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Misreading the Global Economy

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.