TWN Info Service on Finance and Development (Sept11/02)
26 September 2011
Third World Network

A "two-speed recovery", with North losing steam
Published in SUNS #7214 dated 7 September 2011

Geneva, 6 Sep (Kanaga Raja) - The widely varying pace of economic recovery is one of the main characteristics of the post-crisis world economy, with developing economies having regained their pre-crisis growth trend and developed economies seeing a sluggish recovery, which may come to an end due to weak private domestic demand and replacement of supportive macroeconomic policies by austerity measures.

In giving this message in its flagship publication, the Trade and Development Report 2011, the UN Conference on Trade and Development (UNCTAD) warns that while developing economies have sustained their strong growth path mainly based on domestic demand, they face financial instability and speculative capital flows generated in developed economies, and would not be spared by a new recession in the North.

According to the report, whose theme this year is "Post-crisis policy challenges in the world economy", after a rapid post-crisis recovery, the world economy is slowing down from about 4 per cent GDP growth in 2010 to around 3 per cent in 2011. Growth performance is strong in developing economies, which have resumed their pre-crisis growth trend and are expanding at above 6 per cent this year. In contrast, developed economies will only grow between 1.5 and 2 per cent in 2011.

At a media briefing on Monday, UNCTAD Secretary-General Supachai Panitchpakdi said: "What we are seeing is not a full fledged recovery. It's a two-speed recovery that distinguishes between the slow pace being achieved among developed countries and the more normal pace of real recovery among the emerging countries."

"Meanwhile, global economic recovery has entered a renewed phase of fragility because a process of self-sustaining growth through private spending and employment is not assured, especially in developed countries. Many of these countries have shifted their fiscal policy stance from stimulus to retrenchment, which risks leading to prolonged stagnation, or even to a contraction of their economies," further said Supachai in an overview to the report.

"Given the lack of growth in employment and wages in Europe, Japan and the United States, their policies should aim at continued stimulation of their economies instead of trying to 'regain the confidence of the financial markets' by prematurely cutting government spending. The main global risk is that wages and mass incomes might not increase sufficiently to feed a sustainable and globally balanced process of growth based on domestic demand," he added.

According to the UNCTAD report, the pace of global economic recovery has been slowing down in 2011, following a rebound from its nosedive worldwide in 2009. This year, world gross domestic product (GDP) is expected to grow by 3.1 per cent, compared with 3.9 per cent in 2010.

Although the economic slowdown will affect developed and developing countries alike, growth rates will remain much higher in the developing economies (at close to 6.3 per cent) than in the developed ones (at around 1.8 per cent), while the transition economies of the Commonwealth of Independent States (CIS) are set to grow at an intermediate rate of close to 4.5 per cent.

This continues the "two-speed recovery" witnessed in 2010, and the more rapid growth rates of all developing regions since 2003 compared with that of developed countries. More importantly, it may be indicative of some specific obstacles to an economic revival in the developed countries that are not affecting most developing countries.

The report notes that inventory rebuilding and the fiscal stimulus programmes have been gradually ending since mid-2010. Hence, as the initial impulses from temporary factors are waning, the fundamental weakness of the recovery in developed economies has become apparent, namely, that the growth of private demand is not sufficiently strong to maintain the momentum of the upturn. This is partly due to the persistently high levels of household indebtedness in several countries, and the reluctance on the part of banks to provide new credit.

But a major reason is that consumers do not expect their incomes to rise consistently over the medium term. In Europe, Japan and the United States, the current recovery is characterized not only by jobless growth - a feature common to previous recoveries - but also by stagnating wages, which hitherto had been a phenomenon observed mainly in Japan. Unemployment remains high and is dragging down wage growth. This effect is compounded by more flexible labour markets, and could reach a point where negative expectations of wage-earners could hinder the return to normal patterns of consumption, and consequently, of investment in fixed capital.

Another factor that could delay or endanger economic recovery is the implementation of tighter fiscal and monetary policies based on the questionable diagnosis that private-sector-led economic growth is already under way, says UNCTAD.

