The Global Economy Shifts East

In 1497, the Portuguese adventurer Vasco da Gama led a fleet of four ships with a crew of 170 from Lisbon. He followed Bartholomeu Dias’s earlier voyage to the southern tip of Africa then travelled up the east coast of Africa to reach the west coat of India. Ninety-two years earlier, Admiral Zheng He had led an armada of 317 ships (other sources say 200 ships) with a crew of 28,000 (each ship carrying up to 500 men) on his first expedition. Zheng He was a Muslim and a eunuch, the great great great grandson of Sayyid Ajjal Shams al-Din Omar, a Persian who served in the administration of the Mongolian Empire and was appointed governor of Yunnan during the early Yuan Dynasty. Between 1405 and 1433, the Ming government sponsored a series of seven naval expeditions led by Zheng He to reach as far as the east coast of Africa.

Economic Centre of Gravity in 2050

The Marxist scholar, Professor Immanuel Wallerstein in his magnum opus The Modern World System I- III (1974, 1980, 1988) marveled at these two events, one at the start of the fifteenth century and the other at the end of it, and how they contrasted not only the relative economic positions of Europe and China in that century, but also marked the point when China turned inward on itself, and the emergence of the modern capitalist world system out of Western Europe in the sixteenth century. This marked the beginning of the shift of the global economy from the East to the West.

Professor Danny Quah (2011) of the London School of Economics and Political Science has published an article visualizing the recent shift of the global economy’s center of gravity, and the average location of economic activity across geographies on Earth. His calculations take into account all the GDP produced on this planet. He finds that in 1980 the global economy’s center of gravity lay in the mid-Atlantic. By 2008, thanks to the continuing rise of China and India, that center had drifted to a location east of Helsinki and Bucharest. Extrapolating growth in almost 700 locations across the globe, Quah projects the world’s economic center of gravity to settle by 2050 literally between India and China (see Figure 1). Observed from the Earth’s surface, the economic center of gravity will shift from its 1980 location by 9,300 km, or 1.5 times the radius of the planet. This extrapolation assumes that the next 40 years will resemble the past 30 years; a mechanical assumption to be sure, but it provides a telling tale of where the world is heading at the present time and, if the momentum can be sustained, where it will end up.

In a major study to identify the new “Global Growth Generators” or 3Gs, Willem Buiter and Ebrahim Rahbari (2011) and analysts from Citi Investment Research & Analysis forecasted that 11 economies will drive growth for the next 40 years – nine of them in Asia and two in Africa. This is an ambitious undertaking. It goes beyond the simple extrapolation method adopted by Quah, and tries to incorporate the underlying growth drivers within the new growth economics framework. The new growth economics was first developed by Paul Romer in his doctorate thesis at the University of Chicago in 1983. It has since become the workhorse model for understanding economic growth over time and across economies. Romer was named by Time Magazine in 1997 as one of the 25 most influential Americans. To understand the Buiter and Rahbari (2011) study it is useful to grasp key features of the old and new growth economics.

In both the new growth economics model and the obsolete old neoclassical model, understanding economic growth naturally divides itself into two parts. The first part explains the rise of output per worker, often measured in terms of GDP per capita, as resulting from productivity increases due to changes in technology and management. The second part accounts for the rise of output per worker resulting from “catching-up” growth. This occurs when technologically backward economies established institutions and incentives to allow individuals and firms to catch-up with advanced economies by using their better available technology and management.

Two Flaws of Neoclassical Growth Models

In the old neoclassical model the “catching-up” hypothesis implied that the standard of living of backward poor economies would converge to that of the advanced rich economies over time. When, after decades, convergence was not observed economists began to seek policies to promote this and the field of development economics became dedicated to the search for such policies.  The neoclassical model had another problem. It assumed that technological change occurred exogenously outside the economic growth model, i.e., that it occurred with no explanation of why it did so. It was invoked to lend a name to something masquerading as an explanation. Technological progress became a residual explanation, reflecting our ignorance, or inability, to explain why productivity increased in some countries and not in others. The neoclassical model had therefore two major shortcomings. First, it failed to explain why convergence did not take place across economies. Second, it failed to explain why technological progress occurred in some economies and not in others.

