Key Trends in Globalisation

Negative trends in world trade - further confirmation of economic slowdown

Attempts to assess current prospects for the world economy have primarily focused on deceleration  in US and European GDP growth. But world trade is clearly also indicating negative trends.

Trade is a particularly sensitive indicator as its fluctuations have had a greater magnitude than those for GDP but have moved in the same direction. Trade data is also useful in indicating current economic trends as it is available for recent periods for developing countries many of which do not publish quarterly, and therefore up to date, GDP data.

It is significant for indicating the state of the world economy that the overall volume of world trade is currently at best entirely static and may have turned down. It is important this is affecting both developed and developing economies.

World trade

Analysing first the overall trend in world trade, this is shown in Figure 1 - which charts percentage volume changes in world trade compared to the pre-financial crisis peak in April 2008. The numbers on the horizontal axis indicate the number of months since the peak. A three month moving average is used to remove the effect of purely monthly fluctuations.

World trade reached its post-crisis trough in May 2009 at 20.1 per cent below the previous peak. By March 2011 world trade had recovered to 3.5 per cent above the pre-crisis peak. World trade maintained that level in May 2011 and fell to 1.2 per cent above the pre-crisis peak in June – the latest available data. The June dip is only one month, and it is therefore too early to say a decline is taking place, but world trade growth has clearly stalled since March - i.e. since the end of the 1st quarter of 2011.

Theoretically, world exports and imports should naturally be identical, but due to problems in recording and calculation, there is always some disparity in the data. To avoid the possibility of statistical distortions Figure 2 therefore confirms that the same trend appears whether measures of exports or imports are taken.

Figure 1

Figure 2

 

Developed economy trade

It is significant that the downturn in trade has affected both developed and developing economies - Figure 3 shows the data for developed economies and Figure 4 that for developing ones.

Considering first trade of developed economies, it may be seen from Figure 3 that this has not yet recovered to pre-crisis levels either in exports or imports. Again using a three monthly moving average,  developed economy imports peaked in May at 4.6 per cent below their pre-crisis highest level and exports peaked in the same month at 6.5 per cent below their pre-crisis highest level.

Figure 3 shows that there is now no substantial increase in developed economies exports or imports.

Figure 3

 

Developing economies trade

Figure 4 shows the data for exports and imports for developing economies. Unlike developed economies, both exports and imports of developing economies rose to exceed pre-crisis peaks. Growth momentum in trade was continued for a slightly longer period in developing than in developed economies but has also recently stalled.

Taking a three month moving average, developing economy imports peaked at 11.2 per cent above their pre-crisis highest level in May 2011 before falling back to 8.4 per cent in June. Perhaps more significantly developing economies exports rose to 16.6 per cent above their highest pre-crisis levels in March and by June had slipped to 13.1 per cent above.

It would not be correct to project that trade of developing economies is falling, data over a longer period would be required to establish this, but it is clear that the upward momentum has ended.

Figure 4

 

This trend for developing economies is significant as recovery in their exports and imports was much more rapid and stronger than in developed economies.

China

Not all economies are witnessing trade stagnation. China's latest available data, for July, shows exports at an all time peak of $175 billion, up 20 per cent year on year, while China's imports were also up 23 per cent over the same period. China, however, clearly does not represent the overall trend in developing economies.

As the biggest factor in China's growth is now expansion of domestic demand, followed by exports to developing countries, and then exports to developed economies, there is no reason to revise the analysis made previously that the current world economic slowdown will not lead to substantial deceleration of China's GDP growth. However clearly trends in other developing, as well as developed, economies must be watched carefully for indications of how much they are able to deal with decelerations in export demand.

Conclusion

Overall the trends in world trade strongly confirm a picture of economic slowdown - and the wide spread of this phenomenon. China continues to stand out as the largest exception to the trend - the situation of other developing economies requires more detailed analysis. The present stagnation, at best, of trade in developed economies is evident.

 

China's growth will not be significantly reduced by slowdown in developed economies - how China can use the global economy's 'countryside' to surround its 'cities'

The recently published European Union (EU) GDP figures, following those for the US and Japan, complete the picture of slow growth in the developed economies. Given weak growth, and possible recession, in the developed economies an evidently important question for the global economy is how much this will affect China – now by all measures the world’s second largest economy?

Should the present economic situation be conceptualised as generalised ‘economic slowdown’

A number of commentators suggest that the present international economic situation should be conceptualised as a generalised phenomenon of slow growth. The headline of an article by the Financial Times economics editor Chris Giles succinctly expressed such a perspective, ‘Fears rise as global output stalls’. Having analysed the well-known negative growth trends in developed economies the article continued: ‘similar gloom was evident in all other leading economies. In China, although the July figure beat expectations, the PMI also slipped for the fourth month in a row to fall 0.2 percentage points to 50.7.’ Similarly, the normally highly balanced John Authers, in The Long View in the same paper, analyzed: ‘alarm at the slowing down of the world economy – which includes China, nucleus of all hopes, as well as Europe and the US.’

Such analyses imply that a slowdown will occur in China in some sense equivalent to that in the US and Europe – otherwise it is misleading to place phenomena in the same category.

Such an analysis is erroneous as it is in contradiction with any quantitative comparison. China’s GDP growth, which was 9.5 per cent in the 2^nd quarter of 2011, cannot be meaningfully compared to the present extremely slow growth in the US and Europe. Nor, for reasons analysed below, will China’s growth slow to any level which would place it in the same category as the US and Europe. As the question of China’s dynamic is of considerable importance for trends in the world economy it is useful to summarise current factual data and analyse the impact of trends in the advanced economies on China.

Slow growth not double dip is the key issue for comparison

The majority of media discussion in the US and Europe focuses on whether these economies face a double-dip recession. Whether this occurs naturally has short term implications for China’s economy, particularly in the balance of negative pressures it has to contend with. Slow growth in advanced economies is already helping commodity prices fall – by 19 August the Dow Jones-UBS spot commodity index had declined by 8.5 per cent since its end of April peak. This aids China in its struggle against inflation, which in turn would allow a more expansionary policy to be pursued by its economic decision makers. However recession in developed economies would be negative for China’s exports and increase pressure within the US for a new round of quantitative easing, with negative international financial consequences.

However the most decisive trend is not whether developed economies face a ‘double dip’. The key fact, which is already confirmed by the recent data, is that even without a new recession growth in all major developed economies is very slow. As shown in Figure 1:

• By mid-2011 no region among the developed economies had recovered its peak level of GDP more than three years after the high point of the previous business cycle.
• US GDP is 0.4 per cent below its peak in the 4th quarter of 2007.
• EU GDP is 1.8 per cent below its peak in the 1st quarter of 2008.
• Japan’s GDP is 6.0 per cent below its peak in the 1st quarter of 2008 – this is of course affected by the earthquake and tsunami.

Overall this represents over three years net negative growth in the developed economies.

Figure 1

 

China’s economic performance

For comparison China’s economy has already grown by over 30 per cent in the last three years – Figure 2. If growth continues throughout 2011 at the same rate as in the year so far i.e. assuming there is no recession in the US and Europe, then between 2007 and 2011:

• China’s GDP will have expanded by 44.5 per cent.
• US GDP will have expanded by 0.8 per cent.
• EU GDP will have contracted by 0.4 per cent.

Figure 2

 

Naturally there will be some modification in the final outcome from the figures projected above, depending on developments in the second half of 2011. But the relative orders of magnitude are already clear.

Scale of economic issues in the US, Europe and China

These figures put into their appropriate context current issues in China’s economy. Naturally all economies continually face problems – China’s most serious current one is inflation, followed by the need to control the build-up of local government and other debt. But China’s current issues, in the context of 40% plus growth in four years, are clearly qualitatively smaller than those in the US and EU where growth in the same period will be essentially zero per cent.

This outcome factually settles the debate among economists outside China on whether China, or the US and Europe, would come most successfully through the financial crisis. Some non-Chinese economists accurately predicted that China would grow rapidly, that inevitably in such a context some problems would arise, that these would be overcome by economic fundamentals, and that China would have a ‘soft landing’ - Jim O’Neill, former chief economist of Goldman Sachs, who coined the term BRIC, is probably the best known of these.

But others predicted China’s economy would perform badly. The most extreme, such as US hedge fund manager Jim Chanos, advised short selling China in expectation of economic catastrophe. Others projected that the US would recover from the financial crisis more rapidly than China. For example US financial analyst Michael Pettis claimed that: 'the US would be the first major economy out of the crisis and China one of the last.' With China’s economy expanding by 40% while the US has not grown at all, even if China’s growth were to slow it is already clear it has come through the financial crisis much more successfully than the US.

China and developing economies

A clear implication for China’s economy of the slow growth in developed economies is that it will have rely even more on a combination of expansion of its domestic demand and growth in developing economies.

The latter, however, have not slowed during the financial crisis in the same way as developed economies. In 2010, measured in dollar terms and not only percentages, seven out of ten of the world’s most rapidly growing economies were developing ones – China, Brazil, India, Russia, South Korea, Indonesia and Mexico. (Figure 3) Current dollar prices are used in this chart for all economies as this best indicates the growth of markets for China’s exports – which are analysed below.

Figure 3

 

Particularly striking is growth in economies classified by the World Bank as ‘middle income’ – all of which are developing, such as Brazil, India, Mexico etc. In 2010 GDP growth in the developed economies was $1.6 trillion, whereas in middle income ones it was $3.3 trillion – twice as much. (Figure 4)

Figure 4

 

Nor is this a short term trend. If a five year period is taken, starting before the financial crisis, average annual growth in developed economies was $1.4 trillion while in middle income economies it was $2.0 trillion. (Figure 5)

The world economy has therefore moved into a period in which, not only in percentage but in absolute dollar terms, growth in developing economies, particularly middle income ones, is either essentially equivalent to or is greater than in developed ones.

Figure 5

 

This trend gives China considerable advantages. China’s companies face tough competition in advanced markets where, in terms of brands, they are up against firms such as Apple. But in developing economies China’s companies such as Haier and Huawei are already building up strong brand positions. Rapid expansion by such companies in developing economies, in turn, gives them rapidly increasing revenue to plough back into R&D which strengthens their challenge in the developed markets.

Some analysts have correctly noted this. In an excellent recent report ‘Heavy Duty, China’s next wave of exports’ (currently available as a free download, which those following China’s economy should take advantage of) the Economist Intelligence Unit accurately notes: ‘In 2012 it is likely that non-OECD will take over as the primary export market for China. If Turkey, Chile and Mexico are excluded from the OECD group, the transition will take place in the second half of 2011. However defined, developing countries – especially emerging markets such as India and Brazil – will be the dominant driving force between China’s export growth in the coming decade.’

The overall trend regarding China’s overall exports is shown in Figure 6. The rapid rise of China's exports to developing economies, to the point where they will overtake those to developed economies, is clear.

Figure 6

 

China uses the countryside of the world economy to surround the cities

A graphic, accurate, and very Chinese way to conceptualise the above trends was succinctly expressed by an exam student at Antai College of Economics and Management in Shanghai - where I lecture. Having had the statistical trends in world trade outlined in an economist's usual prosaic fashion, i.e. more rapid growth in the developing economies and in China’s trade with them, the student remarked that this was a well known strategy: ‘the countryside will surround the cities’.

For those not familiar with China’s history the significance of this phrase is that leading to the creation of the People’s Republic of China, in 1949, Mao Zedong famously remarked that the correct strategy was that ‘the countryside will surround the cities’.

While the vocabulory of economic statistics is more mundane than the student’s graphic characterisation, nevertheless in essence their statement was both vivid and correct. Slow growth in the advanced economies, combined with rapid growth in developing ones, is creating a situation where China’s companies are building up very strong positions in the ‘countryside’ of the world economy from which to launch a challenge in its ‘cities’.

The growth trends in developing economies, underpinning their rapidly expanding position in China’s exports, combines with rapid expansion of its domestic demand to show why China’s economy will not significantly decelerate under the impact of slowdown in the US and Europe.

The overall international economic situation should therefore not be conceptualised as one of ‘generalised economic slowdown’. It should be conceptualised as one of significant slowdown in the US and Europe combined with continued rapid growth in China.

*   *   *

A shortened edited version of this article appeared in China Daily.

More than three years without full economic recovery in the developed economies – the latest GDP figures in context

The publication of the European Union (EU) and German 2nd quarter GDP figures, following those for the US and Japan, completes the data regarding the state of the business recovery in the main developed economies. The picture is completely clear – Figure 1:

• By the 2nd quarter of 2011 none of the major regions among the developed economies has recovered their peak level of GDP more than three years after the high point of the previous business cycle.
• US GDP is 0.4% below its peak level in the 4th quarter of 2007.
• EU GDP is 1.8% below its peak level in the 1st quarter of 2008.
• Japan’s GDP is 6.0% below its peak level in the 1st quarter of 2008 – Japan’s data is of course affected by the earthquake and tsunami.

Overall, taking the period as a whole, this represents over three years of net negative growth in the developed economies. The key economic issue is not the possibility of a double dip recession, which the media is speculating on, but this extremely low growth rate even without one.

For comparison it may be noted that China’s economy has grown by over 30% in this same three year period.

Figure 1

What lies behind the renewed international economic crisis - and what policies are required to deal with it?

Given the onset of a renewed round of the international financial crisis it is useful to draw together its various elements in an analysis of its overall determinants, its course, and the policies necessary to deal with it. This is the aim of this article.

* * *

For the second time in three years almost all parts of the world economy are being shaken by a renewed financial and economic crisis. The most important immediate drivers of this are not Standard and Poor's downgrading the US's credit rating, or political struggles between President Obama and Republicans in Congress, but weak US economic recovery, Europe's widening debt crises, the consequent $8 trillion loses on international share markets by 9 August with knock on effects on balance sheets and spending, the continuing decline of US house prices and a new developing crisis of the banking system.

Reasons for the open reappearance of crisis

The reason severe crisis has reappeared, and what determines its dynamic, is the failure of US and European government policies to resolve the issues which created 2008's financial collapse. The policies pursued since then, which were adapted to deal with much more minor economic events than the ones which occurred, postponed the unwinding of the crisis without removing its underlying causes. As a result the focus of the crisis changed but it was not resolved.

The immediate cause of the financial crash of 2008 was an unsustainable build-up of US private sector debt – this debt being accumulated due to the attempt to maintain the growth of the US economy and to ensure political stability by sustaining US living standards. By the 4th quarter of 2007, the peak of US economic expansion, total US household, private non-financial company, and government debt was 218 per cent of US GDP – Figure 1. That the fundamental debt build up was private, and not government, is shown by the fact that household and non-financial company debt was equivalent to 168 per cent of GDP compared to 51 per cent of GDP for government debt - i.e. private debt was more than three times as large as government debt.

Figure 1

 

Interest rate increases introduced leading to 2008, in order to deal with inflation, resulted in the inability of the US private sector to finance this debt burden. The US sub-prime mortgage crisis was simply the weakest link in the overall excessive US private debt.

In 2008 the inability of the US private sector to meet its debt obligations, with consequent falls in asset values, initially in housing and then in shares and other financial instruments, destroyed US financial institutions’ balance sheets. The US financial sector overall became insolvent. Therefore a stronger and more centralized financial instrument, the US state, had to step in to rescue the private financial system - with a similar process occurring in other countries. The new crisis has broken out because of the risk that the tools available to the US and European states themselves will be insufficient to restore stability.

Transfer of private sector debt into the public sector

The debt data clearly show the process of transfer of the original excessive US private debt into the public sector – the changes in US debt since the peak of the previous business cycle are shown in Figure 2.

Following the onset of the US economic downturn in 2008, the overall US debt burden rose, reaching 247 per cent of GDP in the 3rd quarter of 2009 – these changes reflecting the decline in US GDP as well as increasing debt. Since then up to the 1^st quarter of 2011, the latest available data, US debt fell only marginally to 243 per cent of US GDP - still 26 percentage points above pre-recession levels.

However the internal structure of US debt shifted. US private sector debt peaked at 180 per cent of GDP in the 2nd quarter of 2009. It then fell to 163 per cent of GDP – still 5 percentage points above its pre-recession level. But any recent decline in private sector debt has been almost entirely offset by increases in government debt created by budget deficits exceeding 10 per cent of GDP.

Figure 2

 

The US therefore simply ‘nationalized’ its debt problem – replacing private with public debt. The mechanisms by which this occurred were the indirect consequences of the financial crisis, with recession increasing welfare payments and reducing tax receipts, as well as transfer of funds to the private sector in bank bailouts and similar measures.

John Mauldin and Jonathan Tepper therefore put it correctly in their book Endgame: ‘Debt is moving from consumer and household balance sheets to the government. While the debt supercycle was about the unsustainable rise of debt in the private sector, endgame is the crisis we will see in the public sector debt.’ (p25)

In short, although the US crisis may currently appear in the form of a government deficit and debt issue, the origins of the problem lay in the private sector and the government debt issue is the consequence of nationalization of private sector debt.

The European debt crisis

Europe followed a similar path to the US but with some countries, e.g. Greece and Italy, building up large public sector debts alongside the private ones in Spain and other states. Europe’s situation is structurally more potentially threatening than the US as the Federal Reserve has greater resources than the European Central Bank and the US state is able to react in a more centralized way than the decentred structure created by the different states of the European Union.

The European Central Bank simply does not have sufficient resources to be able to deal with a spread of the debt crisis into the larger EU economies such as Spain and Italy. Given the exposure of European banks to national state debt the spreading of the European sovereign state crisis to major economies therefore has the potential to bring down the European banking system. For this reason there have been rising European interbank lending rates, reflecting banks decreasing willingness to lend to each other, extremely high rates for bank insurance in a number of countries, and sharply falling bank share prices in both Europe and the US.

Kenneth Rogoff, author of the notable quantitative study of debt crises This Time is Different, and former chief economist of the IMF, accurately summarized the situation in the financial sector as follows:

‘Securitization, structured finance, and other innovations have so interwoven the financial system’s various players that it is essentially impossible to restructure one financial institution at a time. System-wide solutions are needed… the financial system remains on government respirators… in the US, UK, the euro zone, and many other countries today. 

‘Most of the world’s largest banks are essentially insolvent, and depend on continuing government aid and loans to keep them afloat. Many banks have already acknowledged their open-ended losses in residential mortgages. As the recession deepens, however, bank balance sheets will be hammered further by a wave of defaults in commercial real estate, credit cards, private equity, and hedge funds. As governments try to avoid outright nationalization of banks, they will find themselves being forced to carry out second and third recapitalizations.

‘Even the extravagant bailout of financial giant Citigroup, in which the US government has poured in $45 billion of capital and backstopped losses on over $300 billion in bad loans, may ultimately prove inadequate.’ 

Political struggles are the symptom of the renewed crisis and not its cause

Given the scale of the debt situation none of the means used for tackling the debt problem in the US and Europe can avoid severe economic pain. The political fighting which has broken out is simply over how this pain should be shared. The political struggles which have occurred, for example between President Obama and Republicans in Congress, or between Germany’s government and other European states, are therefore not the cause of the renewed economic crisis but its result. Analysing the different responses however leads directly to the issue of the necessary policies to deal with the financial and economic crisis.

The necessity to run budget deficits

The most ideologically right wing forces - the US Tea Party and those in Europe sharing the views of the British Conservatives - advocate limiting the public debt build up by radically reducing government spending. This is linked to a theory that the state is ‘crowding out’ the private sector. This entire analysis is false. Because of its ideological blinkers it fails to see that the origin of the crisis lay in the private sector debt. It is also extremely dangerous in terms of economic policy.

The main transmission belt from excessive debt into recession is the fall in private investment. As may be seen in Figure 3 the entire decline in GDP in the G7 economies between the 1^st quarter of 2008, the peak of the previous business cycle, and the 1^st quarter of 2011, the latest available data, was accounted for by the decline in fixed investment. In fixed price parity purchasing powers (PPPs) the decline in G7 GDP was $381 billion and the decline in fixed investment was $591 billion – the decline in fixed investment can be greater than the decline in GDP as it is offset by increases in household and government consumption.

Figure 3

 

The theory of ‘crowding out’ argues that resources used to finance the budget deficit would be used to generate economic expansion if released to the private sector – for example US financial analyst John Mauldin argues ‘increasing government debt crowds out the necessary savings for private investment, which is the real factor in increasing productivity.’ (Endgame p59)

But reducing budget deficits by cutting public spending cannot create an economic way out in present conditions. Reducing budget deficits cuts demand. But resources released to the private sector are used to pay down debt, so private spending will not increase sufficiently to compensate for the fall in public spending. Total demand will fall, increasing recessionary pressure.

In short, it is vital in the short term to maintain budget deficit spending, including by targeting maintaining or expanding consumption – state spending on investment is analysed below. Attempts to immediately reduce budget deficits must be strongly resisted. Countries facing an economic slowdown should run, or increase, budget deficits to compensate for the shortfall of private sector demand.

Richard Koo, in his important books Balance Sheet Recession and The Holy Grail of Macroeconomics, has dealt with this correctly in analysing the experience of the decades long fight against the consequences of over-indebtedness in Japan. As Koo noted:

‘What sets Japan’s Great Recession apart from the U.S. Great Depression is that Japanese GDP stayed above bubble peak levels in both nominal and real terms despite the loss of corporate demand worth 20 per cent of GDP and national wealth worth ¥1,500 trillion… The financial deficit of the government sector mounted sharply, leaving in its wake the national debt we face today. But it was precisely because of these expenditures that Japan was able to sustain GDP at above peak-bubble losses despite the drastic shifts in corporate behavior and a loss of national wealth equivalent to three years of GDP. Government spending played a critical role in supporting the economy…

‘Japan was left with a large national debt. But if the government had not responded with this kind of stimulus, GDP would have fallen to between one-half and one-third of its peak – and that is an optimistic scenario. U.S. GNP shrank by 46 per cent after falling asset prices destroyed wealth worth a year’s worth of 1929 GNP during the Great Depression, and the situation in Japan could easily have been much worse. This outcome was avoided only because the government decided early on to administer fiscal stimulus and continue it over many years…

‘In summary, the private sector felt obliged… to pay down debt… Disastrous consequences were avoided only because the government took the opposite course of action. By administering fiscal stimulus, which was also the right thing to do, the government succeeded in preventing a catastrophic decline in the nation’s standard of living despite the economic crisis.’ (The Holy Grail of Macroeconomics p22-25)

Naturally the form the budget deficit takes is itself extremely important. Government spending on those on average and low incomes, and on investment, is not only socially more just but is far more effective as a stimulus than tax cuts for the best-off – who save, rather than spend, a higher proportion of their income. Equally spending on investment is far more effective in expanding the economy that military spending – which does not add to productive capacity. But overall it is necessary to fight moves by fiscal conservatives to reduce the budget deficit in the short term. As an immediate response to the financial crisis countries facing the threat of economic downturn should run or maintain stimulus packages funded, if necessary, by budget deficits.

