Is This a Lost Decade for Growth?

Five years into the crisis, the world still faces below-potential growth prospects. The subprime crisis started to unfold in the summer of 2007, and burst in a money-market freeze and credit-crunch in the fall of 2008. A global recession ensued. Between 2009 and 2012, massive fiscal and monetary stimuli prevented a depression, by transferring debt from private to public agents via bank bailouts and central banks’ balance sheet expansion. Most governments’ debt-to-GDP ratios rose above 90 percent, a growth-impairing level. The world’s eight main central banks[1] tripled their combined balance sheets from $5 to $15 trillion. Yet, these policy interventions are falling short of expectations. In Q2-2012, the global economy grew at 2.8 percent, the slowest rate since end-2009. As deleveraging constrains the recovery, the industrialized world suffers from high unemployment and frail consumer confidence. Via trade and financial links, the slowdown is affecting emerging economies, where economic data point to structural weaknesses. It might take a few more years before global growth regains its rising long-term trend.

In the Unites States (US), the economy is muddling-through below-potential. In absence of shocks, the US is set to grow at 2.1 percent in 2012 and 2.0 in 2013. The economy is unlikely to grow above 2 percent despite very significant fiscal and monetary stimuli[2] and a positive business outlook. To sustain growth, incomes need to improve, but a quarter of mortgages are above house value and long-term unemployment is structurally high. Income inequality is widening. Because of anemic employment dynamics (about 100,000 jobs are created per month), four more years are needed to regain the 2007 pre-recession peak, still 4.7 million away. In 2013, the “fiscal cliff” – the automatic expiration of temporary tax-cuts and ratification of expenditure-cuts[3] due to the current political gridlock – could reduce the budget deficit by more than 4 percent of GDP, causing a recession. Vice versa, if Congress were to amend or extend these measures, both deficit and debt would increase. At $60 trillion, the net present value of future liabilities (social security, Medicare, Medicaid) erodes the dollar’s “reserve currency” status.

In Q2-2012, GDP grew at an annualized rate of 1.7 percent, slowing down from 2.0 in Q1-2012 and 4.1 in Q4-2011. In August, unemployment declined to 8.1 percent, from 8.3 in July. Despite signs of housing market stabilization – home prices rose by 1.2 percent in Q2-2012 and home sales by 7.8 in August – personal spending stagnated at 0.4 percent in July and consumer confidence fell in August. Manufacturing activity is also decelerating; in August, industrial production contracted by -1.20 percent and the Institute for Supply Management (ISM) index fell to 49.6, the lowest level since July-2009 – and below 50, the level that separates expansion from contraction. The ratio ‘new orders-to-inventories’ is at its lowest level since January-2009. Declining demand in Europe and China is depressing ‘new export orders’. The consumer price index (CPI) rose by 1.7 percent in August, from 1.4 in July, and the Federal Reserve (Fed) – while announcing a further round of quantitative easing (QE) – kept rates at 0.25 percent.

The Euro-zone (EZ) debt crisis and recession are hurting global prospects. The European Union (EU) is set to contract by -0.5 percent in 2012 and -0.4 in 2013, as a combination of sovereign and banking crisis (over-indebted states and over-leveraged banks keep financing each other), competitiveness divergence, and political impasse hamper growth prospects. Most countries need capital to finance budget and trade deficits. Posing a serious threat to social cohesion, unemployment rose in July to 11.3 percent (25.1 in Spain) and under-25 joblessness reached 22.6 percent (52.9 in Spain; 23.1 in Greece), the highest on record since 1995.