The new growth economics embraces a diverse body of theoretical and empirical work that emerged in the 1980s. It distinguishes itself from the old neoclassical model by emphasizing that economic growth is an “endogenous” outcome of an economic system, not the result of exogenous technological change that impinges from outside. Endogenous growth theory incorporates robust economic reasons for productivity increases by drawing on research from other areas of economics to provide drivers to power the growth model, for example, human capital theory.

By incorporating these economic drivers into the new growth models explicitly and working out their interaction effects formally within the models, the explanatory power and therefore predictive ability of the models is enhanced. Some economic drivers may promote convergence, others enhance productivity, and some may affect both at the same time. The effects of some drivers may either amplify or offset the effects of other drivers promising a richer menu of predictions.

In the new growth economics, drivers that enhance productivity generate positive externality effects that produce a social rate of return that is higher than the private rate of return. This can be described as a sort of “free lunch” and is behind what the old neoclassical model called exogenous technological progress. The endogenously produced externality effects make it feasible for economies to sustain a positive rate of growth of output per worker. Moreover this is not merely the catch-up growth arising from moving an economy from a backward condition to an advanced condition, but what enables advanced economies to sustain a positive and higher rate of growth as well.

High Fertility Rates in Poor Nations

An important implication of the new growth economics, given the central role of positive externalities that sustain higher rates of growth, is that larger economies will grow faster because the positive benefits of such externalities are magnified with size. A larger city, region, or country will benefit more from such positive externalities. Indeed economic growth models make no presumption about the natural unit of observation as to whether it should be a city, a region or a country. With the great diversity in the sizes of countries, large ones that operate as a unified economic entity will necessarily dominate the world economy as they can sustain a higher rate of growth because of the positive externality effects. From the perspective of the new growth economics “Small is Not Beautiful”.

In the new growth economics, drivers that promote convergence allow poor economies to grow faster by investing at a higher rate and adopting state-of-the-art technology and management from advanced economies without having to pay for the full social cost of their discovery. If these drivers are operating with some effectiveness then the poor nations will grow faster than the rich ones. Since poor nations, as a whole, have larger populations and higher fertility rates, if they can trigger catch-up growth the distribution of the world economy will shift in their favor. In the past 30 and 20 years this has occurred to a considerable extent because China and India, respectively, allowed catch-up growth to take place; something that was prevented from happening in the history of their 30 and 40 preceding years.

The most spectacular rates of growth of output and productivity to date have occurred in countries that start from a position of technological immaturity and low capital-labor ratios. These countries have an opportunity to boost both productivity through rapid accumulation of capital, and adopt state-of-the-art technology and management. The idea that the easiest way for a country to achieve a high growth rate of output and productivity is by starting from a very low level of productivity appears trivial until one asks the question ‘how does this gap between the frontier and a country’s actual level of productivity come about in the first place?’

What combination of factors, institutions and policies have prevented the low productivity country from being at the frontier, or closer to the frontier, over the past years, decades or, in the case of China and India, centuries? Are there feasible and likely changes in institutions, policies or in the external environment that would remove the obstacles to catch-up growth and productivity convergence? In the words of economist Deidre McCloskey, “The big economic story of our times is not the Great Recession. It is how China and India began to embrace neoliberal ideas of economics and attributed a sense of dignity and liberty to the bourgeoisie they had denied for so long. The result was an explosion in economic growth.”

Drawing on the findings of the new growth economics literature and also their in-house team of 50 economists based in 19 countries and covering 60 countries Buiter and Rahbari (2011) identified a number of drivers of economic growth. These are reduced down to six common drivers: (1) capital formation and domestic savings, (2) demographic prospects, (3) health, (4) education, (5) quality of institutions and policies, and (6) openness to trade, capital and labor mobility.

