. Additionally, the installation of new productive manufacturing capacity has occurred disproportionately in those same developing countries. As capacity to produce goes, so must production, right?

So further down the leger we have services. The developed world has probably kept up in growing its service sectors, but it's arguable that the content of such services are more consumption than investment--in particular health care and finance. Education has also grown dramatically in aggregate and as a share of GDP; whether or not there is a corresponding increase in future earnings for the host countries is debateable I think--especially when so many of the best and brightest are foreign students who return home after gaining knowledge in the West.

Meanwhile, natural resource depletion/spoliation continues everywhere that mankind can reasonably access. Absent a technological revolution in efficiency, the rapid development of less-finite substitute inputs, or an unexpected severe population crash, we continue to march toward the theoretical (but real) earthly limits to human economic growth.

That billions have been lifted from poverty is wonderful for those concerned. But let's not forget that diffusion is another word for entropy. Whether work is done for $5 or $40 an hour may not impact economic activity but it does matter to the type of technological leaps forward that require a concentration of spare investable resources (e.g. sending satellites into orbit, advancing biological or physical science, or geoengineering to manage climate change). By definition, the hand-to-mouth classes just worry about their next meal; it's all they have time for.

chernyshevsky

Labor and capital are not the only factors that lead to output. What you also need is entrepreneurial spirit. That's the critical "resource" that limits economic growth. In the West, Europe especially, supply of entrepreneurial spirit has been steadily falling. It was able to import it from abroad however: enterprising people fleeing political oppression or poverty. Starting from 1990, this inflow has slowed. At some point, it might even have reversed completely. Many entrepreneurs in the West now look for opportunities in the emerging world instead. The result is stagnation. Economic opportunities exist but are not acted upon. In contrast, advanced economies like Singapore or Hong Kong, where entrepreneurial spirit is high, still manage high level of growth.

guest-iilania

"In other words, the chart creates the appearance that since the early 1990s, and especially since 2000, some emerging market growth has come at the expense of advanced economies."
I think it is only an appearance. In the 90s we had a very strong growth in advanced economies because of the internet and IT. After 2000 there were a lot of problems but not because of price of resources. And then happened the great recession.
In emerging economies growth was very strong thanks to China. India also experienced rapid growth since 90s, and in this millenium Africa is also catching up.
So of course resources could (will) cause troubles in the future but I don't think it is the case now.

Doug Pascover

Great post. Two thoughts: One, I think it is stupid that journalists are required to call BIS the central bank for central banks since it doesn't make much if any policy. The second is that we have to remember that we are measuring by prices. A million houses is a million houses but what that, or personal concierges, are worth can vary. I think that's a key point to consider when you think about the business cycle.

hedgefundguy

I'm surprise that there is no dent in the Emerging Economies GDP around 1998.

A chart of Advanced Economies Total Indebtedness/GPD percentage would be an interesting addition.

The growth of Emerging Economies might be due to them recycling their profits made in the Advanced Economies back into the Advanced Economies - in the form of loans.

This keeps sales going and their currency cheap.

Regards

shaun39

Energy constraints on growth indeed.

Time for a nuclear renaissance in the west - just look at the low cost of energy (and low carbon emissions) in France, and the suffering caused as expensive fossil fuels and renewables make up most new generating capacity.

Save oil and gas (LPG) for vehicles - nuclear can provide far cleaner power and heating for homes, while reducing urban particulate emissions and raising life expectancy in the developed world by about 1.5 months by WHO figures (a further 3.2 months if we can eventually power urban vehicles with nuclear electricity).

The economic, health and environmental benefits are all overwhelming - and the long tail risk of an "accident" is lower now than ever (and there have been no serious incidents yet after 60 years of crazy governments in developed countries).

Forget the scaremongering and look at the evidence. Cheap and clean non-rival energy is needed for the next generation of westerners to live as well as their parents. Don't deprive us of this.

Konker

Most of the developing country growth is from China and a bit from India. Latin America and Africa haven't contributed a great deal and though the rest of East Asia has grown quite rapidly it doesn't match China for size or pace.

