The G20 and the World Economy: Performance and prospects

In this presentation I will talk about the outlook for economic growth of the world economy. Every year there is a meeting of the International Monetary Fund (IMF). That meeting is now underway. There has been an announcement by the new managing director that the IMF has changed its outlook for the world economy in a negative direction. They are now much more pessimistic than they were even very recently. This is something that we need to discuss and this is a great opportunity for us to share our views.

Let me begin with an introduction of the basic framework. I am going to focus on the world economy and then look at the G20. The G20 replaced the G7 as the primary international organization for consultation on important world economic problems in 2009, so it is now a fairly mature institution. I want to pay special attention to the G20 because that is the organization that we need to think of as articulating the consensus about how the world should develop over the next decade.

Following that, I am going look more carefully at the advanced economies of the G7, comprised of Canada, France, Germany, Italy, Japan, the UK, and the U.S. I will also look carefully at the seven major emerging economies of the G20 which I will call the "emerging seven" (EM7). The EM7 is comprised of Brazil, China, India, Indonesia, South Korea, Mexico, and Turkey. I will compare the growth prospects of the two groups, the G7 and the EM7.

As for the basic findings, the IMF has discovered that the world economy is slowing. The advanced economies are going to recover from the financial and economic crisis of the past decade, but slower growth is going to continue and has already slowed substantially. I am going to focus a good deal of attention on the fact that the balance of the world economy is shifting from the advanced economies of the G7 to the emerging economies of the G20. We will look carefully at the reasons for that and try to address the question of how permanent that change is. Finally, we are going to recognize the fact and try to understand the implications of the fact that the transformation of the world economy has led to a new international order. It is a surprising development, but it is now quite well-established that this new order is led by China and not by the U.S, but the U.S., India and Japan will be the next largest players and will therefore all maintain significance in global affairs.

The methodology that I am going to use originated some time ago in a book that I wrote with Frank M. GOLLOP and Barbara FRAUMENI, called Productivity and U.S. Economic Growth, published in 1986. This established a standard methodology for analyzing growth and productivity that is appropriate for our objective. We are going to use the version that I described in a series of papers with Paul SCHREYER, the chief economist of the Organisation for Economic Co-operation and Development (OECD). There is also a more detailed treatment of capital in my book with Mun S. HO and Kevin J. STIROH, called Productivity: Information Technology and the American Growth Resurgence, published in 2005. The information technology component that is important in the research program here is now fully developed and was summarized by SCHREYER in our paper. His reports are the reports for OECD on measuring productivity and capital.

What we showed in our papers and in the books that I have described is that growth and productivity can now be integrated into the United Nations System of National Accounts (SNA). This is important because of the fact that it is what we use to interpret economic activity. It is extremely significant that the concepts that we are going to focus on such as capital input, labor input, and productivity, are developed in a way that is consistent with the SNA.

Japan is developing its own version of an integrated system. It will become part of the official SNA in Japan in about two years. It is going to be part of the official statistics of more than a dozen countries including Canada, Italy the U.K. and the U.S. from the G7. This methodology has been proposed for integration into the new System of Expanded and Integrated Global Accounts (SEIGA) by the United Nations. The data for this system has been developed in regional projects around the world.

First, there is the European project called EU KLEMS. It started in 2003 and is supported by the European Commission (EC) through its Research Directorate-General. It is included in what they call their Sixth Framework Programme, Priority 8, Policy Support and Anticipating Scientific and Technological Needs. The results for Europe were published by four European economists, Marcel TIMMER, Robert INKLAAR, Mary O'MAHONY, and Bart VAN ARK, in their book, Economic Growth in Europe: A Comparative Industry Perspective. Matilde MAS and Robert STEHRER have edited a second report on EU KLEMS called Industrial Productivity in Europe: Growth and Crisis. This presented studies involving Europe, as well as comparisons with economies in Asia and North America.

A second phase of the EU KLEMS project was initiated by Kirsten JAGER in her report, Productivity and Growth Accounts in 2016. This covered 10 countries of the European Union (EU) and is a very important development. She developed this further in 2017 to include all members of the EU, as well as comparable data for the U.S. and Japan. This has been incorporated into the work of the Economic and Financial Affairs Council of the EC. The first of a new series of reports has been published and is going to be developed further.

