Author: Uri Dadush
Originally published by the Carnegie Endowment for International Peace
2009 was a terrible year for the world economy—worse than any other in the postwar period. But, propped up by public support and the rebound of emerging markets, it ended much better than it started and better than expected just a few months ago. Still, most forecasts for 2010 expect the recovery to be slow by historical standards, with the world economy growing below potential for the third year in a row and unemployment remaining high. Studies suggest that this is par for the course for the average financial crisis.
But is this the average crisis? With industrial production and trade recovering rapidly and stock markets continuing to rally, two questions arise: Are forecasters again underestimating the strength of the global recovery? And, if so, should policy makers accelerate the withdrawal of stimulus?
The answer to the first question is, quite possibly, yes. But the answer to the second is, with a few exceptions, no.
Turnaround in 2009
Recovery came faster than expected in 2009, especially in emerging markets. In the third quarter, trade and industrial production grew at or near record rates across a large swath of countries. Though world trade is still some 9 percent below its 2007–2008 average, it grew at an annual rate of 19 percent in the three months to October. December data, including trade numbers from China and purchasing manager surveys (reliable leading indicators) across many countries, also indicate that rapid growth is continuing. In addition, oil and other activity-sensitive commodity prices are continuing to rise.
Global industrial production (IP) is still down about 5 percent from its 2007–2008 average, but the crisis has had notably different effects on the large economies. China’s IP is up a remarkable 23.7 percent and the U.S. decline has been less pronounced than that of Japan and Europe.
Industrial Production
% from pre-crisis levels a
| Country/Region | November 2009, %b |
| World | -4.7 |
| United States | -9.6 |
| Japan | -15.9 |
| Germany | -14.4 |
| UK | -12.2 |
| China | 23.7 |
| a Compared to 2007–2008 average, seasonally adjusted. | |
| b China data is from October 2009. | |
Source: World Bank, Global Economic Monitor. |
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Consensus and IMF Outlook
Consensus forecasts expect GDP growth in 2010 to be 2.7 percent in the United States, and close to 1.5 percent in Japan, Germany, and the UK, with slightly faster growth projected for 2011. These forecasts are based on observations that GDP is currently below trend by a wide margin and that credit remains tight. They also assume that deleveraging by households, banks, and firms will be slow and confidence-sapping. Reinhart and Rogoff’s analysis of 66 financial crises, which finds that output tends not to recover to its trend path, supports these estimates.
At the same time, they imply a very slow rate of recovery compared to previous recessions. For example, based on these projections, U.S. GDP would only recover to its mid-2008 pre-crisis peak a full two and a half years later, in the fourth quarter of 2010, and recovery to that point from the trough, reached in the second quarter of 2009, would occur at the slow annual rate of 3 percent. In other words, according to these projections, the recovery would be two-thirds as fast as the one that followed the 1981–1982 recession—now the second worst recession in the postwar period—when interest rates and inflation hit double digits.
Similarly, the IMF has argued that output in countries hit by a financial crisis could remain some 10 percent below previous trend levels “in the medium term.” If the medium term is taken to mean 5–10 years, that projection would imply cumulative output losses of 50–100 percent of GDP. This seems excessive, and may be one reason that the IMF is, according to its managing director, about to upgrade its projections.
A Better Outlook
Will this recovery conform to the average post financial crisis experience, or will it be different? Four factors distinguish this financial crisis from previous ones and, combined with the building global growth momentum, they suggest that growth in 2010 may in fact be faster than many expect.
First, the policy effort has been unprecedented, and will continue to help in 2010. Most importantly, across the world, low policy interest rates are growing increasingly effective, stimulating both consumer and investment demand more as the world exits the “liquidity trap” amid declining risk aversion and an intensifying search for yield.
In addition, much of the fiscal stimulus has yet to enter the OECD economy. For example, according to the CBO, only $190 billion of the $787 billion U.S. stimulus package had been applied by the end of September 2009 ($100 billion in increased expenditures and $90 billion in tax cuts). And bank support is continuing. For example, of the 737 institutions that received bailout funds from the U.S. Troubled Asset Relief Program (TARP), only 58 have repaid completely, with many small and medium-sized regional banks still receiving support.
