5 puzzles in the international economy

Men work at an e-scooter assembly line of Vinfast Auto and Motorcycle factory in Hai Phong city, Vietnam November 3, 2018. REUTERS/Kham - RC1468580640
Editor's note:

To kick off the Future Development blog in 2019, we present the second in a four-piece series about the future of development.

The global economy continues to baffle economists who generate clever answers to puzzles but not always in convincing fashion. This is not new—Maurice Obstfeld and Ken Rogoff discussed six major puzzles in international macroeconomics almost two decades ago. Here are five issues where I feel the need to take a view in 2019 because the implications are so large. But these are also areas where I have limited conviction either through my own work or through my reading of the literature.

1. Why is so little capital flowing to emerging and developing countries?

The IMF thinks that net public and private capital flows into emerging market and developing economies (or the opposite, the aggregate current account deficit) will be around $4 billion in 2019, a tiny figure in the context of the world economy. This is surprising because developing countries are expected to have great need for big ticket investments that advance economic growth, such as ports, urban infrastructure, education, health system improvements, or nationwide renewable energy networks. These are investments which they cannot—or should not have to—simply self-finance as they are relatively poor. Considering that the size of developing country economies will amount to about $35 trillion in nominal terms, the $4 billion deficit forecast by the IMF is basically equivalent to a rounding error. The most rapidly growing region, Asia, actually is projected to have a small net capital outflow; removing China would leave an inflow for the rest of the region of about $50 billion, still less than 1 percent of the Asia-Pacific region’s (non-China) regional GDP. The Asian Development Bank’s Strategy 2030 estimates that $1.7 trillion per year (10 percent of GDP) will be required for infrastructure investments in Asia. If capital doesn’t flow to a fast-growing region like Asia, then is it realistic to expect it to flow to other regions? There is considerable policy debate about multilateral development banking and making the global financial system work for all, with high-level meetings on financing for development and multiple studies on blended finance (here, here, and here). The micro evidence suggests aggregate blended finance deals of over $100 billion. But the macro numbers on capital flows do not confirm a major surge of capital into developing countries as a result of these new forms of financial engineering. So is this just relabeling the churn of inflows and outflows—like much “green” or “sustainable” finance—or is it a genuine step forward?

2. What is going on with global productivity growth?

Ultimately, most economists believe that living standards are determined by productivity growth and they lament its slowdown across the world. The question is whether this is because today’s innovations are not that impactful or whether it is just a matter of time before the impact kicks in because technology diffusion inevitably takes time. There are other possible explanations. One is that productivity growth is actually more rapid than is commonly believed, but we mismeasure it. While there is some validity to this, the magnitude seems small compared to the aggregate slowdown. Another possibility is that the best firms are happily expanding productivity growth, but laggard firms are keeping the economy-wide average down. The policy implications of each view differ considerably, so it is important to take a view, even though the evidence is not conclusive. To further complicate matters, it is not even clear what the direction of the impact might be. For example, a slowdown in productivity growth in rich countries might hurt developing countries because demand for their exports will be lower, but could benefit developing countries if it causes an exodus of capital towards them. Some models suggest the latter effect could even dominate in the short to medium term. So, it is not obvious if developing countries should cheer or fear a slowdown in productivity growth in advanced countries. They should also worry about what is happening in their own economies. If most productivity growth in developing countries is catching up to the global frontier, as we commonly assume, why have they been bitten by the same productivity slowdown bug as advanced countries?

3. Why is it so hard to fix externalities?

Most politicians in most countries want to increase employment and reduce carbon emissions. So why do we have systems that tax labor and subsidize fossil fuels? The G-7 countries continue to provide at least $100 billion a year supporting fossil fuels and have failed to put in place mechanisms to meet their pledge to phase these out by 2025. Meanwhile, the average OECD country had a tax wedge on labor of 35.9 percent in 2017 (the tax wedge is defined as the difference between the employer’s cost of hiring a worker and the net take-home pay of the worker, expressed as a share of labor cost). In most developing countries, high levels of informality and flexible labor markets reduce the impact of labor tax wedges, but there are exceptions including in several European and central Asian countries. Is there any realistic hope to vanquish the political economy constraints that have blocked reform? How can we move this needle?

4. What constitutes progress in the world?

This is a two-part puzzle. One has to do specifically with the relationship between the U.S. and China. All agree that this is perhaps the most consequential relationship in the world. The question is whether the interests of the two countries coincide or collide. In other words, if China grows economically, is this good for the U.S. because it enlarges a potential market for its exports and perhaps allows it to import additional goods even more cheaply from China? Or is it bad for the U.S. because, relatively speaking, China will gain power (soft or hard) relative to the U.S.? During a debate at Brookings last October, more than half the audience responded that U.S. and Chinese interests are fundamentally incompatible, while the other half took the opposing view. Is there a way of ensuring that China and the U.S. can cooperate more on economic issues to the benefit of the whole world?

The second part of the puzzle is similar in flavor. If one person gains, while others do not, is societal welfare higher? Most economists would say unequivocally “yes”—the famous Pareto-optimality principle. But scholarly research on subjective well-being calls this into question. The relative income hypothesis, introduced by Duesenberry in 1949, is back in vogue as an explanation for why people care about inequality, in addition to their own absolute standard of living. Among other examples, in both India and China, two of the great economic success stories of this century in terms of growth and poverty reduction, life satisfaction has declined on average among the population and suicides have increased. Are our measures of progress simply wrong, or incomplete, or needing time before people realize how lucky they are to enjoy a better material standard of living?

5. Why don’t we spend much more on nutrition and education?

The cost-effectiveness of nutrition interventions is well known. According to the Copenhagen Consensus, each dollar spent on nutrition in the first 1,000 days of a child’s life returns $45 in productivity over a working life span through age 50. Investing in preschool in sub-Saharan Africa similarly would return $33 for each dollar invested. Surely, returns like these are high enough that, even if one accepts inefficiencies in service delivery, the value proposition remains undisputable. Interestingly, returns of a similar order of magnitude for cutting tuberculosis ($43 return), malaria ($36 return) and HIV/AIDS (returns of $28 to $10) have led to major international efforts to expand development assistance. But aid for nutrition and education continues to lag far behind what is needed to achieve the Sustainable Development Goals. Why isn’t there a significant scale up of aid to education and nutrition, as happened with aid for health interventions?

The answers to each of these questions will dictate outcomes that will affect many millions of lives in 2019. Let’s hope we figure out the answers relatively quickly.