Achieving a “strong, balanced, and sustained world recovery”—to quote from the goal set in Pittsburgh by the G-20—was never going to be easy. It requires much more than just going back to business as usual. It requires two fundamental and complex economic rebalancing acts.
First, internal rebalancing. When private demand collapsed, fiscal stimulus helped reduce the fall in output. This helped avoid the worst. But private demand must now become strong enough to take the lead and sustain growth, while fiscal stimulus gives way to fiscal consolidation.
The second is external rebalancing. Many advanced countries, most notably the United States, relied excessively on domestic demand before the crisis, and they must now rely more on net exports. Many emerging market countries, most notably China, had relied excessively on net exports, but must now look to domestic demand.
These two rebalancing acts are taking place too slowly.
Private domestic demand remains weak in advanced countries. This reflects both a correction of pre-crisis excesses and the scars of the crisis. U.S. consumers who had overborrowed before the crisis are now saving more and consuming less; while this is good for the long run, it is a drag on demand in the short run. Housing booms have given way to housing slumps, and housing investment will remain depressed for some time to come. And financial system weaknesses are still constraining credit.
External rebalancing remains limited. Net exports are not contributing to growth in advanced countries; the US trade deficit remains large. Many emerging markets continue to run large current account surpluses, and to respond to capital inflows primarily through reserve accumulation rather than exchange rate appreciation. International reserves are higher than they have ever been and continue to increase.
The result is a recovery which is neither strong, nor balanced, and runs the risk of not being sustained. For the last year or so, inventory accumulation and fiscal stimulus were driving the recovery. The first is coming to a natural end. The second is slowly being phased out. Consumption and investment now have to take the lead. But, in most advanced economies, weak consumption and investment, together with little improvement in net exports, are leading to low growth. Unemployment is high, and barely decreasing.
By contrast, in many emerging market countries, where excesses were limited and the scars of the crisis are few, consumption, investment, and net exports are all contributing to strong growth, and output is back close to potential.
So, what are the policy implications? What can be done to improve things?
First, wherever private demand is weak, central banks should continue with accommodating monetary policy. One should be realistic however. Not much more can be done, and one should not expect too much from further quantitative or credit easing. While there is no evidence yet that sustained low interest rates are leading to excessive risk taking, were such risks to materialize, they should be addressed through macro prudential measures, not through increases in policy rates.
Second, and wherever needed, governments must continue both financial repairs and financial reforms. Many banks do not have enough capital, and tight credit is constraining segments of demand. Securitization, which must play an important role in any financial system in the future, is still moribund. Financial reforms are proceeding, but questions remain about “too big to fail” institutions, about the perimeter of regulation, and about cross border issues. The faster reform uncertainty is reduced, the more the financial system will support demand and growth.
Third, and again wherever needed, governments must address fiscal consolidation. What is essential here is not to so much to phase out fiscal stimulus now, but to offer a credible medium term plan for debt stabilization and, eventually, for debt reduction. Such credible plans may involve fiscal rules, the creation of independent fiscal agencies, and phased-in entitlement reforms. They have not yet been offered in most countries. But they are essential because, when in place, this will give government more fiscal flexibility to sustain growth in the short run.
Fourth, those emerging market countries with large current account surpluses must accelerate rebalancing. This is not only in the world economy’s interest, but also their own. In many of these countries, distortions have led to too low a level of consumption, or too low a level of investment. Removing these distortions and thus allowing consumption and investment to increase is highly desirable. To a large extent, market forces, in the form of large capital inflows, are pushing these countries in the right direction. However, to the extent that some countries do not allow for sufficient exchange rate adjustment, this exacerbates the problem for others. The use of reserves should be limited, and the role of capital controls, if any, should be to direct flows in accord with macroprudential concerns, not to prevent necessary exchange rate shifts.
All these pieces are very much interconnected. Unless advanced countries can count on stronger private demand—both domestic and foreign—they will find it difficult to achieve fiscal consolidation. And worries about sovereign risks can easily derail growth. If growth stops in advanced countries, emerging market countries will have a hard time decoupling. These downside risks, which were described in the GFSR, should not be ignored.
The need for careful design at the national level, and coordination at the global level, may be even more important today than they were at the peak of the crisis a year and a half ago.