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:
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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.
