Info Service on Finance and Development (Oct12/01)
IMF World Economic Outlook calls for stronger policies to bolster economic recovery and contain global risks
The most recent World Economic Outlook (WEO), released in late September and published biannually by the IMF, scales down the global growth forecast and warns that more action is necessary to put economic recovery back on track.
The IMF projects that global growth will drop from about 4% in 2011 to 3% in 2012 due to weak economic activity in the second half of 2011 and the first half of 2012.
Despite a gradual recovery process taking place, the global economy suffered new setbacks in 2011, and its consequent risks are up in 2012. Three key risks are: a) increasing strains in the euro area’s sovereign debt crises; b) recessionary impacts of fiscal adjustment and tight financial credit conditions globally; and, c) the end of the emerging markets boom period.
The WEO’s key message is that global economic policies must be strengthened to pump up the weak recovery and contain the numerous downside risks, including high debt and global unemployment. Among many policy priorities the publication lays out, the emphasis is put on stronger euro-area policies to improve financial conditions in 2013, and avoidance of the ‘fiscal cliff’ by US policymakers by raising the debt ceiling, among other policy measures.
A “temperate approach to fiscal restraint” is called for in response to the continuing sluggish growth prospects in advanced economies. The current trend of quantitative easing in the US, through liquidity increases and near-zero interest rates, is encouraged by the WEO despite its demonstrated instigation of volatile capital flows.
While the WEO does not admonish against austerity, it argues that more is needed, saying “austerity alone cannot treat the economic malaise in the major advanced economies.” Macroeconomic policies must also address the “fundamental problems,” such as weak households in the US and weak sovereigns in the euro area.
The WEO deflects criticisms of the Federal Reserve’s quantitative easing actions over the last several years, saying that related risks are being “overplayed, thereby limiting central banks’ room for policy maneuvering.” Such maneuvering, while admittedly not a substitute for fundamental reform, limits the risk of another major economy falling into debt and deflation, which keeps hurting global economic prospects.
In the major advanced economies, the US, the euro area, Japan, Canada and Australia, a weak recovery with slow but improving economic activity is expected. However, the gains are, and will continue to be, very fragile. The WEO reminds policymakers that they need to continue to implement fundamental changes toward the goal of balanced and sustained growth over the medium-term.
Mild recession predicted for Euro area
The euro area is still projected to go into a mild recession in 2012 as a result of the sovereign debt crisis and loss of confidence, including the effects of bank deleveraging and fiscal consolidation on the real economy. Economic activity is to expand by only 1%, approximately, in 2012 and by 2% in 2013, and job creation is to remain sluggish. On the jobs crisis in Europe, the WEO mentions that “the unemployed will need further income support and help with skills development, retraining, and job searching.”
The most immediate concern highlighted by the WEO is the further escalation of the euro area crisis, to which an entire chapter is dedicated to analyzing. In the case of escalation, euro area output could decline by 3% over a 2-year horizon, which could push the world economy down by 2%.
The WEO deems the Euro area’s fiscal consolidation efforts to be “sufficient,” but advises that the consolidation should be structured to avoid too much decline in demand. In an environment of low domestic inflation there is room for more monetary easing and “unconventional support,” such as purchases of government bonds.
The recent decision to combine the European Stability Mechanism and the European Financial Stability Facility is welcomed by the WEO, as this strengthens the European crisis mechanism and supports the IMF’s own efforts to bolster the global firewall. The WEO infers that the European crisis mechanisms may need to be more flexible in order to directly support the urgent recapitalization requirements of European banks.
Stronger fiscal adjustment needed in US and Japan
The IMF’s position of pushing for large-scale fiscal adjustment is evident in this WEO, with the nuance that adjustment should not hurt domestic demand too much. Approving the fiscal adjustment plans of the US and Japan in the near-term, the WEO goes even further saying that an urgent need remains for even stronger fiscal consolidation in the medium-term.
The WEO contends that reforms to aging-related spending are crucial because they can greatly reduce future spending without significantly harming domestic demand. Such measures “help rebuild market confidence in the sustainability of public finances,” while also demonstrating policymakers’ ability to act decisively. The decisive taboo placed by the IMF on deficit financing is seen in the WEO’s remark that adjustment measures can expand room for fiscal and monetary policy to support financial repair and demand without “raising the specter of inflationary government deficit financing.”
In Japan, in a context of very low domestic inflation pressure, further monetary easing may be needed to ensure that it achieves its inflation objective over the medium term. If the economic lull in the US becomes protracted, more monetary easing will be needed in Japan.
the US, policies directed at real estate markets can speed up the
improvement of household balance sheets and support otherwise anemic
consumption. Given the limited success of US government efforts, a
more forceful approach needs to be attempted. The WEO points out that
fears about moral hazard (letting individuals who made excessively
risky or speculative housing investments off the hook) have stood
in the way of successful intervention in the real estate markets.
In Europe, fears about moral hazard are applied to countries rather
than individuals; however, in both cases the use of targeted interventions
to support demand can be more effective than more controversial macroeconomic
programs. Moral hazard can be address via more stringent regulation
Increasing vulnerabilities in emerging and developing economies
For emerging and developing economies, the primary challenge according to the Fund is to “appropriately calibrate macroeconomic policies” to address the negative spillovers from continued problems in advanced economies. The WEO points that it is a complex setting, and that the approaches of developing and emerging economies will vary in response to challenges such as inflation, high credit growth, volatile capital flows, persistently high commodity prices and overwrought fiscal positions due to fluctuating energy prices.
Real GDP growth in the emerging and developing economies is projected to slow from 6. percent in 2011 to 5. percent in 2012 but then to reaccelerate to 6 percent in 2013, helped by easier macroeconomic policies and strengthening foreign demand. The spillovers from the euro area crisis, discussed in Chapter 2, will severely affect the rest of Europe; other economies will likely experience further financial volatility but no major impact on activity unless the euro area crisis intensifies once again. Accordingly, downside risks continue to loom large, a recurrent feature in recent issues of the World Economic Outlook.
One looming risk in particular is that commodity prices are decreasing, which implies lower revenues and output growth for commodity exporting countries. The WEO cautions that monetary policymakers need to be vigilant that oil price hikes do not translate into broader inflation pressure, and that fiscal policy contains the damage to public sector balance sheets by targeting subsidies only to the most vulnerable households.
Volatile capital flows and their numerous adverse spillovers (e.g. higher exchange rates, risk of capital outflow, bubbles across various asset types) are still a present risk for emerging and developing economies. The IMF’s 2011 WEO documented how a “sudden stop” in capital flows can unwind emerging markets and developing economies as well. The WEO last year showed that a 5 basis point increase in US rates could cause capital flight worth 0.5-1.25% of GDP out of the developing world.
Given that the US Federal Reserve has committed to maintaining near-zero interest rates into the future, this is an ongoing and serious risk to the developing world, especially in the context of the global financial anxiety of the Euro area, which may then instigate sudden reversals of capital flows in a global rush to avert risk.
The WEO also addresses global imbalances, stating that the toll of excessive consumption growth in deficit economies has not been offset by stronger consumption in surplus economies. Accordingly, the WEO states, “the global economy has experienced a loss of demand and growth in all regions relative to the boom years just before the crisis.” Rebalancing is still needed, and requires that key surplus economies increase their demand and consumption in order to strengthen both national and global prospects.