In Q2-2012, GDP fell by -0.5 percent in the 17-country EZ, and leading indicators point to a further -0.5 in Q3-2012. In July, EZ industrial production contracted by -2.30 percent. Business-climate surveys report declining expectations and weakening confidence. The EZ composite purchasing managers index (PMI), which covers manufacturing and services, deteriorated to 46.3 (manufacturing to 45.1 and services to 47.2). As consumer confidence is at record lows, consumption is likely to remain a drag on growth. In July, retail sales fell by -1.7 percent, and were especially weak in Germany and Spain. Despite EZ core CPI down to 1.5 percent in August from 1.7 in July, in September the European Central Bank (ECB) kept interest rates unchanged at 0.75 percent. In Germany, the economy – over 25 percent of EZ’s output – expanded by 0.3 percent in Q2-2012. However, the PMI composite index fell to 47.0 in August, its lowest level in more than three years, signaling a weak manufacturing outlook. Lower growth may hinder German willingness to finance the EZ periphery, where austerity measures and credit rationing hamper growth prospects. Italy and Spain, already in recession, suffered a sharp fall in business activity in August. Despite ECB commitment to conditional bond purchase, sovereign risks and debt restructuring – with Spain next in line – are likely sources of stress and possibly contagion. Spain runs an annual budget deficit of 8.5 percent and has requested a credit line for its banks.

In Japan, post-bubble anemia keeps long-term growth forecasts at 0.9 percent. Between 2012 and 2013, growth is set to decelerate from 2.2 to 0.8 percent. In Q2-2012, GDP grew by 3.5 percent as a result of reconstruction work following the March 2011 earthquake and tsunami. The weakening global economy, however, by depressing exports and industrial output is hampering the recovery. The slowdown in Europe and China is hurting overseas demand for Japanese products. In July, the value of exports to the European Union fell by 25 percent. In August, exports contracted by -5.8 percent and imports by -5.4. In August the PMI fell to 47.7, the lowest level in 16 months. As higher energy prices increase the value of imports, the trade deficit is likely to worsen. As overall macroeconomic data suggest a weakening of Q3-2012 growth performance and CPI contracted by -0.4 percent in July, the Bank of Japan (BoJ) increased monetary loosening by growing its asset-purchasing program to Y80tn.

In Brazil, the economy is decelerating. As Chinese demand for Latin American commodities loses steam, the industrial sector is underperforming. Leading indicators are pointing toward a growth slowdown to 1.6 percent in 2012. In 2013, GDP growth is expected to pick up to 3.8, as fiscal and monetary stimuli sustain demand but also inflation pressures.

In Russia, slow reforms hamper long-term growth. Historically, oil-price increases and commodity exports drove economic performance. After the crisis, given weak external demand and reduced natural-resource revenues, potential growth fell from an average of 7.5 to about 4.5 percent. In 2012 and 2013, meager investment and lower agricultural output will bring about a further deceleration, from 3.6 to 3.5 percent. The reforms needed to spur private-sector development and productivity growth are slow and state-led, but made necessary by macroeconomic and business challenges, such as twin deficits and dependence on foreign financing. In August, after 18 years of negotiation, Russia joined the World Trade Organization (WTO). The accession should improve the business climate by forcing competition into most sectors. Consumption remains the primary growth driver, supported by low inflation and stable interest rates. Expansionary fiscal policy depends on the performance of the natural resource sector. Going forward, the active population is likely to decline and investment spending is needed to support economic performance.

In India, economic activity is suffering from domestic challenges. In 2012, the economy will grow at 5.8 percent, on a declining trend from 6.9 in 2011, and is set to stabilize at 6.2 in 2013. The new five-year plan should spur investment spending, but potential growth is likely to deteriorate in absence of fiscal consolidation and structural reforms, aimed at improving government effectiveness and the business environment. Indeed, several factors are putting a drag on economic expansion, such as reliance on subsidy spending, growing fiscal and current account deficits, major infrastructure bottlenecks, rapid inflation, rising interest rates, a gloomy business sentiment, banking sector fragility, and corruption claims. The current political gridlock and lack of government direction are unlikely to be resolved by the upcoming elections. In Q2-2012, thanks to a 9 percent increase in government spending, the GDP grew by 5.5 percent. In July, industrial production grew by a meager 0.1 percent. The cash reserve ratio – one of the key instruments of monetary policy – was cut to 4.5 percent in September, despite a 7.5 percent increase in wholesale prices in August.

