Martin Wolf


As the latest World Economic Outlook from the International Monetary Fund remarks, “the world economy has entered new and precarious territory”. What are perhaps most remarkable are the contrasts between booming commodity prices and credit-market collapses and between buoyant growth in emerging economies and incipient recession in the US. So where are we? How did we get here? And what should we be doing?

The WEO’s answer to the first question is that the US economy may shrink by 0.7 per cent between the fourth quarter of last year and the fourth quarter of 2008. This is a big shift from the 0.9 per cent increase over that period forecast in the January WEO Update. Moreover, growth is expected to be only 1.6 per cent over the following four quarters. Meanwhile, the eurozone’s growth is expected to fall to just 0.9 per cent between the fourth quarter of 2007 and the fourth quarter of 2008.

While the most important high-income countries stumble, the picture for the emerging economies is of modestly diminished growth: 7.5 per cent growth in emerging Asia this year, with China on 9.3 per cent and India on 7.9 per cent; 6.3 per cent in Africa; and 4.4 per cent in the western hemisphere.

In all, growth of the world economy is forecast to slow considerably, from 4.9 per cent last year to 3.7 per cent in 2008 (measured at purchasing power parity exchange rates). In terms of growth at market exchange rates the slowdown is more significant, down from 3.7 per cent in 2007 to 2.6 per cent. Even so, global growth would remain well above levels in 2001 and 2002 (see chart).

This, then, would be a case of “large earthquakes; not too many hurt”. Yet these forecasts coincide with two huge events: the financial crisis and the commodity price shock. The first is described by the WEO as “the largest financial shock since the Great Depression”. The second is the result either of a gathering inflationary storm or of reaching limits to the rate of growth (or, more plausibly, of both).

Not surprisingly, the WEO concludes that risks are tilted to the downside. So many can be listed: worsening financial conditions; inflation risks; further adverse shocks in the oil market; and disorderly unwinding of global payments “imbalances”, particularly if investors decide that the Federal Reserve has abandoned its duty to conserve the purchasing power of the dollar.

What has brought us to this point has at least five components: the accelerated growth of emerging economies, especially China; the emergence of a huge surplus of savings over investment in significant emerging economies, particularly China and the oil exporters; a long period of low inflation and relatively stable economic activity in high-income countries; financial liberalisation and innovation; and accommodative monetary policies.

Emerging economies have been the engines of growth over the past five years: China accounted for a quarter; Brazil, India and Russia for almost another quarter; and all emerging and developing countries together for about two-thirds (measured at PPP exchange rates) of world growth. Furthermore, notes the WEO, these economies “account for more than 90 per cent of the rise in consumption of oil products and metals and 80 per cent of the rise in consumption of grains since 2002” (with scandalously wasteful biofuels programmes contributing most of the remainder).

Emerging economies have also been huge exporters of capital. China’s current account surplus was 11.1 per cent of gross domestic product last year. Higher prices of petroleum have also shifted income to high-saving countries. The IMF forecasts the aggregate current account surplus of emerging and developing countries at $729bn (€456bn) this year.

The excess savings have been largely absorbed by those high-income countries with liberalised financial systems adept at channelling credit to those people interested in borrowing on the needed scale: households.

The US has been overwhelmingly the most important of these countries (see chart). The Federal Reserve, obliged to keep domestic output more or less in line with potential, accommodated the capital inflow. But in an environment of financial liberalisation and innovation, the resultant excesses produced the disarray we see today.

What, finally, should we be doing? The WEO supports the Fed’s monetary activism and recommends easing to the ECB, as well; it suggests discretionary fiscal stimulus in some countries. It also proposes further currency appreciation and higher interest rates for some emerging economies, notably China.

Yet what shine out to me from this analysis are four longer-term policy questions.

The first is whether the pattern of global payments can or will adjust smoothly, without triggering another round of financial crises, probably in emerging economies, some years hence. Are the latter now financially robust enough to run current account deficits safely?

The second question is how to run monetary policy when a large commodity price shock is under way. Inflation hawks argue that the rate of rise in the prices of everything else should be driven down. The result would be a sustained period of weak growth. At the same time, the longer the rise in commodity prices continues the more difficult it becomes to resist this argument.

The third is what to do about a financial system that has misbehaved so spectacularly. How radically should regulation be changed? Is there, indeed, anything to be done that can make it less crisis-prone, while remaining innovative and flexible?

Finally and most fundamentally, will it be possible to retain a political consensus in high-income countries in favour of a liberalised and globally integrated economy? How do we persuade citizens that the rise of the emerging countries, the brightest story of our era, is to be welcomed, rather than resented or even resisted, when what they experience is financial disarray, falling house prices, recession and soaring costs of essential commodities?

This year is a turning point. It is up to us to make it turn in the right direction. It will not be easy.


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