WEOBy Olivier Blanchard

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The issue probably foremost on everyone’s mind, is the fiscal situation in the United States, and its potential implications.

While the focus is on the shutdown and the debt ceiling,  we should not forget the sequester, which is leading to a fiscal consolidation this year which is both too large and too arbitrary. The shutdown is yet another bad outcome, although one which, if it does not last very long, has limited economic consequences.  

Failure to lift the debt ceiling would, however, be a game changer.  Prolonged failure would lead to an extreme fiscal consolidation, and surely derail the U.S. recovery. But the effects of any failure to repay the debt would be felt right away, leading to potentially major disruptions in financial markets, both in the U.S. and abroad.   We see this as a tail risk, with low probability, but, were it to happen, it would have major consequences.

Transition and tensions

Fiscal risks in the United States, as worrisome as they are, should not however lead us to lose sight of the bigger picture. Behind the daily news, the world economy has entered yet another transition.   Advanced economies are slowly strengthening, more or less as forecast.   At the same time, emerging market economies have slowed down, more so than we had forecast in July.

Let me give you some numbers.  We forecast growth in advanced economies to be 1.2% this year, 2.0% next year, the same as our July forecasts.   We forecast growth in emerging markets and developing economies to be 4.5% this year, 5.1% next year, a downward revision of 0.5% and 0.4% respectively relative to our July forecasts.

These two evolutions are leading to tensions, with emerging market economies facing both the challenge of slowing growth and changing global financial conditions.

Advanced economies slowly strengthening

Let me start with the U.S.  Private demand continues to be strong, and on the assumption that fiscal accidents are avoided (the assumption that underlies our forecast), the recovery should strengthen.  It is time to make plans for exit from both quantitative easing and zero policy rates—although not time to implement them yet.  While there is no major technical issue involved in doing so, the communication problems facing the Fed are new and delicate.  Looking forward, it is reasonable to expect some volatility in long rates.

The recovery in Japan continues, but whether it can be sustained depends on Abenomics meeting two major challenges.  The first, reflected in the debate about the increase in the consumption tax, is the right pace of fiscal consolidation: it has to be neither too slow to compromise credibility, nor too fast to kill growth.   The second is a credible set of structural reforms to transform what is a cyclical recovery ginto sustained growth.

Core Europe is, at last, showing some signs of recovery.  This is not due to major policy changes, but partly to a change in mood, which could however be partly self fulfilling.  Southern periphery countries are still struggling:  definite progress on competitiveness and exports is not yet strong enough to offset depressed internal demand.   In both core and periphery, uncertainty about bank balance sheets remains an issue, which the promised so called "asset quality review" should reduce.   Taking the longer view, and just as for Japan, structural reforms are urgently needed to increase the anemic potential growth rate.

Emerging market growth weakening

The major news comes however from emerging market economies, where growth has declined, often more than we had forecast in July.

The obvious question is whether this reflects a cyclical slowdown, or a decrease in potential growth.   Based on what we know today, the answer is both.   Unusually favorable world conditions, be it strong commodity prices or global financial conditions, led to higher potential growth in the 2000s, with, in a number of countries, a cyclical component on top.   As commodity prices are stabilizing, and financial conditions tightening, potential growth is lower, in some cases compounded by a sharp cyclical adjustment.

Confronted with these changes, governments in emerging market economies face two challenges:  adjust to lower potential growth, and, where needed, deal with the cyclical adjustment.

On the first, while some decrease in growth relative to the 2000s is inevitable, structural reforms can help and are becoming more urgent.  The list is familiar, from rebalancing towards consumption in China, to removing barriers to investment in India or Brazil.   On the second challenge, standard advice also applies:  countries with large fiscal deficits must consolidate.  Countries with inflation running persistently above target must tighten and, often more importantly, put in place a more credible monetary policy framework.

The increase in U.S. long-term interest rates makes the advice even more relevant.  Normalization of interest rates in advanced countries is likely to lead to a partial reversal of the earlier capital flows.   As investors repatriate funds, countries with weaker fiscal positions or higher inflation are particularly exposed.

The right response for emerging market countries must be twofold.  First, where needed, to put their macro house in order, to clarify the monetary policy framework, and to maintain fiscal sustainability.  Second, to let the exchange rate depreciate in response to outflows.   Foreign currency exposure, which led to adverse effects of depreciation in the past, is more limited today, and emerging market economies should be able to adjust to the changed environment without major difficulties.

I have not focused on low income countries.  The good news here is that they continue, in general, to be quite resilient.   Nevertheless, looking forward, they will also face a more challenging environment.

In short, the recovery from the crisis continues, albeit too slowly.  While the focus at this time is more on emerging market economies, other legacies of the crisis are still very much present and advanced economies are not out of the woods.  Public debt, and in some cases, private debt, remain very high, and fiscal sustainability is not a given.  The architecture of the financial system is still evolving, and its future shape and solidity are still unclear.  Unemployment remains too high.  These will remain major challenges for many years to come.