Davos attendees should beware the slowing of potential growth

The global economy is finally delivering solid growth and outpacing expectations after several years of disappointing performance, something World Economic Forum attendees in Davos will surely celebrate. At the same time, they will be doubling down on their efforts to find solutions for making globalization more equitable. 

Global leaders in Davos should also take advantage of the growth momentum to prepare for possibly stormier times ahead.  After all, the theme of this year’s meeting is “Creating a Shared Future in a Fractured World.”

Reasons for optimism

In its latest Global Economic Prospects report, the World Bank estimates global growth has reached 3 percent in 2017. Growth is expected to edge up to 3.1 percent this year, the strongest outturn since 2011.  The drivers of this healthy performance include buoyant global investment, manufacturing, and trade.

The growth acceleration has been broad based: Advanced economies are delivering stronger-than-expected growth and the outlook for emerging and developing economies is bright. Growth among the latter is forecast to rise to 4.5 percent in 2018 from 4.3 percent in 2017.

Reasons for concern

A number of risks, mostly associated with economic, financial, and political developments, could threaten the global recovery, but two of them are particularly worrying.

First, a sudden increase in borrowing costs, whether from a reassessment of the pace of inevitable monetary policy normalization in advanced economies or rising concerns about elevated asset valuations, could lead to financial stress.

Although the risk of rising borrowing costs has been present for several years, it is more pronounced now because the global economy is at a turning point. For the first time since the global crisis, the negative global output gap is expected to close. The global output gap is the deviation of actual output from its potential, that is, the level of output that would prevail when an economy is fully employing its resources. A negative output gap describes excess slack, whereas a positive gap signals excess demand and overheating.

Not only is the output gap closing among advanced economies this year, it is also gradually vanishing among emerging and developing economies, thanks to the recent recovery in commodity markets.

This development is not in and of itself bad news. Difficult though it may be to measure, the expected closing of the global output gap signals a return to health of the world economy after a prolonged period of weak growth.

However, the output gap is an essential yardstick central bankers use in calibrating policy. A closed output gap means that the coming years portend an unprecedented shift in the stance of cyclical policies among advanced economies. This shift brings the risk of a faster-than-expected normalization of monetary policy should inflation rear its head in an alarming way, with potentially destabilizing consequences.

The second major risk to the growth outlook is the slowing of potential growth, which would make the global economy more vulnerable to shocks and worsen prospects for improving living standards. Ultimately, what will improve living standards over the long haul is a rise in potential growth—the level of growth an economy is able to deliver when fully using all of its resources.  And while the short-term growth picture looks rosy, the prognosis for the long term—as defined by the prospects for potential growth—is sobering.

The global financial crisis ushered in a period of persistently weak potential growth. During 2013-17,  our estimates suggest that global potential growth averaged 2.5 percent, 0.5 percentage point off its longer-term 3 percent average. For advanced economies, the decline over the same period was to 1.4 percent from its 1.9 percent longer-term average, while among emerging and developing economies, the slowdown was to 4.8 percent a year, 0.6 percentage point below the longer-term average.

Blame weak capital accumulation, unfavorable demographics, and slowing productivity growth for the fall-off. Whatever the cause, the weakness in potential growth has been broad based, affecting almost half of the emerging and developing economies and close to 90 percent of advanced economies. Further, the factors contributing to subdued potential growth are likely to persist for at least the next decade absent corrective policy measures.

Time for responsible policy

So, amid the glad news about the healthy global outlook, a clear note of caution is called for. This is the best time for emerging and developing economies to undertake responsible forward-looking policies: time to strengthen productive capacity, to achieve better educational and health outcomes, to improve labor market functioning, facilitate business, and strengthen governance—all with a view to improving productivity and increasing investment. These are the policy measures that would lead to higher potential growth.

When growth is strong it is easy to lose sight of the fact that there are formidable long-term challenges. But this is exactly the point. If policymakers want their constituencies to continue enjoying the benefits of solid growth, they now have an opportunity that may not last long. It’s up to them to seize it.