For example, the International Monetary Fund (IMF) believes fiscal expansion is no longer needed since "private demand has, for the most part, taken the baton". Moreover, the Bank for International Settlements (BIS) argues that inflation is presently the main risk in an otherwise recovering world economy, and therefore suggests "policy [interest] rates should rise globally".

According to these views, says UNCTAD, economic policy should no longer aim at stimulating growth, but instead should focus on controlling inflation and reducing fiscal deficits and public debt. But with nearly all the governments of the large developed economies trying to curb public expenditure, including cutting or freezing public sector wages, the consequent diminished expectations of private households threaten to derail recovery of the world economy.

With weak labour market indicators in the United States, risks of financial contagion in Europe and a deterioration in some leading indicators for global manufacturing, the implementation of restrictive macroeconomic policies increases the probability of a prolonged period of mediocre growth, if not of an outright contraction, in developed economies, the report cautions.

According to the report, developing economies present a different picture. Rapid recovery from the crisis and the subsequent sustained growth have been the result of various factors, including counter-cyclical measures, the recovery of commodity prices since mid-2009 and an expansion of real wages.

Some analysts suggest that higher commodity prices have been the main cause of recovery in developing countries. However, while the higher prices have been essential for commodity exporters, commodity-importing developing countries have also grown at a rapid pace. A major factor that should not be underestimated is that in many developing countries, the Great Recession has not led to cuts in real wages; on the contrary, domestic income and demand have remained on a growth trajectory.

In that sense, the recovery in many developing countries, which has been largely wage-led, contrasts with that of developed economies, which is associated with wage stagnation. In addition, since the financial systems in developing countries were largely unaffected by the most recent crisis, their domestic demand is further supported by the availability of domestic credit. Therefore, their growth has become increasingly dependent on the expansion of domestic markets, which may explain the continuing growth and resilience of these economies, despite slow growth in developed countries.

However, economic expansion in developing countries faces several challenges. Paradoxically, some of their problems result from their resistance to financial contagion during the recent crisis. In particular, because emerging market economies appeared to be less risky, they attracted even more short-term capital inflows. Such flows may generate asset bubbles and pressures for exchange rate appreciation, which would erode their competitiveness.

Moreover, higher inflation in several of these countries, owing largely to commodity price increases, has led them to tighten monetary policy and raise interest rates, which further attract foreign capital in the form of carry-trade operations. At the same time, volatility in highly financialised commodity markets suggests that a negative shock originating in developed economies might exert a strong downward pressure on the prices of primary commodity exports, as already happened in 2008.

Hence, says the report, despite the greater role of domestic markets in driving growth, there are significant external risks to sustained economic expansion in developing countries due to economic weaknesses in developed economies and the lack of significant reforms in international financial markets.

"It is therefore evident that the widely varying pace of economic recovery is one of the main characteristics of the post-crisis world economy. While developing and transition economies, as a group, have regained their pre-crisis growth trend following the 2008-2009 slowdown, growth in developed economies remains very sluggish, which suggests that their economic output is currently well below potential."

In the United States, notes the report, economic recovery has been stalling since early 2011, so that growth is too slow to significantly reduce unemployment. Natural disasters badly affected Japan, Australia and New Zealand.

The Japanese economy, which had already been on a downward trajectory since mid-2010, owing to declining household consumption, government expenditure and net exports, fell officially back into recession in the first quarter of 2011.

In the European Union (EU), growth is forecast to improve slightly, from 1.8 per cent in 2010 to around 1.9 per cent in 2011, although with significant variations among the different member countries. Germany and France experienced a quarter-on-quarter acceleration in early 2011. In Germany, growth relied on investment and net exports - as in 2010 - while private consumption remained subdued because of stagnating real wages.