Four Asian Growth Generators

To provide a summary measure of these six factors they gave a weight of 0.5 for domestic savings and investments, and 0.1 for the rest of the five drivers to arrive at a “Global Growth Generators Index”, which they call the 3G Index. They found that of the 58 economies for which they produced forecasts the ones that are most promising in terms of their growth potential in the coming 40 years are Bangladesh, China, Egypt, India, Indonesia, Iraq, Mongolia, Nigeria, Philippines, Sri Lanka, and Vietnam using Purchasing Power Parity (PPP) 2010 US Dollar equivalent income figures (See Table 1). Among these 11 countries, nine are in Asia and two are in Africa. Among these 11 countries, China, India, Indonesia and Vietnam have the highest 3G index scores and suggests that they have the highest growth potential.

Average growth forecasts were produced for all 58 economies using a 3-step process. First, Buiter and Rahbari (2011) draw on the findings from the literature on the new growth economics that in the long-run-growth all economies must converge to the frontier level of per capita income. Their study assumes that the convergence rate is 1.5% per year and the US levels of per capita income proxies for the frontier levels those other economies would converge towards. Second, they rely on their in-house economists to produce initial medium-term and long-term growth forecasts for the economies they regularly monitor and cover. The economists were free to use their locally-sourced knowledge to inform their forecasts. In doing so the economists are likely to take into account developments in both the recent, and not so recent, past and allow some degree of independent thinking beyond extrapolating from the experience of their local economies. Third, they combine these economic forecasts with historical growth rates and impose the convergence assumptions to arrive at 40-year forecasts for all 58 economies. Table 2 below reproduces their forecasts of the 10 largest economies in every decade using Purchasing Power Parity (PPP) 2010 US Dollar equivalent income figures.

Europe Drops Out of Top 10

Between 2010 and 2050, all the old European national economies have dropped out of the top 10 largest economies in the world. It may eventually make sense to consider the European Union as a single economy if integration continues further. India and China are each about twice the size of the US. There is an unmistakable conclusion of economic activities shifting to the East from the old West. The key common attribute of the new rising economies is that they started from the position of poverty so they have plenty of opportunities  to catch-up; their populations are plentiful and young and they have a demographic dividend to capture; their economies are open to trade and investment to maximize the opportunities to adopt state-of-the-art technologies; they adopt market economy institutions that provide proper incentives for individuals and enterprises to create and seize economic opportunities; but  they must avoid making policy mistakes that may stifle the drivers of economic growth in the process of catching-up, and evade bad luck.

In a sense the shifting of the economic center of gravity back to the East is no more than reverting to the old economic balance of 200, or even 400, years ago. But in the process of this journey the world has become a very different place. First, it has grown vastly more prosperous. Second, it has become much more integrated under a modern world capitalist system in the eyes of both Marxists and non-Marxists alike. And if these predictions were to come true then the economic awakening that started in the townships in Western Europe has indeed been the most momentous event in human history.

Hundreds of Millions Lifted Out of Poverty

These seismic changes have caused concern among many observers and participants in this momentous shift on how to adjust to the new global power balance. Needless to say in the years ahead the world will have to grapple with the consequences and policy implications of the changes. If soft power mirrors but lags behind economic power, then the source for global and political influence will  similarly gradually shift east over the next 50–100 years. Policy formulation for the entire global economy, and global governance more generally, will no longer be the domain of the last century’s rich countries but instead will require a more inclusive engagement of the East. Many global policy questions will remain the same, e.g. the issue of promoting growth in the world economy, but others might change in character, e.g. the issue of appropriate political and military intervention. But it does well to remember that if the economic forecast materializes humanity will become much more prosperous and billions of people shall be lifted from poverty. Economic growth has been the most important issue for the world ever since the ideas of capitalism first emerged and its triumph appears to be within sight.

Buiter and Rahbari (2011) also produced forecasts of the 10 Highest GDP per capita economies in every decade using Purchasing Power Parity (PPP) 2010 US Dollars. If these are to be believed then the four Asian Dragons will be the best place to be in the next 40 years.

References

Willem Buiter and Ebrahim Rahbari, Global Growth Generators: Moving Beyond ‘Emerging Markets’ and ‘BRIC’, Citi Investment Research & Analysis, Citigroup Global Markets Inc., 21 February 2011.

Danny Quah, “The Global Economy’s Shifting Centre of Gravity”, Global Policy, January 2011