TWN Info Service on WTO and Trade Issues (Sept10/07)
28 September 2010
Third World Network

Fiscal expansion necessary to prevent deflationary spiral
Published in SUNS #6997 dated 15 September 2010

Geneva, 14 Sep (Kanaga Raja) -- A premature exit from demand-stimulating macroeconomic polices in the developed countries aimed at fiscal consolidation risks undermining the incipient global recovery and might cause a deflationary spiral, with attendant slumps in global growth and employment.

This warning was issued by the UN Conference on Trade and Development (UNCTAD) in its annual flagship Trade and Development Report (TDR) released Tuesday.

"A continuation of the expansionary fiscal stance is necessary to prevent a deflationary spiral and a further worsening of the employment situation," said UNCTAD Secretary-General Dr Supachai Panitchpakdi in an overview to the report.

"The prospect of a premature exit from stimulus in Europe has heightened the risk of a double-dip recession in that region, or even worldwide. In the eagerness to embark on fiscal consolidation, it is often overlooked that a double-dip recession, through its negative impact on public revenues, could pose a greater threat to public finances than continued fiscal expansion, which, by supporting growth of taxable income, would itself augment public revenues," he added.

[Meanwhile, in what appears to be a change from its traditional stance of structural adjustment preached and pushed on developing countries, the International Monetary Fund has come out in favour of governments adopting policy measures to promote employment-generating growth.

[According to a report in the New York Times, speaking at an ILO employment conference in Oslo Monday, the IMF Managing Director, Dominic Strauss Khan, urged governments to start factoring back-to-work policies into their overall equation of stoking growth. Failure to halt persistent high joblessness would fan social tensions in several countries and restrain growth.

[The IMF chief economist, Olivier J. Blanchard, was also reported by the NYT as advocating that "countries that need to rebuild credibility (in the markets) should first re-allocate spending to get long-term unemployed and young people back into the labour market." - SUNS]

According to the TDR, the world economy appears to be recovering from its worst crisis since the Second World War. After a marked slowdown in 2008 and a real contraction of almost 2% in 2009, global GDP is expected to expand by about 3.5% in 2010.

This would mean a return to pre-crisis growth rates in most regions, with the exception of the European Union (EU) and some transition economies where a resurgence of growth is proving to be much slower.

However, the report adds, these prospects are no reason for complacency: the exit from recession may seem to have been rapid but it is unlikely to be either strong or durable if it continues to be based on temporary factors, such as inventory cycles and exceptional fiscal stimulus programmes, and if the underlying causes of the crisis are still in place, such as unregulated financial systems, income inequality and global imbalances.

In developed economies, the rescue packages initiated by governments in 2008 and 2009 prevented the collapse of financial markets, while supportive fiscal and monetary policies partially compensated for sluggish private demand. With some exceptions (e. g. Finland, Greece, Iceland, Ireland, Italy, Spain and the Baltic countries), developed economies returned to positive growth rates between the second and the fourth quarter of 2009.

It is estimated that in 2010, growth rates will be close to 3% in Australia, Canada, Japan and the United States, but it is unlikely that developed countries as a whole will return to rapid and sustainable growth rates in the near future.

According to the report, the main reason is that, in general, final domestic demand remains weak owing to continued high unemployment and low private consumption. Investment remains discouraged by idle productive capacities, uncertain future demand and more difficult access to credit. Indeed, it is likely that balance-sheet adjustments in financial and non-financial private sectors will continue to dampen domestic demand.

Several developed countries seem to be promoting net exports as a possible driver of growth. Very dynamic regional growth in Asia, and the resultant strong demand, contributed most to the significant export-led recovery of Japan - one of the developed countries severely affected by the crisis. In Western Europe, too, policies have aimed at increasing net exports, and the growth rate, albeit more modest, has also been lifted primarily by external demand.

The United States, on the other hand, will find it difficult to follow an export-led growth strategy following the appreciation of the dollar. More generally, if too many big players begin to rely on net exports, they cannot all be successful, and this could lead to trade tensions among them. Moreover, there is a high risk that a withdrawal of fiscal stimulus before the return of strong domestic consumption and investment will jeopardize economic recovery.

The report notes that the financial turmoil had little effect on low-income countries that are largely excluded from international financial markets (such as South Asian and sub-Saharan African countries) and on emerging-market economies that had avoided large external deficits and accumulated significant international reserves in the years prior to the crisis.

This not only gave their governments enough policy space to conduct counter-cyclical macroeconomic policies, but also their previously accumulated reserves provided a buffer against the financial shock-waves and helped them to pre-empt exchange-rate and banking crises.

As a result, most Asian and Latin American emerging-market economies were able to contain a rise in unemployment and achieve rapid recovery of domestic demand, which appear to be the main drivers of their growth in 2010. Latin American GDP is forecast to expand by some 5% in 2010.