The situation seems even grimmer in peripheral Europe: public debt crises, such as in Greece, Ireland and Portugal, have increased the costs of debt rollovers. These countries have been forced to implement fiscal austerity measures, as a precondition for emergency financing by the IMF and the EU. Other countries that face the risk of contagion (e.g. Italy and Spain) are also implementing fiscal tightening in an attempt to maintain the confidence of financial markets. The restrictive policy stances, combined with the already high levels of unemployment, may cause these countries to remain in recession in 2011 or, at best, record weak positive GDP growth.

In developing countries, says the report, growth rates are also expected to slow down in 2011, but this is due to the higher comparison base of 2010 and, in some cases, to slow growth in developed economies rather than to endogenous obstacles to growth. Asian economies continue to record the highest GDP growth rates. However, recent high-frequency indicators, such as those relating to industrial production and trade, suggest that economic growth in East and South-East Asia moderated in the second quarter of 2011, following a strong first quarter.

Growth in Africa is forecast to decline, almost entirely due to political turmoil in a number of North African countries. Growth in Egypt and Tunisia will slow down significantly in 2011, owing to plummeting investments and a slowdown in the vital sector of tourism. However, the most serious impact of conflict has been in Libya, where much of the economic activity has ground to a halt, including oil production and exports. This contrasts with sub-Saharan Africa, where overall GDP growth rates are projected to continue at their 2010 pace.

Mirroring the differences in strength of domestic aggregate demand, the revival of trade has also been uneven among countries and income groups of countries. In developed countries, trade (in terms of volume) has yet to bounce back to a level above its pre-crisis levels. These countries recovered part of their previous trade losses between mid-2009 and mid-2010, but there has been no growth since then, says the report.

Over the past year, says UNCTAD, the instruments available to policy-makers for supporting economic recovery seem to have been limited, especially in developed economies. On the one hand, there was little scope for monetary policy to provide additional stimulus, as interest rates were already at historic lows.

The only possible monetary stimulus seemed to be quantitative easing, which several central banks were reluctant to implement, and which, given the ongoing de-leveraging process, proved to be of little help in reviving credit to boost domestic demand. On the other hand, higher public-debt-to-GDP ratios have convinced many governments that they should shift to fiscal tightening.

However, the report stresses, there is much larger space for macroeconomic policies, especially for proactive fiscal policies, than is perceived by policy-makers. Moreover, there are other policy tools, such as incomes policies, that have been largely overlooked, but which could play a strategic role in dealing with the present challenges.

In the period of intensified globalization from the early 1980s until the global crisis, the share of national income accruing to labour declined in most developed and developing countries. If real wage growth fails to keep pace with productivity growth, there is a lasting and insurmountable constraint on the expansion of domestic demand and employment creation.

To offset insufficient domestic demand, one kind of national response has been an over-reliance on external demand. Another kind of response has taken the form of compensatory stimulation of domestic demand through credit easing and increasing asset prices. However, neither of these responses offers sustainable outcomes.

These are important lessons to be learned from the global crisis, says the report, adding that over and above the risks inherent in premature fiscal consolidation, there is a heightened threat that deflationary policies may accentuate downward pressures on labour incomes as a result of the slump in the labour market. Such policies ignore the vital role of consumer spending in contributing to a sustainable global recovery.

From the perspective of a single country, strengthening the international competitiveness of producers may seem to justify relative wage compression. However, the simultaneous pursuit of export-led growth strategies by many countries has systemic implications: a race to the bottom with regard to wages will produce no winners and will only cause deflationary pressures. With widespread weakness in consumer demand, fixed investment will not increase either, despite lower labour costs.

The report says that global deflationary tendencies and the drag on global demand resulting from wage compression in many developed countries would need to be countered by some form of policy-engineered higher spending somewhere in the world economy. In the pre-crisis era, widespread resort to export-led growth strategies was made possible mainly by fast-growing imports in the United States, leading to increasing external deficits and financial fragility in that economy.

Subsequent crises, with private sector de-leveraging and increasing public debt, clearly showed the deficiencies of this approach.

Trends in income distribution since the 1980s confirm that inequalities within many developed economies have increased as globalization has accelerated. In particular, wage shares have declined slowly but steadily over the past 30 years, with short reversals during periods of recession (particularly in 2008-2009), when profits tend to fall more than wages.

