If ever a stark reminder was needed of the parlous state of the global economy, it came this week in the form of the IMF’s half-yearly economic forecast.
The Washington-based lender warned that without urgent action from policymakers on both sides of the Atlantic, the US and eurozone faced a “dangerous new phase” marked by a growing risk of a double-dip recession. It slashed its 2011 global growth forecast to 4% from 4.5%, warning in its World Economic Outlook that risks are emphatically “to the downside.”
But the fund’s assessment was merely another reflection – albeit an explicit one – of what financial markets have known for weeks: that the world economy is in trouble on multiple fronts; and that the politics of finding a solution is more fraught than ever. Yet without one, the outlook for developed and emerging markets alike looks bleak.
EUROZONE WOES
What has struck many about the today’s downturn is its sheer speed. “I have never seen such a dramatic revision in growth projections as what we have gone through over the last few weeks,” says Mohamed El-Erian, co-CEO of Pimco, the world’s biggest bond fund. “It shows you how uncertain people have become about the global economy.”
Chief among the worries is Europe, where a once unthinkable break-up of the eurozone has now become – at the very least – conceivable. The IMF this week warned Europe to “get its act together” in tackling its sovereign debt crisis that poses a severe threat to global growth.
But the anticipated economic slowdown in the West would itself deal a severe blow to a European debt crisis plan, which calls for growth to bring government budget deficits and debt levels under control.
Concern centres around policymakers’ inability to resolve Greece’s worsening debt crisis. The country is facing increasing pressure from the IMF and the EU to fulfill its promises of cutting its deficit. But for 18 months, European leaders have been unable to agree on how best to help Greece manage its debt burden and introduce structural reforms.
Policy failure – and a messy default by Athens – could have global implications: the worry is not solely about Greece or a small group of countries at the Eurozone’s periphery, but about the prospect of contagion to Italy and France, two of the world’s largest economies.
“The danger zone is Europe,” says Michael Spence, a Nobel laureate economist at New York University. “The thing that could bring the global economy down is if the wheels in Europe come off. That will not only cause a major glitch in the real economy side of Europe but will spill over almost immediately across the Atlantic.”
While negotiations continue over what measures Greece will have to take to receive the next E8billion tranche of its E110 billion loan, questions remain over the feasibility of deeper political and economic integration of the currency bloc – the one thing many experts believe will spare the union from demise.
“This is not just a blip in the road. This is a serious challenge for the world economy,” says Kemal Dervis, vice president and director of the global economics programme at the Brookings Institution. “If catastrophe is to be avoided, then very decisive action is needed now.”
Even barring catastrophe, the growth outlook remains bleak. The IMF predicts eurozone growth will be 1.6% this year and 1.1% in 2012, down from previous forecasts of 2% and 1.7%, respectively. But Dervis says this downward revision is “probably not enough.”
“Probably in the next weeks or months we’ll see further downward revisions in the growth rate,” he says.
CHANGING TACK
The IMF has also warned that in the face of a faltering global recovery, core western economies should change tack on the fiscal austerity measures they have pursued over the past year.
Governments in Germany and the UK are pressing ahead with short-term fiscal consolidation plans, despite being under no immediate pressure from markets to do so. And the US is pursuing deficit reduction with little sign of short-term policy boosts to support growth.
“Low growth, fiscal and financial weakness can easily feed on each other,” IMF chief economist Olivier Blanchard said this week. “Lower growth makes fiscal consolidation harder and fiscal consolidation may lead to low growth.”
The fund called on countries to cool their approach to austerity if growth fell short of its forecasts. “If activity were to undershoot current expectations, countries that face historically low yields should also consider delaying some of their planned adjustment,” the IMF said in its outlook.
The fund meanwhile has also slashed its forecasts for US output this year and next. But getting the world’s largest economy back on track is proving to be a very difficult task.
“The US economy is struggling to gain a strong foothold, with sluggish growth and a protracted job recovery,” the IMF said, as it cut US growth forecasts for this year by one per cent to 1.5%. It has also called for both short-term stimulus in the US, accompanied by a credible plan to cut spending over the medium term.
WAY FORWARD
Given the backdrop of faltering global growth, Dervis says that the case for large-scale fiscal retrenchment to combat debt woes in the West and overheating in emerging economies has lost its appeal.
“The IMF is strongly arguing that you need fiscal stimulus again,” he notes.
Policymakers in advanced economies are more constrained than three years ago, given a loss of fiscal space, challenging debt dynamics and large debt to GDP ratios, so any fiscal stimulus must be accompanied by a plan for future consolidation.
But Dervis says such prescriptions are not so straightforward. “It’s not so easy to stimulate now and consolidate later at the same time,” he says. “People look at the profile of policy over a number of years and it could affect their spending right away; the longer term and the shorter term interact.”
The best-designed fiscal packages, he says, must take income distribution into account. “Fiscal packages that provide support to the broad middle class and to lower income groups in order to be viable in the longer run have to be accompanied by revenue-raising measures that will have to fall on those who are rather easily able to pay.”
