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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.
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.
Filed under: Advanced Economies, Economic outlook, Economic research, Emerging Markets, IMF, International Monetary Fund, Low-income countries Tagged: | bank balance sheets, bank capital, bank lending, current account deficits, current accout surpluses, downside risks, economic forecasts, economic rebalancing, external rebalancing, financial volatility, fiscal consolidation, IMF, iMFdirect, International Monetary Fund, low growth, medium-term fiscal consolidation, Olivier Blanchard, private demand, public debt, public deficits, sovereign bonds, weak balance sheets, World Economic Outlook, world growth
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Well, now we have the rotten problem right in front of us. Now the IMF has to admit to itself that the system has been destroyed by interventionist policies. We have to clean out the ever increasing government spending machine–wherever that may be in the world. Pricing in a free society is irrelevant. The only reason why we have these insane accounting standards is for the government to collect ever increasing mountains of taxes (to be rechanelled for whatever political purpose). The whole thing is a fraud and economic activity will stop because people don’t trust the system any longer.
Mr. Kruger, if countries like Germany, would simply adhere to the policies agreed upon (IFRS), we would know how quickly the contagion could spread. Notorious for their “Houdini-like” bookkeeping magic, they are the anchor around the EU’s neck, every Economist knows that, as it is a fact. There are stringent rules in place, countries have egos which they mistakenly bring to the table with them, that is where it goes wrong.
As far as bashing the IMF, at least they are offering help to those who are in troubledue to no fault but their own. Be grateful that the IMF is willing to overlook the financial transgressions of Germany, and help at all. Transparancy is the key, as the EU’s leading debtor, Germany should come clean now. 5 Trillion in hidden Government Debt discovered just last week, brings Germany to 7 Trillion in Government Debt alone. Everyone is talking about the EFSF being big enough to handle Italy, you need to start worrying about Germany, they are the trigger.
Germany is currently the only industrialized country in the world where you do not need a degree in Finance or Economics, to be the Finance Minister, or the Economics Minister. Mr Schauble is a Lawyer, and Mr. Rosler is a Medical Doctor. Where are the Economists? If politics are ruining everything, as you say, let these two gentlemen step down today. This is clearly a matter which is only for those who possess expert financial competence, or? Would you call a Barber to come repair your automobile?
It seems that the IMF will fail again to predict a deep recession. It is almost certain that economic growth in the euro area will become negative by the end of 2011 and especially in 2012. As was the case with the previous recession, the current slowdown and the new recession is/will be a result of the ECB’s contractionary monetary policy. The money (M1) supply growth rate fell to 0.9%. The IMF should return to traditional monetarism in order to understand and correctly predict macroeconomic developments.
When the going gets to be risky it is high time to allow our not-so-risky risky risk-takers to get going.
Please reduce urgently the capital requirements for banks when lending to small businesses and entrepreneurs, and who are being left out in the cold more than ever. What fault of theirs is it that the regulators allowed minuscule capital requirements for banks when lending to the ex-ante-ultra-safe that turned out to be so dangerous?