With the IMF paring down its global growth forecast, governments should first tweakeconomic policy to minimise vulnerabilities
Another forecast, another downgrade. The International Monetary Fund’s (IMF) World Economic Outlook (April 2016) tells us that the world economy will grow at 3.2 per cent in purchasing power parity terms in 2016, not 3.6 per cent as forecast last October. In 2017, it will grow at 3.5 per cent, not 3.8 per cent as forecast earlier. Contrast these with growth of 4.2 per cent in 1998-2007, the period before the financial crisis.
After years of fiscal and monetary stimuli, we are not about to see a return to high growth in the near future. Welcome to what the IMF Managing Director, Christian Lagarde, calls the “new mediocre”. The key question is whether economic policy can do anything at all about it. India’s own hopes of an early return to growth rate of over 8 per cent hinge on the answer to this question.
The big surprise is that falling oil prices have failed to provide a shot in the arm for the world economy. Oil prices fell by nearly half in 2015 compared to 2014 but this hasn’t helped. As revenues have fallen, oil exporters have cut their expenditure and this has depressed global demand. In emerging markets such as India, the fall in oil price hasn’t been passed on fully to consumers. In advanced economies, consumers are still weighed down by the heavy debt they accumulated in the pre-crisis period, so they are in no mood to step up spending.
Falling oil prices have led to large cuts in capital expenditure in the oil and mining sectors. These cuts have had their own impact on non-energy sectors. A fall in oil prices translates into a fall in the inflation rate. Central banks should have cut their policy rates in response. They couldn’t because policy rates were already close to zero. Inflation has fallen thanks to a decline in oil prices but nominal interest rates haven’t. This translates into a rise in real interest rates.
Two aspects of the global economy today are worrisome. First, in periods of weak growth, financial markets are prone to bouts of turbulence. Nervous investors tend to dump risky assets at the merest hint of trouble. If financial markets sink, even the IMF’s modest forecasts can be undermined. Emerging markets especially can be wrecked by sudden and large capital outflows. Second, geopolitical risks have risen sharply. The World Economic Outlook mentions some of these: the humanitarian disaster and the influx of refugees into Europe; the possibility of the U.K. exiting the European Union; the rise of protectionist tendencies in the U.S. and elsewhere; and internal strife in several emerging markets. However, it omits a far more important development: the heightened tensions between Russia and the West. When geopolitical risks rise, investors tend to retreat.
Solutions and limitations
How do we end the long period of weak growth in the world economy? The IMF urges a familiar set of measures in order to pre-empt the “new mediocre”: loose monetary policies, fiscal support and structural reforms. Experience, however, tells us that each of these has serious limitations.
Following the 2007 crisis, interest rates were cut in the U.S. and elsewhere. Once interest rates come close to zero, they have little effect on aggregate demand. As a result, the U.S. resorted to quantitative easing (QE) in 2008. This meant the central bank buying long-term securities and it was intended to lower the long-term interest rate. The European Central Bank too commenced QE in 2009.
More recently, central banks in Europe as well as in Japan have moved policy rates into negative territory, which means banks charging depositors for keeping cash in banks and paying borrowers for taking loans. However, as depositors have little incentive to put money into banks, banks end up passing on negative rates to borrowers but not to depositors. This undermines banks’ profits at a time when banks in the Eurozone are not in great shape.
Moreover, negative interest rates may lead not to a surge in productive investment but to asset bubbles and another financial crisis.
Some economists now favour the use of “helicopter money”, that is, the central bank monetising government deficits. When economists advocate a measure long regarded as taboo because of its potential to create runaway inflation, we know the situation is pretty desperate.
Others believe that monetary policy has run its course and it is time to bring back fiscal policies such as government spending on infrastructure or tax incentives to promote a higher minimum wage. Governments are, however, unwilling or unable to boost spending. The U.S. has concerns over large burdens on social security and would not like to add to its debt burden. Germany has room to spend but believes there is only so much it can do to help others in the Eurozone. As for higher minimum wages, there is the risk that inflation can get out of control and wages cannot be lowered if it does.
“Structural reforms” is another buzzword. It includes things like cutting unemployment benefits, making it easier to hire and fire, reducing barriers to entry, etc. But many of these measures yield benefits only over a long period.
An era of low growth
Some economists believe that the world has entered an era of low growth. There are several hypotheses. One is “secular stagnation”, that investment has dropped because of slower population growth in the advanced world, people needing fewer things, and modern investment being less capital intensive than in the past. Growing inequality also means more of the income goes into the hands of a few, whose capacity to consume is limited. This causes savings to rise. More savings and lower investment translate into lower growth.
Economist Robert Gordon points out that economic growth is simply the combination of population growth and productivity growth. Like population growth, productivity growth too has fallen in recent years. So, a return to high growth is something of a mirage. Two other economists, Kenneth Rogoff and Carmen Reinhart, contend that the world suffers from an overhang of excess debt, which is what led to the financial crisis. Economies take years to come out of such an overhang.
The underlying message of the debate on the global economy among economists is a stark one. Either the growth potential of the world economy is limited or, even if it is not, we lack instruments to step up the growth rate without creating serious risks.
In dealing with the “new mediocre”, don’t aim for the sky. Just focus on minimising vulnerabilities in the economy, such as those in the financial sector or on the external account. When he chose to stick to the fiscal deficit target for 2016-17 even if it meant sacrificing growth, Finance Minister Arun Jaitley may well have embraced this philosophy.
T.T. Ram Mohan is a professor at the Indian Institute of Management, Ahmedabad.
In opting to stick to the fiscal deficit target for 2016-17, Finance Minister Arun Jaitley may well have done the prudent thing
