Key Trends in the World Economy

Europe's largest economic failure is not in Greece - but in the UK, Italy and Spain

With the European Union (EU) heading into a double dip recession, even before the peak level of GDP of the previous business cycle has been regained (Figure 1), it is evident that the solutions adopted to deal with Europe's economic crisis have failed. But the focus of financial markets on Greece's debt crisis should not obscure the fact that the largest scale economic failures in Europe, with the most direct impact on world growth, are not in Greece, the GDP of which accounts for only 1.8 per cent of the EU’s, but in the UK, Italy and Spain. The latter economies collectively account for over one third, 34.7 per cent, of EU GDP. Furthermore these large EU economies, having failed by significant margins to regain their previous peak levels of GDP, are again turning down.

To give some idea of the relative scale of these problems it may be noted that the combined GDP of the UK, Italy and Spain is equivalent to 40.9 per cent of US GDP, whereas Greece’s GDP is equivalent to a mere 2.0 per cent of US GDP. Even the combined GDP of the three economies under EU bailout measures (Portugal, Ireland and Greece) is only 5.1 per cent of US GDP. In short, while they pose significant problems for financial markets the recessions in the peripheral Eurozone economies are simply to small to make a direct significant difference to global growth prospects.

In contrast the failures in the UK, Italy and Spain - respectively Europe’s 3rd, 4th and 5th largest economies - are on quite large enough scale to create a serious negative impact on global growth – economies approaching half the size of the US are, at best, essentially stagnant and now facing new downturns.

The aim of this article, therefore, is to place the financial difficulties in Greece against the background of these larger growth failures in Europe.

Overall trends in the EU

The overall trends in the EU’s GDP are compared to the US and Japan in Figure 1. They are shown in detail in Table 1 below.

GDP data for the EU for the 4th quarter of 2011 is not yet available – on the basis of partial statistics it is highly likely to show downturn. But on the most up to date data available, for the 3rd quarter of 2011, EU GDP was still 1.7 per cent below its peak in the previous business cycle and Eurozone GDP 1.9 per cent below, In contrast by the 4th quarter of 2011 US GDP was 0.7 per cent above its last business cycle peak. With EU GDP likely to have turned down in the 4th quarter of 2011, Europe is suffering a strictly defined ‘double dip’ recession - i.e. a fall in output before the previous peak level of GDP has been regained .

Figure 1

 

Considering the detailed data for the EU economies, plus those in Eastern Europe, in Table 1 below, the overwhelming majority of European economies have not regained the peak levels of GDP recorded in the previous business cycle. All three economies which have published official Eurostat data for the 4th quarter of 2012 (Spain, Lithuania and the UK) showed a renewed fall in output - a more detailed analysis of the groupings within the European economies is given below.

Failure of recovery in the UK, Italy and Spain

The focus of attention in the European crisis has been on small peripheral Eurozone economies – Portugal, Ireland and Greece – or on a 'Germany v the periphery' divide. But from the point of view of EU GDP by far the most serious situation is the failure of recovery in three large EU economies – the UK, Italy and Spain. These are respectively the 3rd, 4th and 5th largest EU economies. The GDP trends in the five largest EU economies are shown in Figure 2.

Figure 2

 

By themselves the peripheral Eurozone economies are far too small to pull the Eurozone economy into recession - for comparison the combined economies of Portugal, Ireland and Greece are only one eighth of the size of combined economies of the UK, Italy and Spain. The key problem in European output is that while Germany’s economy has recovered - up to the 3rd quarter of 2011 its GDP performance since the peak of the last business cycle was marginally better than the US, and France’s recovery was significant, reaching only 0.6 per cent below the pre-financial crisis peak, the EU’s other large economies had not recovered and were heading into a new downturn. On the latest available data the UK’s GDP was still 3.8 per cent below its peak in the previous business cycle, Spain’s GDP was 3.9 per cent below and Italy’s was 4.7 per cent below. Furthermore in all three economies the latest available data shows a further downturn in GDP.

Failure in the European bail-out economies

In addition to the failure of recovery in the EU as a whole, primarily due to this situation in the UK, Italy and Spain, a further striking feature is that none of the economies subject to special EU bail out programmes – Portugal, Ireland, Greece – shows any sign of recovery (Figure 3). The latest data for both Ireland and Portugal shows renewed economic downturn, while no Eurostat certified Greek GDP data has been published since the 1st quarter of 2011 – it would be highly likely to show further economic decline. This failure of recovery is despite the fact that Ireland, for example, has undergone almost four years of economic downturn and Portugal is well into the third year of downturn.

The EU bailout programmes may therefore be correctly characterised as having failed.

Figure 3

 

Widespread downturn in Eastern Europe

An equallly severe, although less reported, decline in European production than in the bail-out countries has taken place in the Baltic republics – Estonia, Latvia and Lithuania (Figure 4). The downturn in Latvia (16.6 per cent) is the worst for any European country while those in Estonia (8.6 per cent) and Lithuania (9.0 per cent) are only slightly better than Greece (9.9 per cent) and Ireland (11.6 per cent)

This crisis in the Baltic Republics, incidentally, as with the different case of the UK, shows that the European crisis spreads to far more than Eurozone – only Estonia of the Baltic republics is a Eurozone member.

Figure 4

 

In addition to the Baltic Republics economic downturn has continued in most of Eastern Europe (Figure 5) – with only Poland and Slovakia having recovered to pre-crisis levels of output (Figure 6).

Figure 5

 

Recovery economies

The trends above leave only two large European economies, Germany and France, together with a number of medium sized ones (Netherlands, Switzerland, Belgium, and Poland) having undergone serious economic recovery (Figure 6). However, although Germany and France are the 1st and 2nd largest economies in the EU their combined GDP, at 36.2 per cent of the EU total, is only slightly greater than the 34.7 per cent of the UK, Italy and Spain combined.

In short the stagnant and declining situation in the UK, Italy and Spain is enough to essentiallly entirely offset recovery in Germany and France.

Figure 6

 

Large stagnant economies

Finally the position of the UK, Italy and Spain as large economies which have failed to significantly recover, together with smaller economies in the same situation, is clear in Figure 7.

Figure 7

 

Conclusions

A number of clear conclusions follow from these factual trends in Europe.

• Financial crisis may be focussed at present in Greece, but the most serious drags in output are not the peripheral Eurozone economies but the UK, Italy and Spain.
• Remaining outside the Eurozone is unlikely by itself to be sufficient to ensure economic recovery. Economic downturn in the UK, which is outside the Eurozone and has undergone substantial devaluation during the international financial crisis, is as severe as in the other large sluggish economies of Italy and Spain within the Eurozone. The non-Eurozone Baltic Republics of Latvia and Lithuania have undergone as serious declines in GDP as Eurozone member Estonia. Poland, which is outside the Eurozone, has largely escaped recession but due to large scale public investment. 
• Given these trends, overcoming the financial crisis in Greece is unlikely to relaunch economic growth as the largest problems in Europe's economic recovery are located in the UK, Italy and Spain. Of these UK is not even a number of the Eurozone, while the lack of growth in Italy's economy has been prolonged - annual average GDP growth in Italy in the last decade has been only 0.2 per cent.

The overall conclusion is clear. The Eurozone crisis was predictable - the present author noted 15 years ago in 'Fundamental Economic Implications of a Single European Currency' that: '‘The process that would unfold with the creation of a single currency by this method [the Treaty of Maastricht] may be predicted with certainty. Substantial parts of the EU… will be pushed into severe recession if they join. There will be sharply deepening regional imbalances and inequalities. The malignant expressions of economic depression — unemployment, poverty, collapse of the welfare system, weakening of trade unions, racism, chauvinism, crime — will multiply. The end will be either an economic tragedy, or the deepest crisis in the history of the EU, or more probably both.’

This analysis has clearly been vindicated. But it would, nevertheless, as seen above, be wrong to conclude that the exclusive core of the problems in Europe's economy is the Euro - or to see the situation exclusively in terms of a 'Germany and periphery' situation.

The greatest drag on economic growth in Europe is its 'stagnant middle' of the UK, Italy and Spain. These three economies together are equivalent in size to Germany and France. If Germany and France are supposed to provide the 'growth engine' of Europe these three economies may be conceived of as currently providing its 'drag factor'.

Unless the situation within the UK, Italy and Spain can  be resolved it is most unlikely that overcoming the economic problems in Greece will relaunch substantial European growth. For this reason, whatever occurs in Greece, the European crisis is going to be prolonged and other parts of the world economy must both take this into account and understand the more powerful factors in European economic stagnation.

Table 1

The incredible shrinking UK economy

The magnitude of the blow suffered by the UK economy since the beginning of the financial crisis is very considerably minimized by not presenting it in terms of a common international yardstick. Gauged by decline in GDP, using a common international purchasing measure, dollars, no other economy in the world has shrunk even remotely as much as the UK (Figure 1 and Table 1).

As most countries produce only annualized GDP data it will be necessary to wait before a comprehensive global comparison can be made for 2011. However it is clear no substantial growth in dollar terms took place in the UK economy during that year – GDP at national current prices rose only 1.4 per cent between the 1^st and 3^rd quarters and the change in the pound’s exchange rate against the dollar during the year was a marginal 0.3 per cent. Therefore there will have been no significant recovery from the UK data set out in Table 1 below, and the gap between the UK and other European economies, which form the next worst performing major group, is too great to have been qualitatively affected by changes in the Euro’s exchange rate – the Euro declined against the pound by only 3.3 per cent in 2011.

Table 1 shows that the fall in UK GDP in 2007-2010 was $562 billion compared to the next worst performing national economy, Italy, with a decline of $65 billion – i.e. the decline in UK GDP in the common measuring yardstick of dollars was more than eight times that of the next worst performing national economy. Table 1 shows the 10 national economies suffering the greatest declines in dollar GDP.

It is also extremely striking that the UK’s decline was more than two and a half times that of the entire Eurozone. The UK accounted for a somewhat astonishing 77 per cent of the EU's decline.

Table 1

Figure 1

 

Expressed in percentage terms the situation is no better. of all economies for which World Bank data is available only Iceland, with a decline in dollar GDP of 38.4 per cent, suffered a worst percentage fall than the UK - even bail out economy Ireland, with a fall of 18.4 per cent, outperformed the UK economy.

Two trends intersected for the UK's performance to be so much worse than that of any other economy. First, contrary to the government's anti-European rhetoric, UK economic performance in constant price national currency terms has been significantly worse than the Eurozone during the financial crisis (Figure 2). Up to the latest available data, for the 3rd quarter of 2011, UK GDP was still 3.6 per cent below its pre-financial crisis peak compared to the Eurozone's 1.7 per cent below. Second, between the beginning of 2008 and the beginning of 2012, the pound's exchange rate has fallen by 21.0 per cent against the dollar compared to the Euro's 11.4 per cent drop in the same period. The multiplicative effect of the severity of the relative drop in constant price GDP and the fall in the pound's exchange rate accounts for the unequalled decline in UK GDP in dollars.