In Latin America, the story about growth involves the countries from the Economic Commission for Latin America and the Caribbean (ECLAC) in a report published in 2010 by Mario CIMOLI, Andre HOFMAN, and Nanno MULDER in Santiago, Chile, called Innovation and Economic Development: The Impact of Information and Communication Technologies in Latin America. A second project of this type was established by the Inter-American Development Bank in 2016.

Finally, in Asia, the Asia KLEMS was established by the Asian Development Bank Institute in Tokyo in 2010. I just came from Beijing where the fifth Asia KLEMS conference was held. It includes the China Industrial Productivity (CIP) database developed here at RIETI, and the Japanese Industrial Productivity (JIP) database which has been a collaboration involving Hitotsubashi University and RIETI since 2006. The India KLEMS database is supported by the Reserve Bank of India and described by an Indian team in 2016 in a report called Measuring Productivity at the Industry Level: The India KLEMS Database.

What are the trends in the world economy? Throughout the last century, the idea of a fundamental transformation of the world economy seemed to be very implausible. However, the World Bank's International Comparison Program (ICP) showed that China had overtaken Japan in terms of purchasing power parity a decade earlier. By 2012, India overtook Japan, and it became the world's fastest growing major economy in 2015. The question is, when will China overtake the U.S.? The World Bank reported that this actually occurred in 2014 with China becoming the world's number one country in terms of purchasing power.

We come to a very important methodological point which is that we are using purchasing power parities. Purchasing power parities are relative prices of similar goods in different countries. Using China and the U.S. as an example, these prices enable us to express U.S. gross domestic product (GDP) in terms of Chinese prices and Chinese GDP in terms of U.S. prices. The U.S.-China purchasing power parities are indexes of relative prices that combine the data for the two countries.

Why do the financial press magazines like The Economist and newspapers like the Financial Times and the Wall Street Journal continue to report that China is the world's second largest economy? Their reports are based on a different concept of exchange rates. However, purchasing power parities are reflected in the statistical practice of international institutions like the IMF, the OECD, and the World Bank, so you could say it is the standard methodology.

Using these prices, we can identify three major trends in the world economy. First, the growth of the world economy has declined. This is nothing new, but 2005-2010 was is the most severe economic downturn since the 1930s, due to a policy mistake on the part of central banks. The downturn was most severe for Japan, where it was due to the failure of the Bank of Japan to respond to the rapid expansion of the Japanese money supply through unconventional monetary policy. As a consequence, the yen appreciated rapidly, relative to other currencies, and Japanese exports collapsed, leading to a sharp economic downturn.

Second, the growth of the world is shifting from the advanced economies to the emerging economies, especially China and India. We have already observed that Japan was overtaken by India in 2012 and that the U.S. was overtaken by China in 2014. This is based on the International Comparison Project 2011 from the World Bank, which is described as the largest economic research project ever undertaken.

Third, the transformation of the world economy has generated a new world order led by China followed by the U.S., India and Japan.

How did this occur? To explain, I am going to make use of another economic concept which is the sources of world economic growth. They are divided between productivity (output per unit of input) for which I will use the term total factor productivity (TFP), and what turns out to be the most important factor, capital, which itself is divided into information technology (IT) capital and non-information technology (non-IT) capital. A third important factor is the growth of labor input, although it is less important than both productivity and capital. Other factors include labor quality and hours worked.

From 2005-2010, two changes took place. Labor input and productivity shrank in terms of growth, and the contribution of capital input increased. From 2010-2015, the world economy continued to grow more slowly. Even though labor input increased, capital input shrank and productivity growth continued to shrink. From 2015-2018, there is basically no change in labor input, a bit of a decrease in capital input, and a bit of an increase in productivity; a continuation of the trend from 2010-2015. That is our overall picture of the world economy. What we can see is that the growth of the world economy has been declining and slowing for more than 20 years.

Does this look like the world as we read about in our economic textbooks? If we look at the overall picture, from 2000-2018, productivity accounted for about 20% of economic growth, while capital and labor accounted for about 50% and 30% respectively. The capital and labor inputs together accounted for about 80% which is the opposite of what our economic textbooks told us. Robert SOLOW and Simon KUZNETS, who invented the idea of the sources of growth, attributed 20% of economic growth to capital and labor and 80% to productivity. They said that economic growth is all about productivity. Well, that turns out to be totally wrong. What did they do differently in their analysis?