Most South-East Asian economies started 2010 with very rapid growth rates, sustained by both buoyant exports and strong domestic demand. Even if some deceleration is likely in the second half of 2010 and into 2011, the sub-region's GDP should expand by some 7% in 2010. South and East Asia only suffered a deceleration of their rapid pace of growth in early 2009, and most of them are on track to return to their pre-crisis growth rates in 2010.

Policies aimed at boosting domestic demand in China and India, in particular, must be credited to a large extent for that outcome. Fiscal support and credit availability strengthened domestic demand, leading to both higher consumption and investment expenditure.

In China, some reorientation of public expenditure is underway, which would increase the share of social expenditure and reduce that of investment in infrastructure. This, together with sustained increases in real wages, may help re-balance the composition of domestic demand and make its expansion more sustainable in the long run by increasing the share of household consumption and reducing that of investment from its very high current level.

Recovery has been weak in the transition economies of Central and Eastern Europe. Prior to the crisis, these countries often had run large current-account deficits and had depended heavily on net capital inflows. This has since been exacerbated by restrictive macroeconomic policy responses to the crisis, often under IMF-led programmes.

International trade, which contracted sharply in both volume and value, was the main channel through which the crisis spread globally. The volume of world trade plunged by more than 13% in 2009. Given the overall fall in unit prices of trade (close to 11%), the decline in the value of trade in current dollars was even more pronounced, reaching 23% for the year.

Although the crisis-induced squeeze on trade credit played a role in reducing trade worldwide, the decline in domestic demand, amplified by the globally synchronized nature of the downturn since 2008, was the main cause of the slowdown in world trade in 2009.

Overall, says the report, world trade in goods could expand in volume by more than 10% in 2010, which would allow it to return to its pre-crisis levels. However, measured in current dollars, the recovery will take more time, as unit values in international trade remain, on average, clearly lower than their 2008 peaks.

It notes that after the collapse in demand for and prices of commodities in the second half of 2008 as a result of the global financial and economic crisis, most commodity prices rebounded in 2009. This upward trend continued partially into 2010, although the behaviour of prices in the first months of the year was fairly erratic, exhibiting some downward corrections in January-February and May 2010.

While the evolution of demand fundamentals in emerging-market economies certainly will have contributed to the upturn in the prices of a large number of commodities, it does not explain the magnitude of the price increases, which seems to have been excessive given the fragility of the recovery of the world economy during 2009.

An additional major factor that may have boosted commodity prices beyond market fundamentals was the strong presence of financial investors in these markets. After fleeing from commodity markets in the second half of 2008, financial investors returned in 2009, driven by their growing appetite for risk in response to indications of better prospects for global economic activity. The increasing attractiveness of commodities as an asset class has also been reinforced by ample liquidity and low interest rates.

The report finds that the volume of derivatives trading in non-precious metals increased by 132.8% in 2009, while it rose by 12.9% for energy products and by 3.7% for agricultural products. According to Barclays Capital (2010), in 2009, commodity assets under management rose to an all-time high year-end value of $257 billion - representing the largest annual increase on record - with inflows of $68 billion. This has contributed to a 42-fold increase in commodity assets under management over the past decade. The rising trend in commodity investments is expected to continue through the next decade.

In general, commodity prices have remained highly volatile, and their future evolution is extremely uncertain. "As long as excessive speculation on commodity markets is not properly contained, the strong presence of financial investors will continue to add instability to these markets, as investors tend to react quickly to any financial and economic news, even if unrelated to commodity market fundamentals."

In mid-2009, says the report, the global economy appeared to have bottomed out, and has since shown some promising signs of recovery, albeit to varying degrees in different regions and countries.

"As a preliminary assessment, it would be fair to say that the implementation of powerful counter-cyclical macroeconomic policies won global policy-makers an important first round in battling the crisis. However, remaining stresses and re-emerging imbalances as well as renewed fears and instabilities in global financial markets since the first quarter of 2010 indicate that the war against a global depression has not yet been won."

Despite this, calls for an "early exit" from the demand-stimulating macroeconomic policy stance have been growing louder. Such calls have been particularly prominent among European policy-makers, most of whom had agreed only belatedly, and with great reluctance, to contribute to the global effort of countering the crisis in the first place.

Indeed, notes the report, already in 2009 some European countries embarked on retrenchment rather than stimulus programmes, and in the first half of 2010, new austerity measures aimed at balancing government budgets sooner rather than later were being announced.

From a global perspective, adds the report, this is a risky undertaking, because it is precisely in Europe that recovery appears to be the most fragile. In fact, in mid-2010, it is becoming increasingly clear that the centre of the global crisis that originated in the United States in 2008 has shifted to Europe, creating a new hotspot of instability.

"It is therefore important to stress that at this juncture any withdrawal of a stimulus policy seems rather premature, since in many countries private demand remains fragile, having only partially recovered from its trough so far, and with no sign of even approaching its pre-crisis levels. It therefore risks undermining the incipient global recovery and raises the spectre of a double-dip recession that could push the global economy into a vicious circle of debt deflation," cautions UNCTAD.