At the same time, the support that has been given has worked. Most of the largest U.S. and European banks have begun to repay bailout funds and, though this is, in part, a sign that they want to pay big bonuses, it also indicates that they have grown sufficiently confident in their capital bases. The U.S. government has ratcheted down the estimated cost of its banking rescues to 1 percent of GDP and the large surge in risky asset prices in the second half of 2009 suggests that estimates of loan losses still on bank books are also being brought down.
Second, low policy interest rates and positive wealth effects are likely to lead to a stronger replacement cycle. Across the advanced countries, expenditures on all deferrable goods—houses and cars, as well as investment in equipment and inventories—are still at historically very low levels, and construction activity is 25 to 40 percent below pre-crisis levels. The inventory-to-sales ratio in the United States fell to the pre-recession average of 1.28 in December indicating that the downward inventory adjustment is over. In fact, spending on all of these deferrable items (except for investment in commercial structures) grew in the United States, Euro area, and Japan in the third quarter of 2009. In contrast to the sharp declines in the first half of 2009, continued increases in these expenditures could easily lead to growth that is 0.5 percent above consensus forecasts in 2010.
Third, the non-financial sector in the advanced countries appears to have reacted very sharply to the crisis, cutting inventories and capital expenditures faster than warranted by the fall in demand. Especially in the United States, where employment cuts were most aggressive, this has been reflected in rapid labor productivity growth and better-than-expected profits. For these reasons, job growth is expected to resume soon (jobs grew in November but fell again in December).
Fourth, emerging economies are on a high growth path and will continue to lend a hand, particularly given that contagion effects—protectionism, competitive exchange rate devaluations, and sequential sovereign debt crises, which caught on in past financial crises—appear contained. China, now the world’s largest trading nation, is expected to grow rapidly again in 2010, setting the tone for the wider Asian region, which now accounts for more than one third of world imports (excluding intra-EU trade) and is relying more on domestic demand. J.P. Morgan forecasts that the exports of the large advanced countries will grow at double digit rates in 2010, and the IIF predicts net private capital flows to emerging markets will double in 2010, further releasing credit constraints.
If the advanced countries grow at 2.5 percent in 2010, instead of the 2 percent implied by consensus, the recovery will still be modest by past standards, but the outlook for employment, asset prices, and government revenue may be considerably brighter than many fear.
So, Should Policy Be Tightened Sooner?
Generally, the answer is no. Despite this cautiously optimistic assessment, the consequences of underestimating growth remain much milder than those of overestimating it.
The main risks of underestimating growth—the surreptitious build-up of inflation and the sudden appearance of asset bubbles—remain mild in most countries. So far, core inflation indicators are still subdued or negative, and even if growth proves to be stronger than forecast, wage inflation in the advanced countries appears far off. Similarly, widespread asset bubbles have not yet appeared, with most stock prices still below historical averages relative to book values and forward earnings. In addition, in the advanced countries, higher asset prices will help repair the impaired balance sheets of banks and households.
At the same time, the consequences of underestimating growth may be greater in the few advanced countries that suffered a very mild recession (Norway, Israel, and Australia) and in the giant emerging markets (China, India, and Brazil) that avoided a banking crisis and are now experiencing a more advanced recovery and soaring asset prices. The prudent approaches adopted by policy makers there are justified.
In most advanced countries, however, it is the consequences of overestimating growth that remain dire, with confidence still fragile and balance sheets still strained. The effect of withdrawing stimulus, especially the pace of monetary policy tightening, continues to pose the most significant risk.
Historically, many problems are uncovered during a period of policy interest rate hikes, and it is difficult to predict what they might be. Obvious areas of vulnerability include commercial real estate in the United States, several of the 20 emerging markets that currently have IMF programs, and the weaker Euro area members. But there may also be complete surprises.
After 2010
Beyond 2010, the picture becomes murkier, but not necessarily dimmer. The advanced countries will have to deal with the legacy of the crisis: a complex combination of much higher debt levels and fiscal deficits and a liquidity overhang. As expenditure cuts and tax increases become inevitable, inflationary expectations intensify, and economies grow even more vulnerable to adverse shocks, investor and consumer confidence may plummet. On the other hand, a more robust recovery in 2010 could accelerate the healing process and set the stage for catch-up to pre-crisis GDP trend levels. This happened in about one quarter of the financial crisis episodes reviewed by Reinhart and Rogoff. Not after the average crisis, mind you—but then, there is nothing average about this crisis.
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