Reinvest the global dividend, do not spend it

For the fourth consecutive year, world economic growth has remained strong in the face of such headwinds as soaring commodities prices. While the US economy is beginning to slow, the eurozone has gained momentum. Japan's expansion continues and emerging markets and developing countries are delivering impressive growth rates. What accounts for this tremendous performance? Can it last?

Productivity growth, fostered by the revolution in information technology and the rationalisation of production through the creation of global supply chains, has played a critical role in this expansion. While attention has focused on the extraordinary surge in US productivity since 1995, equally impressive productivity growth in emerging markets has drawn little comment.

Rapid and largely unexpected worldwide productivity growth can explain why the demand for commodities is so strong; why emerging markets have weathered commodities price increases without a serious slowdown in investment; why inflation is still largely contained in spite of the unprecedented rise in raw material costs and why both household incomes and corporate profits are buoyant at the same time.

The rise in global competition, fostered by the fall in transport and communication costs, as well as the reduction of trade barriers, has played a key role in this process. Competition has not only provided incentives for manufacturers to raise productivity, but helped contain wage growth. As a result, other inputs in short supply such as commodities have been bid up, spreading the benefits of the productivity surge to commodity producers.

In countries such as the US, strong domestic financial markets have helped finance innovation and reallocate resources to the most productive sectors. New financial products have allowed consumers to borrow against future incomes and consume immediately. These countries have run current account deficits, largely financed by countries whose less sophisticated markets have been less able to translate growth into domestic demand.

What could mar this rosy picture? In our integrated world, inflationary pressures are determined not just by how close an economy is to capacity but by how close the world is to capacity. Increasingly, an educated and skilled labour force is in tight supply the world over. Wages are growing even faster, in spite of evidence that productivity growth in the US has been slowing. Slower productivity growth lowers the potential growth of the economy—the growth it can achieve without accelerating inflation.

The key question for the US Federal Reserve is whether the interest rate medicine it has administered is sufficient to slow the economy to the lower estimates of potential growth. While the housing market is slowing more rapidly than expected, consumption has not weakened, buoyed as it is by jobs and wage growth. Moreover, the effects of both past monetary tightening and the housing slowdown on activity are likely to operate with lags. With the effects of the housing slowdown likely to be non-linear—a big fall in prices will deal a blow to public confidence and the financial sector will not remain unscathed—the Fed has to weigh further moves carefully. It must also be cognisant of the possibility that if high inflation expectations become entrenched, bringing them down will require even higher rates and come at a significant cost to growth.

Slower growth in the US could narrow its current account deficit, but this is not without risks. Foreign investors fund the deficit partly because of the strength of the US economy. If they reassess its attractiveness, they will demand a higher premium to finance US borrowing, with consequences for interest rates and the dollar.

None of this is inevitable. Even if the US slows significantly, large economies such as the eurozone and Japan could catch up in productivity. But this requires greater domestic competition, reallocation of resources to more productive activity and better utilisation of labour. Political impediments to structural reform could come in the way of catch-up. Politics has already interrupted cross-border mergers and acquisitions. With the Doha trade round suspended, productivity growth from rising global competition is also under threat. In the name of national advantage, politicians are once again ensuring collective disadvantage.

Good policy rarely has immediate benefits for growth. The strong world economy is due to past policies to enhance competition, economic sustainability and flexibility. For the good times to continue, leaders should re-focus from spending the dividend to reinvesting for the future.