World Faces Weak Economic Recovery

By Olivier Blanchard

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The global recovery continues, but the recovery is weak; indeed a bit weaker than we forecast in April.

In the Euro zone, growth is close to zero, reflecting positive but low growth in the core countries, and negative growth in most periphery countries.  In the United States, growth is positive, but too low to make a serious dent to unemployment.

Growth has also slowed in major emerging economies, from China to India and Brazil.

Downside risks, coming primarily from Europe, have increased.

Let me develop these themes in turn.

Our baseline forecasts

In Europe, we are observing an increasing divergence between core and periphery countries.

Periphery Euro countries, including Italy and Spain, face a difficult adjustment.  Fiscal consolidation is necessary, but weighs heavily on growth. Structural reforms will bear fruit, but only in the future. Banks have to deal not only with bad legacy loans, but also with increasing non-performing loans, which reflect depressed economic activity. High debt burdens are making borrowing expensive for governments. The result is negative growth this year and next for both Italy and Spain.

Core Euro countries, including France and Germany, face similar problems, but on a more limited scale. The required fiscal consolidation is smaller; banks  in general are in better shape.  Still, their growth is forecast to be low: 1% for Germany, 0.3% for France in 2012, and a bit higher for both in 2013.

In the United States the recovery continues, with some good news early in the year offset by some bad news since. Fiscal consolidation is taking its toll; so are lower exports.  The good news is that housing appears to be stabilizing.  Still, the recovery is not strong enough to substantially decrease unemployment.  Our forecasts are of 2.0% growth for 2012, and 2.3% for 2013, a revision of -0.1% in both cases.

Growth in emerging market countries has slowed down a bit more than we expected in April. For example, we have revised our forecast for China down from 8.2% to 8% for 2012, our forecast for India from 6.9% to 6.1%, our forecast for Brazil from 3.0% to 2.5%.  The proximate causes vary across countries, with lower exports and lower investment playing a dominant role.  In general, we expect these countries to achieve soft landings, but at lower growth rates than in the past.

Putting everything together, our forecast for world growth is 3.5% for 2012, 3.9% for 2013, down .1% and .2% respectively.  

Given the flow of bad news in the press, you might be surprised by this small downward revision.  There are two reasons:  we were not very optimistic to start with; and in many countries, while the second quarter was worse than forecast, the first quarter was better than forecast. This partly explains the small revision for 2012.

The downside risks

More worrisome than these revisions to the baseline forecast is the increase in downside risks.

The main risk is obvious: the vicious cycles in Spain or Italy become stronger, output falls even more, and one of these countries loses access to financial markets. The implications could easily derail the world recovery.   Our baseline forecasts are based on the assumption that policies will be implemented to slowly decrease the spreads on Spanish and Italian bonds from their current high to a still high, but lower level in 2013.  This however requires that the right policies be adopted and implemented.

What must be done

For the Euro crisis to be contained, and eventually resolved, two conditions must be satisfied.

First, the countries under pressure must follow through with fiscal consolidation, wage and price adjustments, structural reforms, and bank recapitalization if and when needed.  Spanish and Italian governments have taken important steps in this direction.  But they can only succeed if they can finance themselves at reasonable rates.

Second, as long as these governments are committed to reforms, other Euro members have to be willing to help make the adjustment feasible.  This implies not only designing a euro level architecture, but also being willing, in the short run, to stabilize funding conditions in sovereign debt markets. Progress was made in recent weeks, but more remains to be done.

For the United States, the issue remains primarily fiscal. Avoiding the fiscal cliff is clearly the short run priority. But the lack of a medium term fiscal plan is worrisome, and the source of risks in the not too distant future.

Emerging economies differ in too many ways to allow for simple, common, advice. The best advice may be: be ready.  Prepare to use both economic and macroprudential policies to respond to a complex external environment. Capital flows are likely to remain highly volatile. Exports to advanced countries are likely to remain subdued.

The world recovery can continue, and can strengthen.  The right pace of fiscal consolidation, continuing expansionary monetary policy, getting the financial sector back to health  to decrease borrowing costs, and solidarity, especially within the Euro zone, are all of the essence.

10 Responses

  1. The global situation is well explained that excepting China, India, and Brazil, all others are hardly balancing themselves. So again, as rightly pointed out by Olivier Blanchard, what is needed is appropriate policy action, ie fiscal consolidation (but with moderation) and stabilizing the funding requirements in sovereign debt markets. But it appears that quantitive easing has not proved as helpful as anticipated. Per Kurowski has rightly emphasized that banks be amply capitalized so that they can give due share of credit to the small and medium enterprises, which in my opinion are considered the backbone of every economy.

  2. [...] World Faces Weak Economic Recovery – Olivier Blanchard [...]

  3. @Olivier Blanchard “Banks have to deal not only with bad legacy loans, but also with increasing non performing loans”

    And, since most those “bad legacy” loans were of the “safe” type for which the banks could hold very little capital, the bank capital scarcity in immense.

    And, since bank capital scarcity is immense, those most suffering from it are the “risky” borrowers for which regulators require banks to hold more bank capital, like the small businesses and entrepreneurs, like precisely those the economy, and the jobless, most need to enter into action.

    When will the regulators understand that for the time being, having caused this crisis, they must lower the capital requirements for banks when lending to the “risky”, those that banks do not want to lend excessively to anyhow?

    • Good idea. Then when those risky loans fail, the government can bail the banks out. What could possibly go wrong? :)

      Bottom line: All banks should be federally owned. See: http://rodgermmitchell.wordpress.com/2012/03/31/the-end-of-private-banking-why-the-federal-government-should-own-all-banks/

      • Mr. Money Printer,
        When has there ever been a major bank crisis because of excessive exposure to what is perceived as “risky”? Do you not know your Mark Twain’s saying “a banker is the one who lends you the umbrella when the sun shines and wants it back when it looks like it might rain”?

        What goes wrong… what went wrong, was that bank regulators, thinking themselves to be the risk managers of the world, decided that AAA-rated securities, loans to “infallible sovereigns” and other similar tidbits, were so absolutely safe that banks could lend or invest in these holding very little capital.

      • “When has there ever been a major bank crisis because of excessive exposure to what is perceived as “risky”?”

        The banks knew the “liars loans” were risky.

      • And by the way, thanks for the snarky title, “Mr Money Printer.” Does that mean you wish to be called, “Mr. Austerity”?

      • The banks knew the “liars loans” were risky?

        Forget it! Most banks, like for instance the European ones, who poured billions into these securities, did not even know what the subprime sector was, much less “liars loans”… they just saw the AAAs and that the regulators trusted these ratings so much that they were allowed to purchase these securities holding only 1.6 percent of very loosely defined capital.

    • “Mr. Austerity”? No! “Mr. Allow the banks to work without distortions” it is.

  4. ●The more budgets are cut and taxes increased, the weaker an economy becomes.
    ●The euro nations are monetarily non-sovereign.
    ●To survive long term, a monetarily non-sovereign government must have a positive balance of payments.
    ●Austerity = poverty and leads to civil disorder.
    ●Those, who do not understand the differences between Monetary Sovereignty and monetary non-sovereignty, do not understand economics.

    Rodger Malcolm Mitchell

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