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Missing Growth Multipliers

PRINCETON – In April 2010, when the global economy was beginning to recover from the shock of the 2008-2009 financial crisis, the International Monetary Fund’s World Economic Outlook predicted that global GDP growth would exceed 4% in 2010, with a steady annual growth rate of 4.5% maintained through 2015. But the forecast proved to be far too optimistic.

In fact, global growth has decelerated. In its most recent WEO, the IMF forecasts global GDP to grow by only 3.3% in 2012, and by 3.6% in 2013. Moreover, the downgrading of growth prospects is remarkably widespread.

The forecast errors have three potential sources: failure to recognize the time needed for economic recovery after a financial crisis; underestimation of the “fiscal multipliers” (the size of output loss owing to fiscal austerity); and neglect of the “world-trade multiplier” (the tendency for countries to drag each other down as their economies contract).

For the most part, the severity and implications of the financial crisis were judged well. Lessons from the October 2008 WEO, which analyzed recoveries after systemic financial stress, were incorporated into subsequent forecasts.

As a result, predictions for the United States – where household deleveraging continues to constrain economic growth – have fallen short only modestly. The April 2010 report forecast a US growth rate of roughly 2.5% annually in 2012-2013; current projections put the rate a little higher than 2%.

By contrast, the fiscal multiplier was seriously underestimated – as the WEO has now recognized. Consequently, forecasts for the United Kingdom – where financial-sector stresses largely resembled those in the US – have been significantly less accurate.

The April 2010 WEO forecast a UK annual growth rate of nearly 3% in 2012-2013; instead, GDP is likely to contract this year and increase by roughly 1% next year. Much of this costly divergence from the earlier projections can be attributed to the benign view of fiscal consolidation that UK authorities and the IMF shared.

Likewise, the eurozone’s heavily indebted economies (Greece, Ireland, Italy, Portugal, and Spain) have performed considerably worse than projected, owing to significant spending cuts and tax hikes. For example, Portugal’s GDP was expected to grow by 1% this year; in fact, it will contract by a stunning 3%. The European Commission’s claim that this slowdown reflects high sovereign-default risk, rather than fiscal consolidation, is belied by the UK, where the sovereign risk is deemed by markets to be virtually nonexistent.

The world-trade multiplier, though less widely recognized, helps to explain why the growth deceleration has been so widespread and persistent. When a country’s economic growth slows, it imports less from other countries, thereby reducing those countries’ growth rates, and causing them, too, to reduce imports.

The eurozone has been at the epicenter of this contractionary force on global growth. Since eurozone countries trade extensively with each other and the rest of the world, their slowdowns have contributed significantly to a decrease in global trade, in turn undermining global growth. In particular, as European imports from East Asia have fallen, East Asian economies’ growth is down sharply from last year and the 2010 forecast – and, predictably, growth in their imports from the rest of the world has lost momentum.

Global trade has steadily weakened, with almost no increase in the last six months. The once-popular notion, built into growth forecasts, that exports would provide an escape route from the crisis was never credible. That notion has now been turned on its head: as economic growth has stalled, falling import demand from trade partners has caused economic woes to spread and deepen.

The impact of slowing global trade is most apparent for Germany, which was not burdened with excessive household or corporate debt, and enjoyed a favorable fiscal position. To escape the crisis, Germany used rapid export growth – especially to meet voracious Chinese demand. Although growth was expected to slow subsequently, it was forecast at roughly 2% in 2012-2013. But, as Chinese growth has decelerated – owing partly to decreased exports to Europe – the German GDP forecast has been halved. And, given that this year’s growth has largely already occurred, Germany’s economy has now plateaued – and could even be contracting.

In good times, the trade generated by a country’s growth bolsters global growth. But, in times of crisis, the trade spillovers have the opposite effect. As the global economy has become increasingly interconnected, these trade multipliers have increased.

Indeed, while less ominous and dramatic than financial contagion, trade spillovers profoundly influence global growth prospects. Failure to recognize their impact implies that export – and, in turn, growth – projections will continue to miss the mark. The projected increase in global growth next year will likely not happen. On the contrary, policy errors and delays in individual countries will seriously damage economies worldwide.

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