GROWTH CHALLENGES IN DEVELOPED ECONOMIES

 

Why are developing countries managing to grow rapidly, even at double digit rates, while developed countries cannot manage to achieve any meaningful growth?

The answer lies primarily in global resource and environmental constraints. An overcrowded planet and massive industrialization of developing countries have brought mankind face to face with the limits of the planet. These limits tend to constrain global economic growth.

In the following pages we will examine the ways these resource and environmental constraints work their way through the global economy and the effects they have on its developed and developing segments. Since the growth challenges we are concerned about mainly emanate from resource and environmental constraints it is important to mention that an important difference between developed and developing economies is their resource intensiveness. This discussion is mainly about the resource intensiveness of developed and developing economies and the resulting growth challenges they face.

 

RESOURCE CHALLENGES

Soaring Global Resource Consumption

Consumption, production and almost every other activity in developed countries involve use of fossil fuel. The structures of developed economies require a high level of resource consumption by people and businesses. Consequently, a very high level of oil and energy consumption is part of life in developed economies.

According to data available for 2007[1] the rate of oil consumption in the US was 69 barrels per day for 1000 people; in China that number was 6 barrels and in India it was 2.4 barrels. For Germany,Japan and the UK the respective numbers are 30, 39, 29 barrels per day. The US is by far the largest global consumer of oil; however, on a per capita basis it is behind two other large countries:Canada and Saudi Arabia, both oil exporting.

Developing countries currently have relatively low rate of oil consumption. However they don’t want to be left behind in resource consumption. They are building factories, homes, and infrastructure that require use of ever increasing volumes of finite global resources, particularly oil. There is an almost worldwide rush to produce and use resource intensive products like cars, trucks, airplanes, air conditioners and other appliances.

This path of growth is rapidly increasing resource consumption; and by building higher levels of resource consumption in the structure of developing economies it is permanently increasing demand for fossil fuel and other resources.

The planet has a finite amount of fossil fuel, particularly oil. Massive fossil fuel based industrialization of developing countries is adding two billion people to the one billion already heavily dependent on fossil fuel. It is difficult to imagine a plausible scenario of oil discoveries whereby three billion people will be consuming oil like those in developed countries. But that is the path leading economies are showing and developing economies are following. The global economy is heading in the wrong direction; no wonder the leading economies are not making much progress.  

Resulting High Oil Prices and Shrinking of Developed Economies

Oil and other fossil fuels are foundational materials for economies in the industrial age. During most of the 20th century oil was under $5 a barrel. When oil was cheap higher per capita oil consumption increased the size of the economy. As long as the marginal benefit from using oil was greater than the cost of oil the economy kept growing by using more oil. No wonder the largest economy of the world uses the most oil. Cheap oil contributed significantly to economic growth.

As advanced economies expanded and grew wages also rose. This cycle of growth and wage increases, over centuries, brought developed countries to their current wage and economic structure. This economic structure that was built on cheap oil has now become an integral part of life in developed economies; it includes high wages and high resource consumption, particularly of energy and oil.

However, in the 21st century cheap oil became a thing of the past. The advent of globalization, towards the end of the 20th century, brought opportunities for development and growth to many countries, some of them very populous. Those countries are now rapidly industrializing and they need increasing quantities of oil; oil is becoming scarce and expensive.

Oil price went from a low of $9.10 a barrel in December of 1998 to a high of $143.95 in July of 2008; it has mostly remained over $75 a barrel in 2010 and 2011, gradually inching higher over time and averaging approximately $100 a barrel in the first half of 2012.

A more than 1000 percent increase in the price of oil in the recent decade, or so, has seriously affected most developed economies. It has rendered unviable a wide range of economic activities that previously made sense; examples include suburban living, driving big cars and over reliance on trucking and aviation.  It has put in retreat economic growth that started with the building of the Interstate Highways and subsequent creation of huge urban and suburban sprawls. Huge segments of the economy have become unviable due to oil price hikes. All sectors of the economy including energy, transportation, housing, recreation and tourism, and retail are affected.

