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The global economy has entered a dangerous new phase. The recovery has weakened considerably, and downside risks have increased sharply. Strong policies are urgently needed to improve the outlook and reduce risks.
Growth, which had been strong in 2010, decreased in 2011. We had forecast some slowdown, due mainly to fiscal consolidation. One-time events, such as the tragic earthquake in Japan, offered plausible explanations for a further slowdown. The initial U.S. data also understated the size of the slowdown. Now that the numbers are in, it is clear that more was going on.
Rebalancing Stalls
What was going on was the stalling of the two rebalancing acts which, as we have argued in many previous reports, are needed to deliver “strong, balanced, and sustainable growth.”
Internal rebalancing: What is needed to sustain growth is that households and firms increase their demand as fiscal deficits are being rolled back. This is not going well, for various reasons. Tight bank lending, the legacy of the housing boom, and high leverage for many households, all turn out to be putting stronger brakes on the recovery than we anticipated.
External rebalancing: If domestic demand is going to be low, advanced countries with current account deficits—in particular the United States—need to compensate for it through higher foreign demand. This in turn requires a corresponding shift away from foreign demand towards domestic demand in emerging market countries with current account surpluses, in particular China. This rebalancing act is not taking place. While imbalances narrowed in the crisis, this was due more to cyclical factors than to a structural adjustment of these economies. Looking forward, we forecast an increase, rather than a decrease, in imbalances.
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Financial worries
By themselves, these developments would have led us to reduce our forecasts. But these problems have been compounded by a second major development, a sharp increase in financial volatility since the middle of the summer.
Markets have become more skeptical about the ability of governments to stabilize their public debt. Worries have spread from countries in the periphery of Europe to countries in Europe’s core, and to others, including Japan and the United States. Worries about sovereigns have translated into worries about the banks holding these sovereign bonds, mainly in Europe. These worries have led to a partial freeze of financial relations, with banks keeping high levels of liquidity and tightening lending. Fear of the unknown is high. Stock prices have fallen. These will adversely affect spending and growth in the months to come.
Growth slows
These developments have, not surprisingly, led us to revise our forecasts down. We now forecast world growth to be about 4% for both 2011 and 2012, down from 4.5% in both years in our April forecast.
4% may not sound too bad but the recovery is very unbalanced. For 2011, we see growth of 6.4% for emerging market countries, but only 1.6% for advanced countries.
As usual—but it bears repeating here—the forecast assumes that policy commitments are met.
Otherwise things could be worse. Low growth, fiscal, and financial weaknesses can easily feedback on each other. Lower growth makes fiscal consolidation harder. And fiscal consolidation may lead to even lower growth. Lower growth weakens banks. And weaker banks lead to tighter bank lending and lower growth. In short, there are clear downside risks to this forecast.
Let me say a word about emerging and developing countries. So far, they have been largely immune to these adverse developments. They have had to deal with volatile capital flows, but in general have continued to sustain high growth. Looking forward, however, they may well face a more difficult environment, with more adverse export conditions, and even more volatile capital flows.
Decisive policy action
In light of the low baseline and the high risks, strong policy action is of the essence. It has to rely on three main legs.
1) Fiscal policy. Fiscal consolidation cannot be too fast, as it would kill growth. It cannot be too slow, as it would kill credibility. The speed must vary across countries; the key continues to be credible medium term consolidation. Going beyond fiscal policy, measures to prop up domestic demand, ranging from continued low interest rates, to increased bank lending, to resolution programs for housing, are also of the essence.
2) Financial measures. Fiscal uncertainty will not go away overnight. And even under the most optimistic assumptions, growth in advanced countries will remain low for some time. During that time, banks must be made stronger, not only to increase bank lending, but also to reduce risks of vicious feedback loops. For a number of banks, especially in Europe, this requires additional capital buffers, preferably from private sources, but if needed from public sources as well.
3) External rebalancing. It is hard to see how, even with the policy measures listed above, US domestic demand can, by itself, ensure sufficient US growth. Thus, the US must rely more on foreign demand, or, in other words, reduce its current account deficit. A number of Asian countries with large current account surpluses, in particular China, have announced plans to rebalance from foreign to domestic demand. These plans cannot be implemented overnight, but they must be implemented as fast as can be.
To conclude: Only if governments move decisively on fiscal policy, financial repairs, and external rebalancing, can we hope for stronger and more robust recovery.