Budget deficit and the medium term

While budget deficits with a large component targeted at maintaining consumption are immediately vital to prevent short term economic decline they are not sufficient, faced with deep economic problems, to relaunch substantial growth because they do not deal with the most fundamental issue driving the downturn – the investment fall. This is in addition to the fact that few countries have Japan’s financial strength, which enabled it to sustain a very large budget deficit over a long period. For most countries large budget deficits can be run in the short term but are financially unsustainable in the medium term.

A policy of running large budget deficits is often inaccurately described as a 'Keynesian' one  - inaccurately as Keynes own central concern was factors affecting investment and not budget deficits.¹ Paul Krugman in the New York Times, for example, regularly but wrongly argues that the budget deficit is both the most central issue in economic policy and the core of Keynes views. US economist Paul Davidson similarly claims in The Keynes Solution: ‘Anything that increases spending on goods and services increases the profitability of business firms and the hiring of workers.’ (p54) But this is false - for example, an increase in spending on goods and services accompanied by cost increases may lead profits to fall.

However, even if profit did increase due to increases in demand, companies may not reverse the cuts in investment that are the core of the recession. Keynes pointed out that to generate investment a price must be paid to overcome ‘liquidity preference’ - the advantages of holding assets in cash and other liquid forms. In circumstances of high uncertainty, such as at present, the cost of overcoming liquidity preference may be prohibitive and therefore it will prevent investment taking place even if such investment would yield a positive profit.

Low interest rates necessary but not sufficient

Even more fundamental than liquidity preference in the present situation is that, given excessive indebtedness, companies use resources to repay debt, that is to build up their balance sheets, and not to invest even if demand increases. Therefore stimulating demand by budget deficits may prevent worse declines in production but does not produce significant output increases.

In such conditions low interest rates are also insufficient as an economic policy to provide a way out. Low interest rates are necessary to prevent interest payments becoming unsupportable and to remove a block to borrowing for investment. But they do not lead to investment under conditions where companies are intent on paying down debt and have no intention of borrowing for investment.

International redistribution of debt

As any solution to the present situation must involve medium term debt reduction a number of states are seeking to achieve this at the expense of other countries even without formal defaults on debt payments. In particular the US, via falls in the exchange rate of the dollar, reduces the real value of its debt at the expense of countries which hold dollar assets. Such policies however clearly only aid one country at the expense of others, effectively redistributing the debt without reducing the overall debt burden.

Inflation is not a relatively harmless solution

It is important to remove an illusion currently being suggested that inflation would be a relatively painless and non-harmful way to reduce debt. The idea behind this is that while the monetary volume of debt, its nominal value, would remain the same its real size would be reduced. Kenneth Rogoff, for example, has argued this:

‘It is time for the world’s major central banks to acknowledge that a sudden burst of moderate inflation would be extremely helpful in unwinding today’s epic debt morass…. Moderate inflation in the short run – say, 6% for two years – would not clear the books. But it would significantly ameliorate the problems, making other steps less costly and more effective. ‘

Similarly the British economist Will Hutton has argued:

‘As the IMF's chief economist, Olivier Blanchard, has suggested, if the options are public and private default, continuing bank weakness, economic stagnation (perhaps depression), or inflation, then the least bad option is to accept inflation, but to manage it within bounds.

‘Since inflation will happen anyway as governments seek the least bad way out, the choice in reality is whether to accept and manage it or not. Once debt is at a sustainable level and growth has resumed, then the world's financial system can be redesigned to avoid a repeat, and price stability restored.

‘This is the truth that cannot speak its name: as a senior financial policy official told me, even to raise it at home or abroad merely as an issue for debate is to invite universal disapproval. But truth must be faced. Britain should provide a lead – both for its own economic fortunes and to set the new international standard. As a minimum it should announce a new programme of quantitative easing, in effect printing money; insist the Bank of England uses the money it prints to buy the broadest range of private debt; and immediately replace the 2% inflation target with a target for the growth of money GDP – so getting Britain off the hook of its unpayable private debts.’²

However someone will have to suffer the loss in real resources created by the inflation. Usually this is the majority of the population as the rate of increase of incomes fall behind the rate of inflation. Politically a policy of lowering debt by inflation is therefore likely to be drastically unpopular for whoever implements it.

Furthermore economically inflation, striking at the majority of the population by reducing living standards, will actually cut consumption – which strengthens recessionary tendencies. Inflation also does not deal with the issue of increasing investment – the fall in which drove the recession. In short inflation is not a solution either politically or economically to a crisis of the depth which currently exists.

Indirect means of stimulating investment

If the way out is turned to, the necessary policies cannot be separated from the analysis of the depth of the crisis.

If the current economic crisis were of small or moderate dimensions then it could indeed be tackled by increases in budget deficits which primarily raised or maintained consumption. Such deficits would increase demand while liquidity preference, lack of profitability and debt levels would be insufficient to prevent companies responding to the increase in demand by raising investment - therefore substantial economic recovery would occur. This, however, has clearly not occurred in the crisis since 2008 despite large budget deficits being run.

Given budget deficits have been insufficient, attempts are also made to raise investment by extremely low interest rates and by seeking to reduce liquidity preference – the latter being a key goal of the talk regarding the need to ‘restore confidence’. These measures have also clearly not succeeded.

Confronted with this impasse more logical economic commentators are therefore beginning to address the need to raise investment. Such discussion currently primarily centres on advocating indirect means such as tax breaks. For example Joseph Stiglitz recently argued:

‘those worried about the shortage of policy instruments are partially correct. Bad monetary policy got us into this mess but it cannot get us out. Even if the inflation hawks at the Federal Reserve can be subdued, a third bout of quantitative easing will be even less effective than QE2. Even that probably did more to contribute to bubbles in emerging markets, while not leading to much additional lending or investment at home.

‘The Fed’s announcement that it will keep the target federal funds rate near zero for the next two years does convey its sense of despair about the economy’s plight. But, even if it succeeds in stopping, at least temporarily, the slide in equity prices, it won’t provide the basis of recovery: it is not high interest rates that have been keeping the economy down. Corporations are awash with cash, but the banks have not been lending to the small and medium-sized firms… The Fed and Treasury have failed miserably in getting this lending restarted, which would do more to rekindle growth than extending low interest rates though 2015.

‘But the real answer, at least for countries such as the US that can borrow at low rates, is simple: use the money to make high-return investments. This will both promote growth and generate tax revenues, lowering debt to gross domestic product ratios in the medium term and increasing debt sustainability. Even given the same budget situation, restructuring spending and taxes towards growth – by lowering payroll taxes, increasing taxes on the rich, as well as lowering taxes for corporations that invest and raising them on those that do not – can improve debt sustainability. ‘

By identifying raising investment as the key target Stiglitz does address the central dynamic of the recession. But the issue is once again quantitative and related to the depth of the crisis. Will measures such as tax breaks be sufficient to raise investment if they are added to other policies such as running budget deficits and low interest rates? If the economic crisis is not deep they will suffice. If the economic crisis, and the necessity to pay down debt, is stronger then indirect measures to target investment, such as tax breaks, will not be sufficient.

The current indications, given the scale of the economic problems and debt burden, is that indirect means to stimulate investment by policies such as tax breaks will be insufficient to relaunch substantial economic growth.

Direct means of raising investment

The most decisive way to overcome the current situation flows from the above trends. Its practical effectiveness was shown by its use by China in its successful 2008 stimulus package, which was followed by over 30 per cent GDP growth in three years. Keynes also analysed and advised it. This is that the state must overcome the reality or threat of a fall in investment by itself undertaking and organizing investment. Keynes noted this in The General Theory of Employment, Interest and Money: ‘It seems unlikely that the influence of banking policy on the rate of interest will be sufficient by itself to determine an optimum rate of investment. I conceive, therefore, that a somewhat comprehensive socialization of investment will prove the only means of securing an approximation to full employment.’ (p378)

Such an analysis flowed from Keynes practical experience regarding the relation between the depth of economic crisis and lack of sufficient efficacy of other economic instruments: 'Only experience… can show how far management of the rate of interest is capable of continuously stimulating the appropriate volume of investment… I am now somewhat sceptical of the success of a merely monetary policy directed towards influencing the rate of interest… I expect to see the State… taking an ever greater responsibility for directly organising investment; since it seems likely that the fluctuations in the market estimation of the marginal efficiency of different types of capital… will be too great to be offset by any practicable changes in the rate of interest.' (p164) Therefore: ‘‘I conclude that the duty of ordering the current volume of investment cannot safely be left in private hands.’ (p320)

Keynes naturally did not advocate an administered economy. But he therefore explicitly argued in the General Theory that the state should have the ability to intervene sufficiently to determine overall investment levels.

Keynes also noted that this 'somewhat comprehensive socialisation of investment' and 'the duty of ordering the current volume of investment' did not mean the elimination of the private sector, but socialised investment operating together with a private sector: 'This need not exclude all manner of compromises and devices by which public authority will co-operate with private initiative… apart from the necessity of central controls to bring about an adjustment between the propensity to consume and the inducement to invest there is no more need to socialise economic life than there was before…. The central controls necessary to ensure full employment will, of course, involve a large extension of the traditional functions of government.' (p378)

The country which most approximates to this economic system is China. China, of course, describes its economy in a different way and using Marxist terminology. China defines itself as passing through ‘the primary stage of socialism’ and its overall system as ‘socialism with Chinese characteristics’. However it is not the important question whether China’s definition of its own system should be accepted, or whether its economy should instead be regarded as conforming in important features to the system described by Keynes in the General Theory of Employment, Interest and Money. What is important is understanding how such an economic system works and to note that China has been able to run the world’s largest stimulus package without an unsustainable budget deficit, and why its macroeconomic policy has come through the international financial crisis more successfully than the US and Europe – and why China’s economic system has generated, during the last thirty years, the most rapid economic growth of any major economy in the world.

China’s economy

The difference between China and the US and Europe, of course, lies in economic structure. After its 1978 economic reforms China abandoned an administered economy. But it did not abandon the ability of the state to set the overall level of investment, and it maintains a state owned banking system which is  stronger in a crisis than the ones in the US and Europe and which can be instructed to expand lending in order to sustain stimulus packages. China therefore actually implements Keynes point that ‘the duty of ordering the current volume of investment cannot safely be left in private hands.’ That is, a ‘somewhat comprehensive socialization of investment’ does exist in China, not in the sense that the private sector is eliminated, on the contrary China’s private sector is large and dynamic, but in the sense that the state has sufficient levers to determine the overall level of investment. In contrast in the US and Europe the conditions outlined by Keynes do not exist, and the state sector is insufficiently large to deliver an investment-led stimulus.

As a conseuence of these differences China has come through the financial crisis far more successfully than the US or Europe

Implication of the differences

Once again the interaction of these different factors cannot be separated from analysis of the scale of economic crisis itself. China’s economic structure clearly gives it a superiority which has allowed it to avert serious downturns, as shown both in the 1997 Asian debt crisis and in the international financial crisis since 2008, and to maintain very long term rapid economic growth. But how serious the lag in the US and Europe compared to China is depends on how serious the economic crisis is.

If the economic crisis is not deep then gradually time, and greater application of the measures which are available to the US and European economies – budget deficits, low interest rates, tax breaks for investment – will overcome the investment decline. China will still grow more rapidly, but the US and Europe will also resume growth. If the crisis is deep then only adoption of full scale Chinese methods of direct state action to implement ‘the duty of ordering the current volume of investment’ would suffice. That, however, would require a huge extension of the state sector of the economy, and therefore greater application of the indirect methods available in the US and Europe will be tried first.

One clear implication, of course, is that in all these different circumstances China continue to will grow much more rapidly than the US and Europe even if the latter escape a 'double dip' recession.

Conclusion

The realistic conclusions which follow from the present renewal of the international financial crisis, in terms of both analysis and the required policy response, are therefore clear:

• The International financial crisis has recurred because the economic policies to deal with the 2008 crash in the US and Europe did not remove its underlying cause - excessive debt build up in an attempt to sustain US economic growth and living standards. The post-2008 policies failed because they were designed to deal with much less serious economic events than the ones which unfolded.
• The effect of the policies pursued after 2008 has been to nationalize large part of the debt that originated in the private sector. Therefore, in most cases, and in particular in the US, even if the crisis reappears around state finances the actual origins of the problem lay in the private sector debt.
• The strategic failure to overcome the debt crisis creates strong pressure to a renewed crisis of the banking system.
• The debt crisis transmits itself into the real economy above all though a collapse in investment – taking the G7, the entire decline in GDP is due to the fall in fixed investment.
• In the short term it is necessary to deal with the crisis by continuing to run budget deficits, and countries that have not done so may well need to introduce budget deficit spending. China is an exception because its economic structure allows it to run large stimulus packages without budget deficits due to its ability to directly stimulate investment. Only a handful of other countries, however, have a state sector large enough to fund and run such investment programmes and therefore other economies will have to run budget deficits in the short/medium term. However while budget deficits are necessary to avoid sharp economic decline the experience of the last three years has shown that the economic crisis is too deep for budget deficits by themselves to stimulate significant growth because they do target the core of the recession, the investment decline.
• Very low interest rates must be maintained in order to lighten the burden of interest payments on the overextended debt, and to remove an obstacle to investment. However, once again the experience of the last three years has shown that the economic crisis is too deep for low interest rates themselves to relaunch investment and substantial economic growth.
• China possesses the advantage that it can directly stimulate investment. In other countries there is also a growing realisation that the core transmission of the economic problem lies in investment falls. But without a sufficiently large state sector most other countries do not have the means to directly launch investment. Therefore indirect methods such as tax incentives for investment and similar measures are being proposed. It remains to be seen in practice, if these are introduced, whether they are effective. Given the depth of the crisis the probability is that even if such measures are introduced they will not be enough to sufficiently overcome the low investment level. Consequently growth will continue to be very slow in the US and Europe even if a new recession can be avoided.
• The world economy will therefore see a further period in which China’s economy will grow rapidly while the US and Europe remain at best relatively stagnant.

 

Notes

1. See Ross, J. ‘Deng Xiaoping and John Maynard Keynes’. Soundings Winter 2010.

2. The British newspaper The Observer made the same call:

‘The only alternative to default is inflation – governments printing money to get out of the corner they, their banks and their citizens are in. The question facing policymakers in the years ahead will be which of the unpalatable options they confront – economic stagnation, public and private default together with endemic bank weakness, or uncontrolled or managed inflation – they are going to choose…

‘The British government's policies are locked in the same impotent stasis as the rest of the world's – battening down the hatches, cutting public spending and borrowing, and refusing to accept realities. The government should declare independence. It should abandon the suffocating 2% inflation target and replace it with a target for the total volume of spending in the economy. It should prepare to stimulate the economy with more quantitative easing – in effect printing money – using the proceeds to lend directly to public agencies and departments prepared to lift capital spending.’

The financial crash and macro-economic policy - why the US and Europe have budget crises and China does not

The events precipitating the renewed financial crash were the combination of debt crises and confirmation of slow US economic growth. Regarding the former countries were either trying to cut deficits (the US, Greece, Italy, the UK) or feared they will have to bail out those running unsustainable ones (Germany, France). But these large deficits were not accompanied by strong economic growth – although it can be cogently argued that they were necessary to stave off sharp economic downturn.¹

Japan is currently preoccupied with overcoming the consequences of the tsunami and earthquake, but it also will soon have to face the reality that, due to decades of budget deficits, it has the largest government debt as a percentage of GDP of any country – twice that of the US.

In contrast China in 2008 launched the world's largest state stimulus package to counter the international financial crisis. But it is not running any substantial budget deficit - this year it will only be around two per cent of GDP. But China has enjoyed rapid economic growth.

It has been claimed that China is applying ‘Keynesianism’, but if budget deficits were the key issue defining such policies then China is clearly not pursuing ‘Keynesianism’ at all.

Actually, the core of Keynes’ analysis did not lie in advocating budget deficits, and in some ways China has a policy which more corresponds to his views than that pursued in the US and Europe. This is is briefly outlined below. But before dealing with this it is illuminating to contrast the nature of the economic policies pursued by the US and Europe in the last three years on the one hand, and by China on the other, and to analyse why the latter was able to launch such a large stimulus package without a significant budget deficit.

The actual core of the Great Recession

The core of the difference between the policies pursued in the US and Europe on the one hand, and that followed in China on the other, requires understanding what actually occurred during the 'Great Recession' after 2008. A more extensive analysis has been given elsewhere but to summarise in the US and Europe the Great Recession was dominated by an investment collapse. To take the largest example, in the 2nd quarter of 2011 US GDP was still $56 billion below its 4th quarter of 2007 peak. However all major components of US GDP except fixed investment were already above their previous peak levels – inventories were $37 billion above, government consumption $51 billion above, personal consumption $66 billion above, and net exports $159 billion above. But US private fixed investment was $388 billion below its 4th quarter 2007 level. The entire decline in US GDP was therefore due to the fixed investment fall.  These changes are shown in Figure 1. A similar pattern exists in almost every major developed country.

Figure 1

 

This investment fall, by driving and maintaining the downturn, produced a decline in personal and company income and therefore a fall in tax revenue – the latter being the primary reason for budget deficits. The crucial issue, both for economic development and to close the budget deficit, is therefore how to relaunch growth.

China's situation was different and explains why it ran no significant budget deficit. China abandoned administrative running of its economy with the economic reforms beginning in 1978, but it still has a sufficiently large state sector that this could be, and was, instructed to increase investment. As the key banks are state owned they could be instructed to increase lending to companies – in the US the opposite occurred and lending to companies fell sharply. The rapid economic growth initially generated by China's state companies in turn stimulated the private sector.

The result, during the crucial period 2008-2009, is shown in Figure 2. Instead of China's investment falling it rose by $420bn. Consequently there was no recession. Under the impact of the increase in jobs and incomes created by the stimulus package, China's household expenditure also rose by $160bn. Therefore despite the combined effect of a fall in net exports and inventories of $160bn China's GDP in 2009 rose by $440bn.

As there was no recession there was no fall in tax revenue and no major budget deficit. As this process continued, by 2011 China's GDP had increased by over 30 per cent, $2.3bn in current price terms, compared to pre-crisis level. In contrast by the 2nd quarter of 2011 US GDP was still 0.4 per cent below its 2007 peak level.

Figure 2

 

In the US and Europe the budget deficits were increased by government attempts to restart growth. China could instruct its state companies to invest and its state banks to lend, but the state sector in the US and Europe is too small for this to be effective. Only indirect means, such as quantitative easing (printing money) and budget deficits were available as policy tools. Both proved ineffective in restarting rapid growth. But the latter policy worsened the deficits. China, due to the rapid growth resulting from the investment stimulus, had no significant budget deficit.

Relative scale of economic problems in the US, Europe and China

Naturally the above does not mean China escaped all economic problems - particularly food price inflation, but these are not on the same scale as the budget deficit crises gripping the US and Europe.

Nor do such developments mean China does not face economic policy choices. It is impossible to judge the size of a stimulus package perfectly in advance. The crucial thing in 2008, confronted with the worst economic crisis for eighty years, was to act rapidly and forcefully to head off downturn. This was achieved.

Indeed, so successful was the stimulus that by the 2nd quarter of 2010 China's GDP growth was 11.9 per cent – well above the average 9.9 per cent since its economic reforms began and unsustainably high. Also, despite the government's efforts, it is always impossible to prevent some part of a stimulus spilling into unintended areas  - creating a too high rate of increase in China's house prices.

In summer 2010 world food price inflation also began. China suffered from this less than other comparable BRIC countries – Brazil, India and Russia. But countering these price rises required monetary tightening and slowing the economy

Finally, a medium term problem must be tackled. It is impossible to implement a huge lending increase, under conditions of international economic downturn, without some increase in bad loans. When China's government launched the 2008 stimulus package it anticipated this by making banks increase provisions for bad loans and stating they would have to raise extra capital. The government's calculation was simply that large scale economic growth resulting from its policies would generate more than sufficient resources to deal with any bad loans problem of the type now appearing in municipal debt – i.e. far more would be gained than lost. With more than 30 per cent growth in three years China's economy has easily enough resources to deal with bad loans.

In short China's economic structure does not produce perfection – which only exists in heaven. But the problems it faces are far smaller than the budget deficit and debt crises in Europe and the US.

China's economy grew by more than 30 per cent in three years while Europe and the US remain below their peak levels of output. It is therefore easy to see which policy has been more successful.