Developed countries have economies and wage structures that were built on $20 barrel oil. (Oil prices started rising in the 1970s and oscillated around $20 a barrel for the remaining part of the century.)  Now that oil is around $100 a barrel the wage and economic structure in developed countries has started to fail. That is, the economies are no longer able to generate the volume of economic activities required to create increasing real incomes for their populations and keep them employed.

The US and other developed countries are extremely exposed to oil prices, directly and indirectly. The direct effects are obvious; the indirect effect is on the size of their economies i.e. higher oil prices mean smaller economies for them. Their economies have started to shrink. Vulnerable European countries are just starting points.

Given globalization and current oil prices, the US and other developed economies have to shrink if the current fossil fuel driven economic structure stays. The pressure to shrink is manifested in the tendency of oil price to batter demand growth. As soon as demand picks up oil prices rise and crush demand. It is a pattern that, if continued, will ensure perpetual recession in most developed economies. Sharp hikes in oil price have preceded 10 of the last 11 US recessions.

The same is not the case with developing countries. Low oil consumption in developing countries helps them keep their costs low, including wages. Developing countries wages are somewhat immune from oil price hikes. Business and economic activities suffer relatively little from oil price hikes in developing countries. Developing economies do not generally go into an economic recession due to oil price hikes. Their economic growth continues in spite of oil price hikes.

Limited and Unfavorable growth in developing countries

Even though there is considerable growth in developing countries, that growth is not translating into much demand for high value products from developed countries.

If oil prices had not risen as much as they did during the recent decade, real incomes in developing countries would have risen much faster. Higher real incomes in developing countries would have translated into demand for high value and high end consumer, industrial and service products, substantially increasing their imports from developed countries. But that did not happen because growth in their real incomes was constrained by a dwindling resource: fossil fuel.

In other words, if global fossil fuel resources were so high that people in developing countries could potentially consume fossil fuel at rates comparable to that in developed countries, growth in developing economies would not be primarily driven by low wages but by higher standards of living. Real incomes in developing countries would have risen freely and be much higher. Developed countries would have plenty to sell to developing countries. There would be economic growth everywhere.

High real incomes and higher employment in developing countries would have also enabled developed countries to take full advantage of comparative advantages of trade. Trade flows would increase in both directions.

During the push for globalization it was mostly assumed, particularly by economists, in developed economies that business lost to developing countries will be more than made up by increasing demand from them. But due to constraints on fossil fuel use and consequently on growth in real incomes, that kind of increase in demand did not materialize. Globalization has therefore not been a net benefit for developed countries, so far.

Zero sum global economy

If the world continues its increasing dependence on fossil fuel, growth in global economic output will not be driven by human, technological, market and other potentials; but will be greatly determined by fossil fuel supply and related constraints. Economic growth is fast becoming a zero-sum game among countries because of fossil fuel supply constraint and the likely consequences of environmental constraints.

Since resource limits will not allow the global economy to grow freely; growth in developing countries will exert offsetting downward pressure on growth in developed countries. Growth in developing countries will come at the cost of growth in developed countries.  Migration of industries without replacement is just one example.

Utility maximization from oil

Assuming that the world is a consumer with a finite amount of oil; it will try to maximize its utility by equalizing the marginal utility from all its different uses of oil. Globalization has helped create conditions where the world is like a consumer trying to maximize its utility from scarce resources. In other words the global economy is trying to equalize its utility from oil use in all parts of the world.

Global utility maximization is working through resource, labor, end product and other prices, to equalize the utility derived from oil use in different parts of the world. Global utility maximization currently translates into reducing resource use in developed countries and increasing it in developing countries. This market pressure to reduce fossil fuel use in developed countries may be called a “market driven correction” but in real life it is the economic crisis!  

 

COMPETITION FROM DEVELOPING COUNTRIES

Low wage competition from developing countries

Wages in developing countries are really low. The wage differences between developing and developed countries are huge which are also reflected in the differences in their per capita GDP. According to 2011 World Bank figures per capita GDP in the US was $48,442 whereas in China it was $5,445; in India and Bangladesh it was $1,489 and $735 respectively.