One thing they did is they left out the growth of labor quality. They simply counted the hours. That was a very important omission. They also left out the part about information technology. That was a very important limitation. Furthermore, they used capital stock and asset values rather than capital services, and they misestimated the contribution of capital and labor input.

You can find out more about this in chapter five of my book with HO and STIROH. Also, in SCHREYER's report from OECD, we discussed the measurement of capital input and concluded that capital services, not capital stock, reflect the contribution to the sources of growth. This debate led to SCHREYER's OECD Capital Manual which established international standards for the measurement of capital, labor, and productivity. It has been adopted by 40 countries and is part of the official statistics in more than a dozen countries. Those changes are going to be made in Japan as well within the next two years and is something that every economist in Japan is going to learn about very soon.

The conclusion is that this framework reversed the most important conclusion of the KUZNET-SOLOW approach to growth accounting. It changed our methodology for economic measurement and set the direction for understanding the development of the theory of economic growth. It is probably the most significant development in empirical growth economics in the post-war period.

The G20 consists of the EU and 19 countries. You can see the same basic picture that productivity is important, but it is of relatively minor importance by comparison with the growth of the inputs. That is true of the G20 and that is true of the world economy. In fact, the G20 makes up about 75% of the growth of the world economy. The rate of economic growth started at around 3.73% from 2000-2005 and went up a little to 3.79% from 2005-2010. This increased further to 3.86% from 2010-2015, before falling a little to 3.77% from 2015-2018.

Let us take a look at the G7. It is a totally different picture. Rather than having stable growth or slightly declining growth, we have an economic catastrophe that took place during the period of 2005-2010. The growth was 2.23% from 2000-2005 and became 0.90% from 2005-2010. That was the Great Recession, the most significant economic downturn since the Great Depression. There was a revival from 2010-2015, and a further revival from 2015-2018, but it never got back to the level of 2000-2005. The sources of G7 economic growth have been one of steady decline and productivity is an insignificant factor.

Looking at the EM7, again, a totally different picture. The growth rate is 6.15% during the period of 2000-2005. There is a huge jump from 2005-2010, a bit of a decline from 2010-2015, and then finally a decrease to 5.77% from 2015-2018. Overall, inputs are dominant and productivity is less significant.

What we need to focus on is the future growth of the world economy. We derive projections of output and capital input from future trends of demography and productivity growth. This is a standard economic growth theory that we refer to as the neo-classical model of economic growth. Trends in demography, whether at the world level or the level of individual countries, are relatively slow to change. Productivity growth is highly variable and future productivity growth is the main source of substantial uncertainty.

To visualize the future growth of the world economy, I utilize various sources of data such as the United Nations' projections of world population growth due to changes in age, gender, and educational attainment. I use productivity projections from work I have done for a conference board in New York, based on future trends in the development of information technology and non-information technology, and use a model to derive output and capital projections. Future economic productivity growth is going to be the main source of what we are going to see as the most substantial uncertainty.

What does the future of world economic growth look like? Using data from the last decade of 2008-2018 for reference, we can construct a base case which is the projection of the next decade of 2018-2028. Comparing the last decade with the next decade, the baseline case is that overall world economic growth is going to decline from 3.36% to 3.24%. For the G7, growth is projected to slow from 1.45% to 1.18%. For the EM7, growth is projected to slow from 6.26% to 4.46%. For the G20, growth is projected to slow from 3.6% to 3.1%.Using the slowest growing five years and the fastest growing five years from the last decade, we can project a pessimistic case and an optimistic case. For the G7, the pessimistic case is 0.91% and the optimistic case is 1.46%. For the EM7, the pessimistic case is 3.70% and the optimistic case is 5.69%. For the G20, the pessimistic case is 2.5% and the optimistic case is 4.0%.

To summarize, the world economy is entering a period of sustainable growth at a rate of 3.24% during the next decade, 2018-2028. This is only slightly below the growth rate of the last decade, 2008-2018. Even with slower growth, the relative importance of emerging economies like China and India will continue to increase. Potential growth will decrease in the G7 and shrink the relative importance of advanced economies in the world economy. The upside potential for the world economy is considerable, but this will require ambitious changes in academic policy which appear to be very unlikely.

In conclusion, the base projection of the world economy is for moderate but sustained growth, and most importantly, from a shift from the advanced economies of the G7 to the emerging economies of the G20. We have now established a new world order for the 21st century which is going to continue to develop. If you are interested, all of this is discussed in my book with FUKAO Kyoji and Marcel P. TIMMER entitled The World Economy: Growth or Stagnation (https://www.rieti.go.jp/en/publications/summary/16120010.html).