Keynes and Chinese descriptions of China’s economic system

How is such an economic system as that operating in China to be described? China itself, of course, uses Marxist terminology – it describes itself as passing through ‘the primary stage of socialism’ and its overall system as ‘socialism with Chinese characteristics’. However there is another, more familiar in the West, way of looking at it.²

Keynes in the General Theory of Interest, Employment and Money evidently did not advocate an administered economy.³ But he did explicitly argue that the state would have to intervene sufficiently to determine the overall level of investment: ‘I conclude that the duty of ordering the current volume of investment cannot safely be left in private hands.’ (p320)

Keynes, as is well known, attached great weight to changes in the rate of interest in affecting the investment level. But he did not believe these would be sufficient by themselves: 'Only experience… can show how far management of the rate of interest is capable of continuously stimulating the appropriate volume of investment… I am now somewhat sceptical of the success of a merely monetary policy directed towards influencing the rate of interest… I expect to see the State… taking an ever greater responsibility for directly organising investment; since it seems likely that the fluctuations in the market estimation of the marginal efficiency of different types of capital… will be too great to be offset by any practicable changes in the rate of interest.' (p164)

This led Keynes to the conclusion: 'It seems unlikely that the influence of banking policy on the rate of interest will be sufficient by itself to determine an optimum rate of investment. I conceive, therefore, that a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment.' (p378)

Keynes noted that 'somewhat comprehensive socialisation of investment' and 'the duty of ordering the current volume of investment' did not mean the elimination of the private sector, but socialised investment operating together with a private sector: 'This need not exclude all manner of compromises and devices by which public authority will co-operate with private initiative… apart from the necessity of central controls to bring about an adjustment between the propensity to consume and the inducement to invest there is no more need to socialise economic life than there was before…. The central controls necessary to ensure full employment will, of course, involve a large extension of the traditional functions of government.' (p378)

It does not seem the most interesting question is whether we should accept China’s definition of its own system, or whether its economy instead should be regarded as conforming in important features to the system described by Keynes in the General Theory of Employment, Interest and Money. What is important is understanding how China’s economy actually works, why it has been able to run the world’s largest stimulus package without a budget deficit, and why therefore its macroeconomic policy has come through the international financial crisis more successfully than the US and Europe.

Notes

1. For an analysis of this see Richard Koo’s The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession.

2. A more detailed discussion of these issues can be found in Ross, J. ‘Deng Xiaoping and John Maynard Keynes’. Soundings Winter 2010.

3. All page references are to the 1983 Macmillan edition of the The General Theory of Employment, Interest and Money.

Since the financial crisis began China's economy has expanded by almost 40% and the US and Europe not at all

The publication of GDP data for the first half of 2011 for the world’s two largest economies, the US and China, provides a suitable moment to assess trends in economic growth since the international financial crisis commenced. Publication of 2nd quarter GDP data for the European Union (EU) and Eurozone later this month will alter details but is highly unlikely to alter the overall picture.

Ideally quarter by quarter GDP growth data would be available for all countries but unfortunately, until the beginning of 2011, China only produced figures for quarterly GDP calculated on a year on year basis compared to the same quarter for the previous year. Fortunately for clear analysis, the differences in growth rates between the main economies are sufficiently large that utilising annual data leaves no doubt as to fundamental trends.

The peak of pre-crisis US GDP was in the 4th quarter of 2007 - the peak for the EU and Japan was only one quarter later in the 1st quarter of 2008. Therefore the appropriate starting point for comparison, using annual data, is with the final pre-crisis year of 2007.

Data for GDP growth using a base year of 2007 is therefore shown in Figure 1. As 2011 is not yet over the working assumption has been made that the growth for this entire year is the same as the year on year change in the latest available quarter – the 2nd quarter 2011 for the US and China and 1st quarter 2011 for the EU. These projections will be modified as subsequent data is published.

Both the US and China are slowing – see Figure 2. Therefore, projecting for the whole of 2011 the latest available quarterly year on year change may therefore somewhat exaggerate growth for the year as a whole. However the difference between China on the one hand, and the US and the US and Eurozone on the other, is so large that no significant change in relative positions will result if the eventual 2011 growth rate for all three is altered by any reasonable margin.

Japan’s data will, of course, be highly depressed by the aftermath of the earthquake and tsunami. Therefore, apart from noting that the fall in Japan’s GDP during the financial crisis was greater not only than for China but also for the US and Eurozone, emphasis is not given here to quantitative comparisons for Japan.

Taking the above assumptions, then taking the entire period between 2007 and 2011:

• China’s GDP will have expanded by 44.5%.
• US GDP will have expanded by 0.8%.
• Eurozone GDP will have expanded by 0.4%.

Assuming some deceleration during the second half of 2011, the essential qualitative parameters of economic performance during the four years since the beginning of international financial crisis will therefore be that China’s economy has expanded by somewhat over 40% while the US and Eurozone economies have approximately not grown at all.

Such facts evidently have major implications both at the level of the objective development of the world economy and of analysis.

• In terms of development of the world economy, a 40%+ expansion of China’s economy during a four year period, simultaneously with essentially zero growth in the US and Eurozone, is sufficient to significantly alter the balance between the world’s major economies. To take an example of implications, in assessing when China’s GDP will overtake the US to become the largest in the world, the types of assumptions typically employed have been that the US economy will expand at around 2.5% a year and China’s at around 8.0% a year. However at present China is somewhat outperforming this figure, with an annual average growth rate of 9.6% in the last four years, while the US is substantially underperforming. Evidently, projecting US growth continuing at only an annualised 0.2%, as would be the case during the last four years from the data above, would be entirely unreasonable. But any lowering of the US annual growth rate below 2.5%, which appears a clear possibility, would bring forward the data when China’s GDP will overtake the US at market exchange rates from the 8-10 year period which is generally calculated to a 5-7 year period.
• The growth of China’s GDP by around forty per cent in the last four years, while the US has not grown at all, is already sufficient to show as incorrect those analyses, publicised in the Financial Times and elsewhere, which projected that  the US would recover from the financial crisis more rapidly than China. For example Michael Pettis of Beijing University analysed that: ''the US would be the first major economy out of the crisis and China one of the last.' Attempts have been made to defend this and similar analyses by stating that the crisis is not yet over, therefore it is too early to pass judgement. In reality, with China’s economy expanding by 40% while the US has not grown at all, even if China’s growth were to slow it is already clear it has come through the financial crisis far more successfully than the US. Michael Pettis and those with similar views should therefore note that they were wrong, that those such such as this blog and others who analysed the opposite were correct, and begin to examine what errors in economic theory and analysis led to these wrong conclusions.

Growth of 40% in China over a four year period, compared to zero per cent in the US and Eurozone, is a quite sufficient test by facts to establish which analysis was right and which was wrong regarding the relative trajectories of China’s and the US economies during the international financial crisis.

Figure 1

Figure 2

US debt deal and its implications for China

I have an analysis of the US debt deal and its implications for China here. Its conclusion is:

'First, slow US growth means weakness in what is still China's second most important export market after the European Union.

'Second, as the debt agreement rules out fiscal tools to expand the US economy, pressure will probably mount for "QE3", that is a new round of quantitative easing. This would increase inflationary pressure in China and elsewhere.

'Third, slow US growth, coupled with continued expansion in China, will bring forward the date at which China overtakes the United States to become the world's largest economy – this is now likely to be in five to seven years compared to the ten-year period that was previously projected.'

Not only debt ceiling deal but worsening trade deficit negative for US growth

Numerous commentators have analysed the negative implications for US growth of the debt deal between President Obama and Republican leaders in the US Congress – this is considered below. But an aspect which should be integrated into analysis is that the drag on growth represented by the cuts in government spending in a debt deal will interact with another negative trend – the widening US trade deficit.

The primary causes of slow growth of the US economy are domestic – above all failure to overcome the severe fall in fixed investment which occurred during the ‘Great Recession’. However a secondary lowering of US growth is being created by its trade position - despite hopes that the decline in the exchange rate of the dollar would boost US net exports.

Instead of assisting US growth the US trade deficit has been widening – i.e. net exports are falling. The US trade balance, having reached a low of $25.5bn in May 2011, increased to $50.2bn in May 2011 - the latest month for which data is available. This is shown in Figure 1. Figure 2 shows the same data expressed as a three month moving average in order to remove the effect of shorter term fluctuations.

As a percentage of GDP, the deficit on US net exports has increased from a low of 3.4 per cent of GDP in the 4th quarter of 2010 to 3.9 per cent of GDP in the 2^nd quarter of 2011 – as shown  in Figure 3. Over that period this represents a 0.5 per cent of GDP downward pressure on US growth. It is clear from Figure 3 that the gap is increasing.

Given these trends, at the best US net trade is therefore unlikely to increase US GDP growth and is more likely to reduce it. Any sources of US growth will therefore necessarily have to be domestically generated.

This evidently interacts with a debt ceiling deal. The reduction in projected US government spending in an agreement, others things being equal, will primarily reduce the increase in government and household consumption – the latter through cuts in social spending programmes. With this consequent downward pressure on the growth of consumption, and no boost coming from net exports, significantly higher US economic growth would require a large boost in the only remaining source of demand – investment. But no substantial measures are being taken by the US government to increase either government or private investment.

No boost from net exports, constrained consumption, and no measures to boost investment is simply to break down into components the constraints which now exist on US growth.  Given both domestic and international trends, the long term slowing of the US economy previously analysed in greater detail by this blog will continue.

Figure 1

Figure 2

Figure 3

Weakness of the current US economic recovery compared to previous US business cyles

It has been pointed out that the present US economic recovery is the slowest since World War II. However the precise parameters of this are frequently not analysed nor are they placed in a longer term context. Both are significant as they show not only the cyclical situation but the continuation of a prolonged slowing of the US economy.

As regards the immediate weakness of the present recovery this is shown in Figure 1, which charts the course of US business cycles since 1973. The starting date in each case is the peak of the previous cycle and the numbers along the horizontal axis show the quarters since that peak. Also shown are a 2.6% growth trend line and a 1.6% trend line – these representing, as analysed below, 20 and 10 year moving averages for US GDP growth.

As may be seen not only was the downturn in US GDP in this recession deeper than in any previous one since World War II but recovery is far slower. The previous deepest decline in GDP in any US post-war recession was 3.2% following 1973 and by eight quarters after the previous peak in that cycle US GDP had regained its previous peak level. In the present cycle the maximum fall in GDP was 5.1% and 14 quarters into the cycle US GDP has still not regained its peak level. For comparison in the slowest previous US recovery, that following 1980, by 14 quarters after the peak of the previous business cycle GDP was already 4.9% above its previous peak level, whereas in this recession it is still 0.4% below it. In short this is both the deepest recession and slowest recovery in US post-World War II history by a considerable margin.

Figure 1

 

Even more significant strategically is the long term slowing of the US economy. This is  illustrated in Figure 2, which shows a 20 year moving average for US growth with the latest data being for the 2nd quarter of 2011 – utilising such a long time frame removes the effect of purely cyclical fluctuations. The downward trend of US long term growth is clear. The annual average US GDP growth rate has declined from 4.3% in 1969, to 3.0% in 1990, to 2.6% by the 2nd quarter of 2011.

Figure 2

 

The current growth rate of the US economy is even lower if a 10 year moving average is considered. This is shown in Figure 3. By the 2nd quarter of 2011 the 10 year moving average of US GDP growth had fallen to 1.6%.

Figure 3

 

As noted, the 1.6% and 2.6% trend lines in Figure 1 therefore represent average 10 and 20 year growth rates for US GDP. As may be seen the recovery in the present recession is far lower even than these long term averages - which are themselves falls from previous levels.

In short the US economy is progressively slowing not only in cyclical terms but from a long term point of view. The present slow recovery is therefore not at aberration but a part of a long term trend.

Such a deep rooted slowing of the US economy clearly has major implications not only for the United States itself but for the pattern of development of the world economy.

US GDP figures even worse than they look

The 2nd quarter 2011 US GDP figures, showing annualised growth of 1.3% in that quarter and a newly revised downwards annualised 0.4% in the 1st quarter of 2011, were interpreted as bad. But they are far worse even than they look at first sight.

First, the downward revision to the depth of the recession, to a trough of 5.1% in the 2nd quarter of 2009, means that instead of having already recovered its pre-recession GDP level the US economy remains 0.4% below its peak in the 4th quarter of 2007. This is shown in Figure 1.

Figure 1

 

Second, as shown in Figures 1, 2 and 3, it is misleading to draw attention to personal consumption expenditure, and its weak annualised 0.1 per cent increase in the 2nd quarter of 2011, as the key feature of the downturn. The really fundamental cause of the US recession is the collapse in fixed investment.

As may be seen from Figure 2, in the 2nd quarter of 2011 US GDP, in 2005 constant prices, was $56 billion below its peak level in the 4th quarter of 2007. However all major components of GDP except for fixed investment were already above their 4th quarter of 2007 levels – private inventories $37 billion above, government consumption $51 billion above, personal consumption $66 billion above, and net exports $159 billion above. However private fixed investment was $388 billion below its 4th quarter 2007 level – i.e. the entire decline in US GDP was due to the fall in fixed investment.

Figure 2

 

Nor was this decline in fixed investment entirely accounted for by the residential sector – see Figure 3. The overall fixed investment fall was divided essentially half and half between residential and non-residential fixed investment – the decline in residential fixed investment being $199 billion and the decline in non-residential fixed investment being $192 billion.

Figure 3

 

In short, as this blog has continuously pointed out, the core of the ‘Great Recession’ in the US, as in other countries, is not a decline in consumption but a huge fall in fixed investment. The ‘Great Recession’ is actually ‘The Great Investment Collapse’. Until this reality is grasped, and the policy consequences drawn, US GDP figures are likely to continue to surprise on the downside.

Meanwhile the latest US GDP data is shockingly bad - worse even than the features the official press release and initial press commentary concentrates on.

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.' 

 

 

Why Adam Smith’s ‘classical theory’ correctly explained Asia’s growth - and how this clarifies why Paul Krugman’s critique of Asian growth failed to predict events

The growth of Asia’s rapidly developing economies is a vital practical issue for the living standards of billions of people and a decisive test of economic theory. This group of economies are the world’s most rapidly growing. They include the only major economies that have made the entire transition from ’low income developing’ to ‘developed‘ status. Those economies in the group which have already achieved developed status continue to grow more rapidly than their equivalents in North America, Japan and Europe. The largest economy in the group, China, has undergone the most rapid growth of any major country for more than thirty years.

It would therefore at first sight appear evident that the rest of the world would wish to understand the reasons for this success and emulate it. Indeed it would appear extremely important to do so – if the rest of the world could enjoy the same economic development as East Asia then international problems of underdevelopment and poverty would be overcome within little more than a generation.

However, a significant number of authors have adopted an opposite course. The success of Asia’s economies is considered sufficiently contradictory to certain economic theories that the facts of its success have to be denied or treated as temporary or limited. As it is difficult to neglect economic development that has already occurred, this approach has taken the form of attempts to demonstrate that Asia’s growth must come to an end ‘soon’, or at least at levels of income per head which are below those of the US and Europe. The most famous of such critiques probably remains Paul Krugman’s ‘The Myth of Asia's Miracle’ (Krugman, 1994)

Actual economic development, however, has over a prolonged period failed to correspond to such critiques. Not only has the growth of the East Asian ‘emerging’ economies continued, but the most developed, Singapore, has achieved a GDP per capita higher, in parity purchasing powers (PPPs), than the US. This latter fact might, indeed, be considered ‘revenge of reality over (erroneous) theory’ as Paul Krugman singled out Singapore for perhaps the most comprehensive criticism for relying on an ‘extensive’ pattern of economic growth, dependent on accumulation of factor inputs of capital and labour, rather than on increases in total factor productivity (TFP).

Such critical assessments of the East Asian economies are logically linked to theories of growth of the developed economies. The East Asian economies share with the developed countries, during the post-war period, a rejection of ‘import substitution’ strategies – both groups pursued ‘open’ economic policies with a high and rising percentage of foreign trade in GDP. However, the rapidly growing East Asian countries strongly differed from the developed ones in having a far higher percentage of fixed investment in GDP. Indeed, East Asian economies typically pursued policies which favoured, or consciously aimed at, such high investment levels.

According to various critiques of the ‘Asian growth model’ it was precisely this high level of mobilisation of capital that represented an ‘extensive’ path of development which would allegedly inevitably come up against its own limits and produce inability of East Asian economies to achieve the levels of GDP per capita of developed economies. The expansion of the developed economies, in contrast, was claimed to be based on TFP growth – a model originally associated with Solow and endorsed explicitly by Krugman.

In reality, as facts demonstrated, the East Asian growth model - as confirmed in the most economically developed version by Singapore, Hong Kong, Taiwan and South Korea - has shown itself not only able to achieve extremely rapid rates of growth over prolonged periods but fully able to achieve the level of GDP per capita of developed economies. Furthermore, East Asian economies which have achieved the levels of GDP per capita of developed economies have continued to grow more rapidly than their US, Japanese and European counterparts. Therefore, whether considered from the point of view of growth from developing to developed economy status, or from the point of view of performance after achieving developed economy status, it is the Asian economies which are outperforming Europe and North America, not vice versa.

If there exists a contradiction between reality and a theory, a scientific approach demands that it is the theory that is changed or abandoned, not that the facts should be disregarded. Furthermore, as will be seen, there is an economic theory which coherently explains the facts both of Asian economic development and that of the developed economies. This may be termed the ‘classical’ theory of economic growth – classical in the strict sense that its formulation was by Adam Smith.

The aim of this article, therefore, is to set out the features of this ‘classical’ theory of economic growth, as formulated by Smith himself, and to show its vindication by modern econometrics. The character of this classical theory will be cast in sharper relief by contrasting its key points to alternative theories which have failed to explain the combined phenomena of the growth of the Asian and developed economies.

Distinguishing features of the classical theory of growth

Adam Smith established four fundamental, interrelated, propositions which may be taken to characterise his ‘classical’ theory of economic growth. These are:

1. The most fundamental force of productivity growth is increasing division of labour.
2. Increasing division of labour requires increasing scale of production and an increasing scale of market.
3. Increasing division of labour and scale of production leads historically to an increasing percentage of investment in the economy.
4. Technological progress is a product of this increasing division of labour – i.e. it is endogenously and not exogenously determined.

The specificity of this classical theory becomes clearer if contrasted to the alternative views to which it is counterposed.

• In the classical theory, economic growth is driven by division of labour, not by ‘entrepreneurship’, as in Schumpeter’s growth theory for example.
• Smith’s view that the percentage of the economy devoted to investment rises historically was followed by others, including Keynes, but such a conclusion was challenged by Friedman and still does not play a central role in many growth theories – indeed, as noted, an extremely high investment level is seen as a policy error in the development of the East Asian economies.
• In Smith’s analysis technological process is driven by the consequences of division of labour, rather than technology being an external driving force of productivity - as for example in the analysis of views typically deriving from Solow.

Because of the importance of these issues, Smith’s ‘classical’ analysis will therefore be set out in more detail before showing its vindication in the light of modern econometric evidence.

Division of labour

Adam Smith unequivocally establishes division of labour as the fundamental lynch pin of productivity growth by stating it as the first sentence of the first chapter of The Wealth of Nations. This asserts simply:

‘The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgement with which it is directed, or applied, seem to have been the effect of the division of labour.’ (Smith, 1776, p. 13)

The whole first three chapters of The Wealth of Nations are devoted to the division of labour. Later, reprising his views after elaboration of further developments, Smith choses to remind his readers ‘perfection of manufacturing industry, it must be remembered, depends altogether upon the division of labour.’ (Smith, 1776, p. 680)

Indeed, Smith formulated his view of division of labour as the driving force of productivity development and economic growth well before writing The Wealth of Nations. In his Lectures on Jurisprudence of the 1760s he noted, in a comparison incorporated wholesale into his magnum opus¹:

‘In yesterday’s lecture I endeavoured to explain the causes which prompt man to industry and are peculiar to him of all the animals… These wants a solitary savage can supply in some manner, but not in that which is reckoned absolutely necessary in every country where government has been some time established…

‘The unassisted industry of a savage cannot any way procure him those things which are now become necessary to the meanest artist. We may see this… in comparing the way of life of an ordinary day-labourer in England or Holland to that of a savage prince, who has the lives and liberties of a thousand or 10,000 naked savages at his disposal. It appears evident that this man, whom we falsely account to live in a simple and plain manner, is far better supplied than the monarch himself. Every part of his clothing, utensils, and food has been produced by the joint labour of an infinite number of hands, and these again required a vast number to provide them in tools for their respective employments. So that this labourer could not be provided in this simple manner (as we call it) without the concurrence of some 1,000 hands.