Globalization and the resultant massive industrialization of developing countries brought two billion people in the global workforce. Consequently, a large number of businesses in developed economies are facing tough low wage competition from developing economies. As a result they are either closing down or moving to developing countries to take advantage of their low wages. When businesses move overseas they not only take the employment and income that they created but also the opportunities and the potentials that they created for other businesses; they take an additional piece of the economy with them.

Given the huge wage differences, the huge pool of available labor in developing countries (according to Gov. Mitt Romney 20 million people come to cities from rural China every year), and constrained growth in incomes there, low wage competition is here to stay.

There are many reasons for low wages in developing countries but an important and enduring one is their low per capita consumption of fossil fuel. In an era of high and rising oil prices this is a quality that is likely to continue to translate into benefit for producers. Producers would therefore continue to move to developing countries as long as the world is hooked to fossil fuel.

Growing Competitive Disadvantage of Developed Economies

Global resource limits, particularly those manifested by oil price hikes, are affecting developed and developing countries in different and opposite ways.

Almost all production and consumption activity in developed countries has a significant component of oil or energy use. Due to high and ubiquitous usage of fossil fuel, the cost structures in developed countries get pushed up higher by oil price hikes. Wage standards are also pushed up or lose downward flexibility because of oil price hikes, particularly given the cumulative effect of hikes in the recent decade. Therefore competitive abilities of business in developed countries tend to be diminished by oil price hikes and related expectations.

In developing countries, on the other hand, oil price hikes do not significantly affect wages and other costs due to their low usage of fossil fuel. Low intensity of energy use also helps them keep wages low.

Due to low intensity of energy use in developing countries their costs do not go up as much by oil price hikes as they do in developed countries. The economic effects of oil price hikes are many times higher in developed countries than in developing ones. Developing countries gain some competitive advantage over developed countries every time oil price increases.

Global resource constraints, i.e. rising oil prices, have put developed countries at a significant and increasing disadvantage vis-à-vis developing countries. If developed countries continue on the fossil fuel path they will keep losing jobs and business to developing countries.

Oil buying power of developing countries

Since consumers in developing countries have a low rate of oil consumption, they are likely to derive higher marginal utility from consumption of oil compared to that in developed countries. Therefore consumers in developing countries are more likely to be willing to pay for rising oil prices. Oil consumption in developing countries will keep pressure on oil prices.

It may seem that developed countries have more buying power, but for oil and similar global resources, the production and consumption economics favor developing countries and give them better buying power. Since oil price hikes do not significantly affect wages, only direct costs have to be transferred to end products in developing countries. Direct costs are easy to transfer to end product prices. Oil price hikes are easier to deal with there.

Developed countries have built their economies on oil prices of around $10, or $20, a barrel whereas developing countries are building theirs on $100 a barrel. Developing countries therefore are able to deal with high oil prices without much pain or restructuring. Their oil buying power even at $100 a barrel is growing. Cities in China are putting registration restrictions on new cars to ease traffic and environmental conditions.

Developing countries’ growth is likely to continue in spite of rising oil and other resource prices. The same cannot be said about developed countries. Because of high intensity of energy and oil use developed economies will be increasingly crippled by rising oil prices.

 

ENVIRONMENTAL CHALLENGES

Irrespective of the controversies about the science and the reality of Global Warming, its impact on the economy is obvious. The uncertainty about carbon tax or other climate change regulation is increasing risks and cost estimates. Significant economic impact of global warming is already here and very real.

Oil supply constraints and global warming are reinforcing each other in developed countries to reduce investments and growth. Fossil fuel is so much part of the fabric of economic life in developed countries that lack of its abundance and uncertainties about its environmental impact increase risks in business ventures and reduce their expected incomes.

Most developing countries however continue to ignore most environmental costs. Local environmental conditions are rapidly deteriorating in most developing countries; Beijing Olympics showed us the extent of those damages to the local conditions. Their commitment to protecting global environmental conditions is certainly lower than their dedication to protecting local conditions.