Q1: You said that the growth rate will decelerate. In order to improve growth, you need very drastic reforms. Could you give some examples of requirements or reforms that would be needed in the U.S. and in Japan?

Dale W. JORGENSON:
The sorts of reforms that we need are those that will stimulate the growth of investment, both in terms of physical capital and human capital. These investments are very expensive and require economic institutions, but investment has to increase. In Japan, the focus has been on achieving a balance of the government budget. Japan has been running a very sizable deficit for decades and is really at the end of its possibilities. You can decide to increase taxes to raise more money, but that will cause further downward pressure on the growth rate. Therefore, you need to figure out a way to raise money without depressing the economy. We need to think about the transformation of the world economy as revolving around investment.

Q2: You said investment in IT is decreasing, but according to some analyses China is working on very hard and has invested a lot in IT. Could you please elaborate on that?

Dale W. JORGENSON:
China's investment relative to its GDP is the highest in the world, but it is something which it is going to have to gradually decrease. I do not see a way for China to avoid this situation. I have just come from Beijing and it is quite clear to me that it is going to be necessary for China to maintain or even decrease their level of the investment, to increase their level of consumption, and to move people from relatively unproductive parts of the labor force, mainly in agricultural areas, to urban situations where they can get a better education and become more productive. The IMF is focused on output for growth, but what matters for economic growth is the input side. The growth of inputs through investment in capital is the way that I view the transformation that is taking place in the world economy. It requires change in the composition of the input side, not of the output side.

Q3: Measures against climate change could have a positive effect or a negative effect on the global economy. What effects can we expect from measures against climate change on the global economy?

Dale W. JORGENSON:
The effect of climate change on the global economy is going to be negative. There is going to be slower growth and it is going to be necessary to have investments that make growth possible. Japan is going to have to bring their remaining nuclear plants back into operation. There is a very important opportunity in the energy sector to deal with this issue. The Paris Agreement, to which many countries have adhered to, is something which could bring about the necessary changes.

Q4: The contribution of capital to economic growth is very large, but the contribution of TFP is relatively small and unimportant. I think it is partly because the calculation is made using capital services and not capital stock. Do capital services include R&D capital?

Dale W. JORGENSON:
That is the direction that technology is going and R&D is going to become relatively more and more important. All of that is something that is going to produce developments in information technology that are going to make it possible to continue a very high growth rate. It is going to be necessary to face the fact that the issues that are going to arise in the future are going to require hard work and lots of investment.

Q5: I am pleasantly surprised that you mentioned China, the U.S., India, and Japan, will continue to lead the world economic order. Where does the EU fit in this picture?

Dale W. JORGENSON:
I think the European countries have demonstrated that they are not able to muster the political consensus that would be necessary to continue to sustain high levels of investment. I think they are going to continue to contribute less and less to world economic growth. The idea is that they are not going to be major contributors. On the other hand, India, China, and many other countries in Asia are going to continue to be leaders and are going to increase in their relative importance. We need to focus more attention on the emerging economies and try to understand what their roles are going to be.

Q6: In the future projection of 2018-2028, you had pessimistic and optimistic cases. Right now, the Fourth Industrial Revolution is ongoing with artificial intelligence and other new technologies coming in. Are these technologies included in the projections, or are there other explanations for the optimistic projections?

Dale W. JORGENSON:
The difference between pessimistic and optimistic is essentially a representation of the uncertainty that is associated with any of these projections. The fact is that there is an enormous amount of uncertainty. For example, productivity is of relatively minor importance, but it is an area where I think we can see that the opportunities are characterized as those that are associated with the development of new technologies. The key is to understand the forces controlling the development of new technologies. This is not something that is limited to information technology. There are many other new technologies that could play a role in this picture. It is clear that most of these new technological developments are not going to be occurring in advanced economies, but are going to take place in emerging economies, where the role of management will become critical, but where management capability is underdeveloped. This is where I think Japan can play a significant role, as a country with economic ties to China, India and other emerging economies, where bridging will be important. Japan is in a unique position of being an advanced economy right in the middle of the area where the uncertainty is greatest. Japanese management and technological potential could pay if opportunities can be identified and exploited effectively.