Economies all have speed limits. Let an economy grow above its speed limit for any length of time, and inflation results. Thats why central banks are so preoccupied with staying within the speed limit, even though most individuals would prefer stronger growth, other things equal.
What is the speed limit for the world economy? Just looking at the basic figures suggests that the speed limit may be rising through time: average global growth during 1983-94 was 3.3%; during 1995-2006, 4.0%; and, in the last four years, global growth has averaged 4.8%.
An economys economic growth speed limit is linked to its underlying potential. Potential output assumes reasonably full deployment of an economys labour force and its capital stock. In mature economies, potential economic growth comes from growth in the labour force (natural population growth, immigration, and lasting shifts in labour force participation), growth in the stock of capital (new investment by companies) and innovation or new technology. By way of illustration, U.S. potential growth is estimated to be around 3.0% per year, while that for Canada is about 2.8%.
Emerging economies are different. Their growth process is usually fuelled by an underlying transformation process, connected either to a major ramp-up in the capital stock (catching up to major economies through massive investments) or the movement of workers from non-productive occupations to productive ones. In China, for instance, unproductive state-owned enterprises are being steadily wound down, and the workers are moving into new manufacturing companies, thereby expanding Chinas potential very rapidly. It is widely believed that Chinas potential growth rate is about 10%. By a similar analysis, Indias potential is rising by about 6% per year, as workers move from agriculture into manufacturing and services. Both of these potential growth rates will drift down during the next 10-20 years, as they catch up to the major economies.
Not surprisingly, global potential economic growth is edging higher mainly due to developments in China and India. Because their actual and potential growth rates exceed the global average, their shares of the global economy are rising steadily. In 1980, each accounted for about 3.3-3.4% of the global economy. Today, India represents about 6% of the world economy (using the World Banks purchasing power parity methodology), and China represents 16%. Accordingly, these two economies have boosted the global growth speed limit by more than 1% during this period.
Increased potential output has meant bigger markets to tap into and falling prices for manufactured goods, which increases purchasing power world-wide. It also makes things more difficult for central banks, because the notion of a speed limit is a key link between the central bank and the rate of inflation. Presently, global monetary policy is gradually shifting to neutral because growth is moderating, but Europe, China and India may still need to tighten further, first.
The bottom line? Global potential growth appears to have risen from 3.5% 20 years ago to 4.5- 5% today. This should mean less inflation for all countries, all other things equal, but uncertainty about what it means for any individual economy will keep central bankers vigilant and cautious.
Stephen Poloz is Senior Vice-President, Corporate Affairs and Chief Economist, Export Development Canada. His column on trade-related issues appears weekly on www.ctl.ca . He will also be appearing at the upcoming SCL annual conference.