After such episodes, however, the declining trend has resumed. This trend is creating hazardous headwinds in the current recovery. As wages have decoupled from productivity growth, wage-earners can no longer afford to purchase the growing output, and the resultant stagnating domestic demand is causing further downward pressure on prices and wages, thus threatening a deflationary spiral.

In most developing and transition economies, the share of wages has behaved differently, notes the report. That share is generally between 35 and 50 per cent of GDP - compared with approximately 60 per cent of GDP in developed economies - and it tends to oscillate significantly, owing mainly to sudden changes in real wages.

In many of these economies, the share of wages in national income tended to fall between the 1980s and early 2000s, but has started to recover since the mid-2000s, though it has not yet reached the levels of the 1990s. The positive evolution of wages and the role played by incomes policies, particularly transfer programmes to the poor, may be the main factors behind the present "two speed recovery".

In developed countries, real wages grew on average at less than 1 per cent per annum before the crisis, which is below the rate of productivity gains; they then declined during the crisis, and tended to recover very slowly in 2010. Arguably, the early move to a more contractionary fiscal policy and the relatively high levels of idle capacity and unemployment imply that the pressures for higher wages could remain subdued, thereby reducing the chances of a wage-led recovery.

In contrast, says the report, since the early 2000s, in all developing regions and in the CIS, real wages have been growing, in some instances quite rapidly. Even during the difficult years of 2008 and 2009, real wages did not fall in most developing countries, as had generally been the case in previous crises. This suggests that to some extent recovery in developing countries was driven by an increase in domestic demand, and that real wage growth has been an integral part of the economic revival.

Examining the evolution of total wage income, which depends on employment and real wages, is essential for understanding the risks of wage deflation, the report underlines. A fall in real wages, rather than leading to an increase in the demand for labour, will affect demand by inducing a fall in consumption. Generally, there is a very close relationship between the rate of change of total wage income and that of final consumer spending.

In this respect, Japan's "lost decades" provide a stark warning of the growing challenge at the global level today. Failure to halt downward pressures on prices and domestic demand left the Japanese economy excessively dependent on exports, resulting in persistent deflation and stagnation for two decades.

As wage-earners' real income stopped growing, so did private consumption. Germany seems to be going the way of Japan owing to deliberate wage compression since the mid-1990s, with vastly destabilizing consequences in the euro area, the report cautions.

"At the current juncture, in view of the unemployment legacies of the crisis, downward pressures on wages in developed economies risk strangling any incipient recovery of private consumption, which is the necessary basis for a sustainable and balanced recovery. The widely shared agenda of structural reform that aims at improving labour market flexibility would only reinforce the bargaining power of employers in labour markets in developed economies."

In contrast, the rise of the wage bill after periods of decline in several developing and transition economies in the 1980s and 1990s boosted private consumption. The rise in real wages and the wage bill in developing countries, in addition to the real appreciation of exchange rates, indicate that the recovery in those countries depends increasingly on the expansion of domestic markets rather than on exports to developed countries.

Nevertheless, developed countries remain important export destinations, and subdued growth in those countries, combined with upward pressures on developing countries' currencies, risks reigniting or reinforcing pressures for relative wage compression in developing countries as well.

"So far, this has not occurred, but the slowdown in global industrial production in the second quarter of 2011 increases that risk. Indeed, a macroeconomic policy mix in developed economies featuring fiscal austerity, tighter monetary policies and wage compression could create new global vulnerabilities, which may also affect developing countries. The global recovery would be ill-served by merely shifting fragility from the North to the South instead of directly addressing the fragilities at their source."

The report suggests that growth-friendly macroeconomic policies, of which a proactive incomes policy is a key element, can also help to contain inflation, since investment and productivity growth create the capacities needed to meet the desired steady expansion of domestic demand. An incomes policy based on clear rules for determining wage income in a growing economy can greatly facilitate policy-makers' task, and support capital formation and sustainable development.