 

CHALLENGES INHERENT TO HIGHER LEVELS OF DEVELOPMENT

Higher levels of development leave smaller room for further development, particularly if future growth is to follow the same course as past development. Most developed countries are trying to grow on the same trajectory that started with the industrial revolution; therefore their potentials for further growth are getting increasingly smaller with higher cumulative growth and higher levels of development.

Additionally, higher levels of development generally translate into higher per capita consumption of finite resources such as fossil fuel. Broad based economic growth and development on the current trajectory will mean more fossil fuel consumption. Given rising global demand for oil and other fossil fuels, and its rising prices, there is little economic room for developed countries to further increase their per capita consumption of fossil fuel. The fossil fuel trajectory for economic growth is pretty much closed out for developed countries.

Economic growth in developed countries is facing dual impediments: smaller room for growth and fossil fuel related constraints. The effects of these dual impediments are felt in all developed economies, including Germany. Reunification of East Germany has provided it new room to grow and the newly integrated markets of the European Union also contribute to Germany’s current health. Japan did not have anything resembling those events and is stuck in a slump for decades.

The explanation for this crisis cannot be found in the structural differences between developed economies. It is a crisis primarily driven by high consumption of fossil fuel that comes with high level of development on the fossil fuel trajectory, a feature common to all developed economies. High level of development slows down growth; additional fossil fuel constraints have brought growth to a halt.

 

RECOVERY STRATEGIES THAT WON’T WORK

Increasing oil and gas production

In March 2012 Citibank in its very bullish report about oil production predicted that North America will be a net exporter of oil by the year 2020. The recent surge in oil exploration and discovery, particularly in North America, has led many to believe that the era of high oil prices are over.  It seems not. These high rates of exploration and discovery have only been possible because oil prices are high. High price of oil makes a large number of oil fields economically feasible for production.

New oil reserves are very expensive to discover and extract. In other words the production costs of these oil wells are high. Their environmental impact and dangers of potential environmental damage are also high. Cheap oil is a thing of the past.

Fossil fuel is the fruit of a process that takes millions of years to bear fruit once. The low hanging fruits are taken we are now going higher up the tree to get fruits. We can increase fruit supply by having a bigger ladder and finding other ways to get to the top of the trees but it does not mean we can keep doing this and keep increasing fruit supply. We know we are nearing the top.

In 2009 remaining proven global reserves of oil stood at 1.3 trillion barrels[2]; at the current rate of consumption we may have just 58 years[3] of oil left. The current discoveries may help improve the supply picture but increasing demand will more than offset those gains. However, even if the supply horizon is extended by more than 50% to 88 years it will not bring back cheap oil nor will it change the long term economic and investment outlook to substantially affect economic growth in developed countries. Almost all economic growth benefits from new oil and gas finds will go to developing countries.

No matter how many new oil deposits are found, the fact that seven billion people are rapidly building their lives on it makes the era of cheap and abundant oil a thing of the past. Even if we entertain an absurdly rosy scenario of global oil reserves increasing by a 1000% and lasting for 500 years, environmental constraints would still tend to limit growth, particularly in developed countries.

Recently there has been a huge increase in known reserves and production of natural gas in the US; consequently natural gas prices have been falling over the last few years. However, plans to shift reliance away from oil to natural gas do not have much future. We cannot expect that gas prices will remain as low as they are because demand will increase domestically and globally. Export restrictions will eventually be removed and gas prices in the US will track international prices.

At international prices natural gas will not provide the economic benefits to justify the cost of shifting away from oil for most current users of oil, particularly cars and trucks owners. It is not worth building a natural gas infra structure for cars and trucks. Natural gas, however, is likely to bring about a shift from coal to natural gas in power plants.

The economic effects of new oil and gas discoveries on the US economy will be small.Saudi Arabia has 19 million Saudis and the US has 319 million Americans.

