The International Monetary Fund has just published its six-monthly World Economic Outlook (WEO). The publication assesses the state of the global economy and forecasts economic growth and other indicators over the next few years. So what is this latest edition predicting?
Well, once again the IMF had to adjust its global economic growth forecasts down from those made six months ago, which in turn were lower than those made a year ago. As Larry Elliott comments in the Guardian article linked below:
Every year, economists at the fund predict that recovery is about to move up a gear, and every year they are disappointed. The IMF has over-estimated global growth by one percentage point a year on average for the past four years.
In this latest edition, the IMF is predicting that growth in 2015 will be slightly higher in developed countries than in 2014 (2.0% compared with 1.8%), but will continue to slow for the fifth year in emerging market and developing countries (4.0% in 2015 compared with 4.6% in 2014 and 7.5% in 2010).
In an environment of declining commodity prices, reduced capital flows to emerging markets and pressure on their currencies, and increasing financial market volatility, downside risks to the outlook have risen, particularly for emerging market and developing economies.
So what is the cause of this sluggish growth in developed countries and lower growth in developing countries? Is lower long-term growth the new norm? Or is this a cyclical effect – albeit protracted – with the world economy set to resume its pre-financial-crisis growth rates eventually?
To achieve faster economic growth in the longer term, potential national output must grow more rapidly. This can be achieved by a combination of more rapid technological progress and higher investment in both physical and human capital. But in the short term, aggregate demand must expand sufficiently rapidly. Higher short-term growth will encourage higher investment, which in turn will encourage faster growth in potential national output.
But aggregate demand remains subdued. Many countries are battling to cut budget deficits, and lending to the private sector is being constrained by banks still seeking to repair their balance sheets. Slowing growth in China and other emerging economies is dampening demand for raw materials and this is impacting on primary exporting countries, which are faced with lower exports and lower commodity prices.
Quantitative easing and rock bottom interest rates have helped somewhat to offset these adverse effects on aggregate demand, but as the USA and UK come closer to raising interest rates, so this could dampen global demand further and cause capital to flow from developing countries to the USA in search of higher interest rates. This will put downward pressure on developing countries’ exchange rates, which, while making their exports more competitive, will make it harder for them to finance dollar-denominated debt.
As we have seen, long-term growth depends on growth in potential output, but productivity growth has been slower since the financial crisis. As the Foreword to the report states:
The ongoing experience of slow productivity growth suggests that long-run potential output growth may have fallen broadly across economies. Persistently low investment helps explain limited labour productivity and wage gains, although the joint productivity of all factors of production, not just labour, has also been slow. Low aggregate demand is one factor that discourages investment, as the last World Economic Outlook report showed. Slow expected potential growth itself dampens aggregate demand, further limiting investment, in a vicious circle.
But is this lower growth in potential output entirely the result of lower demand? And will the effect be permanent? Is it a form of hysteresis, with the effect persisting even when the initial causes have disappeared? Or will advances in technology, especially in the fields of robotics, nanotechnology and bioengineering, allow potential growth to resume once confidence returns?
Which brings us back to the short and medium terms. What can be done by governments to stimulate sustained recovery? The IMF proposes a focus on productive infrastructure investment, which will increase both aggregate demand and aggregate supply, and also structural reforms. At the same time, loose monetary policy should continue for some time – certainly as long as the current era of falling commodity prices, low inflation and sluggish growth in demand persists.
Uncertainty, Complex Forces Weigh on Global Growth IMF Survey Magazine (6/10/15)
A worried IMF is starting to scratch its head The Guardian, Larry Elliott (6/10/15)
Storm clouds gather over global economy as world struggles to shake off crisis The Telegraph, Szu Ping Chan (6/10/15)
Five charts that explain what’s going on in a miserable global economy right now The Telegraph, Mehreen Khan (6/10/15)
IMF warns on worst global growth since financial crisis Financial Times, Chris Giles (6/10/15)
Global economic slowdown in six steps Financial Times, Chris Giles (6/10/15)
IMF Downgrades Global Economic Outlook Again Wall Street Journal, Ian Talley (6/10/15)
World Economic Outlook, October 2015: Adjusting to Lower Commodity Prices IMF (6/10/15)
Global Growth Slows Further, IMF’s latest World Economic Outlook IMF Podcast, Maurice Obstfeld (6/10/15)
Transcript of the World Economic Outlook Press Conference IMF (6/10/15)
World Economic Outlook Database IMF (October 2015 edition)
- Look at the forecasts made in the WEO October editions of 2007, 2010 and 2012 for economic growth two years ahead and compare them with the actual growth experienced. How do you explain the differences?
