The world economy
The next recession
Toxic politics and constrained central banks could make the
next downturn hard to escape
Oct 11th 2018
JUST a year ago the world was enjoying a synchronised
economic acceleration. In 2017 growth rose in every big advanced economy except
Britain, and in most emerging ones. Global trade was surging and America
booming; China’s slide into deflation had been quelled; even the euro zone was
thriving. In 2018 the story is very different. This week stockmarkets tumbled
across the globe as investors worried, for the second time this year, about
slowing growth and the effects of tighter American monetary policy. Those fears
are well-founded.
The world economy’s problem in 2018 has been uneven momentum
(see article). In America President Donald Trump’s tax cuts have helped lift
annualised quarterly growth above 4%. Unemployment is at its lowest since 1969.
Yet the IMF thinks growth will slow this year in every other big advanced
economy. And emerging markets are in trouble.
This divergence between America and the rest means divergent
monetary policies, too. The Federal Reserve has raised interest rates eight
times since December 2015. The European Central Bank (ECB) is still a long way
from its first increase. In Japan rates are negative. China, the principal
target of Mr Trump’s trade war, relaxed monetary policy this week in response
to a weakening economy. When interest rates rise in America but nowhere else,
the dollar strengthens. That makes it harder for emerging markets to repay
their dollar debts. A rising greenback has already helped propel Argentina and
Turkey into trouble; this week Pakistan asked the IMF for a bail-out (see
article).
Emerging markets account for 59% of the world’s output
(measured by purchasing power), up from 43% just two decades ago, when the
Asian financial crisis hit. Their problems could soon wash back onto America’s
shores, just as Uncle Sam’s domestic boom starts to peter out. The rest of the
world could be in a worse state by then, too, if Italy’s budget difficulties do
not abate or China suffers a sharp slowdown.
Cutting-room floors
The good news is that banking systems are more resilient
than a decade ago, when the crisis struck. The chance of a downturn as severe
as the one that struck then is low. Emerging markets are inflicting losses on
investors, but in the main their real economies seem to be holding up. The
trade war has yet to cause serious harm, even in China. If America’s boom gives
way to a shallow recession as fiscal stimulus diminishes and rates rise, that
would not be unusual after a decade of growth.
Yet this is where the bad news comes in. As our special
report this week sets out, the rich world in particular is ill-prepared to deal
with even a mild recession. That is partly because the policy arsenal is still
depleted from fighting the last downturn. In the past half-century, the Fed has
typically cut interest rates by five or so percentage points in a downturn.
Today it has less than half that room before it reaches zero; the euro zone and
Japan have no room at all.
Policymakers have other options, of course. Central banks
could use the now-familiar policy of quantitative easing (QE), the purchase of
securities with newly created central-bank reserves. The efficacy of QE is
debated, but if that does not work, they could try more radical, untested
approaches, such as giving money directly to individuals. Governments can boost
spending, too. Even countries with large debt burdens can benefit from fiscal
stimulus during recessions.
The question is whether using these weapons is politically
acceptable. Central banks will enter the next recession with balance-sheets
that are already swollen by historical standards—the Fed’s is worth 20% of GDP.
Opponents of QE say that it distorts markets and inflates asset bubbles, among
other things. No matter that these views are largely misguided; fresh bouts of
QE would attract even closer scrutiny than last time. The constraints are
particularly tight in the euro zone, where the ECB is limited to buying 33% of
any country’s public debt.
Spending ceilings
Fiscal stimulus would also attract political opposition,
regardless of the economic arguments. The euro zone is again the most worrying
case, if only because Germans and other northern Europeans fear that they will
be left with unpaid debts if a country defaults. Its restrictions on borrowing
are designed to restrain profligacy, but they also curb the potential for
stimulus. America is more willing to spend, but it has recently increased its deficit
to over 4% of GDP with the economy already running hot. If it needs to widen
the deficit still further to counter a recession, expect a political fight.
Politics is an even greater obstacle to international
action. Unprecedented cross-border co-operation was needed to fend off the
crisis in 2008. But the rise of populists will complicate the task of working
together. The Fed’s swap lines with other central banks, which let them borrow
dollars from America, might be a flashpoint. And falling currencies may feed
trade tensions. This week Steve Mnuchin, the treasury secretary, warned China
against “competitive devaluations”. Mr Trump’s belief in the harm caused by
trade deficits is mistaken when growth is strong. But when demand is short,
protectionism is a more tempting way to stimulate the economy.
Timely action could avert some of these dangers. Central
banks could have new targets that make it harder to oppose action during and
after a crisis. If they established a commitment ahead of time to make up lost
ground when inflation undershoots or growth disappoints, expectations of a
catch-up boom could provide an automatic stimulus in any downturn.
Alternatively, raising the inflation target today could over time push up
interest rates, giving more room for rate cuts. Future fiscal stimulus could be
baked in now by increasing the potency of “automatic stabilisers”—spending on
unemployment insurance, say, which goes up as economies sag. The euro zone
could relax its fiscal rules to allow for more stimulus.
Pre-emptive action calls for initiative from politicians,
which is conspicuously absent. This week’s market volatility suggests time
could be short. The world should start preparing now for the next recession,
while it still can.
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