‘His life indeed is simple when compared to the luxury and profusion of an European grandee. But perhaps the affluence and luxury of the richest does not so far exceed the plenty and abundance of an industrious farmer as this latter does the unprovided… manner of life of the most respected savage.... In what manner then shall we account for the great share he and the lowest of the people have of the conveniences of life. The division of labour amongst different hands can alone account for this.’ (Smith, Lectures on Jurisprudence, p. 341 – English spelling modernised)

Smith was naturally not the first economist to note division of labour.² However, he was the first to unequivocally identify it as the most fundamental force of economic development and draw out the conclusions which followed from this.³ Smith therefore noted as a necessary consequence that the more developed, i.e. the more productive, an economy was the more developed division of labour would have to be:

‘The division of labour, however, so far as it can be introduced occasions, in every art, a proportionable increase of the productive powers of labour. The separation of different trades and employments from one another seems to take place in consequence of this advantage. This separation, too, is generally carried furthest in those countries which enjoy the highest degree of industry and improvement.’ (Smith, 1776, p. 15)

Smith drew the consequent conclusion that economic areas, whether sectors or countries, where division of labour could not be or was not pursued would be less productive.⁴

Scale of production/market

Given that division of labour is the most fundamental and underlying driving force raising productivity, Smith drew the immediate conclusion that the possibilities of division of labour depend on the scale of the market and scale of production. Chapter 3 of The Wealth of Nations is straightforwardly titled ‘That the division of labour is limited by the extent of the market’. In its first paragraph Smith notes:

‘the extent of this division must always be limited by... the extent of the market. When the market is very small, no person can have any encouragement to dedicate himself entirely to one employment, for want of the power to exchange all that surplus part of the produce of his own labour.’ (Smith, 1776, p. 31)

Scale of market is linked to scale of production at numerous levels:

‘There are some sorts of industry, even of the lowest kind, which can be carried on nowhere but in a great town. A porter, for example, can find employment and subsistence in no other place... It is impossible that there should be such a trade as even that of a nailer in the remote and inland parts of the Highlands of Scotland. Such a workman at the rate of a thousand nails a day, and three hundred working days in the year, will make three hundred thousand nails in the year. But in such a situation it would be impossible to dispose of one thousand, that is, of one day's work in the year. (Smith, 1776, p. 31)

It may be noted from this that Smith has a much wider concept of the advantages of large scale production than the more limited sense in which most frequently the term ‘economies of scale’ is used. The concept ‘economy of scale’ is typically used as relating to a single productive unit, and the cost reductions that may be achieved by large as opposed to small scale production in it. Smith utilises a much wider sense that a large market, and therefore large scale production, makes possible division of labour - which is itself the most powerful force for raising productivity. Therefore, scale of market raises productivity in the entire economy, and not only in a single productive unit. Thus, completing a passage already cited, he notes:

‘The perfection of manufacturing industry, it must be remembered, depends altogether upon the division of labour; and the degree to which the division of labour can be introduced into any manufacture, is necessarily regulated, it has already been shown, by the extent of the market.’ (Smith, 1776, p. 680)

It may immediately be seen from this that the advantages of foreign trade flow from increased possibility of the division of labour, and not some specific virtue of crossing international borders. While The Wealth of Nations is most famous for its advocacy of free trade between countries, this is a by-product of the fact that the fundamental driving force of economic and productivity growth is division of labour - the significance of international trade is that it makes possible a larger development of the market, not that it crosses national boundaries.⁵ To illustrate this Adam Smith, for example, in discussing the advantages of reduction in transport costs via water travel, a crucial factor in his day, does not distinguish national and international transport – no distinction is drawn in principle between the trade between London and Newcastle and London and Calcutta:

‘As by means of water-carriage a more extensive market is opened to every sort of industry than what land-carriage alone can afford it, so it is upon the sea-coast, and along the banks of navigable rivers, that industry of every kind naturally begins to subdivide and improve itself, and it is frequently not till a long time after that those improvements extend themselves to the inland parts of the country.... A broad-wheeled wagon, attended by two men, and drawn by eight horses, in about six weeks time carries and brings back between London and Edinburgh near four ton weight of goods. In about the same time a ship navigated by six or eight men, and sailing between the ports of London and Leith, frequently carries and brings back two hundred ton weight of goods ... What goods could bear the expense of land-carriage between London and Calcutta? Or if there were any so precious as to be able to support this expense, with what safety could they be transported through the territories of so many barbarous nations? Those two cities, however, at present carry on a very considerable commerce with each other, and by mutually affording a market, give a good deal of encouragement to each other's industry. (Smith, 1776, p. 32)

Similarly, discussing China Smith notes the advantage of its very large internal market, and explains the advantages of foreign trade precisely in terms of the expansion of this market still further:

‘the great extent of... China, the vast multitude of its inhabitants, the variety of climate, and consequently of productions in its different provinces... render the home market of that country of so great extent as to be alone sufficient to support very great manufactures. The home market of China is, perhaps, in extent not much inferior to the market of all the different countries of Europe put together. A more extensive foreign trade, however, which to this great home market added the foreign market of all the rest of the world… could scarcely fail to increase very much the manufactures of China, and to improve very much the productive powers of its manufacturing industry.’ (Smith, 1776, p. 681)

Smith also saw the consequences of what, in modern terminology, would be termed effective demand on productivity as operating through increasing the scale of the market and thereby division of labour:

‘The increase of demand, besides, though in the beginning it may sometimes raise the price of goods, never fails to lower it in the long-run. It encourages production, and thereby increases the competition of the producers, who, in order to undersell one another, have recourse to new divisions of labour and new improvements of art which might never otherwise have been thought of.’ (Smith, 1776, p. 748)

Level of investment

If division of labour was the most fundamental force in raising productivity, Smith noted that increasing division of labour required more capital. Where division of labour did not occur significant investment, referred to by Smith as ‘stock’, was not required:

‘In that rude state of society in which there is no division of labour, in which exchanges are seldom made, and in which every man provides everything for himself, it is not necessary that any stock should be accumulated or stored up beforehand in order to carry on the business of society.’ (Smith, 1776, p. 276)

In contrast division of labour required investment:

‘When the work to be done consists of a number of parts, to keep every man constantly employed in some way, requires a much greater capital than where every man is occasionally employed in very different parts of the work.’ (Smith, 1776, p. 343)

Therefore, as the economy developed, as productivity rose, an increasing proportion of the economy had to be devoted to investment:

‘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, 1776, p. 277)

This process of the rising proportion of investment in the economy applied to agriculture as well as to manufacturing and services. Thus Smith notes of ‘the proportion between that part of the annual produce, which… is destined for replacing a capital, and that which is destined for constituting a revenue, either as rent, or as profit’ that:

‘This proportion is very different in rich from that in poor countries… at present, in the opulent countries of Europe, a very large, frequently the largest part of the produce of the land, is destined for replacing the capital of the rich and independent farmer… but antiently, during the prevelancy of the feudal government, a very small portion of the produce was sufficient to replace the capital employed in cultivation.’ (Smith, 1776, p. 334)

Endogenous theory of innovation

Finally, Smith held that it was division of labour that determined technological development - not that technology was an independent factor, or that division of labour was a result of technology . Thus, in modern terminology, Smith had an endogenous, not an exogenous, theory of technological development. His conclusion on this was emphatic, and covered both proximate and ultimate causes of technological progress. Smith noted:

‘The owner of the stock which employs a great number of labourers, necessarily endeavours, for his own advantage, to make such a proper division and distribution of employment, that they may be enabled to produce the greatest quantity of work possible. For the same reason, he endeavours to supply them with the best machinery which either he or they can think of. What takes place among the labourers in a particular workhouse, takes place, for the same reason, among those of a great society. The greater their number, the more they naturally divide themselves into different classes and subdivisions of employment. More heads are occupied in inventing the most proper machinery for executing the work of each, and it is, therefore, more likely to be invented.’ (Smith, 1776, p. 104)

More generally Smith noted:

‘everybody must be sensible how much labour is facilitated and abridged by the application of proper machinery. It is unnecessary to give any example. I shall only observe, therefore, that the invention of all those machines by which labour is so much facilitated and abridged seems to have been originally owing to the division of labour.’ (Smith, 1776, p. 19)

Smith made explicit that this analysis of the development of technology as being a result of the division of labour applied both to direct invention by users of technology and to more specialised scientific research. Thus, regarding immediate research focussed on particular industries:

‘Men are much more likely to discover easier and readier methods of attaining any object, when the whole attention of their minds is directed towards that single object, than when it is dissipated among a great variety of things. But in consequence of the division of labour, the whole of every man's attention comes naturally to be directed towards some one very simple object. It is naturally to be expected, therefore, that some one or other of those who are employed in each particular branch of labour should soon find out easier and readier methods of performing their own particular work, wherever the nature of it admits of such improvement.’ (Smith, 1776, p. 20)

More generally regarding scientific research:

‘All the improvements in machinery, however, have by no means been the inventions of those who had occasion to use the machines. Many improvements have been made by the ingenuity of the makers of the machines, when to make them became the business of a peculiar trade; and some by that of those who are called philosophers or men of speculation, whose trade it is not to do any thing, but to observe every thing; and who, upon that account, are often capable of combining together the powers of the most distant and dissimilar objects. In the progress of society, philosophy [in Smith’s day no specific distinction was made between science and philosophy – JR] or speculation becomes, like every other employment, the principal or sole trade and occupation of a particular class of citizens. Like every other employment too, it is subdivided into a great number of different branches, each of which affords occupation to a peculiar tribe or class of philosophers; and this subdivision of employment in philosophy, as well as in every other business, improves dexterity, and saves time. Each individual becomes more expert in his own peculiar branch, more work is done upon the whole, and the quantity of science is considerably increased by it.

‘It is the great multiplication of the productions of all the different arts, in consequence of the division of labour, which occasions, in a well-governed society, that universal opulence which extends itself to the lowest ranks of the people.’ (Smith, 1776, pp. 21-22)

Smith related this principle to the training of labour, that is the improvement of human capital, as well as technology:

‘The difference of natural talents in different men is, in reality, much less than we are aware of; and the very different genius which appears to distinguish men of different professions, when grown up to maturity, is not upon many occasions so much the cause, as the effect of the division of labour. The difference between the most dissimilar characters, between a philosopher and a common street porter, for example, seems to arise not so much from nature, as from habit, custom, and education...

‘By nature a philosopher is not in genius and disposition half so different from a street porter, as a mastiff is from a greyhound, or a greyhound from a spaniel, or this last from a shepherd's dog.’ (Smith, 1776, pp. 28-30)

Econometric evidence

Having outlined these four fundamental points of Smith’s classical theory of economic growth, it may be noted that modern econometric research has vindicated this analysis. ⁶ This classical theory of Smith also explains the growth of both the East Asian and the developed economies in a way that alternatives do not. The key points will be briefly considered in turn.

i. Division of labour at a national level – intermediate products

Smith’s analysis of the role of rising division of labour has been strongly confirmed on the national terrain by modern econometric research - as Spengler notes, Smith analysis demonstrates that: ‘in Bohm-Bawerkian terms... production became more roundabout.’ (Spengler, 1959, p. 402). This is strongly shown by analysis of the role of intermediate inputs in production – growth of intermediate inputs being an index of increasing division of labour.

This econometric evidence also indicates a flaw in the original formulation of growth accounting as developed by Solow, that it identified the elements of growth as being capital, labour, plus a residual TFP, but it did not explicitly deal with intermediate inputs (Solow, 1957). The practical significance of such an omission is made clear by the econometric finding that the most rapid increase of inputs in economic growth is neither capital, labour nor TFP but intermediate products and services. Taking account of this, and sub-dividing intermediate inputs into materials, energy and service inputs led to the improved formulation of KLEMS (capital, labour, energy, materials, service inputs) methodology - see for example (Timmer, O’Mahony, & van Ark, 2007)

Regarding factual trends for intermediate products in the most developed economy, i.e. the US, Jorgenson, Gollop and Fraumeni found these were clearly the largest source of growth for economic sectors, noting:

‘the contribution of intermediate input is by far the most significant source of growth in output. The contribution of intermediate input alone exceeds the rate of productivity growth for thirty six of the forty five industries for which we have a measure of intermediate input… If we focus attention on capital and labour inputs, excluding intermediate input from consideration, we find that the sum of contributions of capital and labour inputs exceeds the rate of productivity growth for twenty-nine of the forty-five industries for which we have a measure of productivity growth… the predominant contributions to output growth are those of intermediate, capital and labour inputs. By far the most important contribution is that of intermediate input.' (Jorgenson, Gollop, & Fraumeni, 1987, p. 200)

Considering such findings for the US in more detail Jorgenson noted:

‘The analysis of sources of growth at the industry level is based on the decomposition of the growth rate of sectoral input into the sum of the contributions of intermediate, capital and labour inputs and the growth of sectoral productivity… The sum of the contributions of intermediate, capital, and labour inputs is the predominant source of growth of output for 46 of the 51 industries…

‘Comparing the contribution of intermediate input with other sources of growth demonstrates that this input is by far the most significant source of growth. The contribution of intermediate input exceeds productivity growth and the contributions of capital and labour inputs. If we focus attention on the contributions of capital and labour inputs alone, excluding intermediate input from consideration, these two inputs are a more important source of growth than changes in productivity…

‘The explanatory power of this perspective is overwhelming at the sectoral level. For 46 of the 51 industrial sectors… the contribution of intermediate, capital and labour inputs is the predominant source of output growth. Changes in productivity account for the major portion of output growth in only five industries. (Jorgenson D. W., 1995, p. 5)

To illustrate this trend, Table 1 shows Solow growth accounting categories – capital, labour, TFP - together with the addition of a column for growth of intermediate inputs. As may be seen over the period 1977-2000 the median rate of growth of intermediate inputs in the US economy was 115% of the rate of growth of US GDP - far higher than any other input.

Table 1

Regarding studies of rapidly growing Asian economies:

• Ren and Sun found for China that in the period 1981-2000, subdivided into 1984-88, 1988-94 and 1994-2000: ‘’Intermediate input growth is the primary source of output growth in most industries.’ (Ren & Sun, 2007).
• For Taiwan, analysing 26 sectors in 1981-99, Chi-Yuan Liang found regarding intermediate material inputs: ‘Material input is the biggest contributor to output growth in all sectors during 1981-99, except… seven’. (Liang C.-Y. , 2007).
• For South Korea, Hak K. Pyo, Keun-Hee Rhee and Bongchan Ha found: ‘The relative magnitude of contribution to output growth is in the order of: material, capital, labour, TFP then energy.’ (Pyo, Rhee, & Ha, 2007)

From a theoretical point of view, therefore, the omission of intermediate inputs from the original Solow model led to errors in failing to situate division of labour as the crucial factor in economic growth - for a more detailed discussion see (Ross, 2009)

Considered on a national terrain Smith’s conclusion that increasing division of labour is the most fundamental source of economic growth may be considered as amply confirmed.

ii. Division of labour at an international level

Ideally, to analyse division of labour at an international level comprehensive statistical data on growth of intermediate inputs in production on a global, as well as a national, scale would be available. Unfortunately such data does not yet exist – for an analysis of steps in this direction see (Erumban, et al., 2010). Nevertheless the indirect evidence that division of labour increases at an international level is overwhelmingly strong - improbable processes would have to be postulated in order to justify any argument that international division labour was not increasing.

Most fundamentally the key trends in globalisation - rising share of trade in GDP, rising ratio of foreign direct investment to GDP - plus the studies of particular industries, are powerful evidence of increasing international division of labour. There is no reason to believe that the processes creating the clearly measurable increasing division of labour on a national scale should not operate internationally - Ferreira et al, for example, have provided a theoretical analysis of such processes (Ferreira & Trejos, 2008). Smith’s point that division of labour is the fundamental issue in the effects of foreign trade, and not that of crossing national borders, remains entirely valid. The findings on intermediate inputs within national economies are therefore confirmed by processes that are evident, with lower degrees of statistical rigour, in studies of globalisation.

The correlation of openness of a national economy, which may be a taken as a proxy of participation in international division of labour, with high GDP and productivity growth is confirmed by numerous studies and therefore does not require repeating here. A classic starting point remains Sachs and Warner (Sachs & Warner, 1995).⁷ 

iii. Rising level of investment

Smith’s analysis that the contribution of capital investment to GDP growth historically rises was shared by other major economists - including Keynes. For the modern period such an hypothesis may be tested by growth accounting – its confirmation by such methods is discussed below. Over a longer historical period, however, as the data necessary for proper growth accounting does not exist, the issue was predominantly analysed in terms of the tendency of fixed investment to rise as a proportion of the economy – a process, as already seen, analysed by Smith.

Milton Friedman, In the mid-20th century, challenged the Smith/Keynes analysis of the rising percentage of investment in GDP, on the factual grounds that the proportion of the US economy devoted to fixed investment had not risen with time. (Friedman, 1957). This is the case. However modern econometric findings show conclusively that the US represented an exception, not the overall trend, and that the level of investment in GDP in the other major economies historically rose – for a summary see (Barro & Sala-i-Martin, 2004). Figure 1 shows this trend for the major industrialised economies as calculated by Maddison. (Maddison, 1992)

As may be seen, the data clearly shows a rising trend of investment in GDP, with the US being the exception and not the rule.

• The percentage of fixed investment in GDP in France rose from 9 per cent in 1820, to 15 per cent in 1950, to 21 per cent by 1989.
• In Germany the comparable figures were 15 per cent in 1925, 19 per cent in 1950, and 26 per cent in 1966.
• In Japan the percentage of fixed investment in GDP was 11 per cent in 1885, 18 per cent in 1938, and rising to over 30 per cent in the 1970s.
• In the UK the figures are 8 per cent in 1870, 11 per cent in 1938, and 19 per cent in 1989.

The historically rising proportion of fixed investment in GDP in the main developed economies is therefore clear.

Figure 1

 

Figure 2 shows the long term data Maddison could calculate for developing economies – India, South Korea and Taiwan – as well as for Japan. Again the upward trend for the percentages of investment in GDP is clear.

Figure 2

 

To illustrate this process in a wider historical and geographical context, including in relation to the rapidly growing East Asian economies, the share of fixed investment in GDP for the leading growth economy during successive periods of historical economic development is shown in Figure 3 – these being, in chronological succession, England in the period leading to and following the Industrial Revolution; the US from the second half of the 19^th century; West Germany in its post-World War II ‘economic miracle’; Japan in the 1960s and 1970s; the Asian ‘Tiger Economies’, of which South Korea is taken as the example, in the 1980s, and finally China.⁸

The rising trend of fixed investment in GDP, and its correlation with successively higher rates of economic growth, is evident from the data. Considering countries in the chronological order in which a new peak in the proportion of GDP devoted to gross fixed domestic capital formation appeared in the leading growth economy, the following is the historical pattern.

Figure 3

 

• Immediately prior to the industrial revolution, the proportion of GDP devoted to fixed investment in England and Wales, was 5-7 per cent.⁹ This rose slightly, although current estimates are that it did not rise greatly, during the 19th century - peaking at over ten percent of UK GDP prior to World War I.  This level of investment was sufficient to sustain the first industrialisation of any country but at a rate of growth which, while historically unprecedented, was slow by present international standards - about two per cent a year.
• From the latter part of the 19th century the proportion of US GDP devoted to fixed investment had risen to considerably exceed that for the UK – reaching a level of 18-20 per cent of GDP by the last decades of the century. A sharp fall in the proportion of the US economy devoted to fixed investment commenced in the late 19^th century, and was particularly pronounced during the period between World War I and World War II – being associated with the Great Depression. After World War II the US resumed its pattern of 18-20 per cent of GDP being devoted to gross fixed capital formation. This sustained an average growth rate of 3.5 per cent a year. This investment level and growth rate sufficed for the GDP of the US to overtake Britain.        
• In the period following World War II Germany achieved a level of fixed investment exceeding 25 per cent of GDP – peaking at 26.6 per cent in 1964. This period 1951-64 was that of the post-war German ‘economic miracle’ with average growth of 6.8 per cent a year.
• Starting at the beginning of the 1960s Japan achieved a level of gross domestic fixed capital formation of more than 30 per cent of GDP. This reached a peak in the early 1970s, at 35 per cent of GDP, before later sharply falling – during that period the average annual rate of growth of Japan’s economy was 8.6 per cent.
• From the 1970s onwards, South Korea similarly achieved a level of fixed investment of 30 per cent of GDP. During the 1980s this rose above 35 per cent of GDP.  The other East Asian ‘Tiger’ economies – Singapore, Hong Kong and Taiwan – showed a similar pattern.  South Korea’s economy grew in this period at 8.3 per cent a year.
• From the early 1990s China achieved sustained rates of fixed investment of 35 per cent of GDP with, from the beginning of the 21^st century, this rising to more than 40 per cent of GDP. The result was average 9.9 per cent a year economic growth over a sustained period.

It may therefore be seen that the East Asian economies high level of investment is not an historical aberration - it is the logical culmination of a centuries long pattern of the rising proportion of fixed investment in GDP. Such data clearly confirms the rising contribution of investment to GDP foreseen by Smith.

For more recent periods, the greater availability of data allows detailed growth accounting to be carried out. The results for this are set out in Table 2 and Table 3.

Table 2 shows 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 of Vu (Vu, 2007). Subgroups for developed and developing economies are shown. Table 3 sets out similar calculations from the data for periods defined by Jorgenson and Vu in their study forming part of the World Bank International Comparison Programme – i.e. 1989-1995, 1995-2000, 2000-2004 and 2004-2008 . In addition to periodisations, other differences between the two tables should be noted. Table 2 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 3 is weighted. In Table 2, improvements in labour quality are included in TFP, as in the data presented by Vu (Vu, 2007), whereas in Table 3 improvements in labour quality are included in labour inputs (Jorgenson & Vu, 2007b). There are 109 countries in Table 2 compared to 122 countries in Table 3. As will be seen, however, such differences do not alter the qualitative trends found.

A fundamental finding of Jorgenson and Vu, shown in both Table 2 and Table 3, is the dominance of factor inputs, capital and labour, compared to TFP in international economic growth.¹⁰ Taking all economies in Table 2 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 four periods defined by Jorgenson and Vu in Table 3 they noted: ‘our first objective is to allocate the growth of world output between input growth and productivity… input growth greatly predominates! Productivity growth accounted for less than one-eighth of world growth during 1989-1995, while input growth accounted for more than seven-eighths… Input growth contributed more than four-fifths of growth in 1995-2000 and nearly five-eighths in 2000-2004 and 2004-2008.’ (Jorgenson & Vu, 2010)

Turning to a more detailed breakdown, the greatest contribution to GDP growth is from increase in capital inputs. Taking all economies in Table 2 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 or TFP in all periods - at 57.4%, 49.9%, 41.6% and 41.0%.

It may also be noted from Table 3 that while the role of TFP increases in the world economy in 2000-2004 and 2004-2008, and the role of both labour and capital declines, this is only due to a shift in the developing economies. There is no significant decline in the contribution of capital to GDP growth in the G7 or non-G7 developed economies – indeed there is an increase in the latter group. The contribution of capital to GDP growth in non-G7 developed economies in successive periods is 51.8%, 45.5%, 60.3% and 59.4%. The contribution of capital to GDP growth in G7 economies in successive periods is 62.0%, 59.5%, 60.0% and 59.9%.

In short capital inputs remain dominant in GDP growth throughout the period up to 2008.

It is also evident, and in line with Smith’s analysis, that there is a distinction in the patterns of growth of developing and developed economies. In Table 2 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. Thus the role of capital inputs is greater in developed economies than in developing. This is precisely in line with Smith’s analysis that the role of investment increases with economic development.

In contrast to developed economies ‘capital-intensive’ 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 intensive’ 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.

While the capital intensity of growth increases with economic development, there is, as will be seen below, no tendency for the contribution of TFP growth to increase with economic development.