Figure 2

 

As at present the UK economy shows no substantial sign of recovery, the present UK government, which maintains a steadfastly ostrich like attitude towards Europe in particular, and most other countries in general, may argue that a measure in terms of dollars at current exchange rates is irrelevant – the UK currency is the pound and what counts is constant price shifts. Such an argument is false and an attempt to disguise the true scale of the decline of the UK economy.

The internationally unmatched decline in UK dollar GDP is a huge fall in real international purchasing ability. The far higher than targeted inflation in the UK during the last two years, which has substantially eroded the population's living standards, is itself in part a reflecton of the decline in the UK's exchange rate and consequent raising of import prices. In short, the decline in the international purchasing power of the UK's economy translates into a direct fall in real incomes. The decline in the UKs ranking among world economies in terms of GDP, being recently overtaken by Brazil, statistically reflects the same process  .

It may also be seen that the government's claim that the UK is outperforming Europe and the Eurozone is entirely without foundation even in constant price national currency terms. But when measured in terms of real international comparisons, i.e. in dollars, the UK's performance is incomparably worse than Europe's.

It appears extremely unlikely that the UK's economy will escape from this circle of decline in the next period. The austerity policies pursued by the present UK government have substantially slowed the economic recovery that was taking place in 2009 and the first part of 2010 - between the 3rd quarter of 2010 and the 3rd quarter of 2011 the UK economy grew by only 0.5 per cent. The opposition Labour Party has recently also endorsed essentially the same austerity policies which have failed not only in the UK but in other European economies, such as Greece and Ireland, where they have been pursued.

Even if any partial recovery takes place, for example by some increase in the exchange rate of the pound against the Euro, the sheer magnitude of the decline in the UK economy makes it implausible that this could be on a scale sufficient to reverse the fall in its relative international position.

 

International economic consequences of the Greek debt bailout

The Greek debt crisis is both a significant economic event and a foreign policy success for Germany. It has, for the present, shifted the economic balance of power in Europe, and to some extent more widely, in Germany’s favour and against those in the US and Britain who do not favour the Euro and prefer a weak European Union (EU). These aspects are interlinked and both worth analysing.

Economics of the Greek bailout

At the economic level the media has widely and correctly reported that the new Greek bailout agreement was a step in the direction of European economic integration. It was also a move towards dealing with some of the contradictions that have existed in the Euro since its creation – as analysed below. Most immediately the partial Greek debt default, writing down the value of its bonds by 21 per cent, together with reducing its interest rate on bailout loans from 5.5 per cent to 3.5 per cent, extending the existing repayment period from seven to a minimum of fifteen years, generating debt relief of $19.4 billion or about a quarter of the total, all in the context of an overall $157 billion bailout package, should allow short term stabilization of Greece’s financial situation.

Nevertheless key economic issues remain unresolved. Greece’s debt still stands at 150 per cent of GDP. The 21 per cent write down of its bonds is far less than the 40 per cent by which they were being discounted by the market – an explicit indication the write off may be insufficiently large to generate medium/long term Greek financial stability. The European Financial Stability Facility (EFSF) has not been increased in size to deal with its new obligations. The declaration that this bailout package applies only to Greece is purely words. Despite Ireland and Portugal having had interest rate on bailout funds reduced to 3.5 per cent one or either is likely to enter a new crisis – and the interest rate reduction is already a partial extension of the terms of the Greek bailout.

Most fundamentally the Euro still contains a central contradiction as long as a united European state does not accompany European monetary union. A currency union, such as the Eurozone, means the effects of inevitable changes in relative regional productivity, and therefore costs of production, which take place in a continental scale economy can no longer be dealt with, as in Europe’s past, by changes in exchange rates. Those parts of Europe’s economy with relatively low productivity, such as Greece, will inevitably become increasingly uncompetitive compared to economies with higher rates of productivity and productivity growth such as Germany, France or Holland. This will push the weaker states towards economic depression and social crisis.

In a unified state covering a continental scale economy, such as in the US or China, the resulting problems can be dealt with by budget transfers from richer regions to poorer ones. But this in turn is possible because the largest part of taxation goes to the central government which can then redistribute it between regions.

However, in Europe the central EU budget is small compared to the national budgets. Therefore insufficient resources for such redistributive policies exist. The main European governments remain opposed to any EU budget adequate for such transfers. As the Financial Times cited the current position of Angel Merkel: ‘As for a “transfer union”, if it meant paying for other people’s debts, “my conviction is that it will never happen”.’

Of course Chancellor Merkel’s position need not be taken totally at face value – probably a year ago she would have said that the present degree of partial integration arrived at by the Eurozone was also out of the question. But nevertheless a fully-fledged fiscally federated Eurozone is not politically on the cards at present.

Short term trends

This fundamental contradiction at the heart of the Euro, however, need not explode in the short term. If significant European economic growth can be resumed then the resources will be generated to make adequate transfers to save the financial systems of countries such as Greece and to prevent an uncontrollable financial meltdown in major economies such as Italy or Spain. The time thereby gained can potentially be used to shift European institutions, and possibly public opinion, in favour of greater European integration. But the problem is that at present vigorous European growth appears unlikely – a group of economies around Germany and France are growing rapidly, but Europe as a whole remains bogged down by the low growth of the UK, Italy and Spain.

German economic gains from the Euro

The core to the agreement on Greece, and coming events, is that during a difficult period in the European economy German business gains greatly from the Euro. The Eurozone countries cannot carry out competitive devaluations against Germany – and Germany’s economic strength means it can out-compete the other main European economies. Furthermore, whatever the financial transfers required to countries such as Greece, Germany actually gains in exchange rate terms from its association with weaker economies - as these drag down the Euro’s exchange rate. At the time of writing the exchange rate of the Euro against the dollar is 1.44. However without the weaker currencies, that is if Germany was alone, it would face a significantly higher exchange rate, harming German exports.

Naturally Germany suffers some disadvantages – for example transfers to Greece to help pay interest on the latter’s debts, and higher German bond yields, that is higher German interest rates, because of its links to weaker currencies. These drawbacks have led to some leaders of German institutions, as well as large sections of the public, expressing reservations about the deal. These include Jens Weidmann, president of the German Central Bank who stated: ‘By transferring sizeable additional risks to aid-granting countries and their taxpayers, the euro area made a big step toward a collectivisation of risks in cases of unsolid public finances and economic mistakes… That's weakening the foundations of a monetary union founded on fiscal self-responsibility. In future, it will be even more difficult to maintain incentives for solid fiscal policies.’ Also critical of the deal was the influential Ifo think tank.

But these drawbacks are judged by German business to be smaller than the gains – and believing one can have a policy which only has upsides and no downside is entirely unrealistic – hence the necessity to make compromises provided essential German interests are maintained.

Some opponents of the Euro hope that the electorate of Germany will overturn it under the impact of events such as the deal on Greece. Edmund Conway in the British Daily Telegraph for example analysed: ‘At some point the Germans will realise that the package is a thinly-veiled fiscal union which makes the transfers they funnelled into East Germany look like small change, and they will revolt at the ballot boxes.’

But this is naive nonsense. It is a cardinal principle for arriving at an accurate prediction of the economic course of a country to understand that this will be determined, on central matters, by the interests of big business and not the opinions of the electorate – sentimental analysis to the contrary leads to wrong predictions. German big business has an interest in the Euro and for that reason all major political parties in Germany support it. Therefore, in the end, the key measures to support the Euro will be taken. Even if the Social Democrats returned to power in Germany they would follow essentially the same policies on this issue as Angela Merkel. Only fringe German parties, with no chance of coming to power, oppose the Euro and therefore the policies necessary to sustain it. A few concessions to public opinion may therefore be made round the edges, but there will be no electoral revolt in Germany which will overturn the Euro.

Political dimension

The international political dimension of the Greek bailout is linked to these steps taken to maintain the Euro.

The Euro is today the main alternative reserve currency to the dollar. The fact that the Euro’s exchange rate has risen even more strongly against the dollar since 2000 than alternative potential reserve currencies, such as Japan’s yen or China’s RMB, has increased its attractiveness to both Central Banks and private investors – see Figure 1. While in the future China’s RMB is more solidly based as an alternative to the dollar than the Euro, because of China’s economic dynamism and because unlike the Euro it is backed by a united state, nevertheless immediately China’s economy is still too small, and the convertibility of the RMB too limited, for it to function as a real reserve currency alternative to the dollar. In the immediate situation it is therefore the Euro, not the RMB, which is the real alternative reserve currency to the dollar.

Figure 1

 

The decline of the position of the dollar as a reserve currency is slow. As a percentage of allocated foreign exchange reserves for all countries, holdings of dollars have fallen from 71.2 per cent in the first quarter of 1999 to 60.7 per cent in the latest available data from the IMF for the 1^st quarter of 2011 – see Figure 2. The percentage of allocated world reserves held in euros rose from 18.1 per cent to 26.6 per cent in the same period – no other currency has even a five per cent share.

Figure 2

 

However while the decline in the position of the dollar is slow it is clear. Given that the position of the dollar as the effective world reserve currency is one of the fundamentals of the economic position of the US, and of its current economic policies, therefore how to deal with the Euro is a key issue for US economic policy.

US-European political relations

To the economic challenge constituted by the Euro to the dollar was added in 2003 a political issue between the major European states and the US. France and Russia, supported by Germany, made it clear they would veto in the UN any resolution supporting the invasion of Iraq by the US. Subsequent events showed that the European states stance that this invasion was a major miscalculation was correct – and the new US president Obama had himself opposed the war. But US administrations are accustomed to automatic support from Europe for their foreign policy. ‘Neo-con’ circles in the US were therefore determined to secure renewed European support for whatever foreign policy the US adopted.

Important successes in this goal were subsequently gained by Sarkozy being elected President of France – Sarkozy including in his platform a pledge of a new closer relation of France with the US and he has carried out full French re-entry into NATO. In Germany the Social Democrat led government, which had opposed the Iraq war, was replaced by the Christian Democrat led coalition under Merkel. Both events were seen as important US foreign policy successes by neo-con viewpoints.

These successes also allowed the British Conservative Party which, apart from partial independence for a short episode under Edward Heath, has always reflected US foreign policy in Europe to play an aggressive role in rallying forces opposed to deeper European integration. The Conservatives withdrew from the main centre right grouping in the European parliament, on the grounds it was ‘Euro-Federalist’ – and to do this were prepared to align themselves with various unsavoury xenophobic parties in eastern Europe. US policy simultaneously stressed relations with the ‘new Europe’, centred on Poland and other East European states – which were seen as more supportive of United States foreign policy.

Impact of the international financial crisis

The impact of the 2008 financial crisis, and the successive European debt crises, has shaken up this situation. It became clear to the German government, after some initial prevarication, that either greater steps would have to be taken towards greater European economic and fiscal integration or the Euro would unravel thereby greatly harming German economic interests. Germany also had the economic weight within Europe to impose its solution provided it had the will – which is what Chancellor Merkel chose to deploy.

