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Monday June 19, 2006 - 10:49:46 GMT
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Economics Weekly: Despite market jitters, the world economy is booming

The world economy is expanding rapidly...
Equity markets are falling, bond yields are rising and commodity prices are down sharply. But despite the many risks that have been dominating the financial markets in recent weeks and causing volatility, we must not lose sight of the fact that the world economy remains very buoyant. This year will see the third consecutive year of nearly 5% growth, with forecasts showing that it continues, see chart a, for another 4 years. What is driving this expansion and what could end it? That is the topic of our briefing this week.

...driven by loose monetary and fiscal policy
Low interest rates, as a result of low inflation, have been one of the main planks of the global upturn since 2002. In real terms, i.e. adjusted for inflation, global interest rates are still very low, as shown in chart b, despite increases in interest rates in a number of large economies. This is clearly behind the pace of growth in the global economy, with plentiful liquidity, as shown in chart e and f on the back page, spurring rising money supply growth and being reflected in increased consumer and government spending, partly fuelled by debt. Indeed, this is a feature of the developed economies’ growth, aside from Japan, with consumer spending in the UK and US bolstering their strong growth. In Germany, France, Spain, and Italy, government spending and exports are playing a big role.

...this has increased total investment flows, boosting emerging market economies
Investment flows into the emerging markets, in particular to China and the central Eastern European countries that joined the EU in 2004 are very strong. This has helped to drive economic growth in these economies, particularly from export oriented expansion. Their fast pace of growth, relative to the advanced economies and the rest of the world, is summarised in chart c. As mentioned above, global economic expansion is set to continue for at least this year and next at about 5% per annum. And chart c illustrates that in every year in the last decade with the exception of 1999, growth in the emerging markets has generally exceeded that of the developed economies. To some extent this is because the developing countries have a lot of scope to catch up. They have abundant and cheap labour so with the application of modern technology, capital and management (productivity, in short), the pace of growth can be fast and yet non inflationary. As their exports are sold onto the global market they help to keep down world price and wage inflation pressure, extending the cycle of low interest rates and so sustainable economic expansion.

At some stage price growth will accelerate, but inflation appears unlikely to spiral...
But of course this cannot persist for ever; at some stage wages will start to rise, perhaps as the most productive labour is utilised as the developing economies themselves grow and that drives up demand and pay for skilled people generally. This is one of the factors that might lead to an end to this global economic upswing. Are we close to that point yet? The truth is nobody really knows, but import prices, ex energy, are beginning to rise in the UK, for example, and turned positive in Q1 2006 for the first time in a decade. This implies that the main deflationary effect of the addition of the emerging markets to the global economy is at an end, but this does not mean we are on the verge of an inflation spiral as prices are still low, as chart d shows. Moreover, the gap between wages in the US, say $20-25 an hour, emerging EU, $5 an hour and China, say $2-3 an hour, is still so large that so long as these countries are in the global market system, world price and wage inflation will be under downward pressure for many more years to come.

This is not to say that there will be no economic cycle - we are looking for global growth in 2007 to slow to 4.7% from 5% this year, but there is unlikely to be a prolonged global downturn due to higher inflation from this source. Moreover, the out performance of the emerging market economies, see chart g, suggests they could become growth engines for the global economy should the developed economies falter.

...however, risks remain and some other event could derail global growth
However, there are other factors that could negatively impact global growth, such as high oil prices, financial crisis as a result of market investors borrowing too much and underestimating the risks from higher interest rates; from too much borrowing to fund investments in property, equity and commodity prices at their peak and from high levels of government debt. Possibly, the biggest risk stems from a correction of the US trade deficit, currently 7% of gdp, which could cause a retrenchment in US consumer spending and a sharp fall in the dollar.

Trevor Williams, Chief Economist
trevor.williams@lloydstsb.co.uk
www.lloydstsbfinancialmarkets.com
Lloyds TSB Bank,
Financial Markets
Division,
Faryners House,
25 Monument,
London EC3R 8BQ
Switchboard:
0207 283 - 1000

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