Growth fears at the global frontier

Back in the heady days before the GFC, we got used to a world economy marked by strong annual growth rates plus a rising trend rate of growth.

A key driver of both developments was the growing share in world output of faster-growing emerging markets. Between 2003 and 2007, for example, world real GDP growth averaged an impressive 4.8 per cent when output is measured on a PPP basis (which gives a relatively greater weight to fast growing emerging markets), and a more-than-respectable 3.6 per cent when market exchange rates are used.

In contrast, according to the latest IMF World Economic Outlook, growth this year will perhaps be 3.3 per cent on a PPP basis and 2.6 per cent on a market exchange rate basis. The Fund judges that 'prospects are for sluggish and bumpy growth', with a significant risk that 'global activity could deteriorate very sharply.' More recently, the OECD's latest forecast update reckons that the global economy faces 'a hesitant and uneven recovery' over the next two years. Like the Fund, the OECD is warning of the threat of renewed recession.

Of course, this gloomy outlook for the world economy is largely a legacy of the GFC and the eurozone crisis that followed. And there are more than enough short-term risks, from the looming US fiscal cliff through to continuing eurozone fragility, to keep expectations subdued. Not surprisingly, the subdued growth performance of the developed world has helped drag down activity in emerging markets. 

But is there anything more going on?

Take a really simple model of world growth, where the pace of global activity is a combination of growth at the frontier in the world's advanced economies (driven mainly by productivity growth and innovation) and growth behind the frontier in the world's emerging markets and developing economies (driven mainly by a process of catch-up or convergence). Now think about what's happening in each of those groups.

At the frontier, some analysts are looking beyond the present troubles and worrying that structural or potential growth is now lower than it used to be. Economists like Tyler Cowen and Robert Gordon have highlighted trends in variables such as innovation and demographics to suggest that we should no longer expect the kind of growth at the (US) frontier as we've seen in the past. Other economists worry that the impact of the current crisis – higher public debt stocks, more unemployed workers, a large and perhaps still growing list of shelved investment projects – will all have trimmed potential growth rates in the affected economies.

The pessimists may turn out to be too gloomy in the long run; there's always a tendency to conflate current cyclical conditions with long term trends and there's almost certainly some of that going on now. Still, there's no denying that many advanced economies are likely to face some strong demographic, fiscal and socio-economic headwinds over the medium-term when it comes to raising their growth performance.

Even a slow (or stalled) frontier should in theory be consistent with robust global growth thanks to the process of convergence towards that frontier. After all, sizeable gaps in GDP per head between developed and developing economies indicate that there's plenty of scope for more catch-up growth.

Yet here too, the earlier optimism on sustained emerging market growth performance (part of what I have described in the past as our Consensus Future) has faded somewhat. In part, this is just a case of facts changing opinions; annual growth in India slowed to 5.3 per cent in the latest quarter, with analysts now expecting this year to deliver the weakest growth performance for a decade. Likewise, Brazil's economy is barely growing at all, and even the powerhouse that is China has seen growth dip markedly this year, although here at least there some signs of a turnaround.

As already noted, a significant share of this growth slowdown has been driven by spillovers from the economic mess in the developed world. But there is also a growing debate as to whether there are other, structural factors in play. Two in particular stand out.

First, there is the risk that some of the big emerging economies will find themselves stuck in the so-called middle income trap. There is growing agreement that China has now shifted down onto a lower growth path, leaving the days of double digit growth behind it. Since this slower growth is now operating on a much larger economy, the implications of this change could be modest. But what if the slowdown is not just the side effects of transition to a new growth model and a narrowing of the convergence gap, but rather an indication that the middle income trap is now biting? 

Moreover, China is now a major growth driver for a range of other emerging economies, so the answer to this question would have implications for its key trading partners too. And similar questions can be raised about some of the other emerging powers. For a pessimistic take on the future of growth in the BRICs, see this piece by Ruchir Sharma in Foreign Affairs.

Second, there is the possibility that changes at the frontier (and in the global economy more generally) have had big, adverse implications for the pace of catch-up growth. In other words, maybe the 2003-2007 period represented a short, golden age for convergence, and while the convergence process may well continue, from now on it will do so at a much reduced rate.

For now, I don't think we have anywhere near enough evidence to ditch the the Great Convergence story altogether, although I do think that the case for modifying that story to include a slowdown in the pace of catchup growth is becoming more compelling.

Originally published by The Lowy Institute publication The Interpreter. Reproduced with permission.