Table 2

 

 

Table 3

 

iv. Level of investment and division of labour

While Smith analysed that the contribution of fixed investment to growth increased with time, it is important to note that he analysed that this was a product of division of labour – i.e. division of labour was the most fundamental and determining element, not rising investment. Modern econometrics, as noted above, also finds that the growth of intermediate products is greater than that of capital accumulation during economic growth – capital accumulation is the second most rapidly growing element in economic growth, but one remaining behind growth of intermediate products/division of labour. This is in line with Smith’s analysis.

This order of determination has clear implications against strategies which see increase in the percentage of the economy devoted to investment on the national terrain, without opening of the economy, as the decisive way to achieve growth. This was the strategy pursued, for example, in Stalin’s USSR and in China prior to the 1978 economic reform. It was also attempted in a less extreme form, and using regulated market as opposed to planned economic methods, in a number of developing countries.

It follows from Smith’s analysis of division of labour as the most fundamental force raising productivity that such a strategy of ‘closed economy plus high fixed investment level’ will not succeed – division of labour, including international division of labour, is more fundamental than increasing the level of fixed investment in an economy cut off from large scale, and therefore necessarily international, division of labour. While the USSR collapsed before opening of its economy could occur, the success of China’s ‘opening up’ policy has been stressed by numerous authors – see for example Lardy (Lardy, 1993) and Cao et al (Cao, Ho, Jorgenson, Ren, Sun, & Yue, 2009). The findings regarding this issue are adequately summarised by Ren and Sun:

‘China’s exports have risen from 7% of GDP in the 1979-84 period to 19.3% in 1992-99, and imports have climbed from 7.1% of GDP to 17.3%... Throughout this period of economic integration, China has been experiencing an unprecedented period of sustained high growth. This correlation between economic opening and a higher rate of sustained growth in China was no accident. The international development experience leaves no doubt that causality runs powerfully from economic opening to economic growth.’ (Ren & Sun, 2007, p. 93)

While the evidence is clear that a policy of a high level of fixed investment within a nationally close economy does not succeed, as would flow from Smith’s analysis, the East Asian developing economies strategy of ‘participation in the international division of labour plus a high level of fixed investment’ is entirely in line with Smith’s analysis.

It should also be noted that Adam Smith integrated the concepts of division of labour and rising proportion of the economy devoted to investment as interlinked aspects of the process of economic development. Both consisted of indirect inputs into production, i.e. intermediate products and investment goods, increasing relative to direct inputs. The correlation between high levels of openness to trade of economies to trade and high levels of fixed investment, found for example by Sachs and Warner, is therefore consistent with Smith’s views. (Sachs & Warner, 1995)

v. Relation of division of labour, entrepreneurship and technology

As already noted, division of labour, not ‘entrepreneurship’ or’ technology’, is the driving force of economic development in Smith’s theory – unlike the role played by entrepreneurship in Schumpeter’s analysis or of technology in theories deriving from Solow. This, naturally, did not mean that Smith believed entrepreneurial activity or technological change did not exist, but merely that they were explained by other processes.

In evaluating the role played by entrepreneurial activity in economic growth, a major difficulty in evaluating ‘entrepreneurship’ is the imprecise character of much writing on the issue and the use of invalid statistical arguments. As Audretsch et al note ‘operationalizing entrepreneurship for empirical measurement is difficult’, and they admit ‘the paucity of measures used to reflect entrepreneurial activity.’ (Audretsch, Keilbach, & Lehmann, 2006) Entrepreneurial activity would, however, be measured as part of TFP growth. Regarding technology it has, on occasion, been invalidly taken as explaining the whole of the Solow residual – i.e. TFP growth.

It was already noted above that Smith analyses technological change as being endogenously produced by division of labour. This is consistent with modern research on the contribution of R&D to productivity growth and on the symbiotic relation of universities and technological process – see for example (Jaffe, 1989) (Feldman & Florida, 1994) (Acs, 2002). This, of course, merely expresses a tendency for technological innovation not to come from ‘inspired and isolated geniuses’ but from the application of large resources to R&D and the creation of specialised research institutions! Similarly, as Audretsch et al state regarding modern concepts: ‘unlike the traditional theories of entrepreneurship… opportunities are not to be taken as exogenous, or given. Rather they are endogenously created as the result of targeted and systematic efforts to produce knowledge and new ideas by private firms, universities and research institutes.’ (Audretsch, Keilbach, & Lehmann, 2006) In such an analysis entrepreneurship, as well as technology, is a product of division of labour.

As regards the quantitative extent of the role played by entrepreneurship and technological change on GDP growth, this would be measured within TFP increases. The factual data shows that TFP is a smaller factor in economic growth than, in decreasing order of importance, increase in intermediate inputs, capital accumulation and increase in labour inputs. As already noted, Jorgenson and Vu conclude at a world level: ‘Productivity growth accounted for less than one-eighth of world growth during 1989-1995, while input growth accounted for more than seven-eighths… Input growth contributed more than four-fifths of growth in 1995-2000 and nearly five-eighths in 2000-2004 and 2004-2008.’ (Jorgenson & Vu, 2010):‘

This data, of course, casts further light on why Krugman’s critique of Asian economic development has failed to stand the test of events. For an extensive review of the literature showing that intermediate inputs, capital and labour predominate over TFP in economic growth readers are referred to (Jorgenson, 2009) Overall, as summarised more briefly in Table 2 and Table 3, there is no evidence for Krugman’s claim that economic growth in the developed economies is primarily driven by TFP growth, indeed the opposite is the case. Nor is there evidence that the role of TFP increases with economic development. The mean contribution of TFP to growth in developed countries is 24.0 per cent and the median contribution is 26.0 per cent, compared to a mean contribution of 25.4 per cent in developing economies and a median contribution of 25.0 per cent. The contribution of TFP to economic growth is the same in developing and developed economies. In contrast, as already noted, there is clear evidence that the contribution of capital to economic growth increases with economic development.

Conclusion

As noted at the beginning of this article, a theory in economics, as in any other field, must be judged by its ability to explain reality and events. Adam Smith’s ‘classical’ theory of economic growth both predicts the success of the Asian growth model to date and that its success will continue. It similarly explains growth of the developed economies. In particular:

• Smith’s analysis that division of labour is the most important factor in economic development and productivity is confirmed by econometric analysis of the growth of intermediate inputs in the national economy – these grow more rapidly than factor inputs of capital and labour, which themselves grow more rapidly than TFP. Solow’s original growth model therefore has to be extended to take account of this growth of intermediate inputs, as shown in KLEMs methodology. KLEMs studies show clearly that growth of intermediate products is the largest single source of output growth in the East Asian developing economies.
• As confirmed by numerous researchers, Smith’s analysis of the decisive role of division of labour is demonstrated at the international level by the superior performance of ‘open’ over ‘closed’ economic orientations. The East Asian developing economies based themselves on such open economic orientations – i.e. on integration into and utilisation of the international division of labour.
• The high level of fixed investment in the East Asian economies, accompanying their ‘open’ economic orientation, is not an historical aberration, or an error, but the continuation of an historical trend that has been taking place for over two hundred years and which was correctly foreseen by Smith. Far from being a sign of weakness, this high level of investment, coupled with the open economic orientation, is a decisive strength of the East Asian developing economies. Furthermore, as economies make the transition from ‘developing’ to being ‘developed’ the role played in growth by capital inputs increases. As econometric studies show that capital inputs are, after intermediate products, the most important source of economic growth, the orientation of East Asian developing economies to mobilisation of capital inputs, rather than concentrating on the more limited role of TFP increases, is therefore entirely rational.
• As improvements in technology and entrepreneurship would show statistically within TFP, and as these are themselves products of division of labour, given TFP increases are proportionately less important for growth that increases in factor inputs, there is no reason why strategies based on mobilisation of capital and labour cannot achieve levels of GDP per capita which equal or exceed those of already developed economies. This is confirmed particularly strikingly by the most developed of the East Asian economies, Singapore – for a detailed analysis see (Vu K. M., 2010). This, naturally, is not an argument against promoting technology and entrepreneurial activity, but that these are a product of the more important inputs of division of labour, capital and labour, and strategies based on increasing participation in division of labour and mobilising capital and labour inputs will be most effective.
• Flowing from the above, the ‘Asian growth model’, far from being erroneous, corresponds to the classical theory of economic growth as outlined by Adam Smith. Its success was therefore logical, and for the same reasons, such a strategy will continue to be successful. This is confirmed by the superior growth performance of those East Asian economies which have achieved developed status compared to the countries of North America and Europe.

In contrast to the success of the Asian growth model, corresponding to the classical theory of economic growth, the critique, and alternative model, put forward by Paul Krugman and others, suffers from error, and has been shown to be invalid by factual developments, for the following reasons.

• The theory that TFP plays the quantitatively key role in economic growth is incorrect. In descending order of their quantitative weight in economic growth, division of labour, as shown in the growth of intermediate inputs, mobilisation of capital and mobilisation of labour play the main role in economic growth. All play a greater quantitative role than TFP.
• There is no tendency for the role of TFP in economic growth to increase with economic development. Instead the role of capital inputs increases with economic development.
• Regarding inputs, the character of economic development is not a transition from growth based on inputs of capital and labour to growth based on TFP, but a transition from growth based predominant on inputs of labour to one based on inputs of capital.
• As Krugman’s theory is erroneous regarding the sources of growth in general it is also incorrect specifically regarding the sources of growth in both the developed and East Asian economies.
• In light of the above, it is logical that Paul Krugman’s prediction that the East Asian economies would be unable to achieve ‘developed’ status has been shown factually to be erroneous.

In summary, Adam Smith’s ‘classical’ theory of economic growth has been confirmed by the development of the East Asian economies, while Paul Krugman’s analysis, published in 1994, of the ‘Asian growth model’ has been shown to be in error regarding factual developments. As Adam Smith’s is a correct theory of economic growth, of which Asian development is a further confirmation, and as Paul Krugman’s is unfortunately not a correct theory, the relative track record of the last 17 years of the two in foreseeing events was predictable. Given Adam Smith’s ‘classical’ theory has been demonstrated to be correct on the key issues under dispute, if this approach is maintained, the success of the East Asian economies will continue.

It is not a piety to recall that the ability of Adam Smith’s theoretical analysis to continue to correctly predict the key parameters of economic development 235 years after it was put forward once again confirms it as one of the great achievements in human intellectual history.

 

Notes

Political dogma limits US economic recovery

I have an article with the title ‘Political dogma limits US economic recovery’ at China Daily’s site, and a reply to Gavyn Davies on his Financial Times blog. Both deal with the current relative states of growth of the US and China’s economies.

The two pieces note that recent economic data confirms the analysis, made on this blog over the last three years, that the US economic recovery would be far slower after this recession than in previous post-war business cycles. This trend is not short term but part of a long term gradual but progressive slowdown of the US economy – more detailed statistical data for which can be found here.

This analysis was contrasted to those, for example those of Gavyn Davies or John Paulson, which earlier this year argued that a relatively robust US recovery was taking place. Recent factual data clearly shows this latter position was incorrect.

The situation of the US economy is considered in these pieces in terms of a classical Keynesian ‘liquidity trap’. Why China has not suffered from one is analysed, and therefore why its economic growth is continuing to be much higher than that of the US. The China Daily piece may be found here and the comment on Gavyn Davies’s analysis here.

Lessons China can draw from Apple

I have a new article in Shanghai Daily analysing China's attempt to develop high value added production. It shows that China is rightly emphasising technology. But an equally key issue, that of high quality design, is not receiving the attention which is required. The article looks at the examples of Apple, Intel and Samsung and their lessons.

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.

No improvement in trade deficit means US economic recovery will have to depend on domestic growth

February’s US trade deficit of $45.8bn was worse than the average forecast of $44.3bn. January’s deficit was also revised upwards to $47.0bn from the previous estimate of $46.3bn. However little should be read into a single month’s figures and more important is the trend.

This confirms that the period of improvement in the US trade position which began after the international financial crisis has ended. The US trade deficit reached its lowest point in May 2009, at $24.9bn, deteriorated to $50.0bn in June 2010 and since then has remained in a range from $38bn - $47bn – see Figure 1.

Taking a three monthly moving average, to smooth out purely short term fluctuations, shows the same pattern – see Figure 2.

This stagnation of the trade position means that the period of positive contribution to US GDP growth from an improvement in the net trade position is also no longer operating - contrary to the hopes of the US administration. Unless there is a dramatic improvement in the trade position in March, which on present trends appears unlikely, the speed of growth of US GDP in the the 1st quarter of 2011 will therefore depend entirely on domestic factors.

Looking at the medium term, a pattern of US GDP growth which is dependent only on domestic factors is more vulnerable to the fiscal tightening which the Republican majority in the House of Representatives is pushing for - and with which the Obama administration appears likely to make significant compromises. The February trade figures therefore tend to shave estimates of US economic growth downwards.

Figure 1

 

Figure 2

Paul Krugman proved wrong on China's trade

I have a new article at China,org.cn showing, on the basis of the newly published data, that Paul Krugman was entirely wrong on his factual claims regarding China's balance of payments surplus for 2010, and that the projections made on this blog at the beginning of last year were correct against his claims. It notes: 'Paul Krugman's claim of $450 billion [for China's balance of payment surplus] was therefore entirely inaccurate... he proposed to launch a trade war between the world's two largest economies on the basis of a factual projection that was quite false,'

Those who want a more detailed analysis of Paul Krugman's errors than was possible in a short article,and an examination of the actual trends in China's trade, are referred to  'Paul Kruman's economic illogicalities on China' and the analysis of the declining trend of China's trade surplus carried on this blog earlier this year.

'Keynesian' economic policies and the shape of the 2007 'Great Recession' compared to the 1929 'Great Depression'

Executive summary

The present article compares the US ‘Great Recession’ of 2007-2011 with the ‘Great Depression’ of 1929-1933 from the angle of the internal structure of the US economy. The reason for such a comparison is that it casts significant light on the structural effects of ‘Keynesian’ economic responses to the international financial crisis - in particular the consequences of large budget deficits and expansionary monetary policies on the underlying structure of the US economy. The implications for the short, medium and long term growth of the US economy of these trends are considered. It is shown that present policies will not reverse the long term decleration of the US economy that has been analysed previously.

Downturn

In the 4^th quarter of 2010 US GDP regained the peak level of the previous business cycle – the latter having been achieved in the 4^th quarter of 2007. The frequently used term ‘Great Recession’ to describe the course of the intervening three years of the business cycle is accurate insofar as it indicates that this was the deepest US economic downturn since World War II – Figure 1. The maximum fall in US GDP in the current business cycle was 4.1 per cent, compared to the previous greatest post-World War II decline of 3.2 per cent, which occurred in the cycle commencing in 1973. The duration required in the present cycle to recover the previous peak level of GDP, twelve quarters, was as long as the total length of the double dip recession commencing in 1981, but the latter recession was much shallower than the post-2007 downturn - Figure 1.

Figure 1

 

Comparison to 1929

However, while the term ‘Great Recession’ is entirely accurate in indicating that the fall in GDP in the present business cycle was the deepest since World War II, nevertheless it is exaggerated if taken to imply any serious comparison to the Great Depression itself – the significance of the impact of the current downturn is quite different to that of the Great Depression, as will be analysed below. Outlining the differences between the two economic downturns casts light on present trends as well as issues of economic analysis and policy. 

Evidently the first difference between the current business cycle and the Great Depression is the scale of the respective downturns – Figure 2. The trough of the post-1929 decline came in 1933, by which time US GNP had fallen by 29.7 per cent from its 1929 peak.¹ In contrast, the bottom point of the present recession was the decline of 4.1 per cent in the 2^nd quarter of 2009. The decline after 1929 was therefore seven times as deep as the present downturn. For this reason talk of ‘two depressions’ cannot be justified.² As will be seen, however, the two downturns differ not only in scale but in pattern.

Figure 2

 

Dynamics of GDP during 1929-1933

To show the difference in shape, as well as in scale, between the Great Depression and the Great Recession, the shape of post-1929 downturn will first be outlined and the present business cycle will then be compared to it.

Figure 3 therefore shows the change in components of US GDP between 1929 and 1933 in percentage terms. Figure 4 shows the change in components of US GDP in constant price dollar terms.

Considering first Figure 3, it may be noted that the dominant percentage downturn in the components of US GDP after 1929 was in private fixed investment. ³ Rounding to the nearest percentage point, US GDP fell by 30 per cent between 1929 and 1933. US government consumption over the same period rose by 5 per cent. US consumer expenditure fell by 20 per cents, imports fell by 35 per cent and exports declined by 46 per cent. However the drop in private fixed investment was 74 per cent.

Figure 3

 

Decline in investment and consumption during the Great Depression

Turning to the differing quantitative contributions to the decline in US GDP after 1929, consumer expenditure constituted then as now a far higher percentage of GDP than fixed investment - in 1929 US consumer expenditure, at current prices, accounted for 74 per cent of GDP compared to 14 per cent for private fixed investment.⁴

Technically in assessing the quantitative impact of the changes in different components of GDP it should be noted that constant price components cannot be precisely compared due to index number issues. Fortunately for analysis, however, the trends in changes in most different components of US GDP after 1929 were sufficiently distinct as to leave no doubts as to the underlying development.

Although consumer expenditure accounted for a higher proportion of US GDP than fixed investment, the percentage decline in the latter after 1929 was so severe that its quantitative contribution to the decline in GDP was approximately the same as the fall in consumer expenditure.

In 1982 constant price terms the decline in consumer expenditure in 1929-33 was $93bn and that in private fixed investment was $95bn – see Figure 4. It may therefore be stated qualitatively that the decline in fixed investment and the decline in consumer expenditure contributed approximately equally to the post-1929 GDP decline. In contrast, decline in inventories was only $22bn, a fall in imports offset the decline in exports so that the decline in net trade was only $6bn, and government consumption rose by a marginal $4bn.

In summary, the Great Depression was characterised in percentage terms by the fall in fixed investment, and in terms of contribution to the total decline in GDP approximately equally by the fall in consumer expenditure and the decline in fixed investment. As will be seen this pattern differs sharply from that during the post- 2007 recession.

Figure 4

 

The 2007 business cycle

To illustrate the contrast of the Great Recession to the Great Depression, Figure 5 shows the changes in percentage terms of components of US GDP following the 4^th quarter of 2007. It may again be seen that in percentage terms the decline in private fixed investment in the current business cycle is by far the largest element in the downturn - as after 1929. By the 4^th quarter of 2010, i.e. three years after the peak of the previous business cycle, US GDP had just regained the level of its previous peak in 4^th quarter 2007 - technically reaching 0.05 per cent above the previous peak. US exports were 5.9 per cent above the 4^th quarter of 2007 and government expenditure 5.1 per cent above. Consumer expenditure was 0.9 per cent above the 4^th quarter of 2007 and imports 3.2 per cent below. However private fixed investment was 18.3 per cent below its previous peak level – a decline more than three times as much as any other component of GDP.

It may be noted that recovery in the current business cycle has already begun. Therefore to avoid any distortions caused by making a comparison of present trends to the pattern between 1929 and 1933, i.e. to the low point of the Great Depression, it is also useful to make a comparison between the 4^th quarter of 2007, the peak of the previous business cycle, and the trough of the current recession in the 2^nd quarter of 2009. At that point GDP had declined by 4.1 per cent, government expenditure had increased by 5.8 per cent, consumer expenditure had declined by 2.4 per cent, imports had declined by 18.0 per cent and exports by 10.7 per cent, while private fixed investment had declined by 23.4 per cent – Figure 5.

Figure 5

 

Quantitative changes during the 2007 business cycle

If the quantitative contribution of different components of GDP to the overall post-2007 economic decline is considered it may be seen that the pattern in the current recession is substantially different to that following 1929. Figure 6 shows the comparison, in terms of the movement of components of GDP in constant price terms, between the latest available data for the 4^th quarter of 2010, and the peak of the previous cycle in the 4^th quarter of 2007.

It may be seen from Figure 6 that the post-2007 business cycle is entirely dominated by a decline in fixed investment – compared to the essentially equal contribution of the decline in fixed investment and consumption during the post-1929 downturn. By the 4^th quarter of 2010 all other components of US GDP, with the marginal exception of inventories, were already above their level at the peak of the previous business cycle. Measured in 2005 dollars, US GDP was $7bn above its previous peak level, consumer expenditure was $84bn above its level in the 4^th quarter of 2007, government expenditure $124bn above, and net trade $165bn above. Inventories were a marginal $6bn below. However private fixed investment was $386bn below its level in the 4^th quarter of 2007. It may, furthermore, be noted that this latter figure understates the actual decline in US fixed investment, as this peaked as early as the 1^st quarter of 2006 and between then and the 4^th quarter of 2010 US fixed investment fell by $471.3bn.

To make a comparison to the low point of the present business cycle, i.e. the 2^nd quarter of 2009, in 2005 prices the decline of GDP was $554bn at that point compared to the 4^th quarter of 2007. Consumer expenditure fell by $225bn and inventories by $174bn. Government consumption rose by $94bn and net exports by $214bn. Private investment however had fallen by $495bn, i.e. twice as much as any other component of GDP - see Figure 7.

Contrast of the 1929 and 2007 downturns

Turning to comparison of the patterns of economic decline following 1929 and folowing 2007 it may be noted that in both 1929 and 2007 government final expenditure rose during the recession – in the earlier period, contrary to some popular impressions, this also occurred under Hoover and before Roosevelt’s election. However following both 1929 and 2007 such an increase was entirely insufficient to offset the declines in other components of GDP.

In addition to the differences in scale of the downturn by far the biggest divergence in economic pattern between 1929 and 2007 was that of the difference in balance in the respective downturns between household consumption and investment. In both cases by far the greatest fall in percentage terms was in fixed investment. However in quantitative terms, as already seen, there was an approximately equal decline in private fixed investment and consumer expenditure after 1929. In contrast, the post-2007 downturn was overwhelmingly dominated by the decline in fixed investment with, in comparison, a far smaller decline in consumer expenditure.

These different patterns may be held in mind while analysing the Great Recession and the Great Depression.

