Three reasons for global gloom

Lowy Interpreter

Both the World Bank and International Monetary Fund have recently announced new forecasts for world growth this year and next, trimming more than half a per cent off their forecasts made six months earlier.

Seen in historical terms, the central forecast doesn't look too gloomy: the IMF estimates that growth will be 3.3 per cent this year and 3.9 per cent next year, with the World Bank a bit lower, at 2.5 per cent and 3.1 per cent for the same two years. Why was the headline-hungry press able to paint this as such a disastrous outlook? Figures like this would have been regarded as being around average for world growth in the last three decades of the twentieth century. Why so gloomy?

There are three reasons.

First, the starting point has a lot of slack. With the notable exception of Australia, almost all developed countries are still below (mostly well below) the 2007 GDP peak, with serious slack in the labour market. Economies in recovery phase should do much better than their average growth rate. For example, world growth in 2010 was five per cent, before the recovery stalled. Thus world growth of around three per cent does nothing to wind back unemployment and get back to potential output.

Second, world growth somewhere around three per cent looked respectable enough when the GDP of countries like China, India and Brazil were not large enough to have a big influence on aggregate world growth, even when they were growing fast. By 2000 they were not only growing fast, but they had enough weight in world GDP to have a noticeable effect in boosting what would be considered 'normal' world growth. Instead of three per cent being enough to keep economies bubbling along nicely, the new normal is at least four per cent: anything less means some important countries are performing poorly.

Disaggregating the forecast identifies the laggards: the euro area is the worst, with half-a-per cent fall in GDP forecast for this year and less than one per cent growth in 2013.

Third, all the risks seem to be on the downside. All forecasters routinely qualify their latest offering by saying that current circumstances are much more uncertain than usual. For once, this time it is true. In addition to the usual uncertainties of the economy, the politicians are doing their utmost to boost uncertainty, with a marked downward bias. Such is the downside potential for the euro area that the Fund has explored its magnitude in a separate forecast, a sort of paratext around the central forecast story. The euro area could have a growth profile two per cent below the already-stagnant path in the central forecast.

The US, forecast to grow at around two per cent this year and next, faces a continuing housing recession and fiscal drag. The Fund puts it this way: '...in the absence of well-defined and credible fiscal consolidation strategies, there is the possibility of turmoil in global bond and currency markets. A more immediate risk is that an accident-prone political economy will lead to excessive fiscal tightening in the near term in the United States.'

It doesn't have to be like this. Some countries (the UK?) are stuck with low growth prospects because their debt burden has to be addressed, with the austerity this involves. But sensible policies could get Europe on the positive side of the ledger and could bring forward the US recovery. In any forecast, there must be some possibility of underestimating the economy's inherent 'reversion to mean' tendency: getting back to the potential growth path. Upside is not, however, showing in anyone's crystal ball at present.

Originally published by The Lowy Institute publication The Interpreter. Reproduced with permission.