Policy and Potential
The global economy is in the midst of a synchronised upswing. Notwithstanding political uncertainty, it has serious potential to carry on.
Perhaps as little as a year ago, the world economy appeared perpetually weak. In rich countries especially, growth was anaemic, productivity improvements negligible and investment rates subdued. That is why the robust growth rate of 3% for 2017 was so impressive – it was driven, to a large part, by an unexpected acceleration in developed world growth. The United States, for example, is forecast to have grown at a rate above 3% for most of the year. Meanwhile, Japan and the Eurozone, until recently battling deflation and stagnation, are thought to have grown by 1.7% and 2.3% respectively.
Figure 1: Accelerating growth in both advanced and developing markets (Source: World Bank)
Many economists, spurned by years of over-optimistic forecasts, now hazard to say that a virtuous cycle of rising demand and investment is generating broad-based economic growth. Yet, looking past immediate circumstances, it is clear that two important caveats remain: relating chiefly to ideas of policy and potential.
Policy refers to the real impact that political uncertainty is having on growth. Many are quick to highlight, for instance, that since the Brexit vote the Eurozone, with a 2.3% growth rate, has been growing at about 0.6 percentage points higher than the UK. Whilst perhaps expedient for political purposes, this comparison is flawed: after all the UK and Eurozone are at very different stages in their growth cycles. The UK economy has been expanding strongly since 2010, on average at double the rate of the Eurozone. This has left the UK with a record-low unemployment rate of 4.3% compared to the Eurozone’s 8.7%. The Eurozone can therefore generate substantial growth simply by diminishing its large pool of unemployed. The UK however, running near full capacity, must rely on technological and productivity improvements which by all accounts are harder to come by.
The American economy, expanding solidly since 2010 and now nearing full employment, is a more valid comparison. Yet the US growth rate is forecast at 2.6% in 2018, almost double that of the UK. This differential is driven partially by the America’s breakneck pace of business investment growth, between 8-10% in the second half of 2017 – whereas the UK managed a paltry 1.3% for the entire year. This investment slowdown can be traced directly back to the Brexit vote – in March 2016, three months before the referendum, investment was forecast to grow by 6.1% in 2017. Whilst not bringing the economic Armageddon some had predicted, the vote has undeniably dampened investment, thus harming immediate demand as well as Britain’s longer term productive capacity.
Figure 2: US investment and profit uptick (Source: World Bank)
Donald Trump ought to take note: if he wants to reap the benefits of a strong US economy, he ought to avoid throwing business into trade-induced uncertainty. Unfortunately, there is no guarantee of this: his threats to withdraw from NAFTA and his ability to unilaterally place tariffs on steel imports, as guaranteed by the Trade Expansion Act of 1962, create the potential for a debilitating and investment-dampening trade war.
The other issue with the current expansion is more fundamental and it centres around the idea of ‘potential’ growth. The World Bank insists that whilst cyclical growth is high, without structural economic reform it is likely to slow. Put simply, this means that current growth is driven to a large part by strengthening demand, but what is needed for long term improvements is elevating supply through productivity gains. The Bank suggests some important measures to achieve this: including, strong government investments in infrastructure, education and healthcare. Furthermore, more ought to be done to encourage technological diffusion in the rich world as the gap between the most and least productive firms widens.
The World Bank, however, relies on outdated orthodoxy when it insists that demand-side stimulating has ran its course. If the post-crisis malaise has demonstrated anything, it is the interrelatedness between aggregate demand and supply. Janet Yellen, no economic radical, recognised this in a speech in 2015: she noted that whilst traditional models posited supply as a factor external to demand, in reality during demand-booms there is a greater incentive to invest, improve worker training and form new businesses – all of which raise supply potential. Indeed, the World Bank confirms this in its own analysis, finding that technology driven growth is endogenous to (i.e. partially driven by) the economic cycle. The 2008 Financial Crisis is perhaps the best illustrator of this dynamic: whilst initially a demand-side shock, it ushered in persistently weak productivity growth.
Going into 2018 therefore, treasuries around the developed world ought to maintain an accommodative fiscal stance and avoid damaging policy uncertainty. Indeed, if the demand-side can be maintained and nurtured, supply-side improvements will likely follow. What’s more, this may finally give governments the political capital to carry out the badly needed long-run structural reforms that the World Bank and other institutions so consistently call for.