The final terms of the Greek bailout therefore corresponded, in its key terms, to conditions laid down by Merkel in order to safeguard German business interests. There was a private sector write down, in the form of a partial Greek default in order to lessen the burden falling on the German taxpayer, contrary to the earlier declarations of European Central Bank head Trichet. Contrary to the proposals of Sarkozy no European bank tax was introduced.

Furthermore by forcing through a deal consolidating the Euro Merkel also called the bluff of, and defeated, the British Tory Party. The Conservatives were faced with the reality that a deep crisis or collapse of the Euro, with its side effects, would create such international financial dislocation that it threatened to bring down the already weakened big British banks, with consequent worsening of Britain’s already weak economic position, and that the only way to prevent such a crisis of the Euro was to move towards greater integration in Europe. Therefore the Conservatives, previously bitter opponents of deeper European integration, suddenly became favourable to fiscal union in the Eurozone.

As the Financial Times noted: ‘The chancellor [George Osborne]… was “very ­worried” about the possibility of the eurozone crisis spiralling out of control, warning that it posed an additional threat to Britain’s already “tough” economic situation.

‘“We see the potential for a set of economic events that could be as damaging as 2008,” he said...

‘The chancellor was optimistic that the eurogroup of finance ministers would make progress with involving the private sector in reducing Greece’s debts but said this was only the first step towards a necessary fiscal union in the single currency area.

‘He recognised that his enthusiasm for greater eurozone integration turned British policy on its head… He said “the remorseless logic” of monetary union was greater fiscal union…

‘Mr Osborne… called for greater economic integration of the single currency area, adding that the idea of eurozone bonds was “worthy of serious consideration”…

‘Core eurozone countries, such as Germany, would have to stand behind southern European sovereign debt as guarantors, while the periphery would have to accept German-designed economic policy in return.’

The British government then de facto fell into line with the German imposed settlement for Greece by reducing the interest rate on Britain’s loan to Ireland to 3.5 per cent - in line with the policy of the eurozone countries. The cost to the British Exchequer of this step was up to £400 million ($650 million).

Germany looks east

The ability of Germany’s government to determine the essential conditions for a Greek bailout also comes at a time when Germany has been pursuing a more independent economic policy with important success – Germany has become the first major European economy to regain its pre-crisis level of GDP, and from 2010 onwards it began to enjoy rapid economic growth.

To pursue this policy Germany has sought closer relations with China – German exports to China are now greater than to the US, which has meant Germany not significantly supporting US demands that China increase the RMBs exchange rate. The German government has also sought good relations with Russia – although it has also tried to interfere in Russia’s internal affairs by de facto urging President Medvedev to stand for another term as president rather than Vladimir Putin.

Germany has also declined to participate in the NATO military action in Libya, although it has provided limited financial support for the opposition to Gadaffi. This reflects that Germany does not wish to impose an economic burden on itself through higher military expenditure and because Chancellor Merkel knew she had to push through unpopular policies to bail out Greece and did not want simultaneously to face opposition from a German peace movement.

On both economic and political issues, therefore, Germany has taken a position more independent from the US - and this policy has been accompanied by economic success.

Therefore while media attention has focussed on Chancellor Merkel’s short term success in forcing through a private sector 21 per cent debt write down for Greece much more important was the strategic decision taken by, and victory gained, by Germany – which reflected rather broad policy issues.

While Germany’s current policies have brought it economic success, when pursuing a course relatively independent of US administration policy, it is inevitable that there will be a new attempt by neo-con circles in the US aimed at subordinating German economic policy to US interests and policies. It will be interesting to see what occurs with this.

China and the US

As would be anticipated from the above the steps towards at least immediate stabilisation of the Euro constituted by the bailout for Greece were not welcomed by neo-con circles who fear for the dominance of the dollar. The Wall Street Journal, in particular, carried a whole series of negative assessments of the Greek bailout. This paralleled similar positions among Eurosceptics in the UK – who were critical of the new stance taken by the Conservative Party leadership.

China, on the contrary, strongly welcomed the consolidation of the Euro. Its central bank governor Zhou Xiaochuan issued a statement declaring: ‘This will help in promoting a resolution of the Eurozone sovereign debt issues, maintaining financial stability in the Eurozone and its member states, and maintaining market confidence.’ He noted: ‘We support the efforts made by the European Union and the Eurozone in combating the global financial crisis and improving their fiscal situation.’ Also he noted: ‘China has always been confident regarding the Eurozone and the euro and will continue to play an active and stable role in the international financial market.’ China is clearly far more supportive of the Euro than many circles in the US.

In short the measures taken around the Euro are far from purely a European matter. They affect the interrelation of Europe, the US and China – the three greatest economic powers in the world. Within that framework Germany has gained a notable foreign policy success. The events round Greece are therefore both a major economic and a political event.

Postscript

The key internal problems of the Euro exposed by the Greek, Irish and Portugese debt crises are not newly discovered but were analysed in advance by the theoretical views which inform this blog. Anyone interested in a more comprehensive analyses of these may therefore like to read the September 1996 article 'Fundamental economic implications of a single European currency.' 

 

 

Europe's 'stagnant middle' will determine EU's economic trajectory

Summary

Media attention regarding Europe's economy has largely focussed on the debt crisis in Greece, Ireland and Portugal, together with some discussion of whether the radical cuts in public spending in the UK will undermine its economic recovery. Both are important topics. However they are insufficient to answer a more general question – how well is the European Union (EU) recovering from the Great Recession?

This relates to another misunderstanding of the trend in Europe's economies - a tendency to present the situation as a 'two track Europe'. In this conception, there is primarily a division between ‘northern' and 'southern’ Europe – with the former recovering and the latter not (in this perspective Ireland is an honorary member of southern Europe).

Examination of factual trends, however, shows a different situation. There are three groups, not two, within the EU's economy:

• Significantly recovering economies - centred on Germany and France.
• Small economies which have undergone serious economic decline, of which the most well known cases are Greece and Ireland - but even taken as a group these are too small to determine the course of Europe's economy.
• A group centred on what may be termed the ‘large relatively stagnant economies’ - the UK, Italy and Spain, which underwent substantial economic decline and in which recovery is currently slow.

Due to their size it is likely to be this third group that determines the dynamic of the EUs economy in the coming period.

This article analyses these trends

The overall situation in the EU economy

To give a context for the the EU's economic performance, the overall trends in GDP in the three major centres of developed economies – the US, the EU, and Japan – are shown in Figure 1. This shows GDP since the peak of the previous business cycle.

Regarding the EU, its GDP in the last quarter of 2010 remained 2.8% below in its peak – the latter occurring in the 1st quarter of 2008. It is highly improbable that growth in the 1st quarter of 2011 will be sufficient to take EU GDP back to its previous peak level. Therefore, over a three year period, the EU will have experienced net negative growth.

To take a comparison, three years after the beginning of recession, US GDP just regained its previous peak level in the last quarter of 2010 - technically on OECD data it was 0.1% above it. Japan’s GDP remained 4.2% below its previous peak.

Figure 2 shows that there is no essential difference between the performance of the EU as a whole and that of the Eurozone. Therefore in this article concentration will be on the Eurozone plus the one large European economy outside it – the UK. Together these determine the European economic situation.

Figure 1

 

Figure 2

 

Three groups in the EU

Considering trends within the EU in more detail, three distinct groups in terms of economic recovery can be identified.

• The first group, centred on Germany and France, is enjoying relatively synchronised and significant recovery.
• A second group, consisting of Greece, Ireland, Estonia, and Slovenia has undergone severe economic contraction and recovery in these states is either limited or so far has not occurred. The combined GDP of these countries is, however, too small to determine the overall economic situation in the EU.
• A third group includes three major European economies – the UK, Italy and Spain. These underwent more substantial economic decline than the grouping centred on Germany and France. Recovery in this third group of economies substantially slowed during 2010. Given that these economies have significant economic weight, equal to approximately three quarters of the GDP of the states centred on Germany and France, it is the performance of what may be termed ‘large relatively stagnant economies’ that is likely to determine the course of the EU’s recovery as a whole. These might be termed so far 'Europe's stagnant middle'.

The three groups will be considered in turn.

German/French group of recovering economies

The first group of EU economies centres on Germany and France. Their situation is shown in Figure 3. All have recovered significantly from recession.

Both Germany and France are specified in this group as, contrary to some media impressions, Germany's overall economic performance during the ‘Great Recession’ has not, so far, been notably superior to France’s. While in the most recent quarters German economic growth has been more rapid than French, German economic decline at the beginning of the downturn was significantly greater than in France. Overall, by the 4th quarter of 2010, Germany and France’s economic recovery differed only marginally – Germany’s GDP being 1.4% below its previous peak and GDP in France being 1.6% below its peak.

Continuation of more rapid German economic growth in 2011 would, of course, alter this picture and create a situation of significantly superior German recovery. This trend must therefore be watched. However to date France’s economy has also recovered significantly.

The smaller states in this group of substantially recovering economies are the Netherlands, Belgium, Austria, Portugal, the Slovak Republic, and Luxembourg. The GDP of none, in the 4th quarter of 2010, was more than 2.1% below its previous peak level.

As analysed elsewhere, it remains to be seen if Portugal’s agreement of an austerity package with the EU will lead to it dropping out of this category.

The combined GDP of this group of economies, measured on an annualised basis in the 4th quarter of 2010, was $8.2 trillion, or 55% of the GDP of the combined Eurozone plus UK – Table 1.

The size of this group of economies is therefore substantial, but as it represents only slightly over half the GDP of the Eurozone economies plus the UK it is not sufficient in itself to determine the course of the EU’s economy. Only if these economies can act, together with other factors, as a locomotive for a wider range of states can Europe's broader economy undergo substantial or accelerated recovery.

Figure 3

Table 1

EU economies suffering sharp economic decline

The second economic group, which has received much attention due to the European debt crisis, includes the two economies which have agreed emergency debt packages with the EU – Greece and Ireland. Two other Eurozone economies, Estonia and Slovenia, have also suffered severe economic declines without having to reach debt agreements with the EU. In the case of all these economies, current GDP is at least 6% below the peak of the previous business cycle – Figure 4.

Slovenia and Estonia are undergoing some recovery. Greece and Ireland, in the 4th quarter of 2010 were still undergoing economic decline.

The financial impact of the crises in Greece and Ireland was, of course, considerable. The economic impact of their recessions on the population of these countries is severe. But this entire group of economies is too small to determine the economic course of the EU or Eurozone. Their collective GDP, $0.5 trillion, is significantly smaller than that of the Netherlands alone, and less than 4% of the total GDP of the Eurozone plus the UK. It is only 7% of the size of the recovering economy group centred on Germany and France – Table 2.

While this group of economies has received great publicity due to the impact of the debt crisis, it is therefore too small to directly inflect the course of EU GDP.

Figure 4

Table 2

Large and relatively stagnant EU economies

The third group, which may be charcterised as ‘large and relatively stagnant economies’ –  is constituted by the UK, Italy and Spain. These underwent both more substantial recession than the group centred on Germany and France and their recovery is much weaker. In each case their GDP’s remain 4-6% below previous peak levels – Figure 5. In the 4th quarter of 2010 Spain's GDP was 4.3% below its peak, the UK's 4.6% below, and Italy's 5.2% below. In Italy and Spain, after the decline during the recession, recovery has been extremely weak, while in the UK there was significant recovery during 2009 which then stalled in the the last quarter of 2010.