- Why is forecasting even two years ahead fraught with difficulties?
- What factors would cause a rise in (a) potential output; (b) potential growth?
- What is the relationship between actual and potential economic growth?
- Explain what is meant by hysteresis. Why may recessions have a permanent negative effect, not only on trend productivity levels, but on trend productivity growth?
- What are the current downside risks to the global economy?
- Why have commodity prices fallen? Who gains and who loses from lower commodity prices? Does it matter if falling commodity prices in commodity importing countries result in negative inflation?
- To what extent can exchange rate depreciation help commodity exporting countries?
- What is meant by the output gap? How have IMF estimates of the size of the output gap changed and what is the implication of this for actual and potential economic growth?
In the second part of this blog, we look at an interview with the Guardian given by Robert Chote, Chair of the UK’s Office of Budget Responsibility. Like Mervyn King’s, that we looked at in Part 1, Robert Chote’s predictions are also gloomy.
In particular, he argues that if Greece leaves the euro, the effects on the UK economy could be significant, not just in the short term, but in the long term too.
The concern is that you end up with an outcome in the eurozone that creates the same sort of structural difficulties in the financial system and in the economy that we saw in the past recession, and that that has consequences both for hitting economic activity in the economy, but also its underlying potential. And it’s the latter which has particular difficulties for the fiscal position, because it means not just that the economy weakens and then strengthens again – ie, it goes into a hole and comes out – but that you go down and you never quite get back up to where you started. And that has more lingering, long-term consequences for the public finances.
The interview looked not just at the effects of the current crisis in the eurozone on the eurozone, British and world economies, but also at a number of other issues, including: the reliability of forecasts and those of the OBR in particular; relations between the OBR and the Treasury; allowing the OBR to cost opposition policies; the economic effect of cutting the 50p top rate of income tax; the sustainability of public-sector pensions; and tax increases or spending cuts in the long term.
In Part 3 we look at attempts by the G8 countries to find a solution to the mounting crisis.
Robert Chote interview: ‘I would not say in the past there’s been rigging’ Guardian, Andrew Sparrow (18/5/12)
UK ‘may never fully recover’ if Greece exits euro Guardian, Andrew Sparrow, Helena Smith and Larry Elliott (18/5/12)
British economy may ‘never quite recover’ from a severe Euro collapse The Telegraph, Rowena Mason (18/5/12)
Economic and fiscal outlook Office for Budget Responsibility (March 2012)
- Why is it very difficult to forecast the effects of a Greek withdrawal from the euro?
- Why may Greek withdrawal have an effect on long-term potential output in the UK and the rest of Europe?
- Why are economic forecasts in general so unreliable? Does this mean that we should abandon economic forecasting?
- Why are public finances “likely to come under pressure over the longer term”?
- Why might the cut in the top rate of income tax from 50% to 45% have little impact on economic growth? Distinguish between income and substitution effects of the tax cut.
This has been a week of gloomy prognostications. On Wednesday 16 May, the Bank of England published its quarterly Inflation Report – and it makes worrying reading.
The forecast of UK economic growth for 2012 has been reduced from 1.2% in the previous report to 0.8%. But the rate of inflation is forecast to remain above the 2% target well into next year. However, at the two-year horizon, inflation is now forecast to be 1.6% – below the target, thus giving the MPC scope for further quantitative easing.
In the introduction to the report, the Governor, Mervyn King, writes:
Over the past year or so, two factors have hampered the recovery and rebalancing by more than expected. First, higher-than-expected world commodity and energy prices have squeezed real take-home pay, dampening consumption growth. Second, credit conditions, far from easing, have in some cases become tighter. The direct and indirect exposures of UK banks to the euro-area periphery have affected funding costs as the challenges of tackling the indebtedness and lack of competitiveness in those countries have intensified.
And at the news conference launching the report, he said:
We have been through a big global financial crisis, the biggest downturn in world output since the 1930s, the biggest banking crisis in this country’s history, the biggest fiscal deficit in our peace time history and our biggest trading partner – the euro area – is tearing itself apart without any obvious solution.
The idea that we could reasonably hope to sail serenely through this with growth close to the long run average and inflation at 2% strikes me as wholly unrealistic. We’re bound to be buffeted by this and affected by it.
The following articles look at the Bank of England’s predictions and at the challenges facing the UK economy as the crisis in the eurozone deepens and as inflation in the UK remains stubbornly above target. They also look at the issue of the extent to which capacity has been lost as a result of the continuing weakness of the UK economy. As The Economist article states:
Business surveys suggest only a small proportion of firms are operating below capacity. That finding looks odd given the economy’s output is still 4% below its level at the start of 2008, and is much farther below the level it would have reached if GDP growth had continued at its long-term rate. The picture painted by surveys could be right if a chunk of the economy’s potential has been written off for good. But Sir Mervyn King, the bank’s governor, doubts this. There is “no obvious reason” why the economy could not rejoin its pre-crisis path, though it might take a decade or two to get there, he said on May 16th.