Another risk is that countries or regions that make a premature exit from a domestic-demand-supporting policy stance could become over-dependent on exports for their growth. This could result in the emergence of new divergences and renewed tensions at the regional and/or global levels, prompting retaliatory measures in the form of protectionism, which, if practised widely, could magnify any contractionary effects and stall the recovery.

The report notes that as some large developed economies continue to struggle with problems in their financial sector and with sluggish domestic demand due to half-hearted stimulus measures, China - and to a lesser extent India - have again achieved GDP growth rates high enough to make them global leaders in the recovery. Their GDP growth resumed quicker than elsewhere, based on an expansion of domestic demand, and is even expected to grow faster in 2010, once again boosting employment and expansion in production capacities.

In China, stimulus measures fully offset the negative impact of lower net exports on GDP growth and, similar to the United States, recovery is being driven mainly or almost entirely by domestic demand, in contrast to Germany and Japan.

In a repeat of global pre-crisis patterns, among the developed countries, the United States has been experiencing a stronger recovery in domestic demand than the leading developed surplus countries, says the report, noting that the United States authorities are pinning their hopes for recovery on strong growth in exports. A weaker dollar would support this strategy, which would also be in line with the needed global re-balancing.

But Europe, which is the main market for United States exports and was late in joining the global boom of 2002-2007, is now also the outstanding laggard in the current global recovery. This limits the scope for faster export growth in the United States. Moreover, the sharp depreciation of the euro against the dollar in the first half of 2010 will certainly not contribute to any benign global re-balancing.

From mid-2009, a very moderate recovery began in Europe, mainly as a result of a revival of global trade, and in mid-2010, the euro area in particular remains highly dependent on exports for its meagre GDP growth. While the inventory cycle is providing a temporary boost to activity, final domestic demand growth continues to be weak.

Instability in the euro area is largely a homegrown problem, says the report, adding that the sub-prime mortgage crisis in the United States merely acted as the trigger for a series of events that led to the European debt crisis of 2010.

While sub-prime-related write-downs have certainly added to pressures for the de-leveraging that is under way within European banking systems, the root cause of the European crisis can be traced to serious intra-regional divergences and to the related build-up of regional imbalances that had long been negligently ignored by market participants and policy-makers alike.

By mid-2010, the measures agreed in Europe had still failed to restore calm in global financial markets and the euro's real effective exchange rate continued to depreciate. Doubts remain as to a possible sovereign default of Greece and whether the underlying real intra-regional disequilibria will be addressed.

According to the report, questions are also being raised as to the effectiveness of the draconian fiscal retrenchments in achieving fiscal sustainability when countries are pushed into deep recession, particularly as retrenchment in those countries with current-account deficits is not being offset by simultaneous expansion in surplus countries in the region.

Following Germany's lead in committing to fiscal consolidation to regain market confidence, fiscal austerity is set to spread across the continent in 2011. With the prospect of a premature end to stimulus policies in Europe, there is growing fear of a possible European, or even global, double-dip recession occurring.

The crisis in Europe suggests that the euro area's current policy regime may well be unsustainable, and that member countries' uncoordinated national policies are on a collision course.

"It is mainly for these reasons that Europe is today's global hotspot of instability and divergence. Originating in the United States, the global crisis is now centred on Europe, and the region is slowing down global recovery, given its importance in world trade."

At the current juncture, notes the report, in the eagerness to embark on uncoordinated consolidation, there is a tendency to forget that a double-dip recession which could result from a premature abandoning of expansionary policies poses by far the greatest threat to public finances.

Coordination does not mean that all countries should withdraw their stimulus programmes simultaneously; it primarily concerns the free-rider problem. "As a rule, governments should withdraw stimulus in line with the recovery of private domestic demand in their country."

Ending stimulus to domestic demand before that point means having to rely on exports for recovery, thereby shifting the burden of sponsoring demand stimulus onto others. Ideally, the timing of a stimulus withdrawal should contribute towards re-balancing global demand.

At the peak of the global crisis, says the report, G-20 members managed to see eye-to-eye on the need for coordinated measures to generate a strong demand stimulus, as the sheer severity of the events discounted any alternative.

Today, there is a strong belief among policy-makers in the euro area that fiscal austerity will not harm, but rather support, growth by boosting confidence. In contrast, policy-makers in the United States fear that continued domestic demand stagnation in Europe will undermine any recovery of United States exports.

Failure to coordinate policies at the G-20 level raises the prospect of global imbalances reemerging, especially among developed countries. A re-emergence of global imbalances would be contrary to the declared G-20 objectives and reflect a failure of the G-20 process of international cooperation.

So far, that process has fallen short of launching serious reforms of the international monetary and financial system, the report concludes.