Finland's much smaller economy falls in the same range of percentage decline but its recent grown has been more dynamic.

These economies are substantial, accounting for 42% of the GDP of the Eurozone plus the UK.

It is clear that without serious recovery in the three large economies in this group, France and Germany by themselves are not large enough to lead to rapid economic recovery in the EU as a whole. It is therefore in these economies constituting 'the stagnant middle' that the trajectory of Europe's economy will be decided.

Figure 5

Table 3

Conclusion

The analysis of Europe's economy as being essentially divided into a 'recovering north' and a 'crisis ridden south' is not accurate. A bloc of countries centring on Germany and France is clearly recovering. A number of states, most spectacularly Greece and Ireland, remain in deep crisis but are too small to determine the overall economic trajectory in Europe. It is therefore likely to be the so far 'stagnant middle' - the UK, Spain and Italy - which detemines whether relatively rapid recovery remains confined to economies centred on Germany and France or spreads to Europe as a whole.

Regarding this group of economies, the evident key factors will be the unwinding of the property bubble in Spain, the impact of the deep cuts in public spending in the UK, and whether Italy can break out of what is now a prolonged economic stagnation - Italy's average annual growth rate over the last 20 years is 0.9%, a performance as bad as Japan's.

The UK, Italian and Spanish cases should therefore be analysed not only individually but in terms of their impact on the trajectory of Europe's economy as a whole.

Debt deals ravage Ireland and Greece's economies - Portugal's package to have the same result?

The full scale of the economic declines in Ireland and Greece, under the impact of the debt agreements and consequent contractionary fiscal policies agreed by their governments, is shown in Figure 1 below. This illustrates the change in GDP, since the peak of the previous business cycle, in the so called ‘PIGS’ economies (Portugal, Ireland, Greece, Spain) compared to Germany and France.

GDP in Greece has fallen by 8.9% since its peak. In Ireland the decline is 14.6%. Both countries saw GDP in the 4th quarter of 2010 fall to its lowest level in the recession – i.e. no recovery had begun. In contrast GDP in Germany is 1.4% below its peak and in France 1.6% below - in both economies recovery has been taking place for seven quarters, since the 1st quarter of 2009.

Figure 1

 

Considering Portugal, the latest country to apply for an EU economic package, it is clear that to date its economy has more closely followed the performance of France and Germany than Greece or Ireland. Portugal has also outperformed Spain. In the 4th quarter of 2010 Portugal’s GDP was 2.0% below its peak level compared to Spain’s decline of 4.3%. Furthermore until the 4th quarter of 2010 Portugal’s GDP had been recovering.

Based on the experience of Ireland and Greece, and basic economic analysis. the imposition of a fiscally contractionary debt agreement on Portugal, after its request for an agreement with the EU, will lead to sharp economic decline.

The sharp economic contraction in Greece and Ireland has already made it more difficult for them to repay their debts according to the agreed terms. The problem in both economies is not liquidity but their balance sheets. The debt to GDP ratio in Greece, for example, is 140% of GDP. In Ireland exposure to bank bail outs is several times GDP.

The rationale for the loans organised by the EU for Ireland and Greece would be that their economies would grow and therefore make possible repayment of the loans at a future date. In fact the severe economic decline resulting from the contractionary fiscal policies makes this implausible. Figure 1 therefore also indicates the likely consequences if such policy spreads to Portugal.

The EU package likely to be developed for Portugal will therefore contribute to worsening the EU debt situation rather than alleviating it.

 

Trends in investment and labour inputs with economic development, as indicated in the data of Jorgenson and Vu

Key Trends in Globalisation has published two articles on: (i) the contribution of capital investment to GDP growth in developed and developing economies,(1) (ii) differing patterns of labour inputs in developed and developing economies.(2) These are based on analyses of the major database on international growth published by Jorgenson and Vu (Jorgenson & Vu, 2007b). The reason for such detailed analysis is both the importance of the issues involved and a relation to long standing research topics. The present article introduces these articles.

The most fundamental issue involved is that of the tendency of the contribution of investment to economic growth to increase with economic development. This trend was first analysed by Adam Smith and affirmed by other economists including Keynes.(3)However, it was rejected in analyses of economic growth put forward by various mid 20th century theorists. The latter asserted, against the analysis flowing from Adam Smith, that the division of the economy between investment and consumption remained constant with economic development – this is, of course, a central assumption of the widely employed Cobb-Douglas production function, of the economic growth model put forward by Solow (Solow, 1957), and continues to be repeated in many(4), although no longer all,(5) economic textbooks.

As discussed in detail elsewhere (Ross, 2009), the present author from the early 1970s concluded, on the basis of the long term historical data on growth that was then beginning to be published, than Adam Smith and those who followed his analysis were clearly correct. Despite the fact that the theories of Solow et al of a constant contribution of investment to GDP growth were the prevailing orthodoxy they were clearly contradicted by the historical data. Jorgenson has outlined more general reasons for the breakdown of such econometric models. (Jorgenson D. W., 2009) The theory that the proportion of the economy devoted to investment remained constant, rather than rose with economic development, was erroneous and classical economics was correct.

Initial statistical unclarity in this discussion was undoubtedly aided by the fact that the US is untypical in that, unlike the great majority of other economies, the proportion of the US economy devoted to fixed investment has indeed not risen for the approximately 150 year period for which reliable statistical data exists. (Ross, 2008a) (Barro & Sala-i-Martin, 2004).(6) Analyses based on generalisations from the US, therefore, arrived at the erroneous generalisation of a constant, rather than rising, share of investment in GDP.(7)

A consequence of the difference between the pattern in the US economy and the general international trend of a rising share of investment in GDP, is that the US share of fixed investment in GDP, which was above the international average in the 19th and first halt of the 20th century, has now fallen below the international average – in particular the US level of investment in GDP has fallen below the level of rapidly growing Asian economies. This contributes to the slow growth of the US economy compared to Asian competitors, the US balance of payments deficit with Asia, and present international financial developments. (Ross, 2008b)

The question of whether the role of fixed investment in economic growth rises with economic development, or remains constant, has numerous practical economic implications. The key pieces of evidence demonstrating the rising contribution of fixed investment to GDP growth with economic development, prior to the publication of the database of Jorgenson and Vu, included:

1. Trends in leading international growth economies. The analysis of leading growth economies, in successive historical periods of economic development from the 18^th century, carried out by the present author from the 1970s onwards, showed that each such leading economy – in chronological succession the UK, the US, West Germany, Japan, South Korea and now China – was characterised by a higher percentage of fixed investment in GDP than the preceding lead growth economy. This trend is shown in Figure 1.

Figure 1

2. The comprehensive comparative analyses, published by Angus Maddison, of economic growth in developed economies since World War II, including his Phases of Capitalist Development (Maddison, 1982) and Dynamic Forces in Capitalist Development (Maddison, 1991), demonstrated that capital investment was the largest contributor to post-World War II GDP growth in a wide range of advanced economies. Maddison demonstrated over a longer time frame than the post-World War II period that both non-residential fixed investment rates and savings rates, which were correlated with fixed investment rates, rose with time in most advanced economies – the US, as already noted, being an exception and not a rule. (Maddison, 1992)

3. Studies by Jorgenson and his co-authors demonstrated that capital investment was the largest single contribution to GDP growth in the US, the G7 and a number of developed economies.(8)

While these studies analysed a wide range of developed, and a number of leading developing, economies they were however not entirely comprehensive in coverage – in particular they did not include a comprehensive range of developing economies. The publication by Jorgenson and Vu (Jorgenson & Vu, 2007b) of a comprehensive growth accounting base for up to 122 economies, constituting more than 95% of world GDP, therefore provides an opportunity to fill this major gap.

A striking trend that may be analysed in its data, in addition to those drawn attention to by Jorgenson and Vu themselves, is that GDP growth in developed economies is capital-intensive while GDP growth in most developing economies is labour- intensive. The path of economic development is therefore a transition from labour intensive growth to capital intensive growth. The East Asian developing economies may be seen as an intermediate group between the majority of developing economies and the developed economies.

Such a pattern is, of course, consistent with the other evidence showing the rising contribution of investment to GDP growth with economic development. However, such a comprehensive database for evaluation of these trends has not previously been available – in particular it allows an integration of trends in developing economies with those in developed economies. It is for this reason that these three analyses of trends in the data of Jorgenson and Vu for capital and labour inputs in different stages of economic development have been published.

Summary

It is clear on the basis of the above data that there is overwhelming evidence of a tendency for the contribution of investment to GDP growth to rise with economic development. In light of such clear evidence it is evident that the assertion that the contribution of investment to GDP growth remains constant with time, rather than rising, is erroneous.

Economic models and theories therefore must take into account that the contribution of investment to GDP growth increases with economic development - Adam Smith and those who followed him on this issue were correct.

The implications of this for economic theory and practice of such a trend are numerous as has been analysed elsewhere (Ross, 2008a).

The normal disclaimer must, of course, be made that while these papers utilise calculations based on data produced by Jorgenson and Vu they do not bear responsibility for the conclusions drawn.

* * *

Since this analysis was carried out Jorgenson and Vu have extended their data to 2008. (Jorgenson & Vu, 2010) The new data does not alter the main trends analysed above. A detailed analysis from the angle of approach in this article will be published.

Notes

Labour inputs in stages of economic development – trends revealed in the data of Jorgenson and Vu

Summary

An earlier article (Ross, 2010 August) analysed trends in the contribution of capital investment to GDP growth in the database published by Jorgenson and Vu of growth accounting data for economies compromising more than 95% of world GDP. (Jorgenson & Vu, 2007b) Jorgenson and Vu themselves drew attention to two trends:

• Factor inputs of capital and labour greatly predominate over total factor productivity [TFP] in percentage contribution to international GDP growth.
• The increasing role played by capital investment in information technology (IT).

Analysis of this database by the present author showed another trend. (Ross, 2010 August)

• Developed economies have a capital-intensive path of growth compared to developing economies – i.e. the percentage contribution of capital investment to GDP growth is higher in developed than developing economies. The East Asian/Asian developing economies are an intermediate group - the percentage contribution to GDP growth of capital investment in these economies is greater than in the majority of developing economies but less than in developed economies.

This previous article looked only at investment in capital. It did not examine improvements in labour quality, which typically requires investment in human capital. This was because the percentage contribution to GDP growth of investment in physical capital in developed economies considerably exceeds that of improvements in labour quality and, for clarity, it was therefore helpful to concentrate on the primary trend.

It is, however, also revealing to analyse the combined contribution of physical capital and improvements in labour quality – in particular given this has direct practical implications. Investment in physical capital and improvements in labour quality require expenditure/investment – the latter in education, training etc. Taking capital investment and improvements in labour quality together, therefore, gives an indicator of the different patterns of such expenditure and investment in economies at different stages of development.

