The Crisis Is Dying, Slowly

Author: Uri Dadush
Originally published by L’espresso”

The global economy’s slow and painful healing from the financial crisis continues. According to the IMF’s July report, for example, world output growth – expressed at market exchange rates – will be around 2.5 percent this year and about 0.5 percent faster next year. These rates of growth represent a downgrade of the IMF forecast just three months ago and are far slower than those that preceded the crisis, but they still mean the average world citizen will see a rise in living standards, and many will see improved job prospects. In addition, indicators of the last fortnight, including production and consumer surveys in the Eurozone and the seemingly irrepressible optimism in stock markets, provide encouragement.

But how certain can we be that the recovery is not a false dawn and that it will take hold in the countries most devastated by the crisis, namely those in the European periphery? There are no certainties, but the chances, in my view, are good.

There are three great challenges confronting the global recovery

The first challenge is exiting stimulus policies in the United States. The first phase of stimulus exit, consisting of a large fiscal contraction (the so-called “fiscal cliff”) appears to be occurring so far without significant damage to consumer and investment demand, which is clearly recovering. The second phase of stimulus exit lies in the future and consists of the Fed reducing its bond purchases, and judging by the near-panic in financial markets that followed a speech by outgoing Chairman Bernanke announcing its imminence, could prove to be more problematic. Yet, the Federal Reserve Bank remains very sensitive to the fact that unemployment remains high and is determined to ensure that monetary tightening will only occur in response to clear signs that the economy is strengthening.

The second challenge is to avoid the recent sharp slowdown in emerging markets, most notably China, becoming a rout. Growth has also slowed sharply in Brazil, India, Turkey and Russia, among others. Yet, even with this slowdown, emerging markets as a group continue to benefit from technological catch-up, high savings, big investments in education and favorable demographics. They are still growing at rates near 5 percent. China suffers from overly large and misallocated credit-fueled investment as well as inadequate demand by households. But as its huge reservoir of surplus labor depletes, China’s wages are now rising fast, pointing to a country less competitive in international markets and more inclined to consume. China is unlikely to return to the explosive 9-10 percent growth of the last three decades, but its solid fiscal position, robust household balance sheets, and huge reserves suggest it will find a way to sustain a more moderate pace and continue to support the global recovery.

The third and greatest challenge is to complete the extremely painful adjustment in the European periphery. Countries such as Spain and Italy need to regain international competitiveness and reorient the economy away from domestic activity, such as construction and public services, towards exports and import-substitutes, such as manufacturing and tourism. This is now happening at a steady if unspectacular pace and is reflected in sharply lower current account deficits. For example, in 2012 and 2013, exports in Italy and Spain have grown in line with world trade (around 2.5-3 percent), while imports fell about 3 times faster than GDP. In economies such as Italy and Ireland, the consolidation of the government sector has been largely achieved and throughout the European periphery the domestic sector has been downsized with new construction, for example, essentially disappearing. Domestic demand will only fall so far, however, as many households will run down their assets, even if modest, to maintain basic consumption and firms will invest in efficiency even if they do not add capacity. Sooner or later, perhaps this year or in early 2014, the domestic sector will stabilize at a painfully low level and the international sector will begin to slowly pull the economy out of the slump. As confidence returns credit will begin to flow again, but a return to full employment is unfortunately many years away.

Many will stay at home for the summer holidays, and only the most fortunate inhabitants of the Northern hemisphere will head to the beaches or the mountains. But we can all be more confident than at any point in the last five years that things are looking up. Fingers crossed.