By Olivier Blanchard

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The global recovery continues, but the recovery is weak; indeed a bit weaker than we forecast in April.

In the Euro zone, growth is close to zero, reflecting positive but low growth in the core countries, and negative growth in most periphery countries.  In the United States, growth is positive, but too low to make a serious dent to unemployment.

Growth has also slowed in major emerging economies, from China to India and Brazil.

Downside risks, coming primarily from Europe, have increased.

Let me develop these themes in turn.

Our baseline forecasts

In Europe, we are observing an increasing divergence between core and periphery countries.

Periphery Euro countries, including Italy and Spain, face a difficult adjustment.  Fiscal consolidation is necessary, but weighs heavily on growth. Structural reforms will bear fruit, but only in the future. Banks have to deal not only with bad legacy loans, but also with increasing non-performing loans, which reflect depressed economic activity. High debt burdens are making borrowing expensive for governments. The result is negative growth this year and next for both Italy and Spain.

Core Euro countries, including France and Germany, face similar problems, but on a more limited scale. The required fiscal consolidation is smaller; banks  in general are in better shape.  Still, their growth is forecast to be low: 1% for Germany, 0.3% for France in 2012, and a bit higher for both in 2013.


In the United States the recovery continues, with some good news early in the year offset by some bad news since. Fiscal consolidation is taking its toll; so are lower exports.  The good news is that housing appears to be stabilizing.  Still, the recovery is not strong enough to substantially decrease unemployment.  Our forecasts are of 2.0% growth for 2012, and 2.3% for 2013, a revision of -0.1% in both cases.

Growth in emerging market countries has slowed down a bit more than we expected in April. For example, we have revised our forecast for China down from 8.2% to 8% for 2012, our forecast for India from 6.9% to 6.1%, our forecast for Brazil from 3.0% to 2.5%.  The proximate causes vary across countries, with lower exports and lower investment playing a dominant role.  In general, we expect these countries to achieve soft landings, but at lower growth rates than in the past.

Putting everything together, our forecast for world growth is 3.5% for 2012, 3.9% for 2013, down .1% and .2% respectively.  

Given the flow of bad news in the press, you might be surprised by this small downward revision.  There are two reasons:  we were not very optimistic to start with; and in many countries, while the second quarter was worse than forecast, the first quarter was better than forecast. This partly explains the small revision for 2012.

The downside risks

More worrisome than these revisions to the baseline forecast is the increase in downside risks.

The main risk is obvious: the vicious cycles in Spain or Italy become stronger, output falls even more, and one of these countries loses access to financial markets. The implications could easily derail the world recovery.   Our baseline forecasts are based on the assumption that policies will be implemented to slowly decrease the spreads on Spanish and Italian bonds from their current high to a still high, but lower level in 2013.  This however requires that the right policies be adopted and implemented.

What must be done

For the Euro crisis to be contained, and eventually resolved, two conditions must be satisfied.

First, the countries under pressure must follow through with fiscal consolidation, wage and price adjustments, structural reforms, and bank recapitalization if and when needed.  Spanish and Italian governments have taken important steps in this direction.  But they can only succeed if they can finance themselves at reasonable rates.

Second, as long as these governments are committed to reforms, other Euro members have to be willing to help make the adjustment feasible.  This implies not only designing a euro level architecture, but also being willing, in the short run, to stabilize funding conditions in sovereign debt markets. Progress was made in recent weeks, but more remains to be done.

For the United States, the issue remains primarily fiscal. Avoiding the fiscal cliff is clearly the short run priority. But the lack of a medium term fiscal plan is worrisome, and the source of risks in the not too distant future.

Emerging economies differ in too many ways to allow for simple, common, advice. The best advice may be: be ready.  Prepare to use both economic and macroprudential policies to respond to a complex external environment. Capital flows are likely to remain highly volatile. Exports to advanced countries are likely to remain subdued.

The world recovery can continue, and can strengthen.  The right pace of fiscal consolidation, continuing expansionary monetary policy, getting the financial sector back to health  to decrease borrowing costs, and solidarity, especially within the Euro zone, are all of the essence.