The present article therefore supplements the previous one by analysing the contribution of labour inputs in different economy groups.

It should be pointed out that while this paper utilises calculations based on data produced by Jorgenson and Vu they do not bear responsibility for conclusions drawn in the present article.

Capital-intensive and labour-intensive patterns of growth

The basic data for the present analysis is set out in Table 1 and Table 2. These show the percentage contribution to GDP growth of capital, labour and TFP, and of labour hours and labour quality, in economy groups for the periods 1995-2000, 1995-2000, and 2000-2006 as calculated from the data set out by Jorgenson and Vu (Jorgenson & Vu, 2007b). The pattern of the contribution of capital investment to GDP growth in the different economy groups was already analysed in the previous article and is therefore merely summarised here. (1) If the non-generally applicable case of East European economies, experiencing transition from Communism to capitalism, is left aside the patterns of growth of economies fall into two large groups according to their stage of economic development.

• The first are developed economies – the G7 and the 15 additional non-G7 developed economies. In the developed economies the percentage contribution to GDP growth of capital inputs exceeds the contribution of either labour or TFP in all periods – i.e. developed economies display capital-intensive growth.
• The second group are the majority of developing economies - in Sub-Saharan Africa, Latin America, the Middle East and North Africa. In these, with only one exception, Sub-Saharan Africa in 2000-2006, the percentage contribution of labour inputs exceeded the contribution of either capital or TFP in all periods – i.e. the majority of developing economies show labour-intensive growth. (2)

The Asian developing economies, in particular East Asian developing economies, are ‘intermediate’ between the developed and the majority of developing economies.

• In the Asian/East Asian economies the percentage contribution of capital inputs to GDP growth was larger than in the other developing economy groups in all periods. However in no period was the percentage contribution of capital inputs to GDP growth in the Asian/East Asian developing economies as high as in the G7. In two periods out of three the percentage contribution of capital inputs to GDP growth was lower in the Asian/East Asian developing economies than in the non-G7 developed economies.

It is notable that neither in the developed economies groups nor in the majority of developing economies was TFP growth the main percentage contributor to GDP growth. (3) This trend in developed and developing economies is of course in line with the overall conclusion of Jorgenson and Vu: ‘‘We allocate the growth of world output, as measured in the World Bank’s International Comparison Program, between input growth and productivity. We find… that input growth greatly predominates. ‘(Jorgenson & Vu, 2009)

Trends in labour inputs will be analysed in conjunction with this overall framework.

Trends in labour inputs

First labour inputs in the developed economies will be considered in Jorgenson and Vu's data and then those in differing groups of developing economies.

i. The Developed Economies

As already noted, both the G7 and the non-G7 groups of developed economies follow a pattern of capital-intensive growth – i.e. in all periods the contribution of capital inputs to GDP growth exceeds the contribution of either labour or TFP. However, G7 and non-G7 economies differ in the role played by different forms of labour inputs.

The contribution of increases in labour hours in all periods is smaller in the G7 than in the non-G7 economies.

In the G7 economies, in two periods out of three, the percentage contribution of labour quality to GDP growth exceeds that of increase in labour hours, whereas in two periods out of three in non-G7 developed economies the contribution of labour hours exceed the contribution of labour quality. That is, the bias in G7 economies within labour inputs is towards a higher percentage contribution of labour quality than labour hours, whereas in the non-G7 economies the bias is towards a higher contribution of labour hours than labour quality.

There is also a difference between forms of labour input and TFP growth in the G7 and non-G7 developed economies. In the G7 economies, in two out of three periods, the percentage contribution of TFP exceeds the total contribution of labour inputs, and in all periods the percentage contribution of TFP to GDP growth exceeds the contribution of either labour hours or labour quality considered individually. In contrast, in all periods, in the non-G7 developed economies the contribution of labour inputs exceeds the contribution of TFP growth.

In short, in both G7 and non-G7 developed economies the predominant contribution to GDP growth comes from capital inputs. But the pattern of growth in the G7 economies is predominantly based on ‘capital investment, plus increases in TFP and labour quality’, whereas in the non-G7 developed economies the pattern of growth is predominantly based on ‘capital investment, plus increases in labour inputs - in particular increases in labour hours’.

The dominance of capital inputs and labour quality in the G7 economies may be seen clearly in Table 1. The combination of capital inputs plus labour quality inputs plays an overwhelmingly dominant role in the contribution to GDP growth in the G7 economies – accounting in successive periods for 74.9%, 61.6% and 68.5% of GDP growth.

ii. Developing economies in Sub-Saharan Africa, Latin America, and the Middle East and North Africa

The dominant role played by labour inputs in GDP growth in the developing economies of Sub-Saharan Africa, Latin America, and the Middle East and North Africa is shown in that in all groups and periods except one, Sub-Saharan in 2000-2006, labour inputs exceeds either the input of capital or the input of TFP to GDP growth.

The contribution of labour inputs to GDP growth exceeds the contribution of TFP in all these economy groups in all periods .

Within this framework the dominance of increases in labour hours over increases in labour quality is clear. The percentage contribution of increases in labour hours exceeds the percentage contribution of increases in labour quality in all three economy groups in all three periods.

The pattern of growth of the majority of developing economies is therefore not only labour-intensive, but within that framework it is dominated by increases in labour hours rather than increases in labour quality.

iii. Developing Asian economies

In the developing Asian economies the percentage contribution of capital to GDP growth exceeds the contribution of labour in all periods. The percentage contribution of TFP also exceeds that of labour in all periods. In this overall pattern of higher inputs of capital and TFP than of labour inputs Asian developing economies are closest to the G7 group.

However, the pattern of labour inputs in the developing Asian economies differs markedly from the G7 economies. In all periods in the developing Asian economies, the percentage contribution of labour hours exceeds the percentage contribution of labour quality.

The pattern of growth of the Asian developing economies is therefore primarily based on inputs of capital, TFP and labour hours with a smaller percentage contribution from improvements in labour quality. If the developing Asian economies resemble the developed economies in the dominance of capital inputs over labour inputs, nevertheless within labour inputs the Asian economies resemble developing economies in that increases in labour hours predominate over increases in labour quality.

The Asian developing economies may therefore be taken as being ‘intermediate’ between the developing and developed economies in a dual sense.

• In terms of the contribution of capital inputs to GDP growth the Asian developing economies have clearly moved out of the ranks of developing economies closer to the capital-intensive pattern of growth in the developed economies - although the contribution of capital investment to growth in the developing Asian economies has still not yet reached the level of the developed economies.
• The developing Asian economies, unlike in particular the G7 economies, however continue to have a pattern of development similar to the majority of developing economies whereby inputs of labour hours are greater contribution to labour inputs than increases in labour quality.

Conclusion

These trends may now be summarised.

• The fundamental pattern of development whereby developed economies follow a pattern of capital-intensive growth and developing economies one of labour-intensive growth has already been noted. (Ross, 2010 August)
• Developing Asian/East Asian economies may be understood as occupying a position of transition from developing to developed status, with a capital-intensity of development that is higher than the other groups of developing economies but not as high as that of the developed economies.

In may, however, be seen from the present analysis that a second trend also occurs within labour inputs.

• The pattern of GDP growth of the developing economies is not only labour-intensive but, within that framework, is primarily dominated by increases in labour hours rather than by increases in labour quality.
• In the G7 group, in contrast, increases in labour inputs are somewhat more determined by increases in labour quality than by increases in labour hours.
• In the percentage contribution within labour inputs, the Asian/East Asian developing economies remain closer to developing economies than to the G7 in that the contribution of labour hours is greater than the contribution of labour quality.
• In terms of labour inputs, the Asian/East Asian developing economies are closer to the non-G7 developed economies than the G7, in that, unlike the G7, both groups tend to remain far more dependent on increases in labour hours than increases in labour quality for labour inputs.

There therefore appears to be a progressive development pattern, in terms of labour inputs, whereby most developing economies, including in this case Asia, have a larger contribution of labour hours than labour quality, the non-G7 developing economies retain this characteristic on a lesser scale, and the G7 economies have the greatest percentage contribution of increases in labour quality compared to increases in labour hours.

The pattern of economic development shown in the data of Jorgenson and Vu is therefore of an increase in the percentage contribution of capital to GDP growth compared to labour, and of an increase of improvements in labour quality compared to labour hours.

* * *

Since this analysis was carried out Jorgenson and Vu have extended their data to 2008. (Jorgenson & Vu, 2010) The new data does not alter the main trends analysed above. A detailed analysis from the angle of approach in this article will be published here.

Table 1

Table 2

 

Bibliography

The transition from labour-intensive to capital-intensive growth during economic development – trends revealed in the data of Jorgenson and Vu

Summary

One of the most important databases and analyses regarding the international economy released in the recent period is that calculated by Jorgenson and Vu to evaluate the relative contributions of capital, particularly information technology (IT), and labour inputs compared to that of total factor productivity (TFP) in GDP growth ((Jorgenson & Vu, 2007a), (Vu, 2007)) This has formed part of the World Bank’s International Comparison Programme (Jorgenson & Vu, 2009)). Because of the comprehensive nature of the published data trends can be identified in addition to those emphasised by Jorgenson and Vu themselves.

One of the most important of such trends is clear evidence that as economies become more developed the contribution of capital inputs to GDP growth increases relative to that of labour inputs, i.e. ‘capital-intensive’ growth replaces ‘labour-intensive’ growth. Such a pattern of transition from labour-intensive to capital-intensive growth with economic development would be important in itself and indicate a confirmation of analyses in classical economic theory.

The present article outlines these trends. It should be pointed out that while this paper utilises calculations based on data produced by Jorgenson and Vu they do not bear responsibility for conclusions drawn in the present article.

Source of economic growth in developed and developing economies

Table 1 sets out annual average GDP growth, together with the percentage contributions of capital, labour, and TFP, for 109 economies, 22 developed and 87 developing, for the ten year period 1995-2005. The calculations are from the data set out by Vu (Vu, 2007). Subgroups for developed and developing economies are shown. Table 2 sets out similar calculations from the data for periods defined by Jorgenson and Vu - 1989-1995, 1995-2000 and 2000-2005 (Jorgenson & Vu, 2007b).

In addition to periodisations, other differences between the two tables should be noted. Table 1 shows unweighted means and medians – i.e. the significance of each country is treated as equal, whereas the data of Jorgenson and Vu in Table 2 is weighted. In Table 1 improvements in labour quality are included in TFP, as in the data presented by Vu (Vu, 2007), whereas in Table 2 improvements in labour quality are included in labour inputs (Jorgenson & Vu, 2007b). There are 109 countries in Table 1 compared to 122 countries in Table 2. As will be seen, however, such differences do not alter the qualitative trends found.