Subsidies are not a solution nor is cap and trade

Building sustainability into a sizeable economy through subsidies is too massive a task for any government. For example, governments were able to provide subsidies to build solar panel but weren’t able to continue to subsidize the high price electricity produced by these solar panels. The recent (2012) glut of solar panels in China is not due to overcrowding of roofs, mountainsides and deserts with solar panels but due to the 10 gigawatts a year of solar energy subsidy limit of the Chinese government.

Cap and trade is a patch work to offset some of the effects of a financial system that works against sustainability. Since it is a patch work its effects will be negated by other forces in the system. It will not achieve significant lasting results. Cap and trade assumes a level of effectiveness in administrative and governing structures that does not exist in most of the world. A system to address a planetary problem cannot succeed if it can’t work equally well in almost all countries. Cap and trade has little chance of success at the global level.

Government subsidies, taxes and cap and trade will not be enough to move the economic base away from fossil fuel under the current financial system. It will be a huge economic waste to have subsidies and taxes push the economy away from fossil fuel while the financial system pushes it towards fossil fuel.

Lowering Wages

There are many reasons for low wages in developing countries but the most important one is low per capita consumption of fossil fuel. Low wages in developing countries is not all about standards of living but also about economic structure.

Similarly, in developed economies it is not the wages that are causing the economic difficulties but the economic structure that is unsustainable in an era of high oil prices. If the economic structure is changed to one where cheap energy is available from sustainable sources i.e. back to an era of cheap energy, the wages would again trend up.

Cutting wages will not solve the problem or make developed economies grow. According to Tom Foreman of CNN (Fact Check – October 23, 2012) the total hourly labor cost in China is $2 whereas it is $34 in the US for a comparable manufacturing job. Even if wages are cut significantly the economy would not start growing because, while it would not make the US competitive with China, it would significantly reduce aggregate demand. The US economic structure is very good at creating high aggregate demand; with only 300 million people it has been able to create by far the largest economy. Sacrificing that ability will severely damage prospects of employment and prosperity.

Cutting wages and sticking with the current economic structure will cause huge suffering. It will destroy the social and political fabric of the country. It is painful even to imagine of conditions where developed economies’ wages or energy consumption will be any where near that in developing countries. It is like giving up centuries of development.

Instead of cutting wages developed countries should try to build a 21st century sustainable economy that will require advanced knowhow, innovation and creativity. Innovation and creativity will justify high wages common in developed countries. Chances of innovation and creativity are improved with freedom and opportunities. Freedom and opportunities will be abundant if the economies are free to grow.  To have an economy driven by ideas and innovation we have to unfetter the economy from the constraints of fossil fuel.

Textbook recovery efforts

The ongoing global economic crisis that continues to spread for the fifth year is the first crisis of its kind. There is no known solution for this crisis. Solutions from the known economic policy toolkit can prevent the economy from falling off the cliff but cannot put it back on track to lasting growth.

In spite of huge recovery efforts over the last five years and trillions of dollars spent there are no signs of lasting recovery in the US. The basic reason for this epic failure is that these efforts don’t address the core problem: un-sustainability of the economic structure.

 

NEW CAPITALISM

The basic purpose of this chapter was to show that economic recovery in developed economies is only possible if the resource consumption pattern in developed economies is changed to a sustainable one. Sustainability is not a matter of choice and doing good but a matter of necessity and economic survival.

It is clear that developed economies will remain stuck in recessionary conditions for the foreseeable future if they continue their dependence on the fossil fuel. Short of a devastating global war or other catastrophe there is no way that developed economies will have lasting growth unless they become sustainable.

Developing countries can however continue their growth on the fossil fuel path because, given their per capita oil consumption, they are certainly more sustainable than developed ones. In an era of globalization, the un-sustainability of all economies will tend to equalize.

Developed economies, therefore, have to shift their reliance away from fossil fuel and similar resources; in other words, become sustainable. Sustainability will start a new trajectory of lasting growth in developed economies.

The next chapter will introduce a solution to the economic growth problems in developed economies. That solution is New Capitalism.

 



[1] www.nationmaster.com

[2] The Energy Information Administration, an agency of the US government Department of Energy.

[3] Consumption data: The Energy Information Administration an agency of theUS government.