April 28, 2017

Why is Global Growth Slowing and How Does It Affect Estonia?

REUTERS/Thomas Peter
A man carries sacks from a recently demolished house in a hutong neighborhood near the Forbidden City in Beijing, China April 20, 2017.
A man carries sacks from a recently demolished house in a hutong neighborhood near the Forbidden City in Beijing, China April 20, 2017.

The economic growth of recent centuries is more of an exception.

Prognoses for global economic growth have been continuously lowered in recent years, and various statistics indicate that it may remain slow for a very long time. This is due to different issues, such as aging populations and a decline in establishing trade relations, but also that emerging Asian economies are falling into the middle-income trap. Estonia is affected, on the one hand, through its direct trade relationships. On the other hand, it is interesting to see how Estonia’s economic problems are similar to the issues that affect the economic development of the rest of the world.
Global growth can be measured with different indicators. Statistics differ significantly depending on whether countries’ growth indicators are drawn up using their GDPs at market prices or adjusted to purchasing power parity (PPP). In the first case, the slowdown in world GDP growth is more evident. Taking PPP into account means that, since the share of rapidly-developing poorer countries is bigger, average global growth is also higher. The indicator weighted on the basis of PPP also amplifies the fact that market economy reforms, which enabled the countries that are developing quickly today to achieve their growth, have been undertaken in recent decades. The economic growth of the so-called emerging markets accelerated only in the 1990s.
Regardless of which indicator is selected, the comparison of the prognoses and the past points to the slowing of global growth. If the average growth of the last five years and the next five, as predicted by the International Monetary Fund (IMF), is compared to average growth in the first decade of this century, the global growth index based on PPP also indicates a slowdown of growth.
The World Bank estimates that the global economy grew an average of 5.5% per year in the 1960s, slightly more than 4% in the 1970s, 3% in the 1980s, and less than 3% after that. This means the major slowdown in global growth took place several decades ago. It is noteworthy, however, that since 1960, global growth has not been less than 3% for five consecutive years, as has happened now. There has always been a year with faster growth in between. According to the IMF prognosis, global growth calculated with weightings based on market rates will remain below 3% in coming years.
Part of the slowing growth of this decade might be explained by short-term factors. For example, major oil price fluctuations have affected the growth of oil-producing countries. Recovering from the last economic crisis takes time, so the growth of advanced economies has been especially slow. The alleviation of these problems should somewhat increase economic growth.
Secular stagnation or the so-called Japan scenario—where growth, inflation and investments remain at a low level for a long time in a setting of high amounts of savings at low interest rates—is also often discussed in relation to advanced economies. Situations like this have developed after major economic crises and various theories have related it to changes in risk behaviour and expectations regarding the development of technology, failures in the financial sector and population processes, etc. Periods of slow growth after economic crises have occurred before, and thus far these have been overcome. But it takes time.
In advanced economies, the slowdown of growth is caused by the long-term aging of the population, which reduces labour supply. Large (in numerical terms) generations that were born after World War II are exiting the labour market and this significantly affects labour supply. In many countries, the negative effect of the demographic change on labour supply coincided with the economic crisis that began in 2008. In Finland, for example, the number of people who are 65 years old or over has increased by 28% compared to 2008, and in the US by 17%. A sudden change occurred even earlier in Germany.
What might be even more important than a specific growth expectation is how expectations have changed over recent years. Forecasts are often mean-reverting, so the growth projections are converging towards an average growth rate of the past. Sudden slowdowns or changes are, of course, difficult to account for in prognoses, even when they have a high probability. In the context of slowing global growth, it is telling that in recent years the IMF has reduced the global growth estimate at a rate of 0.1 percentage points a year on average. In April 2015, the IMF expected economic growth in 2019 to be 3.3%, but this number has decreased by 0.1 percentage points each year since and, according to the latest World Economic Outlook, the figure remains slightly below 3%.
One could always ask whether economic growth is the best indicator to consider. People should be interested in well-being, which is much more than mere GDP. Besides, GDP can only take into account transactions with a monetary value and probably underestimates improvements in the quality of life. In practice, it is very difficult to take into account a change in product quality over time. GDP also leaves aside, at least partially, how the so-called new economy affects well-being because most of its benefits are free of charge. For example, social media and online communications software definitely have a positive impact on our well-being but, since we do not pay anything for them, this is not reflected in our consumption or GDP. Despite everything, GDP is the best indicator for measuring well-being because of its international and temporal comparability.