The dominance of factor inputs in GDP growth

One of the fundamental findings of Jorgenson and Vu, shown in both Table 1 and Table 2, is the dominance of factor inputs of capital and labour compared to TFP in international economic growth. Taking all economies in Table 1, the mean percentage of growth accounted for by increases in inputs of capital and labour is 74.8% and the contribution of TFP growth is 25.1%. Taking the three periods defined by Jorgenson and Vu in Table 2, the contribution of factor inputs of capital and labour to GDP growth is 83.7%, 76.8% and 64.3%. From their data Jorgenson and Vu conclude: ‘We allocate the growth of world output, as measured in the World Bank’s International Comparison Program, between input growth and productivity. We find… that input growth greatly predominates. ‘(Jorgenson & Vu, 2009)

Role of capital inputs

Turning to a more detailed breakdown, the greatest contribution to GDP growth is from increase in capital inputs. Taking all economies in Table 1, the mean percentage contribution of increases in capital to GDP growth is 39.6% and the median contribution is 42.6% - which is above the mean of 35.2% and median of 35.1% for the contribution of increase in labour hours, which itself exceeds the mean contribution of TFP growth of 25.1% and median contribution of 25.1%.

Taking the periods defined by Jorgenson and Vu, the contribution of capital inputs to GDP growth is greater than either labour hours or TFP in all periods - at 54.1%, 46.4% and 40.7%. Jorgenson and Vu conclude: ‘About 40-45% of world growth can be attributed to the accumulation and deployment of capital and another 25-33% to the use of labour input… productivity accounted for only 20-35% of growth.’ (Jorgenson & Vu, 2009)

The different pattern of growth in developed and developing economies

Taking the data in Table 1, however, there is a clear contrast in the pattern of growth between developed and developing economies. The contribution of increases in capital inputs is significantly greater in the developed economies than in the developing ones – i.e. developed economies follow a ‘capital-intense’ path of development compared to developing economies. Considering all economies in Table 1, the mean contribution of capital inputs to GDP growth in developed economies is 52.9%, significantly above the 36.3% in developing economies. The median contribution of capital inputs to growth in developed economies is 50.6% compared to 39.3% in developing economies. 

Table 1

Table 2 

In contrast to developed economies ‘capital-intense’ path of growth, the contribution of labour inputs to GDP growth is significantly higher in developing economies than in developed ones – i.e. in contrast to developed economies, developing economies have a ‘labour intense’ path of growth. The mean contribution of inputs of labour hours to GDP growth is 38.3% in developing economies compared to only 23.1% for developed economies, while the median contribution of increase in labour hours to GDP growth is 40.6% in developing economies compared to 23.8% for developed economies.

Summary of trends

Consolidating the above data, capital inputs are the dominant contribution to GDP growth in developed economies whereas the role of labour hours exceeds capital inputs in developing economies even if improvements in labour quality are included in TFP. The mean contributions to GDP growth in developed economies are, in order of percentage contribution, capital 52.9%, TFP 24.0%, and labour hours 23.1%, compared to, in developing economies, 38.3% labour hours, 36.3% capital, and 25.4% TFP. The median contributions to GDP growth in developed economies are capital 50.6%, TFP 26.0%, and labour hours 23.8%, compared to 40.6% labour hours, 39.3% capital, and 25.0% TFP in developing economies.

To see these trends visually, the mean percentage contribution of capital, labour hours and TFP to GDP growth for developed and developing countries is shown in Figure 1 and the median contributions in Figure 2.

Figure 1

Figure 2

  
 

Periodisation of Jorgenson and Vu

Jorgenson and Vu in their papers do not present a consolidated figure for all developed and all developing economies but the same pattern as in Table 1 may be seen from the data in Table 2:(1)

• In Jorgenson and Vu’s data, the percentage contribution of capital inputs to GDP growth in the G7 economies is the highest for any group in all periods. In all three periods capital investment contributed more than 50% of GDP growth in G7 economies. The capital-intensive path of development of G7 economies is therefore evident.

• The contribution of capital to GDP growth for the non-G7 developed economies is lower than for the G7 in all periods, but it is also higher than in the non-Asian developing countries in all periods. The contribution of capital to GDP growth for the non-G7 developed economies is higher than in the developing Asian economies for two periods and lower in one. This overall pattern confirms that, after the G7, the group of economies most dependent on capital investment for GDP growth is the non-G7 developed economies - although the gap with the East Asian developing economies is not great.
• The contribution of capital to GDP growth in the developing Asian economies is higher than for all other groups of developing economies in all periods – i.e. among developing economies the Asian economies most resemble the developed economies in the high intensity of capital investment in GDP growth.

• For the Latin American, Sub-Saharan African, and North African and Middle Eastern developing country groups, with only one exception, Sub-Saharan Africa in 2000-2006, the contribution of labour inputs to GDP growth exceeds the contribution of capital inputs to GDP growth in all periods.

• Eastern Europe(2), undergoing transition from Communism to capitalism, differs sharply from all other groups in that growth has weak inputs of capital and labour and relies primarily relied on TFP increases.

Therefore, although Jorgenson and Vu do not present a consolidated figure for developed and developing countries, the more capital-intensive character of economic growth in the developed economies compared to most developing economies is clear in their periodisation. Developing Asian economies constitute an ‘intermediate’ group between the majority of developing economies and the developed economies. The percentage contribution of capital to GDP growth in the periods and for the country groups defined in Jorgenson and Vu is shown visually in Figure 3.

More detailed analysis by country group within the above overall trends will now be considered. 

Figure 3

The G7

The ‘capital-intensive’ pattern of development of the G7 economies is clear.(3) Taking the period 1995-2005 the G7 is the most capital-intensive in terms of its pattern of growth of any economy group. The mean contribution of capital inputs to GDP growth is 60.3% for the G7 compared to 39.6% for all economies, and the median contribution of capital inputs to GDP growth in the G7 is 50.9% compared to 42.6% for all economies - see Table 3.

Taking the periodisations of Jorgenson and Vu, shown in Table 2, the percentage contribution of capital inputs to GDP growth in the G7 is 60.0%, 53.4% and 56.3% - the highest of all groups for all periods.

The relative contribution of increases in labour hours to GDP growth in the G7 economies is low – a mean of 11.3% in the G7 economies compared to 35.2% in all economies and a median of 15.9% in the G7 economies compared to 35.1% for all economies. Taking the periodisation of Jorgenson and Vu the percentage contribution of labour inputs to GDP growth in the G7 is below the average for all economies in all periods.

The G7 economies therefore have a clear ‘capital intensive/low growth of labour inputs’ pattern of development.

Table 3

Non-G7 developed economies

The pattern of development of the non-G7 developed economies also shows a capital intensive path of development compared to developing economies.(4) Taking the period 1995-2005, the mean contribution of capital inputs to GDP growth is 49.5% for non-G7 developed economies compared to 36.3% for developing economies - the median contribution is 50.3% compared to 39.3% for developing economies. Compared to the G7, the contribution of capital inputs to GDP growth for non-G7 developed economies is either slightly lower or the same as for G7 economies – the mean for G7 economies being 60.3% and that for non-G7 developing economies being 49.5%. The median for the G7 economies is 50.9% and the median for non-G7 developed economies is 50.3%.

Taking the periodisation of Jorgenson and Vu, the non-G7 developed economies have a higher percentage contribution to GDP growth of capital inputs than all developing economy groups in all periods with the one exception of the East Asian developing economies in 2000-2005 – i.e. the more capital-intensive path of economic development in the non-G7 developed economies compared to developing economies is clear.

Given both G7 and the non-G7 developed economies have a more capital-intensive pattern of growth than developing economies, the more capital intensive growth of developed economies compared to developing economies is clear. 

Table 4

East Asian and Asian developing economies

Jorgenson and Vu analyse the developing Asian economies as a single group – see Table 2. It may be preferable to divide them into an East Asian and a South Asian group – although the distinction is not vital from the point of view of the trends considered in this article. First the East Asian group will be considered and then the developing Asian economies as a whole.

The pattern of growth of the East Asian developing economies in the period 1995-2005 is shown in Table 5.(5) The East Asian group of developing economies are slightly less capital intensive in their path of development than the G7 and non-G7 developed economies – although the difference is not great. The mean percentage contribution of capital to GDP growth is 60.3% in the G7, 49.5% in the non-G7 Developed Economies and 47.2% in the East Asian Developing Economies, while the median contribution is 50.9% in the G7, 50.3% in the non-G7 Developed Economies and 48.4% in the East Asian economies. Overall, however, the East Asian developing economies clearly show a relatively similar capital-intensive path of GDP growth as the developed economies.

Taking the periodisation of Jorgenson and Vu, as shown in Table 2, and considering the developing Asian economies as whole, then as already noted the developing Asian economies have a lower percentage contribution to GDP growth of capital inputs compared to the G7 for all periods and compared to the non-G7 developed economies for two out of three periods. However, the developing Asian economies have a higher percentage contribution of capital inputs to GDP growth than all other groups of developing economies for all periods. The intermediate situation of the Asian/East Asian developing economies, in terms of capital-intensity of growth, between the developed economies and the other developing economies is therefore clear.

The developing East Asian/developing Asian economies are, however, not equidistant between the developed and the developing economies in their pattern of growth. Their pattern of growth, while not as capital-intensive as the developed economies is nevertheless closer, in its capital-intensity, to the developed economies than to the majority of developing economies.

Table 5

Other developing economies

Turning to wider groups of developing economies, Table 6 shows the pattern of GDP growth for the period 1995-2005 for developing economies excluding East Asia, which have already been examined, and Eastern Europe – which is analysed below. This covers 63 developing economies in South Asia, (6) Latin America,(7) Sub-Saharan Africa(8) and the Middle East and North Africa(9). This constitutes the majority of developing economies. The pattern of growth of these developing economies, compared to the developed economies and the developing East Asian/developing Asian economies, is clear. Unlike the developed economies and East Asian developing economies, GDP growth in these other groups of developing economies is dominated by labour inputs.

Taking the period 1995-2005 the mean contribution of inputs of labour hours for the 63 developing economies is 50.1% - compared to 28.8% for the East Asian developing economies, 28.5% for the non-G7 developed economies, and 11.3% for the G7 economies. The median contribution of inputs of labour hours is 44.2% compared to 26.9% for the East Asian developing economies, 24.5% for the non-G7 developing economies and 15.9% for the G7 economies.

Taking the periodisation of Jorgenson and Vu, as set out in Table 2, and taking their groupings of Sub-Saharan African, Latin American, and North African and Middle Eastern developing economies, the percentage contribution of inputs of labour is the highest input to GDP growth in all groups in all the periods up to 2006 except for Sub-Saharan Africa in 2000-2006.

The more labour-intensive path of growth of the majority of developing countries is clear.

Table 6

Eastern Europe and the former USSR

It may be seen from Table 2 that the pattern of economic changes in Eastern Europe in the period studied differed fundamentally from the rest of the world economy.(10)
The East European economies suffered severe falls in production in the early 1990s – this lasting until 1998 in the case of the former USSR.(11) The percentage contribution to GDP growth of input of labour hours in Eastern Europe and the former USSR was negative. The contribution of increase in capital inputs to GDP growth was very weak by comparison to the rest of the world economy. Taking the periodisation of Jorgenson and Vu, as shown in Table 2, after being negative in 1989-95, TFP accounted for 136.1% of GDP growth in Eastern Europe in the period 1995-2000, and for 88.9% in the period 2000-2005 – i.e unlike the rest of the world economy growth in Eastern Europe was overwhelmingly due to TFP increases.

