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The long road to sustained recovery

By Martin Wolf
Published: January 26 2010 15:50 | Last updated: January 26 2010 15:50

What a difference a year can make. When the World Economic Forum had its annual meeting a year ago, the world
economy was still in the midst of the hurricane. Now the worst of the storm has passed. Yet how far has the world
economy really come out of the crisis? What are the biggest economic challenges ahead? And what lessons should
we learn from the disaster?

The obvious achievement is the removal of panic from financial markets. Yet that is not so surprising. According to
calculations by the Bank of England, the total support offered to the financial systems of the UK and US
amounted to 74 per cent and 73 per cent of gross domestic product, respectively. Even in the eurozone, it was 18
per cent.

In truth, the balance sheet of the state was put at the disposal of the financial system. Yet states also devoted their
efforts to supporting demand. Central banks – particularly the Federal Reserve and the Bank of England – adopted
exceptional measures of quantitative and credit easing. Fiscal deficits of a scale never seen before in peacetime
also opened up.

The largest deficits emerged, predictably, in the countries where the private sector has been hit directly by the
bursting of the asset price bubbles and consequent financial collapse: according to the Organisation for Economic
Co-operation and Development, the OECD area as a whole ran a general government deficit of 8.2 per cent of GDP
last year, with a US fiscal deficit of 11.2 per cent and a UK deficit of 12.6 per cent of GDP.

These rescues have worked: the downturn in the economy was arrested and reversed, in most high-income
countries. Yet relief must be tempered: in the third quarter of 2009, none of the economies of the Group of Seven
leading countries were significantly larger than at the start of 2006. The hole into which the high-income countries
have fallen is deep.

Emerging economies have done better. This is particularly true for the Asian giants. China used the room for
manoeuvre won by its enormous currency reserves to do a vast amount of fiscal and monetary pump-priming of its
own. As a result, the December consensus of forecasts is for growth of 8.5 per cent in 2009 and 9.6 per cent in
2010. India, meanwhile, is forecast to achieve growth of 6.6 per cent in 2009 and 7.7 per cent in 2010.

The immediate challenge ahead is creating a decent recovery. What is now widely expected this year does not meet
that criterion, at least in the high-income countries.

For 2010, the US and Canada are the only G7 member countries with a consensus forecast growth of more than 2
per cent. But at 2.6 per cent and 2.7 per cent, respectively, growth even in these countries would be insufficient to
recoup lost output, relative to trend. In the European members of the G7, growth forecasts vary from 0.9 per cent for
Italy, to 1.4 per cent in the UK, 1.5 per cent in France and 1.7 per cent in Germany. Japan’s growth is forecast at 1.5
per cent.

This, then, would be a grossly unsatisfactory recovery. These forecasts suggest, too, that there is a risk of
premature withdrawal of monetary and fiscal stimulus. At the same time, there is also a risk of withdrawing the stimuli
too late, with severe consequences for inflation expectations. That could force severe tightening and lead to a
double-dip recession.

Also disturbing is the almost universal desire for export-led growth. Countries hard-hit by the bursting of their asset
bubbles, with weak financial systems and overindebted private sectors, such as the US, UK, Spain and Ireland,
need export-led growth. But countries such as Germany and Japan also continue to rely heavily on export-led
growth. China, too, is hoping that export-led growth will soon return.

Yet it is impossible for countries with a combined GDP close to 70 per cent of the world’s to have the export-led
growth they desire. The world economy needs strong and sustainable domestic-demand-led recovery in important
countries. It is far from clear which these will be. That creates significant doubt about the vigour and sustainability of
recovery itself.

Finally, what are the lessons of the disaster? There are at least two big ones. First, the macroeconomic policy
framework needs to be reviewed. Inflation targeting has proved far less stabilising than advertised. Moreover, fiscal
policy also proved much less tight, particularly in bubble-affected countries, than most people imagined.

Second, financial crises are indeed “an equal opportunity menace”, as Carmen Reinhart of the University of

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Maryland and Kenneth Rogoff of Harvard have argued. It is possible for even the most sophisticated financial
systems in the world to succumb to severe financial crises.

Are policy changes now in place that reduce the likelihood of further severe crises? The answer, alas, seems to be
no. Yet the challenge of creating a global financial and economic system more robust than today’s must now be met.
Rescue and even the beginnings of recovery are not enough.

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