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Mind The Global Output Gap

Escalating food and fuel prices are a sign the global economy is approaching full resource utilization and the limits of sustainable output.

Policy-makers, commentators and investors are still fiercely debating whether high unemployment and idle factories in the United States and Europe are caused by cyclical lack of demand (in which case Keynesian demand management is the appropriate remedy) or reflect structural shifts (making Keynesian responses irrelevant).

But a quick look at the global picture makes it clear that the problem is structural (distribution of demand) rather than cyclical (lack of demand at a worldwide level).


The attached chart shows output growth in the advanced economies and emerging markets since 1991, based on data compiled by the Netherlands Bureau for Economic Policy Analysis (CPB), one of the most respected trackers of global output and trade flows (http://graphics. thomsonreu ).

CPB assigns a weight of 35 per cent to the industrial output of emerging markets, based on their output in 2000. But following the banking crisis in the advanced economies and continued strong growth in developing ones, emerging markets now probably account for almost half the global output.

Emerging markets will consume almost as much oil in 2011 (43.2 million barrels per day) as OECD economies (45.9 million barrels), according to the International Energy Agency, confirming that emerging markets now account for half the global economy.

The performance of the two groups of countries could not be more different. In advanced economies, while industrial output has recovered from the depths of the recession, it is no higher than in 2003, far below the 2008 peak, let alone the trend line. In contrast, emerging market output is 14 per cent higher than before the crisis erupted, and more or less back on its (accelerating) trend.


Central bank officials and commentators in the United States and Europe focus on the persistence of an “output gap” in the advanced economies. But the chart suggests there is no output gap in emerging markets. For the world economy as a whole, the output gap is probably small or non-existent.

If emerging markets’ share of global output were reweighted to 50 per cent, the CPB’s measure would show world output rising even more since the crisis, putting production at or very close to its long-term trend.

Rapid increases in commodity prices, tightening supply-demand balances, and falling inventories, tend to confirm that the global economy is nearing its maximum sustainable output, at least in the near term. While there is still some spare capacity in most commodity-producing sectors, investors anticipate it will be quickly used up, driving spot and future prices higher now.

In this context, it may not be possible to use fiscal and monetary policy to make advanced economies grow much faster and reduce unemployment without triggering big increases in the cost of food, oil and other industrial raw materials.

Only increases in productivity, reductions in real wages and incomes, weaker currencies and a shift into higher-value adding businesses can solve the problem of mass underemployment.


This is the painful reverse side of globalization. Emerging markets’ increased integration into the world economy means more competition for resources and employment in the advanced economies, and reduced living standards for households and firms which compete most directly with rivals in developing economies. Globalization is creating losers as well as winners.

Structural shifts are not new. Britain’s farmers in the nineteenth century suffered a massive decline in real incomes and living standards as the prairies opened up in the Americas. Its coal-producing, steel-making and cotton-spinning communities were devastated by the emergence of new competitors in Europe and Asia during the 20th century.

The point is these shifts were structural, not due to lack of demand. Attempting to reverse them by boosting government spending or cutting taxes and interest rates would not have resulted in long-term gains unless it was accompanied by competitive devaluations of the exchange rate and protectionist measures – precisely the retreat into autarky which intensified the Great Depression in the 1930s.

With some exceptions, such as Germany’s precision engineering and capital goods industries, the same hollowing out (now called off-shoring) is occurring across much of the North American and European manufacturing and service-producing sectors.


Policy-makers and commentators are still focused too much on measures of unemployment and spare capacity within individual economies. But in a globalized economy, it makes little sense to focus on national output gaps. Commodity prices and other forms of inflation are driven by the global supply-demand balance rather than joblessness and silent factories at national level.

Policy-makers can try to reallocate demand from one country to another by manipulating exchange rates. In one particularly brazen example, Britain’s central bank is pursuing an aggressive strategy of competitive devaluation in a bid to boost the country’s export and import-competing manufacturing sectors.

But competitive devaluation is not feasible for larger economies such as the United States and the euro zone – and it cannot be pursued by all countries at the same time, otherwise it will become mutually self-defeating. In a global economy with little or no spare capacity overall, particularly in the natural resource sector, a strategy of monetary expansion and competitive devaluation will simply result in accelerating inflation.

John Kemp is a Reuters market analyst


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