This unique situation in the East European economies statistically raises the percentage contribution of TFP to GDP growth for the total economies in Table 1 and Table 2. However as Eastern Europe accounted for only 6.6% of the GDP of all countries analysed in 1989-1995, and only 5.5% in 1995-2000 and 2000-2005, the combined size of these economies is too small to alter substantively either the overall balance between inputs of capital and labour and TFP, or the capital intensive pattern of GDP growth of the developed economies.

The dependence of economic development on TFP growth in Eastern Europe may be regarded as either a unique one off event, due to the collapse of the former economic system in Eastern Europe and the former USSR, therefore not giving general lessons for economic growth, or treated as that in any period there will be statistical outliers. A case can therefore be made for excluding Eastern Europe and the former USSR from comparisons, on the grounds of their undergoing a unique experience, which would lower the average international contribution of TFP to GDP growth. However, in order to avoid the suggestion of selective inclusion of data, the case considered here is that of all economies including Eastern Europe.

Relevance to the path of development in classical economic theory

The finding that developed economies follow a capital-intensive path of growth compared to most developing economies, with the East Asian/Asian developing economies forming an intermediate group between the developed economies and other developing economies would be, of course, important in itself. It however would also cast light on an important issue in economic theory.

In the classic founding work of modern economics, The Wealth of Nations, Adam Smith analysed that the role of capital and intermediate inputs, which he jointly termed ‘stock’, would increase as an economy developed. Smith noted: ‘As the accumulation of stock must, in the nature of things, be previous to the division of labour, so labour can be more and more subdivided in proportion only as stock is previously more and more accumulated… As the division of labour advances, therefore, in order to give constant employment to an equal number of workmen, an equal stock of provisions, and a greater stock of materials and tools than what would have been necessary in a ruder state of things must be accumulated beforehand.’(Smith, 1999, p. 372) Other economists, including Keynes, arrived at the same conclusion of an increasing role of capital investment in economic development via a somewhat different chain of reasoning.(12) (For a wider discussion see Ross, 2009).

Smith, of course, had no systematic econometric data of the modern type with which to verify his findings – his conclusion was based on theoretical reasoning drawn from particular observations. Jorgenson and his collaborators have, however, already found that intermediate inputs, one element of Smith’s category of ‘stock’, grow more rapidly than capital, labour or TFP.(13) The finding in the data of Jorgenson and Vu that the percentage contribution of capital inputs to GDP growth is higher in developed than in developing economies is therefore also in line with, and casts important light on, Smith’s analysis and that of his successors.

Contrast of classical economic formulations with others

The pattern in the data calculated by Jorgenson and Vu is in line with classical economics. It however does not support other more recent theories regarding economic development. These contrasting views of the pattern of economic development are:

• Classical economic theory, as originally formulated by Adam Smith, foresaw a dynamic of transition from labour-intensive growth to more capital-intensive growth during economic development.

• Alternative theories, for example popularised by Krugman in regard to the East Asian economies (Krugman, 1994), instead suggested that the dynamic in economic development is one from growth dominated by factor inputs of capital and labour to one dominated by TFP growth in the most developed economies. (14)

The data presented by Jorgenson and Vu provides substantial evidence for the analysis of classical economics that economic development is accompanied by a transition from labour intensive to capital intensive growth. It however provides no evidence for the view that economic development leads to a greater role being played by TFP rather than factor inputs. Taking the six comparisons in the periodisation of Jorgenson and Vu (the two sets of developed economies, the G7 and the non-G7, times the three periods 1989-1995, 1995-2000, 2000-2005) TFP growth makes a lower percentage contribution to GDP growth in the developed economies than the average for all economies in four periods and a higher contribution in only two.

Conclusion

Jorgenson and Vu, in analysing their data, have emphasised:

• that capital and labour inputs predominate over TFP in GDP growth,
• the increasing role of IT investment in GDP growth,

However, a further significant trend is that their data shows a pattern whereby capital is the predominant input to GDP growth in developed economies – i.e. as economies develop they make a transition from labour-intensive to capital-intensive growth. Such a finding is of considerable importance:

• It indicates that, given such a pattern, an economy and its policy makers should anticipate growth becoming more capital intensive as an economy moves towards developed economy status.
• East Asian developing economies form an ‘intermediate’ group between the developed economies on the one side and the majority of developing economies on the other – although in greater reliance on capital inputs for growth than most developing economies they more resemble developed economies.
• Most developing economies are more dependent on labour inputs compared to capital inputs for GDP growth compared to developed economies.
• Such a transition from labour-intensive growth to capital-intensive growth as economies develop is in line with classic formulations of economic theory flowing from Adam Smith.
• Jorgenson and Vu’s data provides clear evidence in line with the classical economic view that as an economy develops its pattern of growth becomes more capital intensive, but it provides no evidence supporting views that as economies become more developed the role of factor inputs in GDP growth declines relative to TFP.
• Such a transition from labour intensive to capital intensive growth with economic development, while foreseen by classical economics, is not theorised in a number of standard contemporary treatments of economic growth – for a brief historical review see (Ross, 2009).(15)

The data produced by Jorgenson and Vu, and the trends it reveals, is therefore of great importance both from the practical point of view of view of study of economic growth and policy making, and from the point of view of economic theory.

* * *

Since this analysis was carried out Jorgenson and Vu have extended their data to 2008. (Jorgenson & Vu, 2010) The new data does not alter the main trends analysed above. A detailed analysis from the angle of approach in this article will be published here.

Notes

'The Great Recession' is actually 'The Great Investment Collapse' - by John Ross, Li Hongke and Xu Xi Chi

Much analysis of the international financial crisis, since it began to unfold, has been focussed in the wrong place. It has been projecting an alleged ‘exhaustion of the US consumer’, centring attention on US consumer deleveraging etc. In fact, as this blog has consistently pointed out, the real core of the ‘Great Recession’ is a fixed investment collapse.

Nearly two years into the financial crisis it is possible to show clearly in figures which of these two contrasting analyses is correct – they evidently lead to different conclusions as regards policies. As will be shown below the overwhelming driving force of the Great Recession is a collapse in fixed investment, not a decline in US consumption - or consumption in other economies. This also casts clear light on why China has been the country which has come the most successfully through the financial crisis. To summarise the statistical conclusions below:

'Decline in fixed investment accounts for approximately 96% of the fall in GDP in the OECD area as a whole and for 76% of the decline of GDP in Europe. In three countries - the US, Spain, and Portugal - the decline in fixed investment was greater than the decline in GDP. In Japan, France and Greece the proportion of the fall in GDP due to the decline in fixed investment was over 70%, 80% and 90% respectively. In every country except Germany the fall in fixed investment was the single biggest component of the decline in GDP. In short the decline in fixed investment entirely dominates the Great Recession'

The focus of this article is therefore a detailed factual account of what has actually occurred during the Great Recession. These facts leave no doubt. The ‘Great Recession’ is actually ‘The Great Investment Collapse’. Policies for dealing with the Great Recession must therefore primarily address reversing the investment decline.

The OECD as a whole

Taking first aggregate changes in the components of GDP in the OECD area as a whole, i.e. all advanced economies, Figure 1 shows these since the beginning of the economic downturn after the first quarter of 2008 up to the latest available aggregated OECD data. As may be seen the GDP fall is entirely dominated by the decline in fixed investment.

During the period from the first quarter of 2008 to the fourth quarter of 2009 OECD GDP fell by $1.04 trillion dollars in constant parity purchasing power (ppp) terms - the form in which the OECD aggregates data. Of this fall $0.99 trillion, equivalent to approximately 96 percent, was accounted for by a decline in fixed investment. In contrast the decline in personal consumption expenditure was $0.25 trillion, only one quarter of the decline in investment, government consumption rose by $0.23 trillion and the balance of trade of the OECD economies improved by $0.23 trillion.

Figure 1

The US

Turning to the US, the changes in the components of GDP in the downturn after the second quarter of 2008 to the first quarter of 2010 are shown in Figure 2. Again, as may be seen, the fall in US GDP is entirely dominated by the decline in fixed investment. During this period US GDP in constant price terms, 2005 dollars at annualised rates, fell by $177bn. However most components of US GDP actually rose over the period as a whole – consumer expenditure by $8bn, government expenditure by $58bn, inventories by $78bn, and net trade by $108bn.

The entire decline of US GDP is therefore due to the $420bn decline in fixed investment.

Figure 2

In order to avoid any suggestion that this investment decline is due simply to the fall in residential investment, propelled by the sub-prime mortgage crisis, Figure 3 divides the decline in US fixed investment in the period into residential and non-residential. The decline in non-residential fixed investment is $310bn and the decline in residential fixed investment is $110bn – i.e. the decline in US fixed investment is overwhelmingly accounted for by the fall in non-residential investment.

Figure 3

Europe

Taking Europe as a whole, the changes in the components of GDP in the downturn after the first quarter of 2008, up to the latest available OECD data, are shown in Figure 4. The fall in GDP is again dominated by the decline in fixed investment.

In constant price ppp dollars, the form in which the OECD calculates aggregated data, the GDP of the OECD area in Europe fell by $583.5bn. Of this $445.7bn, or approximately 76%, was due to the decline in fixed investment. Personal consumer expenditure fell by $145.6 bn, while government consumption rose by $123.3 bn and net trade improved by $47.4bn. 

Figure 4

Japan

Turning to Japan, the changes in the components of GDP in the downturn after the first quarter of 2008, up to the latest available OECD data, are shown in Figure 5. The downturn in almost all components of Japan's GDP, except government consumption, is severe. However by far the largest decline is accounted for by the fall in fixed investment.

During the period since the start of the economic downturn Japan's GDP, in constant price terms, fell by ¥8.3 trillion. Government consumption rose by ¥0.3 trillion while personal consumption fell by ¥1.1 trillion, and net trade worsened by ¥2.2 trillion. However fixed investment fell by ¥5.7 trillion - i.e. approximately 69% of the fall in Japan's GDP was due to the decline in fixed investment.

Figure 5

Germany

Turning to the individual major European economies, the components of GDP in the downturn in Germany's economy after the first quarter of 2008, up to the latest data for the first quarter of 2010, are shown in Figure 6. Germany is specific in that, as will be seen, it is the only major economy in which the worsening of the net trade balance is greater than the decline in fixed investment in terms of its impact on GDP. The combination of the fall in investment plus the worsening of the net trade balance accounts for the severity of the German recession - GDP in Germany in the first quarter of 2010 was still 5.3% lower than in the first quarter of 2008.

In constant price terms German GDP fell by €30.4bn between the first quarter of 2008 and the first quarter of 2010. Government expenditure rose by €6.0bn, personal consumption fell by €5.6bn, fixed investment fell by €14.7bn and net trade worsened by €21.6bn.  