Figure 6

Figure 7

 

Comparison of 1929 and 2007

It was noted above that after 1929 the contribution of the decline in consumer expenditure to the total fall in GDP essentially matched that of the decline in private fixed investment. In the 2007 cycle, in contrast, the contribution of the fall in consumer expenditure, even at the lowest point of the downturn, was less than half that of the drop in private fixed investment and by the 4^th quarter of 2010 US consumer expenditure was already above its previous peak level.

Given the radically different scale of the events of 1929 and 2007 it would not be reasonable to draw conclusive quantitative causal connections between the present economic events and the governmental  policies pursued. It may, however, be noted that the pattern of economic events after 2007, compared to 1929, was consistent with the economic policies pursued. Furthermore, noting the divergent trends in the private sector and government policy, it is difficult to escape the conclusion that the latter bore a large measure of responsibility for maintaining consumption during the Great Recession.

The US private sector and US government policy

By themselves developments in the US private sector after 2007, both directly and indirectly, undoubtedly operated to produce a sharp downturn in consumer expenditure. In terms of direct effects, unemployment rose sharply, reducing incomes and therefore potential purchasing power of those made unemployed, while there were also widespread reductions in wage rates and other measures which reduced income. US real wages have continued to decline – in March 2011 US nominal wages had risen by 1.7 per cent in the last year whereas inflation in the same period was 2.0 per cent. (Reddy, 2011) Indirectly, precautionary motives due to the impact of the financial crisis, fear of unemployment, and other reasons, initially led to a sharp increase in personal savings rates. These have remained significantly above pre-crisis levels despite their recent decline – also exercising a depressive effect on consumer expenditure.

However, in contrast to private sector trends, US government policy was strongly counter-cyclical as regards consumer spending – alongside the modest increase in final government consumption already noted. If the operation of the private economy reduced consumer demand then state policy deliberately boosted it – such support coming via tax reductions, prolongation of unemployment pay, mortgage support and other measures. The maximum decline in US consumer expenditure was 2.4 per cent, in the 2^nd quarter of 2009, and by the 4^th quarter of 2010 consumer expenditure was already 0.9 per cent above its 4^th 2007 level - despite the fact that unemployment remained at high levels and that the real wage reductions since the start of the financial crisis had not been reversed.

It is not possible to state definitively that this relatively strong sustaining of US consumer spending was due to government policy, although this would be a reasonable supposition, however it was evidently consistent with the policy.⁵

The US Great Recession is not a fall in consumption

This relative lack, in comparative terms, of a severe fall in consumer expenditure during the Great Recession is important to note as it refutes a widely held interpretation of the impact of the Great Recession that its primary effect would be to reduce US consumption (see Ross, 11 February 2010). On the contrary, not only did consumer expenditure recover relatively rapidly but the share of consumption in US GDP increased significantly – see Figures 8 and 9.

The percentage of consumer expenditure in US GDP rose from 69.9 per cent in the 4^th quarter of 2007 to 70.8 per cent in the 4^th quarter of 2010. The share of total consumption, i.e. both personal and government, rose from 85.8 per cent to 87.7 per cent of US GDP in the same period.

This failure of US consumption to fall significantly during the Great Recession therefore contrasts strongly with post-1929 developments.

Figure 8

Figure 9

 

US government policy and fixed investment

If, however, developments in the post-2007 US economy were consistent with US government policies to prevent a sharp fall in consumption, no such correlation existed with any government policy attempting to reverse the decline in fixed investment. On the contrary, as already noted, post-2007 US private sector fixed investment fell sharply and the marginal increase in state fixed investment was entirely insufficient to offset this.

Between the 4^th quarter of 2007 and the 4^th quarter of 2010 US defence fixed investment rose by $25.7bn, Federal non-military fixed investment rose by $9.2bn, and there was a decline of $11.1bn in fixed investment by the individual US states. This was entirely inadequate to offset the $325.5bn decline in private fixed investment.

The scale of the fixed investment decline shows that policies such as low interest rates had no effect in preventing this drop which were comparable to trends preventing the fall in consumer expenditure.

It may therefore be argued that US government policy was successful in preventing a severe decline in consumption, and certainly in this field economic events and the goals of policy coincided, but clearly no equivalent success was achieved in preventing a decline in fixed investment. It may also be noted that there was no equivalent US government practical policy announced to halt the decline in fixed investment that compared in scale with the tax reductions, extension of the period of unemployment benefit, mortgage protection and other measures that were counter-cyclically deployed to sustain consumer expenditure.⁶

As a consequence of its sharp decline, the share of US fixed investment in GDP fell from 19.0 per cent of GDP in the 4^th quarter of 2007 to 15.6 per cent of GDP in the 4^th quarter of 2010 – see Figure 10.

Figure 10

 

Implications for medium and long term US growth

Finally, regarding the consequences of the pattern of economic trends, it is clear that this post-2007 decline in fixed investment has substantial implications for the medium and long term performance of the US economy. Investment is the main factor in US economic growth – more than fifty per cent of US GDP growth being accounted for by capital inputs. (Ross, 8 September 2009) The current decline in fixed investment is therefore likely to continue the long term slowing of the US economy – the annual moving average for US 20 year growth having declined to 2.5 per cent and the 10 year moving average having fallen to 1.7 per cent. (Ross, 9 January 2011)

A case can therefore clearly be made, on the basis of the trends in the US economy since 2007, that US government policy moderated or halted the decline in consumption. It did not, however, halt the investment decline and the fall in the latter will continue the trend to a slowing of the US growth rate.

Were post-2007 policies those of Keynes?

Turning from factual economic trends to the implications for economic analysis and theory it may be noted that in references to the economic policies pursued since 2007 the term ‘Keynesian’ in this article has been placed in inverted commas. The reason for doing so is that it not to be implied that the US policies pursued to deal with the Great Recession – budget deficits, and accommodative monetary policy but no significant intervention in investment – are in fact the gamut of policies advocated by Keynes in the General Theory of Employment Interest and Money. For reasons dealt with elsewhere, the policies advocated by Keynes in the General Theory included centrally, and may be said to have focussed on, investment - see (Ross, Winter 2010). However, as already noted, US government policy in dealing with the post-2007 economic downturn focussed on consumption and not investment.

Authors such as Paul Krugman have presented budget deficits as the central issue of 'Keynesian' economics – see for example (Krugman, 2 September 2009), (Krugman, 21 March 2011) and and (Krugman, 2 April 2011). However this is not actually in accord with the General Theory of Employment Interest and Money.

The policies pursued post-2007 by the US government may, therefore, be taken as a partial test of the efficacy of the policies of budget deficits and highly accommodative monetary policy, but they cannot be taken as a test of Keynes policies - as they did not correspond to the policies set out by Keynes himself. To clarify this distinction the term ‘Keynesian’ economics (in inverted commas) is therefore used to describe the policies advocated by Krugman and others, while Keynes economics (with no inverted commas) may be used to describe the policies advocated by Keynes himself. A further analysis of the difference is given elsewhere (Ross, Winter 2010).

Conclusion

The following conclusions may therefore be drawn from the above analysis of the comparison of the pattern of economic trends in the Great Recession and Great Depression, in addition to the different magnitude of the two developments:

• A fall in consumption during the Great Recession contributed proportionately far less to the economic downturn than in the Great Depression.
• The relative resilience of US consumption during the Great Recession, compared to the Great Depression, was consistent with US government policies aimed at sustaining consumption.
• No comparable policies to sustain US fixed investment in the Great Recession were deployed comparable to those utilised to offset the decline in consumption.
• A fall in fixed investment contributed proportionately far more to the decline in US GDP in the Great Recession than in the Great Depression.
• The fall in fixed investment will ensure that the trend to a long term slowing of the US economy will continue.

In summary, policies of budget deficits and monetary accommodation deployed by the US government, which are popularly but inaccurately referred to as ‘Keynesian’, may well have contributed to the relative shallowness of the decline in US consumption during the Great Recession. They are, however, insufficient to prevent the fall in fixed investment and therefore the long term slowing of the US economy.

Notes

1. The latest version of the Bureau of Economic Analysis NIPA Table 1.1.6 shows a decline of US GDP of 26.7 per cent between 1929 and 1933 (Bureau of Economic Analysis, 2010). However the data in this table does not give a breakdown between private fixed investment and inventories. For this reason the GNP data from The Economist’s One Hundred Years of Economic Statistics is used for calculations (Liesner, 1989). Given the order of magnitude difference between the economic downturns after 1929 and after 2007 the difference in percentage between the new NIPA data and that used by the Liesner does not affect in any significant way the different patterns found.

2. For an example of such a type of analysis see ‘A Tale of Two Depressions’ (Eichengreen & O'Rourke, 2009). For their update of this analysis in 2010 see (Eichengreen & O'Rourke, 2010).Paul Krugman also characterised the present economic situation as a depression: ‘We are now, I fear, in the early stages of a third depression. It will probably look more like the Long Depression [after 1873] than the much more severe Great Depression… And this third depression will be primarily a failure of policy. Around the world — most recently at last weekend’s deeply discouraging G-20 meeting — governments are obsessing about inflation when the real threat is deflation.’ (Krugman, 27 june 2010)

3. Keynes diagnosed this correctly from the beginning of the 1929 recession and well before the publication of The General Theory of Employment Interest and Money (Keynes, 1936). In his The Great Slump of 1930, published in December 1930, Keynes noted: ‘If, then, I am right, the fundamental cause of the trouble is the lack of new enterprise due to an unsatisfactory market for capital investment… By the middle of 1929 new capital undertakings were already on an inadequate scale in the world as a whole, outside the United States. The culminating blow has been the collapse of new investment inside the United States, which to-day is probably 20 to 30 per cent less than it was in 1928.’ (Keynes, 20 & 27 December 1930)

4. Calculated from (Liesner, 1989).

5. The importance of transfer payments and other state measures in sustaining consumption in modern business cycles, compared to 1929, has of course rightly been highlighted by a number of economists - including Hyman Minsky. (Minsky, 1986)

6. It should be made clear that what is being considered here is the macroeconomic category of household consumption. During the Great Recession the distribution of incomes, and therefore of consumer expenditure, was shifted away from the worst off sections of the population.

 

Works Cited

US GDP data shows savings fell in 4th Quarter

The final release of data for the 4th quarter 2010 US GDP showed the highly significant trend that US savings fell as a percentage of US GDP – see Figure 1. The drop for one quarter was entirely marginal – from 11.74 per cent of GDP to 11.71 per cent. However the significance is that US savings are continuing a long term trend to fall as a percentage of its economy.

This is in contradiction to the analysis that the effect of the financial crisis would be a ‘rebalancing’ of the US economy through a rise in its savings rates.

Figure 1

 

The new decline was due to a fall in the US household savings rate – which has now dropped from its recent peak of 5.7 per cent of GDP in the 2nd quarter of 2009 to 4.3 per cent in 4th quarter 2010. Over the same period US net government dissaving fell from 9.8 per cent of GDP to 8.7 per cent.

This trend to a decline in US saving will limit the potential for a recovery in US investment and therefore growth. Unless there is an increase in foreign financing, via an increase in the US balance of payments deficit, i.e. an increase in global imbalances, US investment will continue to be constrained by the declining domestic savings rate.

US economic recovery is therefore likely to continue to be lower than in previous post-World War II business cycles.

The central date for China's GDP to overtake the US at market exchange rates is 2019 - a study of growth assumptions and analyses

Summary

The question of when China’s GDP will overtake the US, to become the world’s largest national economy, is self-evidently significant.¹ It has become much discussed among Western economic commentators (Rachman, 2011).

When Goldman Sachs first suggested that China’s GDP would exceed that of the US by 2041 this caused surprise (Wilson & Purushothaman, 2003). When Goldman Sachs revised this forward to 2027 this caused greater shock (O'Neill, 2009). But it has since become evident that, on current trends, Goldman Sachs forecasts projected too long a period for China’s GDP to overtake the US – and did so before the international financial crisis.

In the last two years, work carried out by the present author in the Research Group China in the International Financial Crisis, at Antai College, Shanghai Jiao University, arrived at an estimate of the most central date for China’s GDP, at market exchange rates, to exceed the US as being 2019 – there is inevitably a degree of variance on either side in such projections.

Interestingly, as noted below, other recent analyses now arrive at essentially the same date range regarding parity purchasing power (PPP) estimates. A remaining weakness in a number of these latter studies, however, is that they have in the past underestimated China’s growth and still project too long a time scale for China’s GDP to equal the US at market exchange rates. The reasons for this are considered in detail below.

Perhaps surprisingly, it turns out that projections on this issue are not highly sensitive to the ranges of precise growth rates utilised - provided that these are within realistic historical bounds. The central conclusion is that, unless there is a qualitative change in the economic situation, China’s GDP at market prices is likely to exceed the US in the period 2017-2021. It is also significant that the rate of growth of US current dollar GDP is decreasing while the rate of growth of China’s dollar GDP is accelerating – purely linear projections therefore tend to overestimate the period of time before which China’s GDP equals that of the US.

This article surveys literature on this issue, clarifies the reasoning for such time frames, and analyses their key parameters. A fundamental qualitative characterisation of the relative position of the US and China’s GDPs is indicated.

Calculations on the range of reasonable US GDP growth rates to be projected have been considered in detail in other articles and these are utilised below.² Concentration in this article is therefore on reasonable projections of the growth rate of China’s GDP in dollar terms.

Background – systematic underestimation of the growth rate of China’s economy

In any subject, including economics, the ultimate test of analysis and theory is how accurately it predicts developments. Therefore the two fundamental tests of analysis regarding former planned economies have been the success of China’s reform policy and the failure of shock therapy in Russia and the former USSR. The former produced the most rapid growth in any major economy, and the latter saw the greatest peacetime decline in production in any major country in modern history.  

In both cases majority conventional wisdom at the time transpired to be incorrect. When in 1992 the present author contrasted favourably the success of China’s economic reform to the ‘shock therapy’ then being introduced in Russia, and predicted continued rapid economic growth in China compared to negative results in Russia, majority opinion disagreed with such analysis (Ross, 1992). However, at that time, China’s economy at market exchange rates was only 6.7 per cent the size of the US and only 67.5 per cent the size of the former USSR (World Bank, 2010). Therefore understanding of the potential of China’s economic policy was primarily based on issues of economic theory, related to the early progress of its economic reform, and not to the level of realised accomplishment which now prevails. Study of China’s economy in 1992 was also a minority interest, with the fashionable focus of attention at that time being the alleged benefits of shock therapy and with a prevailing view that China would lag because of its failure to adopt this.³

Nineteen years later the results are evident. China’s economy is the world’s second largest. It has maintained the highest rate of growth of any major economy throughout the almost two decade intervening period. Attention to China’s economy is no longer based primarily on potential or economic theory but on accomplished achievement. For comparison China’s economy today is almost three times as large as the economy of the entire former USSR, more than four times as large as the economy of Russia, and has overtaken Japan to become the world’s second largest. The relevant discussion now is when its GDP will overtake the US - hence this article.

Analysis of China’s economy has now also become highly fashionable and no longer of minority interest. Nevertheless, as will be shown below, many of the most widely cited predictions regarding China’s economy – for example those of Goldman Sachs and PWC – have underestimated how fast China’s economy would develop and have therefore regularly upgraded their forecasts. This error has still not been fully corrected. Most forecasters now project that China’s GDP will exceed that of the US in PPP terms during the next 10-20 years - with the majority of such projections falling towards the early part of this range. But, for reasons considered in detail, they continue to underestimate how rapidly China’s GDP will equal that of the US at market exchange rates.

The relevant literature will therefore first be surveyed and then a detailed examination will be made of the assumptions involved in projections of the size of China’s GDP compared to the US at market exchange rates. 

Recent projections on China’s economic growth

Goldman Sach’s projection for China’s GDP to overtake the US in 2041, made in the well known paper ‘Dreaming with BRICs’, was based on the assumption that China’s GDP in nominal dollar terms, rather than at constant prices or exchange rates, would increase at 8.1 per cent a year between 2005 and 2040 (Wilson & Purushothaman, 2003).⁴ This projection turned out to be less than half the relevant rate of China’s growth in the last 10 years to 2010 – the actual outturn, in current dollars, was 17.2%. Jim O’Neill, former chief economist of Goldman Sachs, was therefore correct to note: ‘What many casual observers of our BRIC projections never realized is that we used extremely conservative assumptions.’ (O'Neill, 2009b) Unsurprisingly, therefore, Goldman Sachs, subsequently brought forward their projection of the year China’s GDP will overtake the US - to 2027 (O'Neill & Stupnytska, 2009). A further analysis of Goldman Sachs projections is given below.

More recent projections by others have calculated significantly earlier dates than Goldman Sachs. In the most extreme estimate Arvind Subramanian, of the Peterson Institute of International Economics, argues that in PPP terms, China has already overtaken the US (Subramanian, 2011). The Conference Board, estimates China’s GDP, again in PPP terms, could overtake the US in 2012 (The Conference Board, 2011). The current projection of the IMF in PPP terms is that China’s GDP will overtake the US shortly after 2015 (International Monetary Fund, 2010). The Economist projects China will overtake the US in 2019 (The Economist, 2010). PWC conclude China’s GDP will overtake the US before 2020 (Hawksworth, 2010) (Hawksworth & Tiwari, 2011). Standard Chartered bank predicts China will overtake the US by 2020 and that by 2030 its economy will be twice the size of the US (Adam, 2010)

In contrast, China’s media has tended to take a highly cautious approach to this issue - insisting that comparisons be made only in current exchange rates and utilising relatively optimistic projections regarding the US’s growth and relatively pessimistic ones regarding China’s (China Daily, 2010).

This echoes the Chinese media’s similar approach to comparisons of China’s economy with Japan. Calculations made in terms of PPPs showed that China overtook Japan to become the world’s second largest economy in 2001 (International Monetary Fund, 2010). China, however, only acknowledged that it was the world’s second largest economy in 2010, when it overtook Japan in current exchange rate terms.

In one sense such caution by China’s media is well founded. Serious issues need objective consideration. Exaggeration of achievements is unhelpful. Furthermore, as is well known, even when China’s GDP is the same as that of the US, China will still be a far poorer country in terms of income per person - to be precise, as China has approximately four times the population of the US, when China’s total GDP equals that of the US China’s GDP per capita will only be one quarter that of the US.

Nevertheless, while conservatism in assumptions is commendable, distortions in perspective and policy also occur if underestimates are made. The only really useful calculations are those which are accurate as regards fundamentals. Given that it is spurious exactitude on such a complex issue to give a single precise date it is necessary to analyse the key parameters involved and therefore the reasonable range of projections.

Official exchange rate and PPP studies

As is well known there exist two fundamental measures for estimating the relative sizes of the US and China’s economies – those made at market exchange rates and those made in terms of PPPs. Some studies, notably those carried out for PWC, analyse both. (Hawksworth, 2006) (Hawksworth & Cookson, 2008) (Hawksworth & Tiwari, 2011).

Both measures and approaches are relevant.⁵ However because market exchange rates are more objectively verifiable, because actual transactions are carried out in these terms, and because the Chinese authorities themselves generally only utilise calculations in market exchange rates, emphasis in this paper is on this measure. First however, to set parameters, literature utilising PPPs will be compared to those for the US and China’s GDP at market exchange rates.

Official exchange rate and PPP calculations

Calculations of the relative size of the US and China’s GDP at market exchange rates are simple and up to date. China has released its first official estimate of GDP in 2010 - 39.8 trillion yuan (National Bureau of Statistics of China, 2011). No official exchange rate for conversion of this annual GDP to dollars was published, but utilising a simple unweighted daily average for 2010 yields a figure of $5.9 trillion - the final data will not differ greatly from this.⁶ This compares to a US GDP in 2010 of $14.7 trillion.⁷ (Bureau of Economic Research, 2010). At official exchange rates, China’s economy is approximately 40 per cent of the size of the US.

PPP calculations start from the well known fact that average prices in China, as with most developing countries, are lower that average prices in the US when converted at market exchange rates. The real comparative size of China’s GDP, in terms of real inputs and outputs, is therefore understated compared to the US,. It is for this reason that analysts have supplemented, or replaced use of, market exchange rates and attempted to calculate PPPs for China, the US and other economies.⁸

Nevertheless a drawback of this approach remains that the calculation made for PPP exchange rate is crucial for the estimate of the relative size of the two economies compared to market exchange rates - which in contrast are readily objectively verifiable. As will be seen, estimates based on calculated PPP’s therefore may yield very early dates for when China’s GDP will exceed the US.

Three PPP estimates of China’s GDP

Taking an overall review of the range of PPP estimates for the size of China’s economy three calculations essentially coincide – those of the World Bank, the IMF (International Monetary Fund, 2010) and the CIA (Central Intelligence Agency, 2011). Taking 2009, the latest date available for PPPs:

• the World Bank estimates the size of China’s GDP at $ 9091bn;
• the IMF estimates the size of China’s GDP at $9047bn;
• the CIA estimates the size of China’s GDP at $8950bn.

All, for 2009, therefore give a PPP estimate of the size of China’s GDP at 63-64 per cent of the US’s $14 256bn.

These figures are essentially calculated from the baseline estimate of the size of China’s GDP in PPPs in 2005 published by the World Bank International Comparison Programme (World Bank, 2007). This revised downwards the previous estimate of the size of China’s GDP by 40 per cent. This downward revision has, however, been contested by a number of authors on various grounds – for example that that backward projections of the data yield implausible results, or that basing price calculations only on cities yields inaccurate results as prices are lower in China’s rural areas (Deaton & Heston, 2008) (Subramanian, 2011).

Higher PPP estimates of China’s GDP

There therefore exist, for the above and other reasons, higher estimates of China’s GDP in PPP terms. The most extreme, as noted, are Subramanian’s, who argues that in these terms, China’s GDP is $14.9 trillion, and has already marginally overtaken the US (Subramanian, 2011). Subramanian, however, is an outlier in such estimates whose conclusions have not received any widespread support.

