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Global macro & geopolitics from a small economy perspective

Advanced economies are here to stay

David Skilling
30 March 2012

There has been much talk of the transfer of economic – and political – power from the developed world to developing countries, as well as of the loss of influence of Western models of capitalism. Of course, tectonic plates are moving, relative decline is an arithmetic reality as emerging markets grow, and advanced economies are facing many social and economic challenges. But this week’s Observer suggests that this process is more than simply a straightforward shift from a sclerotic group of advanced economies to a dynamic set of emerging markets.

Levels and growth rates
The emerging markets of Asia, and increasingly Latin America and Africa, have grown rapidly due to a combination of population growth, investment, and strong productivity catch-up. China’s share of global GDP has increased from 2% to 10% in the last 30 years (at market exchange rates) and is expected to overtake the US as the largest economy within the next 15 years. Over half of global GDP growth now comes from outside of the developed world. And in an heroic effort of forecasting, HSBC estimate that by 2050 19 of the largest 30 economies will be countries that are currently regarded as emerging markets (although the US, Germany and Japan will remain in the top 5). This rapid change is ending a period of 200 years of Western economic dominance. As economic historians remind us, this is a return to the situation that prevailed prior to the Industrial Revolution.

But despite this income convergence process, substantial gaps will remain in terms of the levels of per capita income. Although absolute size of GDP matters for economic and political power projection, per capita income is the better measure of welfare. Even assuming continued strong growth rates in emerging countries, relatively little change is likely in the composition of the IMF’s listing of advanced economies (the poorest of which is currently Estonia with a per capita income of around US$14,400). Some middle income countries may make it onto the advanced economy list, but they have a way to go (for example, the per capita income level of Brazil and Russia is about $8,500, it is about $4,000 in China, and $1,300 in India). And HSBC’s 2050 GDP estimates report little change in the leading countries in terms of per capita income levels. The current group of advanced economies may well be overtaken at some point, but they will remain prosperous economies for some time. We should not confuse income levels and growth rates. Governments (and companies) should think carefully about how fast they rotate their focus away from the developed world.

The middle income trap is hard to spring
One reason for this slow change in the rankings is that growth rates tend to reduce as countries get richer, because there are fewer catch-up opportunities. Indeed, only a small number of emerging economies have been able to exit the ‘middle income trap’ and become high income countries. These successful economies, mainly from Asia (Japan, Taiwan, Hong Kong, Singapore, South Korea), took advantage of globalisation and continually upgraded their economies to sustain growth into high income levels. But the more common experience is for a period of strong growth to be followed by significantly lower growth rates. It is difficult to transition from growth models based on factor accumulation, imported technology, and low production costs, to models driven increasingly by domestic sources of productivity and innovation with a higher cost structure.

As countries develop, a new set of policies becomes important to sustain growth. For example, investment in human capital, the development of social safety nets, the provision of education and health services, and so on. And importantly, there are a set of ‘soft’ institutions and norms that are important to the development process (rule of law, property rights). This political and institutional capacity takes time to build, and many countries that have grown rapidly are still in the process of developing the supporting soft infrastructure. Over time, many emerging markets will get there – but the transition is likely to be bumpy. In contrast, the institutions and norms are better established in many advanced economies (even if imperfectly so, as the financial crisis demonstrated). The speed of development in many emerging markets is remarkable, but hubris should be avoided. Emerging markets have weaknesses as well as strengths, and advanced economies have assets as well as challenges.

But advanced economies have work to do
But although it is not plain sailing for emerging markets, advanced economies also face serious challenges. Advanced economies cannot rest on their legacy if they want to stay at the frontier; history shows that countries can lose high income status if they do not continue to invest in institutions and capacity. Indeed, many advanced economies are facing acute economic and social challenges as well as a tendency to political sclerosis. Structural changes are required across many advanced economies to restore competitiveness, redefine the social contract, and respond to a changing global environment. A deliberate re-think of many aspects of the Western economic and political model is needed to ensure that they remain appropriate for the new global realities. To be clear, this is not a move towards a different model like state capitalism – but a more effective blend of government and markets, as well as improved political decision-making.

So advanced economies need to avoid both complacency – a view that nothing meaningful needs to be done because the situation will right itself inevitably – and fatalism – that nothing meaningful can be done to strengthen their performance. Indeed, competitive pressure from emerging markets may provide a useful discipline and lead to actions to strengthen institutions and policies across advanced economies. The challenges are real, but many advanced economies have the ability to overcome the challenges – small advanced economies provide some confidence in this regard. Advanced economies have responded to challenges effectively in the past and many may be able to do so again. We should be careful not to write the advanced economies off too quickly.