The world economic recovery is gaining strength, but it remains unbalanced.
Three numbers tell the story. We expect the world economy to grow at about 4.5 percent a year in both 2011 and 2012, but with advanced economies growing at only 2.5 percent, while emerging and developing economies grow at a much higher 6.5 percent.
On the good news side. Earlier fears of a double dip—which we did not share—have not materialized. The main worry was that, in advanced economies, after an initial recovery driven by the inventory cycle and fiscal stimulus, growth would fizzle. The inventory cycle is now largely over, fiscal stimulus has turned to fiscal consolidation, but private demand has, for the most part, taken up the relay.
Fears have turned to commodity prices. Commodity prices have increased more than expected, reflecting a combination of strong demand growth and a number of supply shocks. These increases conjure the specter of 1970s style stagflation, but they appear unlikely to derail the recovery.
- In advanced countries, the decreasing share of oil, the disappearance of wage indexation, and the anchoring of inflation expectations, all combine to suggest small effects on either growth or core inflation.
- The challenge is greater in emerging market and developing countries, where the share of food in consumption is larger, and the credibility of monetary policy is often weaker. Inflation may well be higher for some time but, as our forecasts indicate, we do not expect a major adverse effect on growth.
Turning to the bad news. The recovery, however, remains unbalanced.
In most advanced economies, output is still far below potential. Unemployment is high, and low growth implies that it will remain so for many years to come. The source of low growth can be traced to both pre-crisis excesses and to crisis wounds. In many countries, especially in the United States, the housing market is still depressed, leading to anemic housing investment. The crisis itself has led to a large deterioration in fiscal positions, forcing a shift to fiscal consolidation, while not eliminating market worries about fiscal sustainability. And, in many countries, banks are struggling to achieve higher capital ratios in the face of increasing non-performing loans.
The problems in Europe’s periphery—with the combined effects of low growth, fiscal woes, and financial pressures—are particularly acute. Reestablishing fiscal and financial sustainability, in the face of low or negative growth and high interest rates, is a substantial challenge, and will take time. And, while they are extreme, the problems of Europe’s periphery point to a more general problem, an underlying low rate of growth of potential output. Adjustment is very hard when growth is very low.
The policy advice to advanced countries remains largely the same as in previous World Economic Outlooks, and so far, has been only partly heeded. Increased clarity on banks’ exposures with ready recapitalization plans if and where needed. Smart fiscal consolidation, that is neither too fast, which could kill growth, nor too slow, which would kill credibility. The redesign of financial regulation and supervision. And, especially in Europe, an increased focus on reforms to increase potential growth.
In emerging market countries by contrast, the crisis has not left lasting wounds. Their fiscal and financial positions were typically stronger to start, and adverse effects of the crisis have been more muted. High underlying growth and low interest rates are making fiscal adjustment much easier. Exports have largely recovered, and whatever shortfall in external demand they experienced has typically been made up through an increase in domestic demand. Capital outflows have turned into capital inflows, due to both better growth prospects and higher interest rates than in advanced countries.
The challenge for most emerging countries is quite different from that of advanced countries, namely how to avoid overheating in the face of closing output gaps and higher capital flows. Their response should be twofold.
- First, rely on a combination of higher interest rates and fiscal consolidation to maintain output at potential.
- Second, use a mix of reserve accumulation and macroprudential tools, including, where needed, capital controls, to avoid increases in systemic risk stemming from inflows. Countries are often tempted to resist the exchange rate appreciation which is likely to come with higher interest rates and higher inflows. But appreciation increases real income, is part of the desirable adjustment, and should not be resisted.
Overall, the macroeconomic policy agenda for the world economy remains the same, but with the passage of time, more urgent. For the recovery to be sustained, advanced countries must reduce government deficits and debt levels. To do so and to maintain growth, they need to rely more on external demand. Symmetrically, emerging market countries must rely less on external demand, and more on domestic demand. Appreciation of emerging market countries’ currencies relative to advanced countries’ currencies is an important key to this global adjustment.
The need for careful design of policies at the national level, and coordination at the global level, may be as important today as they were at the peak of the crisis two years ago.