We have yet to witness an increase in protectionism

One of the reasons for the slowing of global growth could be the modest development in establishing new trade relationships. Before the economic crisis that began in autumn 2008, global trade increased nearly twice as fast as the global economy but this ratio decreased after the crisis. Foreign trade growth that exceeded economic growth was an indication of greater economic openness, which meant faster market growth, i.e. an increase in demand. In addition to demand, supply has also played an important part in trade, for example with international specialisation and knowledge transfer. Increased competition has made products better and cheaper, led to improved quality, etc.
Specialisation plays an important role in productivity growth and the rise in living standards. A slowdown in trade, therefore, most probably inhibits global growth.
A simple explanation for reduced global growth could be an increase in protectionism. The standstill that followed the economic crisis impaired mutual trust. Populist politicians have gained more votes in elections. Countries are prioritising the enhanced competitiveness of exports, which may be interpreted as market distortion. For example, in order to attract international companies, tax advantages or support are granted, or a blind eye is turned to violations of environmental, construction and other regulations. This list could also include our predominant idea that economic growth can rely on exports alone. Some measures of increasing competitiveness may seem useful on a national level, but they might not be good for the world economy as a whole because they distort the price mechanism and prevent the international division of labour from becoming more efficient. Relations between different countries and cultures are also strained. All of this may be the reason why countries want to trade less with each other.
However, identifying protectionism as the cause of slow growth is contradicted by the fact that freedom of global trade has not diminished following the last economic crisis. So it is premature to talk about the significant impact of protectionism. For example, the trade freedom sub-index of the Heritage Foundation’s economic freedom index has improved since the economic crisis, despite the fact that countries with below-average economic freedom have been added to the index. Compared to 2007, freedom of trade has increased in 80% of countries. The most well-known economic restrictions that have affected Europe and Estonia in recent years are probably the sanctions applied by the West against Russia and vice versa; but they affect only a relatively small fraction of trade.
Western countries lack the political means to restrict trade freedom in practice. This means that the promises of politicians who talk about introducing economic restrictions may not be realised or might take a long time. On the one hand, enforcing trade restrictions is legally complex because they might go against national and international regulations. This means that establishing restrictions is time-consuming, not least because it requires numerous rules to be amended but also the replacement of key figures in institutions, which in turns means agreements with many parties. On the other hand, the market powers that remain prevent the restrictions from having an impact. The appreciation of the US dollar has also been related to the expectations of the market regarding trade restrictions, which softens the macroeconomic impact of the expected restrictions.1
A changed connection between trade growth and economic growth is probably an indication that the situation is normalising. In other words, this denotes the end of deepening international trade that followed the liberalisation of world trade. Diversified trade opportunities have increased economic opportunities and we may now have reached the level where, within the limits of current freedoms, the further improvement of labour division efficiency—which proceeds from the freedom of trade—may become exhausted as the source of economic growth. For the world economy to grow as it did before, the freedoms we have today do not suffice and trade rules need to be further liberalised.