We look in more detail at the question of lost capacity in Part 2.
Bank of England cuts growth forecasts: Sir Mervyn King’s speech in full The Telegraph (16/5/12)
Bank of England sees inflation up and growth falling Independent, Ben Chu (17/5/12)
Hard going The Economist (19/5/12)
Bank of England optimism dented again Financial Times, Chris Giles (16/5/12)
Eurozone is ‘tearing itself apart’, says Mervyn King. True, but the UK’s problems are as intractable as ever The Telegraph, Philip Aldrick (16/5/12)
Inflation Report: portal page Bank of England
Inflation Report: May 2012 Bank of England (16/5/12)
Statistical annex to European Economy. Spring 2012 European Commission, Economic and Financial AffairsAnnual macro-economic database European Commission, Economic and Financial Affairs (11/5/12) (see particularly section 6.5)
Forecasts for the UK economy HM Treasury
- What explanations are given for the rate of CPI inflation remaining persistently above the 2% target?
- Why have the prospects for economic growth worsened since the publication of the February Inflation Report?
- How might it be possible to have a narrowing (negative) output gap and yet a stagnant economy?
- Why may capacity have been lost since the financial crisis of 2008?
- Why has M4 declined despite the programme of quantitative easing? (See M4 in record fall despite QE.)
- What scope is there for monetary policy in achieving faster economic growth without pushing inflation above the 2% target?
On the 14th May the IMF published its latest Fiscal Monitor. The key message coming out of this was the need for countries to reduce their public debt ratios, i.e. public debt relative to GDP. Specifically, the IMF is arguing that public debt ratios should be reduced to their ‘post-crisis levels’. In effect, this means countries need to undertake fiscal consolidation. The IMF recognises that the pace of fiscal consolidation should reflect underlying fiscal and macroeconomic conditions, but warns of the dangers of not doing so especially in those countries where the credibility of the current and medium-term fiscal position is weakest.
Underpinning the IMF’s argument for fiscal consolidation is their concern that higher public debt ratios necessitate higher interest rates in order to entice investors to purchase government debt. In those countries with weak fiscal credibility, a sizeable interest rate premium may be needed to entice investors to hold government debt over other types of investments. For instance, we have seen how the markets reacted to the perceived lack of fiscal credibility in Greece and how a series of measures, as discussed in Fixing the Euro: a long term solution or mere sticking plaster were needed to both restore normality to debt markets and to prevent contagion in markets for other country’s public debt.
The IMF argues that the impact of higher interest rates from high public debt-to-GDP ratios would be to reduce an economy’s potential growth. The mechanism by which this would happen would primarily be a reduction of labour productivity growth resulting from lower levels of investment and, hence, from slower growth in the country’s capital stock.
In short, the IMF is arguing that without credible fiscal consolidation plans, countries – particularly advanced economies – run a real risk of restricting their rate of economic growth over the longer-term. Of course, the challenge is to implement fiscal consolidation plans that protect short-term growth by cementing the current economic recovery but do not hinder longer-term growth. Now that is a real challenge!
Fiscal Monitor, May 14 2010 IMF
IMF Says Rising Public Debt Risk ‘Cannot Be Ignored’ Bloomberg Businessweek, Sandrine Rastello (14/5/10)
US faces one of the biggest crunches in the world – IMF Telegraph, Edmund Conway (14/5/10)
IMF says that developed countries must curb their deficits BBC News (14/5/10)
Outlook for rich economies worsening – IMF Eurasia Review (14/5/10)
Britain’s public debt falls under IMF focus Financial Times, Alan Beattie (15/5/10)
Advanced Economies Face Tougher, Not Impossible, Fiscal Adjustment MarketNews.com, Heather Scott (14/5/10)
A good squeeze The Economist (31/3/10)
IMF Data and Statistic Portal IMF
For macroeconomic data for EU countries and other OECD countries, such as the USA, Canada, Japan, Australia and Korea, see:
AMECO online European Commission
- Evaluate the argument put forward by the IMF that fiscal consolidation is necessary to prevent harming long-term economic growth.
- What are the economic dangers of consolidating a country’s fiscal position too quickly?
- What do you understand by short-run and long-term economic growth?
- What do you understand by potential growth?
- What could a government do to increase the perceived credibility of its fiscal position?