In China, economic rebalancing entails a multi-year slowdown. In 2012 and 2013, GDP is expected to grow at 7.7 and 7.5 percent, below 8 for the first time this century, hampered by a weak property-market, lower export to recessionary Europe, and capital outflows. The economy’s reliance on infrastructure-spending and property-speculation, which has priced middle-class families out of big-city markets, needs policy action. In the long run, domestic consumption can drive the economy, but time is needed for reforms to unlock savings. Required conditions are strengthened social safety nets, improved financial liberalization, and a non-undervalued exchange-rate. In the absence of these measures, government-led policy stimuli can still support growth. Indeed, to contain the slowdown the central government approved in September a RMB 1 trillion (2 percent of GDP or $158bn) fiscal-expansion package, to build 25 urban rails in 19 cities, 13 highways for a total of 2,000 km, nine waste water treatment plants and seven waterways. At the same time, most top tier cities (Beijing, Shanghai, Guangzhou and Hangzhou) increased land supply. Yet, policymakers know that reviving growth via increased fiscal spending and reduced interest rates (and bank reserve requirements) is likely to delay needed structural reforms. Fixed-investment – at about 50 per cent of GDP – is already high and possibly inefficient. Eventually, over-investment will lead to overcapacity, declining productivity, low returns and bad debt, resulting in lower potential growth. In Q2-2012, as external and domestic demand faltered, exports and residential investment fell, imports decelerated, and growth declined to 7.6 percent, the slowest rate since the financial crisis. CPI rose to 2 percent in August, from 1.8 in July. Industrial production slowed to 9.2 percent in July, down from 14 percent a year earlier. In August the official PMI fell to 49.2, its lowest level in nine months and the HSBC manufacturing PMI declined to 47.6. Exports grew by a mere 2.7 percent, while imports fell by -2.6. While unsold goods increase stocks, ‘new export orders’ were at their weakest since March 2009. Shanghai’s stock market is at a three-year low. Corruption and rent-seeking are increasingly deplored, but still tolerated.

In Turkey, growth depends on global macro-conditions, which remain fragile. Over the past 10 years, GDP growth relied on external financing, suffered volatility, and averaged 4.4 percent. With 74 million citizens and a growing young population, demographic fundamentals are supportive of long-term growth prospects. However, as 900,000 young adults enter the workforce every year, unemployment is likely to remain structurally high. In 2012, growth will slow to 2.2, to pick up to 4.8 percent in 2013. Exports are decelerating, because of external demand weaknesses and stagnation in the EU, the major trading partner. The current account is burdened by a trade deficit, mostly due to energy prices and currency depreciation. The fiscal position is deteriorating, as slower economic activities reduced tax revenues and the government increased stimulus-spending. An outlook-induced deceleration of capital inflows remains the biggest risk to economic performance. Domestic credit conditions – currently tight to preserve currency stability, reduce inflation, and gradually readjust the external balance – are restraining consumption and investment. Inflation is forecast at a concerning 9.2 in 2012, but the policy interest rate is likely to be reduced from 5.7 in 2012 to 4.1 in 2013.

Downside risks remain and threaten the outlook. The global economy is threatened by the possible spillovers of “tail risks”, low-probability, high-impact events that could have systemic consequences via negative feedback loops. In the US, EU, and China, policymakers’ guarded or delayed actions hint at partisan divisions, insufficient leadership and preoccupation for power. With the US presidential election and China’s politburo transition approaching, policy mistakes – such as excessive fiscal tightening – due to political deadlock or wait-and-see attitude could induce a contraction in the US, a prolonged recession the EU, and a hard-landing in China. In the US and EU, policy tools are almost out of steam: fiscal space is tight and – with the unlimited bond purchases by both Fed and ECB – the risks of a liquidity-trap are rising. Global geopolitical risks are high. A conflict between Israel and Iran, tied to Iran’s nuclear ambitions, as well as Iran’s closure of the Strait of Hormuz provide an upside risk to oil prices, but are unlikely. Syria’s civil war, the Arab turmoil and China’s rising power are unlikely to be frictionless. Banks, in need of capital and allergic to regulatory reform, will foster financial sector jitteriness. Unemployment, already affecting 200 million people worldwide (up 27 million since the start of the crisis, with under-29 joblessness at almost 100 million), is likely to depress consumer confidence and spark unrest.