Some emerging economies are approaching the middle-income trap

Global growth in recent decades has been led by emerging Asian economies, whose increasing demand has supported the growth of developed countries. History has shown, however, that growth in such countries tends to slow as they become richer. It is unlikely that the countries that are currently growing rapidly will escape this. Only a few have managed to grow very fast for long.
One of the reasons for this is that labour force growth in countries with rapid economic growth slows down. China’s demographic explosion took place 60 years ago and the one-child policy has already led to a decrease in the working-age population. Another important factor is the slowing of productivity growth. Poor countries with a low level of technology are able to increase productivity quickly by copying, but the more complicated the economy becomes, the more difficult it is to take over technology and the more they need to develop themselves.
The third factor that impedes economic growth when wealth increases is a change in preferences. As society becomes more prosperous, it starts to spend more on comforts and niceties and there is less resource left for growing the economy. The desire to rest longer and work less grows at a certain salary level. Convenience and pleasantness may manifest themselves in better working conditions or a cleaner environment. These certainly improve welfare but their impact on measurable economic growth is very small. Such changes in preferences have also taken place in Estonia in the past ten years.
China’s growth is becoming more consumption-based and the service sector has an increasing share of the economy. This is a natural change in the long-term perspective and a prerequisite for continued balanced development. If the role of consumption in China’s economy were not to increase, the slowdown might be even more sudden than so far expected. At the same time, an economy that relies on consumption and services has fewer opportunities for productivity growth. From the perspective of Estonia, it is even more significant that this type of economic structure provides fewer export growth opportunities for the industrial sectors of advanced economies that produce complex technology.
Growth has slowed suddenly in many countries, and not gradually, as we hope to see in Asia.2 The majority of European countries witnessed this type of slowing growth in the 1970s. Economic growth during the seven years that preceded and followed the slowdown has differed by 3.5 percentage points on average worldwide. The sudden slowing of economic growth in Estonia probably coincided with the economic crisis of 2008 and 2009. Why should it be any different in Asia?
One common factor behind the rapid slowdown of economic growth is a country’s standard of living. Slowing has generally taken place when the per capita GDP on the basis of PPP has been nearly 20,000 dollars at 2016 prices.3 Estonia had already achieved this level by the time it joined the European Union, so it is actually surprising that, compared to other countries, its fast growth lasted so long. Latvia and Lithuania reached this level during the boom and China is getting close to it.
Based on prior experience, it can be assumed that China’s growth is probably decreasing, and this has a significant impact on global growth. Simulation models have demonstrated that the slowing of China’s economic growth would considerably affect the exports of developed countries. This would mainly have an impact on primary producers, because China is a major consumer of primary products. However, primary producers are the target export market for the industrial sectors of developed countries, which would suffer indirect losses due to China’s decreased growth. China’s slowing growth would significantly affect Estonia’s trade partners Finland and Russia, and Estonia would also feel the influence through them. Given the non-linear nature of the process, it can be expected that this is not reflected in the baseline scenarios of the prognoses.
Estonia’s economic development is closely linked to the outside world, and slower growth in overseas demand affects the export opportunities of Estonian companies. Nevertheless, in the context of a general economic downturn, the impact on economic growth of the falling trend of the external environment may be relatively small compared to other factors. Estonia is going through similar changes to Asian countries, where economic growth is expected to decline. The role of investments has also diminished, and demand is based more on consumption. The added value of companies carries an increased share of labour costs (especially in companies under foreign control who are also large exporters), which has slowed growth in other countries in the past. The same goes for investing: the rate of investment has fallen the most in foreign-controlled companies.
In the longer term, global growth is probably slowing down. This could in fact be considered a normalisation of the environment, because the growth in recent centuries is somewhat unusual in world history. The role of economic policy in the slowdown of growth is not decisive, at least for the time being, because market forces are extremely strong. On a long-term basis, it is possible to reorganise institutions and influence the course of development. Economic growth would benefit from the continued enhancement of economic freedoms.
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1 Eichengreen, B. “Powerful forces will lead to a strong dollar under Trump”. Financial Times, 26 January 2017. www.ft.com/content/2a01d6c2-de6f-11e6-86ac-f253db7…
2 Eichengreen, B. Park, D. and Shin, K. When Fast-Growing Economies Slow Down: International Evidence and Implications for China. Asian Economic Papers, 11(1) (Winter/Spring 2012), 42–87. www.nber.org/papers/w16919
3 Estimate converted to 2016 prices on the basis of the IMF’s World Economic Outlook.

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