Speed limit is a legally binding sign telling drivers how fast they can go without paying a price, which is a ticket you get when caught by police. In economics speed limit refers to the maximum rate of growth which can be maintained in the long run without paying a price in the form of rising inflation. In economics slang we call this speed limit the potential output growth rate.

There are a lot of similarities with road speed limit. You do not pay the price (ticket) always, only when police finds you were speeding. Similarly, sometimes economy can grow more that estimates of potential output suggest without causing higher inflation, for example if other factors keep inflation down. Most people agree that good monetary policy and globalization kept inflation low in recent years. In road analogy, police officers decided that improvements in car and road safety features and higher drivers (central bankers) skills allow for faster driving than in the past, without harming traffic security. In economic slang inflation expectations stay low despite tight labor market.

Sometimes police (or other authorities) may decide that speed limit should be lowered. It usually happens when there are a lot of accidents on a particular road, or for other reasons (area was unpopulated before, and now there are new houses built). I have heard many respected economists speaking about possible reduction of a speed limit for US economy. What could be the reason? We have seen few accidents, i.e. productivity growth slowed indeed in recent quarters, and inflation is above the Fed comfort zone, although FOMC December 12 minutes released yesterday suggest that Fed expects inflation to slow, with economic slowdown more broad than previously expected:

… Nearly all members felt that maintaining the current target for now was most likely to foster moderate economic growth and a gradual ebbing of core inflation from its elevated levels. Several members judged that the subdued tone of some incoming indicators meant that the downside risks to economic growth in the near term had increased a little and become a bit more broadly based than previously thought. Nonetheless, all members agreed that the risk that inflation would fail to moderate as desired remained the predominant concern…“.

FOMC minutes also state that

“… The growth of structural labor productivity could be weaker than currently thought...”.

There is no way I can know more about US economy than economists at US investment banks of Fed economists, although I do follow US economy very closely because I am supervising investing Poland’s foreign exchnage reserves, with large, but falling percentage being invested in US assets (in 2006 we reduced the share of US dollar, as reported in 2005 NBP annual report ). But I just finished a book on globalization, which led to the follwing conclusion: internet (or ICT) enabled gains from global optimization of business processes, especially in services, are just starting to appear. It will accelerate, leading to a massive improvements in productivity around the globe. We are not able to track this process properly, becasue we do not collect proper data (India services exports to US reported by India are different that India services imports to US reported bu US) and big part of this business process optimization is taking place within companies (global multisourcing strategies, for instance). We are not able to understand and fully appreciate this productivity enhancing trend, in five to ten years when we will adjust our data collection methods we will probably see that major productivity trend acceleration has been trigered by great ICT deepening in early XXI century. My second point is that growth is becoming increasingly dependent on knowledge assets (ability to innovate, in terms of new products, new ways of doing things) and while we may not see machinery and brick investment accelerating, we do have growing investment in knowledge assets. I will elaborate on evidence on this claim in another post in next few days, impatient Polish readers of this blog can take a look at my globalization book.

My basic point is this: while looking at traditional productivity data (national GDP growth divided by national employment growth) we see slowing labour productivity growth, if one drops the border limits, on the company (global) level and properly accouting for investment in knowledge assets we continue to see fast productivity growth. So in my view the global speed limit, if anything, has been increased, which means that global economy can grow fast without generating global inflationary pressues. Of course domestic part of inflation in various countries can remain under upward pressure amid tight labor markets, but global inflation, which appears to be an attractor for country inflations around the globe will make it more difficult for inflation pressures to emerge.

Of course, optimal monetary policy involves communication focused on anchoring inflation expectations on level consistent with definition of stable prices. But to base monetary policy actions on firmer footing, we urgently need more research on the two issues I raised above: understanding ICT based global optimisation of business processes and understading the impact of investment in knowledge assets on long term productivity.

I will conitue blogging on these issues. Take a look at yesterday links presenting different views productivity:

  • Ed Yardeni on 2007 outlook
  • Robert Samuelson Washington Post article on US productivity

And new google hiring methods, which shows, that knowledge assets are becoming more productive also because job-matching methods are becoming more efficient

  • Have a dog, you may get a Google job, check NYT article