Why a country’s economy can grow “too fast”

By: ispeculatornew
Date posted: 02.22.2011 (5:00 am) | Write a Comment  (3 Comments)

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The other day I had a discussion with a friend of mine who said he had heard about China‘s economy overheating and the fact that the government was trying to slow things down by doing a few things mostly geared towards the exploding real estate market. My friend said that the argument did not make any sense and that the Chinese should be thrilled that their economy was growing so fast when everywhere else around the world things were going so badly. I could see his point in a way but did explain my point of view on the situation.

Yes, an economy can grow too fast

First off, let’s clear something off. Many bad things can happen to an economy and we won’t try to name all of them but I think it’s fair to say that inflation is probably the most dangerous in most countries. Why? Because it creates a bunch of issues that have very bad effects on the economy. A few examples? International investment is rarely done in countries with high inflation rates. Why? Because those countries currencies usually lose value quickly which destroys any return that was made through the actual investment. As well, high inflation usually must be resolved through high interest rates which can cause a recession. I could go on and on but the basics are that inflation (and deflation) is a major threat. That is why central banks in industrial countries have their goals measured in terms of the inflation rate rather than economic growth. Most countries aim for 2% or so of annual inflation.

Now back to our main issue

The fact is that each country has a theoretical economic growth target. How is it determined? Economic growth would originate from:

Economic Growth = Working Population growth + Productivity growth

Each country is different and the more a country is advanced, the more difficult it becomes to post huge productivity growth every year. For example, the Chinese have a lot to learn and to do in terms of increasing their productivity either through more advanced technologies, equipment, etc. For most of these things, they can simply buy equipment abroad or learn techniques developed in foreign countries. The US however is much closer to the cutting edge which makes it much more difficult to improve as fast.

When an economy starts growing faster than what is theoretical growth is, it usually means that resources such as workforce and capital are missing which causes companies to start paying more and can bring inflation to spiral out of control. Let’s not forget that most economies would much prefer grow at a steady rate (as much as possible) for 20 years and than having 5 years of intense growth followed by a 2 year recession, in each 7 year cycle.

Hopefully this clears things up a bit?

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