Figure 6

France

For France Figure 7 shows the changes in the components of GDP in the downturn after the first quarter of 2008 up to the first quarter of 2010. As may be seen, the fall in GDP is dominated by the decline in fixed investment. During this period France's GDP in constant price terms fell by €11.7bn. Net trade worsened by €1.0bn while personal consumption rose by €3.6bn and government consumption by €4.6bn. However fixed investment fell by €11.7bn - i.e. approximately 87% of the fall in France's GDP was due to the decline in fixed investment. 

Figure 7

The UK

Figure 8 shows the changes in the components of UK GDP in the recession after the first quarter of 2008 up to the first quarter of 2010. Again, as may be seen, the largest component of the fall in GDP is fixed investment.

In constant price terms UK GDP fell by £18.6bn. Net trade improved by £2.0bn, government consumption rose by £3.6bn, and personal consumption fell by £8.3bn. However fixed investment fell by £10.5bn - i.e. approximately 56% of the fall in UK GDP was due to the decline in fixed investment. 

Figure 8

Italy

Turning from the major north European economies to the southern European states, the so called PIGS (Portugal, Italy, Greece, Spain), the situation is equally clear.  Figure 9 shows the changes in the components of GDP in Italy in the recession following the first quarter of 2008 up to the first quarter of 2010. In constant price terms Italy's GDP fell by €19.6bn. Government consumption rose by a marginal €0.3bn, net trade worsened by €4.4bn and personal consumption fell by €4.8bn. Fixed investment however fell by €10.0bn - i.e. 51% of the fall in Italy's GDP was due to the decline in fixed investment.

Figure 9

Spain

Turning to Spain the changes in the components of GDP in the downturn after the first quarter of 2008, up to the first quarter of 2010, are shown in Figure 10. The fall in GDP is dominated by the decline in fixed investment.

During this period Spain's GDP in constant price terms fell by €9.2 billion. Government consumption rose by €3.0 billion and net trade improved by €10.6 billion as Spain began to reverse its wide balance of payments deficit. There was a significant fall in personal consumption of €7.1 billion but by far the dominant element was the €13.7 billion fall in fixed investment. The fall in fixed investment in Spain was greater than the entire decline in GDP. 

Figure 10

Portugal

Figure 11 shows the changes in the components of GDP in Portugal in the recession after the first quarter of 2008 up to the first quarter of 2010. In constant price terms GDP fell €0.8bn, net trade improved by €0.2bn while personal consumption increased by €0.3bn and government consumption by €0.4bn. Fixed investment however fell by €1.5bn - more than the entire decline in GDP.

Figure 11

 

Greece

Finally Figure 12 shows the changes in the components of GDP in Greece from the beginning of its recession, which commenced in the third quarter of 2008, up to the first quarter of 2010. In constant price terms Greece's GDP fell €2.0bn. Net trade improved by €0.2bn while personal consumption fell by €0.1bn and government consumption by €0.3bn. Fixed investment fell by €1.8bn - i.e. approximately 90% of the fall in GDP was due to the decline in fixed investment.

Figure 12

China

It is evident from the above data that whether considering the advanced economies as a whole, or looking at individual economies, the overwhelmingly dominant element in the economic downturn is the fall in fixed investment.  Decline in fixed investment accounts for approximately 96% of the fall in GDP in the OECD area as a whole and for 76% of the decline of GDP in Europe. In three countries - the US, Spain, and Portugal - the decline in fixed investment was greater than the decline in GDP. In Japan, France and Greece the proportion of the fall in GDP due to the decline in fixed investment was over 70%, 80% and 90% respectively. In every country except Germany the fall in fixed investment was the single biggest component of the decline in GDP. In short the decline in fixed investment entirely dominates the Great Recession. The policy conclusions which follow from this are evident. The decisive question is to reverse the decline in investment.

It is equally clear from this data why China has come most successfully through the financial crisis. China's government carried out its stimulus package not via an increase in the budget deficit, which has remained at less than 3% of GDP, but by a major increase in infrastructural and other fixed investment.The comparative paths of fixed investment in China and the US under the impact of their stimulus packages in 2009 are shown in Figure 13. Whereas in the US fixed investment fell by twenty percent China's urban fixed investment rose by more than thirty percent due to the stimulus package. The impacts, in terms of the changes in US and China's GDP in 2009, are shown in Figure 14.

China's stimulus package dealt directly with the central issue in the Great Recession. China focussed on  investment - rather than attempting primarily to influence this indirectly via the hope that a stimulus to personal and government consumption, maintained by a large budget deficit, would induce a reversal of the investment decline. Consequently China was able to launch a large stimulus package without running a large budget deficit. The GDP growth induced by the investment rise in turn produced large scale tax revenue - China's fiscal income in 2009 rose by 11.7%, compared to major declines in tax revenue in the US and European economies. China therefore currently does not face the choice faced by the US and European governments of whether to maintain large scale budget deficits, to attempt to sustain economic stimulus, or whether to engage in fiscal consolidation. In light of the actual character of the Great Recession China's stimulus package was therefore significantly better designed than those in the US and Europe. 

Understanding what has been the real core of the Great Depression will therefore better aid the policy response in recovering from it.

Figure 13

Figure 14

*   *   *

The views expressed in this article are solely those of the author of this blog. The statistical calculations are those of the Research Group 'China and the International Financial Crisis' at Antai College of Economics and Management, Shanghai Jiao Tong University.

Germany's 'continental economy' - comparisons to the US, India and China

Data released by the German statistical service shows how much Germany, until this year the world's largest exporter, and still the second largest, relies on its European market - particularly in a period of severe economic downturn such as 2009.

Approximately three quarters of German exports were to European countries. 63% of all exported German goods were delivered to the member states of the European Union.

Asia, the second most important market for German export goods in 2009, trailed far behind with 14% of German exports. The US accounted for 10%.. Africa and Oceania (including Australia) accounted for only 2% and 1% of German exports.

In terms of imports Germany was almost equally Europe dominated. 71% of Germany's imports came from Europe, with 18% from Asia and 9% from the US. Goods from Africa and Oceania represented just 2% and 0.4%, of Germany's imports.

Germany's economy, in short, is not really a balanced 'international' one - in particular in an economic downturn. It is, in export terms in particular, a European continental economy with secondary add ons in Asia and the US.

What implications flow from this?

The first is to reinforce the decisiveness of preserving the Eurozone for Germany - as against somewhat facile talk that the Euro may split or disintegrate. Germany has by far the highest percentage of exports in GDP of any major economy - 47.1% on the eve of the international financial crisis in the 2nd quarter of 2008. This has increased hugely, from 28.0%, since the introduction of the Euro.

The fact that Germany is operating in a continental scale economy, Eurozone Europe, with a fixed exchange rate, allows it to gain or maintain tremendous economies of scale. Conversely introduction of unstable exchange rates,including the possibility for major European trading partners to carry out competitive devaluations, would almost certainly make it impossible for Germany to maintain such a high proportion of exports in its economy - that is it would greatly weaken the 'continental' scale of its economy. The Euro, in short, is not a 'monetary union' but a decisive mechanism for Germany to enjoy the advantages of a continental scale economy. As the gains are great German economic policy, being rational, can pay a major price to maintain the Euro - something to be kept in mind in the coming battles over debt in Greece, Portugal and Spain.

Second, the trade data casts an important light on the optimal size of a modern economy. It is well known that the world's largest and most productive economy, the US, has only a relatively small share of foreign trade in GDP. In the 2nd quarter of 2008, prior to the recent decline in world trade, exports accounted for 13.6% of US GDP and imports for 18.5% - evidently far below German levels. Exports of goods and services were only 5.7% of US GDP in 1929, 3.4% of US GDP in 1938, and 7.0% of US GDP in 1950.

The reason for the far more self-contained character of the US economy, of course, is the fact that it was the first continental scale integrated economy in history. The second continental scale economy was the USSR, which has since disintegrated, the third is China and the fourth is India. Germany's economic configuration is that of the single most important component of a continental scale economy attempting to come into existence in Europe. Whether it succeeds or not of course depends on the future course of European integration.

These parameters also cast a very interesting light on possible future dynamics of China's economy. China's economy is far more open than any economy of its scale has been historically. In real, that is parity purchasing power (PPP), terms China's has already been the second largest economy in the world for several years. In PPP terms China's economy is slightly over half the size of the US - on IMF calculations $7.9 trillion compared to $14.3 trillion. In terms of percentage of GDP, at official exchange rates, China's exports of goods and services peaked at 39.1% of GDP in 2006 - far exceeding the ratio of exports to GDP of the US. By 2008, under the impact of the upward movement in the exchange rate of the RMB, and the beginning of the international financial crisis, exports of goods and services had fallen slightly to 35.9% of China's GDP.

If China's exports in dollars are compared to a parity purchasing power figure for its GDP, however, then  exports are only 20% of GDP. This is still above the figure for the US but not vastly so. It is entirely possible that as the size of China's GDP at official exchange rate grows towards US levels, both through economic growth and revaluation of the RMB, the percentage of exports in China's GDP will actually decrease. Unlike the historical pattern of most economies, which developed on the basis of their domestic markets and then expanded into exports, China may develop on the basis of exports and then statistically partially  'retreat' into a large scale domestic market. This would be a type of economic 'convergence' towards the type of $15 trillion GDP economy which is the scale represented by both the US and the EU.

Such a development would, of course, not be a retreat of China from globalisation - the absolute scale of China's exports, imports and inward and outward investment would continue to rise, but it casts the present rebalancing of China's economy towards domestic demand in not only a tactical but a strategic light. The only proviso that needs to be made, because of some confusions expressed in sections of the press, is that 'domestic demand' for China, as for every country, does not consist only of domestic consumption but also domestic investment. The present rise in the proportion of both domestic investment and domestic consumption in China's GDP, at the expense of its trade surplus, would constitute part of that process.

The process of 'globalisation' should therefore not hide the reality that the present is also an epoch of the integrated continental scale economy - with a common state to sustain a common currency, a unified budget, and the other features of an integrated economy. The US, China, and India have all created this, even if they are at different levels of economic development. Europe has not. Champions of 'national sovereignty' in Europe in fact lead their own nations towards decline. Whether Europe succeeds in creating a real integrated continental scale economy, or retreats into individual country units which are too small to be economically efficient in a modern world economy, will largely determine not only the continent's fate but that of the individual countries within it.

Germany's trade data shows the strength of the forces leading to the creation of a real European continental scale economy. The present parochial state of European politics - increasingly influenced by obsessions about banning minarets, immigrants, discussion of non-existent threats to ' convert Europe to Islam', and other forms of xenophobia and racism - leads the continent and the individual countries within it to decline.

It is a common pattern that a European country reached a peak of power followed by a prolonged period of fall - Italy in the 15th century, Spain in the 16th, Holland in the 17th, Britain in the 18th and 19th. Europe, which for several centuries was the world's most powerful continent, seems on the political level intent on pursuing the same path. 

It remains to be seen whether the forces expressed in Germany's continental scale economy, and the parallel processes in other countries, can reverse the processes of decline which are expressing themselves in European politics.