April 7, 2014
The post-crisis panic might be subsiding but medium-term prospects are problematic
The world’s finance ministers and central bank governors gather in Washington this week for the biannual International Monetary Fund meetings. While there will not be the sense of alarm that dominated the convocations in the years after the financial crisis, the unfortunate reality is that the medium-term prospects for the global economy have not been so problematic for a long time.
The IMF in its current World Economic Outlook essentially endorses the “secular stagnation” hypothesis, noting that the real interest rate necessary to bring about enough demand for full employment is likely to remain depressed for a substantial period. This is made manifest by the fact that inflation is well below target throughout the developed world and is likely to decline further this year. Without robust growth in, and greater demand from, these markets, growth in emerging economies is likely to subside. That is even without considering the political challenges facing countries as diverse as Brazil, China, South Africa, Russia and Turkey.
In the face of inadequate demand, the world’s primary strategy is easy money. Base interest rates remain at floor levels throughout the developed world and central banks signal that they are unlikely to rise soon. While the US is tapering quantitative easing, Japan continues to ease on a large scale, and the Eurozone seems to be moving closer to this. This is all better than the tight money that in the 1930s made the Depression the Great Depression. But it has problems as a growth strategy.
We do not have a strong basis for supposing that reductions in interest rates from very low levels have a big impact on spending decisions. Any spending they do induce tends to represent a pulling forward rather than an augmentation of demand. We do know they strongly encourage economic actors to take on debt; that they place pressure on return-seeking investors to take increased risk; that they inflate asset values and reward financial activity. And we cannot confidently predict the ultimate impact on markets or the confidence of investors of the unwinding of central bank balance sheets.
While monetary policies lower capital costs and so encourage spending that businesses and households judge unworthwhile even at rock-bottom interest rates, many elements of investment exist that can be increased and that also have high returns but are held back by misguided public policies.
In the US the case for substantial investment promotion is overwhelming. Increased infrastructure spending would reduce burdens on future generations, not just by spurring growth but also by expanding the economy’s capacity and reducing deferred maintenance obligations. For example: can it be rational in the 21st century for the US air traffic control system to rely on paper tracking of flight paths? Equally important, government could do much at no cost to promote private investment including authorizing oil and natural gas exports, bringing clarity to the future of corporate taxes, and moving forward on trade agreements that open up foreign markets.
Japan, with the increase in value added tax on April 1, is engaged in a major fiscal contraction at a time when it is far from clear whether last year’s progress in reversing deflation is durable or a reflection of one-off exchange rate movements. A return to stagnation and deflation could rapidly call its solvency into question. Japan takes a dangerous risk if it waits to observe the consequences before enacting fiscal and structural reform measures to promote spending.
Europe has moved back from the brink, with defaults or devaluations now remote as possibilities. But no strategy for durable growth is yet in place and the slide towards deflation continues. Strong actions to restore the banking system so that it can be a conduit for a robust flow of credit, as well as measures to promote demand in the countries of the periphery where competitiveness challenges remain, are imperative.
If emerging markets’ capital inflows fall off substantially, and so they move further towards being net exporters, it is hard to see where in the developed world can take up the slack by accepting trade balance deterioration. So measures to bolster capital flows and exports to emerging markets are essential. Most important are political steps to reassure about populist threats in a number of countries, such as where authoritarian governments give signs of disregarding contracts and property rights, and provide investor protection and backstop finance. In this regard passage by the US Congress of authorisation for the IMF to enhance its ability to provide backstop finance, is imperative.
Creative consideration should also be given to ways of mobilising the trillions of dollars in public assets held by central banks and sovereign wealth funds largely in the form of safe liquid assets to promote growth.
In a globalised economy, the impact of these steps taken together is likely to be substantially greater than the sum of their individual impacts. And the consequences of national policy failures are likely to cascade. That is why a global growth strategy framed to resist secular stagnation rather than just muddle through with the palliative of easy money should be this week’s agenda.
The writer is Charles W Eliot university professor at Harvard and a former US Treasury secretary