More significant, and more frequently quoted, are estimates by The Conference Board and those in the data of Angus Maddison - the Conference Board’s Total Economy database is now widely cited and Maddison was not only a leading authority on economic growth in general but made specific analyses of China’s GDP (Maddison, 1998) (Maddison & Wu). Regarding these:

• The Conference Board gives an estimate of $12.9 trillion for China’s GDP in PPP terms in 2010, compared to $14.5 trillion for the US, producing an estimate that China’s economy is already 89 per cent of the size of the US.
• Maddison died in 2010 and the latest year for which he gave estimates of the GDP of the US and Chinese economies was 2008. His calculations were expressed as 1990 Geary-Khamis dollars. Maddison’s base year was 1990, for which he calculated China’s GDP as $2124bn. Maddison’s views were emphatic, for reasons stated in detail in his Chinese Economic Performance in the Long Run, and his conclusion was already that: ‘In 2003 its [China’s] GDP was about 73 per cent of that in the USA.’ (Maddison, 1998) (Maddison & Wu, p. 1) Maddison also concluded that in these terms in 2008 US GDP was $9.5 trillion and China’s $8.9 trillion – i.e. on this measure China’s economy was 94 per cent the size of the US (Maddison, 2010).⁹

Subramanian reports that the new version of the Penn Tables, to be released in February 2011, will revise its estimate of China’s PPP up by 27 per cent (Subramanian, 2011).

Utilising such higher PPP estimates of the size of China’s GDP can give projections for when China’s GDP will overtake the US which are very short – as already noted that it has already occurred in the case of Subramanian and that it will occur in 2012 in the case of The Conference Board. It may be noted, however, that even the IMF, utilising its own lower estimates, now projects that China’s GDP will overtake the US in PPP terms shortly after 2015 (International Monetary Fund, 2010).

Valuable as PPP methodology is, however, due to the high degree to which estimates based on PPPs depend on the calculated PPP exchange rates, and because actual transactions are carried out at market prices, primary emphasis here will be on calculations based on market exchange rates and PPPs are used only for comparison.

Combination of PPP and exchange rate studies

A series of studies which have sought to compare market exchange rate and PPP data for the relative size of the US and China’s economies are by Hawksworth and collaborators for PWC. (Hawksworth, 2006) (Hawksworth & Cookson, 2008) (Hawksworth, 2010) (Hawksworth & Tiwari, 2011)

These successive studies have progressively brought forward their estimate of the date at which China’s GDP will equal that of the US. In the 2008 study China was projected to overtake the US in PPP terms in 2025 (Hawksworth & Cookson, 2008, p. 2). In the most recent, 2011, study China: ‘is expected to overtake the US as the world’s largest economy (measured by GDP at PPPs) sometime before 2020.’ (Hawksworth & Tiwari, 2011, p. 8).

Even more striking is the degree to which the PWC studies have brought forward the date at which China is projected to overtake the US in terms of market exchange rates. In its 2006 study PWC projected that China’s GDP would still be six per cent smaller than the US at market exchange rates in 2050 (Hawksworth, 2006, p. 22). By the 2011 study China was projected to overtake the US at market exchange rates in 2032. (Hawksworth & Tiwari, 2011, p. 16)

Goldman Sachs

In similar fashion to PWC, Goldman Sachs, which made the earliest well known projection of when China’s GDP will exceed that of the US, has also progressively brought forward its date for this – these estimates have been made as part of Goldman Sachs BRIC studies. In 2003 Goldman Sachs predicted that China’s economy would be larger than the US by 2041 (Wilson & Purushothaman, 2003).¹⁰ Goldman Sachs however subsequently noted that China, in particular, was growing substantially faster than its earlier projections.¹¹ Thus, for example, in December 2009 it analysed: ‘how the BRIC economies stand today compared with how we projected them to be back in 2003... All four economies have attained levels of USD GDP that we had not originally expected until later – with China, of course, the main standout. We now assume a much stronger GDP performance for China by 2050 than we originally estimated. (O'Neill & Stupnytska, 2009, p. 5) More succinctly ‘China tops the list of countries whose growth performance has surpassed our expectations.’ (O'Neill & Stupnytska, 2009, p. 4) The date for China’s economy exceeding the US was brought forward to 2027 (O'Neill, 2009).¹²

Goldman Sachs 2003 prediction was based on projecting that China’s GDP in nominal dollar terms would increase at 8.1 percent a year. In fact in 2000-2010, the most recent 10 year period for which data is available , China’s annual nominal dollar GDP growth was 17.2 percent.¹³

Goldman Sachs has not revised its own BRIC forecasts since 2008. Even then, as seen, its assumptions had tended to underestimate China’s growth rate - and since 2008 the US economy has lost momentum, due to the international financial crisis, while China has not. When Goldman Sachs next revise their forecast as to the date when China’s economy will be as large as the US they will almost certainly bring it forward – as they have done in major previous revisions.

Different variables

For calculations made at market exchange rates, the date at which China’s GDP will equal the US primarily rests on the assumptions made regarding the rate of growth in constant prices of the US and China’s economies, their respective inflation rates, and the exchange rate of the RMB relative to the dollar. It is, therefore, possible to make a range of combinations of assumptions regarding these variables - The Economist has even produced a ready reckoner with which to do so! (The Economist, 2010)) The issue is evidently what range of values it is reasonable to insert and what is the sensitivity of the result for such different variables?

The Economist’s central projection was that annually China’s economy grows at 7.75 per cent, its inflation is 4.0 per cent and the yuan revalues by 3.0 per cent a year against the dollar, while the US grows at 2.5 per cent and its inflation is 1.5 per cent. This combination yields the result that China’s GDP overtakes the US at market exchange rates in 2019.

Interestingly, as also found when doing research at Antai College, the combination of such variables yield results which are not highly sensitive to any precise entry of figures which lie within historically reasonable ranges. For example, leaving all other parameters the same as in The Economist’s variant above, and increasing China’s growth rate to its average since 1978 of 9.9 per cent, only brings forward the date in which China’s GDP overtakes the US to 2018. The same result is obtained by using the highly favourable assumption to China of 9.9 per cent annual growth and utilising the 10 year annual growth rate of US GDP of 1.7 per cent (Ross, 2011a). Even taking the wildly favourable assumptions for China, all other things remaining equal, of 9.9 per cent GDP growth, 5.0 per cent yuan appreciation, and US growth at 1.7 per cent, only brings the date forward to 2017. Similarly taking a highly favourable conclusion for the US that its growth rate over the next decade accelerates to its historical 3.4 per cent, which is above its average growth rate for last 20 years, and assuming China’s growth decelerates to 7.75 per cent, and taking the Economist's assumptions as above for inflation and exchange rates, only pushes out the date China’s GDP overtakes the US to 2020.

These variants therefore confirm the author’s own studies that, provided any historically reasonable range of variables is used, the results target a relatively narrow range of 2017-2021, centred on approximately 2019.

A sense check

There is, however, another way to carry out such estimates. This is to do a ‘quick and dirty’ sense check calculation of the relative rates of growth of the US and China’s nominal dollar GDPs. As robust projections normally rely on having a small number of assumptions, and this is preferable to excessive numbers of variables, such estimates are of interest.

Such ‘quick and dirty’ methods consists of simply analysing the trends in nominal GDP, at official exchange rates, of China and the US without attempting to decompose these into movements in real GDP growth, inflation and exchange rate movements - such overall trends in nominal GDP in dollars may be taken as ‘summarising’ the GDP growth, inflation and exchange rate movements.¹⁴ Making such an analysis strikingly reveals clear long term trends illustrated in Figure 1 and Table 1. These show:

• the rate of growth of US nominal GDP is decelerating with time – i.e. the more recent the period of time the lower the growth rate of nominal US GDP.
• China’s GDP growth rate in current dollar terms is accelerating – i.e. more recent periods show higher growth rates than older ones.

Continuation of such trends, of course, implies that linear projection of past growth rates, i.e. those not taking into account the deceleration of US nominal GDP growth and the acceleration of China’s, will tend to overstate the period until China’s GDP exceeds the US.

Figure 1

Table 1 

Taking precise figures, if the overall period from the beginning of China’s economic reforms, in 1978, to the latest available data for 2010 is considered then the annual rate of increase of US nominal GDP is 6.0 per cent. However if the most recent two decade period 1990-2010 is taken annual US nominal GDP growth is 4.8 per cent. If the most recent 10 year period 2000-2010 is taken then annual US GDP growth is 4.1 per cent. If the most recent 5 year period is taken, 2004 to 2009, then the annual average increase in US nominal dollar GDP is 3.1 per cent.

The deceleration of US GDP growth in terms of current prices and current exchange rates is therefore evident. An element in this, as analysed elsewhere, is not only the deceleration of US inflation rates in the recent period but also the gradual slowing of the US economy in real constant price terms (Ross, 2011c).

China shows the reverse trend. If the overall period since the start of economic reform, i.e. 1978-2010, is taken then China’s annual nominal dollar GDP growth is 12.2 per cent.¹⁵ If the most recent 20 year period 1990-2010 is taken then annual nominal GDP growth is 15.0 per cent. If the most recent 10 year period 2000-2010 is taken then annual nominal dollar GDP growth is 17.2 per cent (calculated from World Bank, 2010). If the most recent 5 year period is taken, 2005 to 2010, then the annual average increase in nominal dollar GDP is 21.1 per cent. The rate of growth of China’s GDP in nominal dollar terms has therefore clearly shown an accelerating trend.

To take a central illustrative case of such trends, if a linear projection of the last 10 year period is taken then the answer as to when China’s GDP will overtake the US at market exchange rates is 2019. As, however, the trend is for acceleration of China’s growth rate in nominal dollar terms, and for deceleration of the US, then 2019 might be taken, using this method, as an indication of an outer bound of when China’s GDP overtakes the US.

Sensitivity of the results

Fortunately, and interestingly, it again turns out that provided projections made using such estimates are within the realm of reasonable results based on past performance, then results are not extremely sensitive to precise figures used.

As shown in Table 2, if the ultra-favourable assumption for China were made that its annual growth rate in nominal dollar GDP remained that of the last five years, i.e. 21.1 per cent, and the growth rate of the US also remained at that of the last five years, i.e. 3.1 per cent, then China’s GDP still does not overtake the US until 2016 – however this five year period is too short to be used for serious projections, particularly as it includes the impact of the international financial crisis, and is therefore not taken here as part of the central results but treated as an outlier used for illustrative purposes. If China’s and the US’s 10 year average growth of nominal dollar GDP are taken, i.e. respectively 17.2% and 4.1%, then China’s GDP exceeds the US in 2019. If a 20 year average growth of nominal dollar GDP increase for China and the US is taken, respectively 15.0% and 4.8%, then China’s GDP exceeds the US in 2020.

In short, unless a drastic change in the relative behaviour of China and the US’s GDP is assumed, of a type not experienced in the last 20 years, then China’s GDP will exceed that of the US sometime in the period 2016-2021 with 2019 a central point of such a range. A graph for the latter projection, using 10 year averages, is shown in Figure 2.

A ‘quick and dirty’ sense check therefore coincides with analysis based on the wider series of values for real constant price growth rates, inflation rates and exchange rates.

Table 2

Figure 2

 The qualitative features

What conclusions may be drawn from the above data?

It is not particularly valuable to attempt to refine the figures further to arrive at a more precise date – too many elements, with too high a degree of uncertainty, exist to try to determine whether China’s GDP will exceed that of the US in, for example, 2018 or 2020. What is significant, however, is that on any input of the range of actual comparative performance during the last twenty years China’s economy, in current exchange rate terms, will exceed the US at some point during the period 2017-2021. Furthermore such a date range is not greatly sensitive to changes in reasonable, in light of past performance, inputs.

Such a finding has a precise economic meaning. It means that some fundamental change must take place in existing trends within approximately a ten year time frame for China’s GDP at market prices not to overtake the US in the period 2017-2021.

If, as pointed out above, PPP calculations lead to excessively early projections for when China’s GDP will exceed the US, it is equally the case that projections that China’s GDP will not overtake the US at market exchange rates within the range 2017-2021 have to rely on asserting that an absolutely fundamental change will take place during the next decade. The ‘status quo’ scenario is that China’s GDP at market exchange rates will exceed the US in this period.

While, of course, a sharp change in relative inflation or exchange rates could produce a significant change in the above trends most frequently those who assert that China’s GDP will not overtake the US during the coming decade postulate a major change in relative US and China constant price growth rates. For these to prevent China’s GDP overtaking the US at market exchange rates during the next ten years it must be postulated either that a fundamental acceleration of the US economy will occur or, as few analysts predict such a development, more usually it must be asserted that for some reason a severe slowing of China’s economy during the next decade will occur.¹⁶

It is perhaps due to a difficulty in accepting the reality of China overtaking the US as the world's largest economy that there exists a large ‘catastrophist/drastic slowdown’ literature on China.¹⁷ Detailed examination of these various perspectives is beyond the scope of this paper. For present purposes it is sufficient to note that short of such a drastic slowdown in the near future, that is on the basis of continuation of the trends that have prevailed over the last decades, China’s GDP at market exchange rates will overtake the US approximately in 2017-2021.

For purposes of qualitative analysis, the simplest way to cut through the Gordian knot of detailed calculations is that China’s GDP ‘in approximately ten years time will be approximately the same size as the GDP of the US’. This will, of course, constitute a new period in world economic history.¹⁸

Conclusions

The following fundamental conclusions follow from the above data and review:

• The majority of international analysis of China’s underestimated its growth and considered as likely to produce more favourable results ‘shock therapy’ pursued in the former USSR. It is no longer possible to sustain such analysis in the light of the test of economic development over almost  three decades. China’s economic approach has been overwhelmingly more successful than shock therapy.
• Even studies which have emphasised the shifting balance of economic weight towards emerging markets, such as those of Goldman Sachs and PWC, have nevertheless systematically underprojected China’s growth. They have therefore successively revised upwards their estimates for the development of China’s GDP.
• The majority of such projections now estimate that China’s GDP in PPP terms will exceed that of the US in the period prior to 2020.
• Such projections continue to lag behind trends as they do not grasp that China’s GDP at market prices will also equal the US in the period to 2017-2021.

Notes

US 4th quarter 2010 GDP shows cyclical upturn and continued long term economic deceleration

Summary

US GDP growth figures for the 4^th quarter of 2010 of 3.2% came in below the average analyst forecast for the quarter of 3.5%. Cyclically the US economy is expanding but its growth rate is significantly slower than in previous post-World War II business cycles. Despite the cyclical upturn the long term slowing of the US economy, analysed in previous articles, therefore continues. The underlying reason for this deceleration remains the decline in US fixed investment.

Trends in this business cycle

To place the latest US economic data in comparative context, the performance of US GDP during successive business cycles since 1973 is shown in Figure 1. The label for each cycle is the year of the peak level reached by GDP in the previous cycle, with the data lines then showing the consequent recession and continuing to the high point of GDP in the expansion. For comparison trends lines for 2.6% and 1.7% growth are shown – these being, respectively, the current 20 year and 10 year moving averages for US GDP growth.

Figure 1

 

It may be seen that recovery in this US business cycle is slower than in previous cycles.

The 4^th quarter of 2010 was three years after the peak of the previous business cycle in the 4^th quarter of 2007. US GDP in the 4th quarter of 2010 was 0.1% above that previous peak level. In comparison:

• three years after the beginning of the double dip recession commencing in 1980 US GDP was 0.6% above its previous peak level;
• three years after the beginning of the recession starting in 1973 US GDP was 4.8% above its previous peak;
• three years after the beginning of the recession beginning in 1990 US GDP was 5.3% above its previous peak;
• three years after the beginning of the recession commencing in 2000 US GDP was 6.2% above its previous peak.

The slow pace of recovery of US GDP in the present business cycle compared to previous ones is therefore clear.

The results of the latest data on longer term US growth are shown in Figures 2 and 3 – showing respectively 20 year and 10 year moving averages for US growth rates. The latest 20 year moving average for US growth, to the 4th quarter of 2010, is 2.6% and the latest 10 year figure is 1.7%.

The deceleration of long term US growth is evident. The 20 year moving average of annual US GDP growth fell from a peak of 4.3%, in the 2^nd quarter of 1969, to 2.6% in the 4^th quarter of 2010. The 10 year moving average of US annual GDP growth has fallen from a peak of 5.0%, in the 2^nd quarter of 1968, to 1.7% in the 3^rd quarter of 2010.

Figure 2

Figure 3

 

The slow rate of US economic recovery

To show the consequences for US growth if recovery were to continue at the present rate, Figure 4 shows 3.2% US GDP growth projected to the end of 2011 - this growth rate is both that for the latest quarter and the average projection, in economists polled by the Wall Street Journal, for US growth in 2011.

To take a comparison for the rate of recovery during US business cycles, the 4th quarter of 2011 will be exactly 4 years after the peak of the previous business cycle. Given 3.2% annualised growth until the end of 2011, US GDP in the 4th quarter of 2011 would be 3.4% above its previous peak. For comparison, after 4 years of the 1980 business cycle US GDP was 9.1% above its previous peak, in the 2000 business cycle the equivalent figure was 9.5%, after 4 years of the 1973 business cycle US GDP was 10.0% above its previous peak, and after 4 years of the 1990 business cycle US GDP was 10.5% above its previous peak.

Average growth over these cycles shows clearly the slow trend of the current recovery. Annual US GDP growth after 4 years of the 1980 business cycle averaged 2.3%, with the equivalent figures for the 2000 cycle being 2.4%, for the 1973 cycle 2.5%, and for the 1990 cycle 2.6%.  However, given an average 3.2% growth until the end of 2011, annual average US GDP growth over 4 years of the present US business cycle would be only 0.9% – a slow recovery in comparison.

 Figure 4

 

Decline in investment

The reason for both the depth of the US recession and relatively slow growth during recovery in the present business cycle is clear.  As analysed in previous articles the present US recession is dominated by the fall in fixed investment. Figure 5 shows, in constant price 2005 dollars, the change in the components of US GDP since the peak of the previous business cycle. As may be seen, both US GDP and all components of GDP, excluding the marginal decline in inventories, are now above their previous levels - except for fixed investment.

US GDP is $19bn above is previous peak level, while inventories are down a marginal $5bn. The increase in personal consumption is $89bn, the rise in government consumption is $131bn, and the increase in net exports is $168bn. However US private fixed investment is $386bn below its 4th quarter 2007 level.

As shown in Figure 6, the current decline in US fixed investment far exceeds that seen in previous post-World War II business cycles. In the 4th quarter of 2010 US private fixed investment was still 21.5% below its peak level - the latter being reached almost five years previously in the 1^st quarter of 2006.

Not only is the depth of fall of fixed investment in this business cycle far greater than in the previous ones, but it is unprecedented in a post-World War II business cycle that after five years US private fixed investment is still below its previous peak.

Figure 5

Figure 6

 

Decline in non-residential fixed investment

It is important to note that this decline in US fixed investment is not confined to the residential sector. As shown in Figure 7, approximately half the decline in fixed investment is due to decline in the residential sector and half to the non-residential sector - the fall, in constant price terms, in residential fixed investment is $197bn and the decline in non-residential fixed investment $193b.

Figure 7

 

Figure 8 similarly illustrates that the decline in non-residential fixed investment in this business cycle is more severe than in previous cycles.

US non-residential fixed investment peaked in the first quarter of 2008 and by the 4^th quarter of 2010, i.e.  11 quarters after this peak, was 12.5% below its previous highest level. After the same number of quarters in the 2000 cycle non-residential fixed investment was 9.9% below its previous peak, in the 1973 cycle 6.1% below its previous peak, in the 1980 cycle 5.4% below, and in the 1990 cycle 4.7% below its previous peak.Therefore the fall in non-residential fixed investment in this business cycle was more severe than in previous post-war cycles.

It is interesting to note that the slowest pace of recovery of non-residential fixed investment, prior to the present cycle, was in the 2000 cycle – i.e. recovery of non-residential fixed investment has been slower in the last two US business cycles than in previous ones. Such a slow rate of recovery of non-residential fixed investment would, of course, in large part explain the slowing long term rate of growth of the US economy.

Figure 8

 

The long term trend of US fixed investment

In order to show the structural consequence of this weakening trend of US investment, Figure 9 shows total US fixed investment, i.e. including both private and government fixed investment, as a percentage of GDP at current prices.

As may be seen, until the mid-1980s, with relatively short term fluctuations, US fixed investment remained relatively stable as a percentage of GDP – essentially centred on a level of 20% of GDP. This was, however, from the mid-1980s followed by a decline, with the percentage of fixed investment in GDP falling to 17.0% of GDP by 1991, recovery and then a lesser fall to 18.4% of GDP in 2002, and a precipitate drop to 15.3% of GDP in 2009.

In short, from the mid-1980s onwards, the level of fixed investment in the US has experienced both greater fluctuations and greater declines as a proportion of GDP. The consequence of the aftermath of Reaganite economics has therefore been a fall in US fixed investment as well as slower US growth rates.

Figure 9

 

Figure 10 shows that this fall in US fixed investment affected not only the residential but also the non-residential sector. US non-residential fixed investment rose relatively steadily to a peak of 14.0% of GDP in 1981 but then began to decline overall and fluctuate more significantly – the low point being reached at 9.5% of GDP in 2009.

The fall in residential fixed investment after 2005, to a low of 2.5% of GDP in 2010, is evident in Figure 10.

In short the last two and a half decades have seen a significant fall in US fixed investment in both residential and non-residential sectors.

Figure 10

Conclusion

The US economy has continued to turn upwards after the Great Recession. Such cyclical recovery may be expected to continue in the coming period - as it has so far been in place for only six quarters. But the pace of economic US growth is significantly slower than in previous post-war economic cycles. It is  insufficient to reverse the long term slowdown in the average growth rate of the US economy. Only a reversal of the underlying decline in US fixed investment would be sufficient to halt this slowing of the US economy.

For a longer term, and more detailed, analysis of the long term deceleration of the US economy readers are referred to an earlier article.

