PRINCETON – In April 2010, the International Monetary Fund’s World Economic Outlook offered an optimistic assessment of the global economy, describing a multi-speed recovery strong enough to support roughly 4.5% annual GDP growth for the foreseeable future – a higher pace than during the bubble years of 2000-2007. But, since then, the IMF has steadily pared its economic projections. Indeed, this year’s expected GDP growth rate of 3.3% – which was revised downward in the most recent WEO – will probably not be met.
Persistent optimism reflects a serious misdiagnosis of the global economy’s troubles. Most notably, economic projections have vastly underestimated the severity of the eurozone crisis, as well as its impact on the rest of the world. And recovery prospects continue to depend on the emerging economies, even as they experience a sharp slowdown. The WEO’s prediction of a strengthening recovery this year continues the misdiagnosis.
European Central Bank President Mario Draghi’s announcement last summer that the ECB would do “whatever it takes” to preserve the euro reassured financial markets. But, as pressure from financial markets has eased, so has European leaders’ incentive to address problems with the eurozone’s underlying economic and political dynamics. Easy ECB liquidity is now sustaining a vast swath of Europe’s banking system.
The eurozone is operating under the pretense that public and private debts will, at some point, be repaid, although, in many countries, the distress now is greater than it was at the start of the crisis almost five years ago. As a result, banks, borrowers, and governments are dragging each other into a vicious downward spiral. Politicians have exacerbated the situation by doubling down on fiscal austerity, which has undermined GDP growth while failing to shrink government debt/GDP ratios. And no decisive policy action aimed at healing private balance sheets appears imminent.
Moreover, Europe’s problems are no longer its own. Europe’s extensive regional and global trade networks mean that its internal problems are impeding world trade and, in turn, global economic growth. In 2012, world trade expanded by only 2.5%, while global GDP grew at a disappointing 3.2% rate.
Periods in which trade grows at a slower pace than output are rare, and reflect severe strain on the global economy’s health. While the trauma is no longer acute, as it was in 2009, wounds remain – and they are breeding new pathologies. Unfortunately, the damage is occurring quietly, enabling political interests to overshadow any sense of urgency about the need to redress the global economy’s intensifying problems.
Against this bleak background, it is easy to celebrate the success of emerging markets. After all, emerging and developing economies are growing much faster than the advanced countries. But even the world’s most dynamic emerging markets – including China, Brazil, and India – are experiencing a sharp deceleration that cannot be ignored.
Consider India, where growth is now running at an annualized rate of 4.5%, down from 7.7% annual growth in 2011. To be sure, the IMF projects that India’s economy will rebound later in 2013, but the basis for this optimism is unclear, given that all indicators so far suggest another dismal year.
The emerging economies’ supposed resilience, which has buoyed economic forecasts in recent years, needs to be reassessed. Like the advanced economies, emerging economies experienced a boom in 2000-2007. But, unlike the advanced economies, they maintained high GDP growth rates and relative stability even at the height of the crisis. This was viewed as powerful evidence of their new economic might. In fact, it was largely a result of massive fiscal stimulus and credit expansion.
Indeed, as the effects of stimulus programs wear off, new weaknesses are emerging, such as persistent inflation in India and credit misallocation in China. Given this, the notion that emerging economies will recapture the growth levels of the bubble years seems farfetched.
Economic forecasts rest on the assumption that economies ultimately heal themselves. But economies’ powerful self-healing capabilities work slowly. More problematic, a misdiagnosis can lead to treatments that impair the healing process. Overly optimistic economic projections based on mistaken assessments of the global economy’s ailments thus threaten recovery prospects – with potentially far-reaching consequences.
In Europe, the banks’ wounds must be closed – weak banks must be shut down or merged with stronger banks – before recovery can begin. This will require an extensive swap of private debts for equity. For the global economy, the malaise reflected in anemic trade growth calls for coordinated fiscal stimulus by the world’s major economies. Otherwise, the risk of another global recession will continue to rise.