US president Barack Obama earlier in the week delivered a tough speech defending his plans to increase taxes on the rich as part of his plan to cut the deficit. He has set out plans to cut more than $3 trillion from the deficit over the next 10 years – almost half that sum to come from tax increases.
Yet Obama’s fiscal reform proposal has little chance of passing a Republican-controlled Congress. “The danger is that the package will be very incomplete,” says Dervis. “Either it will include some weakened stimulus measures but without a longer term revenue generating commitment. That will not be good because it will scare the market and make the debt dynamics worse. Or nothing will happen. The chances for a real package where the revenue measures come in looks thin.”
For Spence, the only way for the US economy to recover is for it to fundamentally rebalance. “We’re running an economy on lop-sided domestic aggregate demand, on excess consumption and zero savings,” he says.
“If we really want to restore growth and employment given the fiscal situation, we’re going to have to sacrifice in terms of consumption and devote the resources that we have into investing in things that have a longer-term effect on growth and employment.”
But, he says: “A quick return to pre-crisis levels of income, consumption and employment is not possible.”
MONETARY POLICY
Many are now looking to the Federal Reserve to breathe life into a faltering US recovery. As Emerging Markets went to press, the central bank was poised to embark on a plan to push down long-term borrowing costs by rebalancing its $2.8 trillion bond holdings – a plan referred to as “Operation Twist.”
“We’re likely to see the Fed try to do more,” says El-Erian. Aside from changing the composition of its balance sheet, other options open to the Fed include increasing the size of its balance sheet or expanding its asset purchases. “I suspect we’ll see one or more of these things, not because it’s the right thing to do but because the Fed will feel it has to do something.”
But he says that while such crisis-management operations could boost markets in the short run, they also carry the risk of market malfunction.
The central bank, he says, is powerless to address structural impediments facing the US economy, including: housing, the labour market, medium- and long-term public finances, the flow of credit to small businesses and households, and infrastructure.
Only the government or Congress can solve these problems, but “they require structural and not cyclical responses,” El-Erian says.
“At best the Fed can create a bridge for other policymakers, but if other policymakers don’t step up and do their work, then the Fed’s bridge is a bridge to nowhere.”
“The trouble is that the minute the Fed moves, other policymakers feel that the pressure is off them. That is the problem,” El-Erian says. “Rather than make it conditional on other people moving, the Fed finds itself out there all on its own.”
NOWHERE TO TURN
Policy options for advanced economies look bleak and policymakers are fast running out of options. Given the limited scope for expansionary fiscal policy in the US and Europe and interest rates at a historic low, support for economic growth from developed nations appears elusive.
The question for the rest of the world is what it can do to guard against the consequences of a downturn in developed markets.
Spence argues that emerging economies are in a position to sustain their growth. “They can generate enough of the right kind of demand to keep growing at relatively high rates because they really don’t need our growth,” he says. “They have a very big role to play in the short-, medium- and long-term restoration of stability and recovery.”
“Once inflation is controlled, the best response will be for emerging market policymakers to step up reforms designed to help diversify the supply side of the economy and the expansion of domestic demand from the growing ranks of the middle classes.”
Others warn, however, that if the downturn in developed markets is severe, nowhere will be immune to the fallout.
“The world economy is more integrated than ever through various channels – financial and trade – but also very importantly the animal spirits channel, the psychological channel. When people panic, they tend to panic all over the world,” says Dervis. “If there’s a slowdown in major parts of the world economy, it will impact the rest. The cyclical correlation is quite strong.”
So if there’s a slowdown in major parts of the world economy, it will impact the rest. The cyclical correlation is quite strong.”
Given this economic interdependency, the need for a coordinated global response to the looming crisis is imperative.
Spence says that the G20 has “in principle the main players that need to be present to have a frank conversation about what it’s going to take to restore growth in the global economy. The big emerging economies and particularly China could contribute to that.”
But policy coordination remains a thorny issue, especially within the G20, where divisions are growing between advanced and emerging nations on the appropriate path of fiscal and monetary policy.
Says El-Erian: “At the global level you require coordination and you require people to trust the actions of the other side. The US is too weak to be the conductor of this orchestra. The G20 is still too new and the IMF lacks legitimacy. So you have no conductor. And in the absence of a conductor people are going to play from different sheets of music. And for those of us that listen to this orchestra it sounds incredibly incoherent.”
The consequences of this incoherence are likely to be severe. William White, chairman of the OECD’s economic and development review committee and former chief economist at the Bank of International Settlements believes that the only solution is to address fundamental underlying imbalances within the global economy.
“Unless we can get some agreement on what the problem is, we won’t get any agreement on what the solution is and that’s the problem that faces the G20 in the whole political context,” he says.
“If we had an international monetary system with some degree of control, this crisis would not have been able to happen and it is very important to start thinking seriously about frameworks.”
For Dervis, the issue is ultimately one of action. “The G20 can do a lot psychologically,” he says. “But the worst thing is to set up expectations and nothing happens.”