Average economist predictions for US GDP would mean only 0.9% annual average growth over business cycle to end 2011

Summary

A recent Wall Street Journal survey of economists revealed an average prediction of 3.2% US GDP growth in each quarter of 2011. This figure may be used to  further clarify the analysis of US growth trends carried on this blog and discussion of the conclusions of Gavyn Davies, Jim O’Neill, and others regarding the issue.

A previous post noted the US economy has been slowing for several decades. The average growth rate currently projected for cyclical US recovery is insufficient to reverse such gradual but long term deceleration. The implications of 3.2% growth to the end of 2011 are that US GDP would have grown at an average of only 0.9% in 4 years of the current business cycle – substantially below trend to an equivalent point in previous post-World War II cycles. Such a 3.2% growth rate, even maintained for a 4 year period, would not reverse the US economy's long term deceleration.

Therefore, unless there is a sharp acceleration of US growth above current projections, the trend of long term slowdown of the US economy will continue.

Trends in US business cycles

To allow comparison of US performance during business cycles, Figure 1 shows quarter by quarter economic growth in each US cycle since 1973. The lines show the development from the peak of the preceding cycle, through the cyclical recession, to the final quarter of growth before the ensuing recession – the year indicated for each line is the starting one for the the cycle. For comparison a 2.5% annual growth trend line and a 1.7% annual growth trend line are shown – these being respectively average the 20 year and 10 year US annual growth up to the latest available US GDP data for the 3rd quarter of 2010. For the latest business cycle, starting in the 4th quarter of 2007, a 3.2% growth projection for five quarters after the latest available data, i.e. to the end of 2011, has been added.

It may be seen from Figure 1 that 3.2% growth to the end of 2011 would leave US GDP growth considerably below that in the equivalent stages of previous US business cycles.  .

Figure 1

 

Taking comparisons, the 4th quarter of 2011 is exactly 4 years after the peak of the previous business cycle in the 4th quarter of 2007. Given 3.2% annualised growth until the end of 2011, US GDP in the 4th quarter of 2011 would be 3.4% above its previous peak. For comparison, after 4 years of the 1980 business cycle US GDP was 9.1% above its previous peak, in the 2000 business cycle the equivalent figure was 9.5%, after 4 years of the 1973 business cycle US GDP was 10.0% above its previous peak, and after 4 years of the 1990 business cycle US GDP was 10.5% above its previous peak.

Average growth over the cycles shows trends clearly. Annual US GDP growth after 4 years of the 1980 business cycle averaged 2.3%, with the equivalent figures for the 2000 cycle being 2.4%, for the 1973 cycle 2.5%, and for the 1990 cycle 2.6%.  However, given an average 3.2% growth until the end of 2011, the annual average US GDP growth over the 4 years of the present US business cycle would only be 0.9% – self-evidently a significantly slow recovery in comparison.

10 and 20 year moving averages

To show the effect of such performance on longer term US growth rates, Figure 2 shows the 10 year moving average of US GDP growth with a projection of 3.2% growth until the end of 2011. Figure 3 shows the same projection analysed in terms of a 20 year moving average.

Figure 2

Figure 3

 

As Figures 2 and 3 show the average economists prediction of 3.2% growth in 2011 would be insufficient to reverse the long term slowdown in US growth whether a 20 year or a 10 year moving average is taken.

Considering the 20 year moving average, 3.2% US GDP growth to the end of 2011 would raise 20 year average US GDP growth to 2.7% from the present 2.5% – still below the 3.0% in the 4th quarter of 2007, before the current cyclical downturn commenced, and which was itself below the long term rate of growth of US GDP.

Taking the 10 year moving average, 3.2% US GDP growth to the end of 2011 would raise the 10 year average growth figure to 2.0% from the present 1.7% – still well below the 2.9% in the 4th quarter of 2007.

Therefore it is clear that 3.2% growth in 2011 would be insufficient to reverse the long term deceleration of US growth.

Long term consequences of a 3.2% growth rate

Taking a longer time frame, it is also clear that a much more prolonged period of  growth rates at current projections would not greatly alter the situation regarding failure to reverse the gradual but clear long term slowdown of the US economy. To show this, Figure 4 illustrates the result of 3.2% US GDP growth maintained until the end of 2015, i.e. over a 4 year period, for a moving 10 year US annual average growth rate. Figure 5 shows the same for a  20 year moving average. It may be seen that in neither case would a reversal of the long term deceleration of US growth rates occur.

Figure 4

Figure 5

 

Taking figures, 3.2% US growth maintained until the end of 2015 would raise the 20 year moving average for US growth to 2.7%, compared to 3.0% in the 4th quarter of 2007, before the current recession, and raise the 10 year moving average for growth to 2.1% compared to 2.9% in the 4th quarter of 2007.

Even a 4 year period at currently projected growth rates would not reverse the long term slowing of the US economy. Only if there were an acceleration of US growth rates to levels significantly above those currently projected would the gradual but progressive slowing of the US economy be reversed.

Conclusion

Analysis of prospects for the US economy has tended to concentrate on “spectacular” or short term trends such as predictions of double dip recession, Japan style prolonged stagnation, or fast cyclical growth. The fundamental trend in the US economy, however, is its long term slowing from its historic growth rate. Current projections for US growth rates would not alter this deceleration.

Long-term and short-term cyclical prospects for US growth

Gavyn Davies, chair of Fulcrum Asset Management and former head of global economics at Goldman Sachs, launched a discussion on his Financial Times blog on prospects for US economic growth. This, among other issues, refers to material which has appeared here.

This discussion, as both Gavyn Davies and the present author note, highlights the need for clarity in distinguishing between short-term cyclical and longer term trends in US growth and problems in perspective that arise if the two are conflated.

The aim of the present article is therefore to provide some precise numbers which clarify these points. This also gives parameters by which to judge US short (and long) term growth performance as economic data is released – the US will publish new GDP data, for the 4th quarter of 2010, on 28 January.

Assumptions on US economic growth

Gavyn Davies referred to an article which appeared here entitled “The long term slowing of the US economy”. This noted the progressive long term deceleration of the US economy.

If a 20 year moving annual average of US GDP growth is compared at 10 yearly intervals, then 20 year annual average growth to the 3rd quarter of 1970 was 3.8%, to the 3rd quarter of 1980 3.6%, to the 3rd quarter of 1990 3.2%, to the third quarter of 2000 3.2%, and to the 3rd quarter of 2010 2.5%. For further details readers are referred to the article.

Gavyn Davies confirmed the article’s overall trend conclusion on the long term deceleration of US growth and provided further information on US GDP per capita GDP, which had not been dealt with in the article. He commented: “The rate of [US] growth has clearly slowed down in recent decades. I do not think this trend has been arrested or reversed, but there could still be scope for several years of cyclical recovery.”

I strongly agree with emphasising this distinction and it therefore further clarifies the discussion if definite numbers are plugged in.

Gavyn Davies, and Jim O’Neill chairman of Goldman Sachs Asset Management, both suggest as parameters of strong US growth performance in the coming period figures in the region of an annualised 3-4%.

Gavyn Davis noted positively: “according to the ISM business surveys and much other data published lately, the growth rate of [US] GDP may have risen to around a 3.5 to 4 per cent rate.” Jim O’Neill wrote: “A number of quarters of 3-4% or more real GDP growth are likely in the next couple of years.”

Certainly, compared to recent US growth performance, an annualised 3-4% would be high – the current US 5 year average annual growth is 0.9% and current 3 year growth is zero.

However, it should be noted that such stronger cyclical growth would still be insufficient to halt the long term slowing of the US economy. To show this Figure 1 shows the 20 year moving average for US GDP growth with two projections for the next two years 2011 and 2012 - that US growth is 3% or 4% in the nine successive quarters from the latest available data (the 3rd quarter of 2010) to the end of 2012. Figure 2 shows the same projections using a 10 year moving average.

It may be seen from Figures 1 and 2 that neither a 3% or a 4% growth rate sustained over the next two years would be sufficient to reverse the long term deceleration of the US economy.

Figure 1

Figure 2

 

Results of projections

Taking first a 20 year moving average, if a 3% US growth rate were maintained to the end of  2012 the 20 year US annualised growth rate would  advance from 2.5% to 2.7%. If 4% growth were maintained for two years then the US 20 year moving growth average would be 2.8%.

However in the 4th quarter of 2007, that is the quarter before the start of the current US recession, the 20 year moving average growth rate was 3.0% – and as can be seen from Figure 1 this was a decline from the US rate of growth in previous decades. Therefore neither 3% nor 4% growth for the next two years would be sufficient to reverse the long term decline in the US growth rate.

Turning to a 10 year average, 3% growth over the next two years would take the 10 year US growth rate to 2.0% and 4% growth would take it to 2.3%. However the US 10 year moving average growth in the 4th quarter of 2007 was a significantly higher 2.9%.

Therefore annual average US GDP growth over years of 3-4%, as may be seen from Figures 1 and 2, would be insufficient to halt the declining trend of US 10 year GDP growth.

Longer term projections

It is indeed striking that even if 3-4% annual growth were continued for over four years, until the 4th quarter of 2014, this would still not be enough to reverse the slowing long term trend of US growth. A 4% US growth rate sustained until the end of 2014, for 17 successive quarters, would take the 20 year annual average of US growth to 2.8% and the 10 year average to 2.4%. A 3% US growth rate sustained until the end of 2014 would take the 10 year annual average growth rate to 2.0% and the 20 year annual average to 2.6%.

In neither case would this be sufficient to take the long term US growth rate back to pre-recession levels.

Recovery in business cycles

This above data illustrates, of course, that trends and cycles are not separate. Closer examination indicates that the long term slowing of the US economy is due not simply to deeper recessions, most notably the present one, but to slower growth during expansions. Long term deceleration of the US economy is a result both of the depth of recessions and of the relative slowing of recoveries. 

To illustrate this the fundamental data regarding successive US business cycles is illustrated in Figure 3. This shows economic growth in each US cycle since 1973. The lines show the development from the peak of the preceding cycle, through the cyclical recession, to the final quarter of growth before the next recession – the year indicated for each line is the starting year of the cycle. For comparison a 2.5% annual growth trend line and a 1.7% annual growth trend line are shown – these being respectively average 20 year and 10 year US annual growth to the latest available data.

Figure 3

 

The fundamental trends shown by Figure 3 are clear. The current business cycle naturally saw the deepest fall of US GDP in any post-World War II recession. The 1973, 1980 and 1990s cycles culminated in annual average growth over the cycle above the 2.5% trend, while the 2000 and 2007 cycles showed growth below it – which simply illustrates in detail the long term slowing of the US economy.

The 2007 recession shows a trend which is so far significantly below both the 2.5% 20 year annual average and the 1.7% 10 year US average. Failure of US growth to eventually finish above these figures over the cycle would confirm a further slowing of the US economy.

Comparisons of US growth

Such trend rates of US growth in previous cycles give an appropriate benchmark for considering US economic recovery. Evidently, if a comparison is made to extreme scenarios then US performance might appear strong.

Jim O’Neill, for example, makes a comparison to Japan’s two decade long stagnation after 1990: “My hunch for the surprise of 2011 is that the US will positively shake people up… I believed that in spite of the considerable challenges for the consumer, the US economy would not fall into a Japan-style abyss of a lost decade or two. The evidence that the US will not go down this route will, I suspect, be this year’s surprise.”

By comparison to Japan’s post-1990 performance US performance of course would appear robust. But only if it were held that there was a major chance the US could enter a Japanese 1990s style stagnation would the fact that it did not do so constitute a surprise. An exaggerated standard of comparison has the inevitable effect of making US economic performance appear “strong”.

When making a more sober and quantitative standard of comparison, however, Jim O’Neill’s data is not precise and therefore obscures an appropriate comparison - precisely the slowing trend of US long term growth. He writes: “underlying productivity performance, together with its relatively more favourable demographic dynamics, suggested to me that the US might at some stage shift back into a growth trend of close to 3%… the behaviour of both the Federal Reserve and post midterm election Congress has probably allowed the momentum to take the US back into its growth trend…. A number of quarters of 3-4% or more real GDP growth are likely in the next couple of years.”

But, as the data given above shows, 3 per cent has not been US trend growth for more than 20 years – as noted 20 year US trend growth is 2.5% and 10 year trend growth is 1.7%. Nor, as illustrated above, would 3-4% GDP growth over the next couple of years reverse the long term slowdown of the US economy.

Speed of growth in previous US expansions

Indeed figures of 3-4% growth during recovery would be significantly below those experienced in US business cycles. For example, US GDP in the third quarter of 2010, the latest available data, was 0.6% below its peak in the 4th quarter of 2007 - i.e. after 11 quarters. By chance 11 quarters after the start of the US double dip recession of 1980 (in 4th quarter 1982), the previous most serious US post-World War II recession, US GDP was also 0.6% below its peak. The annualised growth in the succeeding quarters was then 5.0%, 9.0%, 7.9% and 8.3% – i.e. of a totally higher order of magnitude than the 3-4% recovery rates currently being projected in this US business cycle.

Even if the post-1980 cycle is discounted as being particularly strong, the post-1990 cycle saw three quarters with more than 6% annualised US GDP growth and six quarters additional quarters with more than 5% annualised growth – i.e. nine quarter of above 5% annualised growth. So “a number of quarters of 3-4% or more real GDP growth are likely in the next couple of years” would not represent a strong performance.

It is true that the post-2000 cycle only saw two quarters with more than 5% annualised growth but this precisely reflected the slowing of the US economy to the 2.5% 20 year average and 1.7% 10 year moving average. The projections made by Jim O’Neill would, therefore, not constitute strong US economic growth in historically comparative terms and would be insufficient to reverse the long term slowdown of the US economy. This is a more appropriate scale of comparison.

Glass half-full and glass half-empty

Finally, to summarise the importance of the necessary distinction between short term cyclical and longer term trends, the old analogy of a glass half-full or a glass half-empty might be used.

Taking first the “glass half-full”, the above data shows there is considerable potential for a near term US cyclical upturn even within the framework of a long term slowing of the US economy. If the reasonable assumption is made that the long term deceleration of US growth is determined by structural factors, and long term acceleration cannot occur without a change in these structural factors, then it is nevertheless clear from the above data that even without any structural changes US growth could average 3-4% over the next two years – i.e. such a growth rate would not require overturning the structural elements creating long term US slowing. This is simply because 3-4% growth over the next two years would actually be consistent with the pattern of long term slowing of the US economy, and would be weaker than in previous cyclical recoveries.

This, of course, is not a prediction that US growth over the next two years will average 3-4% – this depends on more short term factors. It is merely a statement that there would appear to be no element in the data on long term trends in US growth that would prevent an acceleration of growth to 3-4% over the next two year period. This might well have favourable consequences for US equity and other markets – that is, the short term cyclical pattern might be considered a “glass half-full”.

But the “glass half-empty” is that even growth rates of the 3-4% type projected over the next two years, or even for a four year period, would be insufficient to reverse the long term deceleration of the US economy. Only a US recovery at growth rates substantially above those currently projected, and/or sustained for significantly long periods, would reverse the trend of the long term slowing of the US economy.

Conclusions

What conclusions derive from the above? Two self-evidently “spectacular”  perspectives for the US economy, either a 1929 style depression or a post-1990 Japanese style stagnation, are not supported by the data. However a more “mundane” but significant one is. The US economy has been decelerating for several decades. None of the rates of growth presently projected for cyclical US recovery are sufficient to reverse this gradual but long term slowing of the US economy.

This result may appear more prosaic than some other scenarios, but given the central role played by the US in the world economy its results are likely to to be profound.

Gavyn Davies’ initiating of a thorough, and clarificatory, discussion on prospects for US growth is therefore very welcome.

The long term slowing of the US economy - and its implications

Summary

Current discussions on the US economy have tended to focus on shorter term issues - the likelihood, or otherwise, of a double dip recession, or perspectives of short term accelerations or decelerations in the US business cycle. These are significant issues. But they may obscure a more fundamental but less commented on trend – a long term deceleration of the US economy which has been under-way for several decades.

The long term annual growth rate of the US economy has slowed from its historical average of 3.4% to a 20 year moving average of 2.5% and 10 year moving average of 1.7%. As the US remains the world’s largest economy, and the single most important influence on international economic trends, the importance of such long term deceleration is self-evident.

This article focuses on establishing the facts of this gradual structural deceleration of the US economy. Further implications of this trend are considered in the conclusion of the article.

Background

To understand the significance of the long term deceleration of the US economy it is important to note that, in relative terms, the steady growth rate of the US economy was a central feature of the world economy for the last 120 years.

Taking the historical period 1889 to 2009, US annual GDP growth averaged 3.4%. As shown in Figure 1, with the exception of the fluctuations during and between World Wars I and II, a striking feature of US growth is its regularity. A virtual ruler might be placed along the US growth path for much of this 120 year period - a pattern strikingly differing from the majority of other economies.

Figure 1

Long term deceleration

Despite this considerable regularity in US economic growth a very gradual slowdown is visible in Figure 1. This trend may be seen more clearly by taking historical average growth rates over different periods to the latest available annual data - for 2009. Such long term growth rates, taken at 10 year intervals, are illustrated in Figure 2. The number of years indicated under the bars are the period over which the average growth rate is calculated up to 2009 and the percentages above the bars indicate the annual average GDP growth rate during the period.

Figure 2

 

Taking first the longest timescales, in the 120 year period 1889-2009, as already noted, annual average US GDP growth was 3.4%. During the 70 year 1939-2009 annual average US GDP growth was 3.6% etc.

Taking very long term 120 to 70 year periods, US growth rates remained essentially constant or arguably mildly accelerated - the lowest average annual growth in this period was 3.3% and the highest 3.6%.

From this point on, however, it may be seen from Figure 2 that US growth decelerates slowly but perceptibly and continuously. The 70 year annual average growth rate to 2009 (1939-2009) is 3.6%, the 60 year rate (1949-2009) is 3.3%, the 50 year rate (1959-2009) is 3.1%, the 40 year rate (1969-2009) is 2.8%, the 30 year rate (1979-2009) is 2.7%, the 20 year rate (1989-2009) is 2.5%, and the 10 year rate (1999-2009) is 1.9%.

The trend of deceleration is unequivocal. The US 10 year growth rate is now only slightly over half of the historical growth rate of the US economy. The more recent the period the slower the average US growth rate - i.e the US economy is decelerating with time.

As will be seen below, extending the data to the most recently available lowers the figures marginally further.

Recent trends

In order to illustrate post-World War II trends in the US economy more clearly, Figure 3 shows a 20 year moving average for US annual GDP growth - the 20 year period being chosen as sufficient to smooth out cyclical fluctuations. The calculation is for each quarter up to the most recently available data - that for the 3^rd quarter of 2010.

The gradual, but clear, downward trend in the rate of US GDP growth is evident. The 20 year moving average of annual US GDP growth fell from a peak of 4.3%, in the 2^nd quarter of 1969, to 2.5% in the 3^rd quarter of 2010. There was some recovery centred on the 1990s, although insufficient to regain previous growth rates, followed by a sharper decline to the most recent period.

If a 20 year moving annual average is compared at 10 yearly intervals, then the 20 year annual average growth to the 3rd quarter of 1970 was 3.8%, to the 3rd quarter of 1980 3.6%, to the 3rd quarter of 1990 3.2%, to the third quarter of 2000 3.2%, and to the 3rd quarter of 2010 2.5%.

In short the recent sharp deceleration of the US economy is an extension of a gradual but clear long term decline in the US growth rate.

Figure 3

 

In order to show the timing of the trend more clearly, Figure 4 superimposes a 10 year moving average US annual GDP growth on the 20 year moving average. Evidently a 10 year moving average shows greater fluctuations than the 20 year moving average, but the downward trend is also clear.

The 10 year moving average of US annual GDP growth has fallen from a peak of 5.0%, in the 2^nd quarter of 1968, to 1.7% in the 3^rd quarter of 2010. The deterioration due to the international financial crisis, of course, also shows more sharply using a 10 year moving average.

Figure 4

 

Implications

To summarise, the data clearly show a long term slowing of the US economy. The recent worsening of economic performance is not purely cyclical but is superimposed on a more long term slowing of the US economy. There are numerous implications of such a trend. Among these are:

1. It is significant to study short term fluctuations in the US economy, for example whether there will be a double dip recession (unlikely) or how strong will be the short term cyclical recovery. However a more fundamental trend is the long term slowing of the US economy.

2. As US GDP growth outperformed the other main developed economies in Europe and Japan in the most recent periods, but the US economy was itself slowing, this gap was wholly due to the poor performance of Europe and Japan and not acceleration in the US.

3. The lack of success of Reaganite/neo-Liberal policies in the US is evident from the data. Recent US growth rates are slower than those either in the period of "Keynesian" dominance of US economic policy, from World War II to the 1970s, or during US growth prior to World War II.

4. "New economy" claims, that is of a new period of rapid US growth based on Information Technology from the 1990s onwards, do not withstand statistical examination. Higher levels of US investment during the 1990s partially reversed  slowing rates of US growth but this was temporary, and was followed by a new decline of US growth to a lower level than previously.

5. Claims by economists, for example Barro, that "U.S. data do not reveal major changes... in the average rate of economic growth" are incorrect.¹ On the contrary, as shown above, the US economy is slowing with time.

6. Careful analysis must evidently be made, in the the light of data above, of figures used to project US economic growth. As the US is currently recovering from deep recession, above average trend growth would be expected in the immediate period. This would tend to lead statistically to convergence over the cycle to an average US growth rate. But what average should be taken? It would appear clear from the data above that taking a 3.4% historic US average GDP growth rate is too high. For example, should a 20 year average or a 10 year moving average be taken? As these are respectively 2.5% and 1.7% this is a significant difference.² 

7. The rapid growth decrease in the gap in total GDP between developing and developed economies clearly reflects not only acceleration in developing economies but also slow down in the most important developed economy, i.e the US.

As the long term slowing of the US economy is evident from statistical data, it must be integrated into analyses of both the US and international economies.

Notes