Is R.A. suggesting that rapid growth in China has caused slow growth in America and Europe because of global physical resource constraints? Sounds a bit weird. What's the mechanism?...the price of these resources is higher than it otherwise would be? But resource usage of oil, rare earths and the like is more connected with the size of the economy, not the growth rate. If China is slowing down the developed world by causing resource blockages it will be far worse in future when China is much larger.

Also "some readers (and perhaps a lot of you) may shout that this is what non-economists have been complaining about for years: cheap foreign workers stealing American jobs and leaving the emerging world's industrial core to rot"...Stiglitz has been saying this for years. He's an economist. It works using the principle of division of labor with some Ricardian economics that says developing countries should do lower value labour intensive work etc etc. Why is this something non-economists only say?

fundamentalist

The graph begins in the year that the USSR died. Since then, emerging market countries have abandoned socialism for free markets while developed countries have become increasingly socialist.

Kim77 in reply to fundamentalist

I would suggest it's the other way around; the 20-year period since the collapse of the USSR has been the most capitalism-friendly period in the history of the West since socialism was made fashionable in the 30s.

fundamentalist in reply to Kim77

Based on deregulation since Reagan/Thatcher? I think that was overblown. Currently the US fallen in the rankings of economic freedom to below socialist Denmark. Denmark didn't become more capitalist, it just reshuffled its socialism away from corporate taxes to individual taxes. The Federal Register of new regulations in the US was running at an average of 70,000 pages annually until the healthcare and financial regulation bills; now it will probably double that.

I haven't seen any net move toward freer markets in the US. Socialists scream like teenage girls at a horror movie over every tiny move toward less regulation, but are totally silent about the tens of thousands of new regulations that appear every year.

I read recently that the banking industry receives on average five new regulation every day.

chernyshevsky in reply to fundamentalist

I think "socialist" is the wrong description here. It's more apt to say that the advanced economies have become more Keynesian in the last two decades. The focus has almost exclusively on propping up aggregate demand, while supply side issues are neglected. In some way this is worse than socialism. At least central planners in communist countries don't believe that demand will magically create its own supply.

Jintelo

Of course at that time america was about as rich as indonesia, and north western europe between india and pakistan, if looked at from GDP per captia, from todays standerds these were really developing countries

Jintelo

Actualy if Anything America was the world leader in technology and production and contenentle western Europe the economic follower,

Dhruv

My Contentions with the post are the following:

i)I would not include the Asian Tigers in the advanced economies growth; especially over the period prior and following the Asian Crisis 97. This more importantly brings into fore the evolving composition of emerging economies.

ii) If their is a resource constraint then it is naive to model on a perfectly competitive market for resources like oil.

iii) The dichotomy is to simple, many parts of an economy, for instance the production of knowledge based services, are not resource extensive. Which with the correct mixture of labour and capital can be easily mimicked.

iv) I would also look at the bigger picture, and observe how growth evolved in the classical gold standard period 1880-1914, between the then advanced [western europe] and emerging economies [western offshoots, including the US].

jouris

I think it was a good choice to call this the "lump of growth." It makes the parallel to the "lump of labor" concept very clear. And I suspect that it is equally (in)valid.

Just for openers, one of the constraints on growth, as you note, is innovation. And you get more significant innovation as more and more people are lifted closer to developed world levels of education. That allows you to shift the long-term trend line higher. For a while, developing countries will become more productive ("grow") by using innovations made earlier when developed countries were in similar circumstances. But for the long term, there is only so much "catch-up" you can do; then you start to help with the leading-edge innovation.

Saiaj

A little curious if the Asian Tigers distort the advanced country statistics a tad. Not really sure what they're growth rate has been the past 20 years but if the 90's were the back end of their catch-up growth and have subsequently shifted into standard, fully developed country growth mode they could artificially be pulling down the growth rate measurement for the advanced countries, when in reality they shouldn't have always been included in that category.

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