Such a policy, which aims at achieving wage growth in line with productivity growth (plus an inflation target), paves the way for a steady expansion of domestic demand as a basis for expanding investment while containing cost-push risks to price stability.

An incomes policy is therefore also an instrument of inflation control, says the report. Wage growth based on the abovementioned principle would contribute to keeping inflation within the government's target by preventing an overshooting of unit labour costs and maintaining a steady increase in demand. While incomes policy could focus on inflation control, monetary policy could concentrate on securing low-cost finance for investment in real productive capacity, which would create new employment opportunities.

By achieving a rate of wage growth that corresponds approximately to the rate of productivity growth, augmented by a target rate of inflation, it would be possible to control inflation expectations. The problem in the euro area is that these macroeconomic considerations have not been taken into account in some of the member countries.

In view of the slow recovery in developed countries, the risk of demand inflation in these countries is minimal.

The United States and Europe are experiencing enormous labour market slack, despite the fact that real wages are barely growing. Weak employment growth and stagnant wages, resulting in slow growth of disposable income, are hindering a sustainable domestic-demand-led recovery and are increasing the risk of an excessive reliance on exports for growth. In certain peripheral euro-area countries in particular, debt deflation is an additional acute threat.

According to the report, the lack of proactive and coordinated incomes policies is one of the main causes of present tensions in Europe, particularly within the euro area. Since the launching of the Economic and Monetary Union (EMU), serious imbalances have been building up as a result of diverging national wage trends. In a monetary union, national wage trends are the main determinant of the real exchange rate among its member economies.

To avoid dislocations in intra-regional competitiveness positions, national wage trends need to follow an implicit norm that is the sum of national productivity growth and the agreed union-wide inflation rate (defined by the European Central Bank as "below but close to 2 per cent").

Countries in the periphery that are experiencing severe public-debt crises today departed from this norm somewhat in the upward direction, whereas Germany, the economy with the largest trade surplus within the euro area, also missed that implicit norm, but in a downward direction. As a result, over time, Germany experienced cumulative competitiveness gains vis-a-vis its European partners, especially vis-a-vis the countries in the periphery.

If inflation rates differ among countries with their own national currencies, they always have the possibility to compensate for inflation differentials by means of exchange rate adjustments. However, this solution is not possible within the EMU, which makes the resolution of the crisis even more difficult than that of comparable crises in a number of emerging market economies over the past 30 years, says the report.

With the reappearance of severe debt market stress in a number of countries in the second quarter of 2011, most governments are convinced that fiscal austerity is needed for debt sustainability, and that wage compression and labour market reform will restore competitiveness.

Reflecting a dogmatic rejection of government intervention, the euro-area authorities only reluctantly considered fiscal stimulus measures. Initially slow to act, they were then the first to call for an early exit from global stimulus, even before recovery had properly taken root.

In the event, the euro area has proved the laggard in the global recovery and is now a hotspot of economic instability. Today's financial and economic instabilities arise from an unresolved debt crisis that has its origins in private debt, and which the euro area's policy-making mechanism seems ill-equipped to handle.

The area's policy response remains single-mindedly focussed on fiscal retrenchment and on "strengthening" the so-called Stability and Growth Pact that was established to govern and asymmetrically discipline member countries' fiscal policies, says the report.

In concrete terms, excessive wage increases in the economies now in crisis, on the one hand, and stagnating unit labour costs in Germany on the other, have allowed the accumulation of current-account surpluses in the latter at the expense of other countries in the area. By further weakening economic growth, the policies proposed by the euro-area authorities may not succeed in improving debt sustainability either.

"Thus, the current predicament in Europe should be resolved by promoting growth and reducing intra-regional imbalances. The European experience holds important lessons for the rest of the world, in particular that austerity without regard for regional domestic demand growth may backfire badly. Well-coordinated monetary policies and debt management aimed at keeping borrowing costs in check region-wide is therefore of the utmost importance," the report concludes.