Disinflation to persist, inflation unlikely.  Inflation is low across the globe, and going forward deflationary pressures are likely to outweigh inflationary ones. Thanks to a combination of below-trend GDP growth and high unemployment, unused capacity in good and labor markets should override upward pressure on prices, due to rising food and oil costs. Additionally, despite governments’ spending and central banks’ easing over the past five year, several factors will reinforce downward pressures, such as private sector deleveraging, reduced bank lending, cost-containment, productivity increases, and demographics, as older people have lower spending propensity.

Oil prices are supported by demand-supply dynamics and loose monetary policy. Given the macro environment, the price of a barrel of oil should fluctuate around $90-100 for Brent and $80-90 for WTI. Monetary easing in EZ, US and stimuli in China will provide a floor to prices. While decelerating growth prospects are reducing global demand, in absence of a geopolitical shock global supply is set to grow. In 2012, Iraq is likely to produce more than 3 million barrels per day (bpd) thanks to capacity expansion, regardless of disputes with the Kurdish regional government and frequent sabotages of the Turkish pipelines.  Iran extracts 3 million bpd, but the embargo has reduced exports, dropped from 2.7 million bpd in July 2011 to less than one million one year later. Kuwait is pumping 2.7 million bpd. Libya with 1.8 million bpd is almost back to pre-war levels, and is likely to offset future sanctions-driven declines in Iran’s production and exports. Saudi Arabia remains well positioned to respond to most disruptions in global energy markets.

In this environment, corporations are on hold. As sales, profit margins and corporate earnings might suffer, the corporate world lacks the confidence needed to make significant business and investment decisions. Unable to properly assess the economic outlook – and whether the EZ sovereign debt and US “fiscal cliff” are likely to have systemic implications on 2013 – businesses are reluctant to make longer-term choices about adding workers and capital spending. As business confidence suffers, firms remain unwilling to invest and tend to choose leaders oriented to cost-cutting rather than expansion. Large companies, even when cash-rich, contain capital expenditures and cut corporate research and development. Small and medium-sized firms, a major source of job creation, lost access to capital.

The world economy may be in the middle of a lost decade. Global growth is likely to languish below potential for a few more years.

First, financial crises result in prolonged stagnation. The economy, even when supported by fiscal and monetary expansion, does not regain its rising long-run trend for years. As private and public balance sheets are overstretched by excess leverage, banks increase their core capital and consumers deleverage. Until this process ends, growth hovers below potential. Reducing debt levels becomes essential to achieve job-generating growth and recoup pre-crisis levels of per-capita income.

Second, the most likely shortcut to a sustained recovery is an unfair mix of orderly debt restructuring and mild inflation. In other words, a transfer from creditors to debtors (debt restructuring) and from savers to borrowers (inflation) is the only way to clean up balance sheets whilst maintaining the integrity of the global financial system. In the US, negative-equity mortgages need to be written-down. Germany will have to forgive peripheral-debt and guarantee central government debt of core countries. China will see the purchasing-power of its dollar reserves dwindle.

Third, the path to global rebalancing is likely to be uneven and will lead to lower growth. While developing economies need to spend more, a rise in private consumption is likely to take years. Reducing savings entails cultural changes and difficult policy reforms, such as boosting household income and strengthening safety nets. As advanced economies save more, fiscal consolidation – ongoing in the EZ and upcoming in the US and Japan – will reduce economic activity. In sum, the upcoming drop in consumption in advanced economies will not be offset by final demand in emerging markets, where most countries still rely on export-led growth.

Fourth, governments and central banks cannot create growth; they can at best prevent it from dropping. Monetary authorities now bear most of the policy-making, but are in experimental territory. Going forward, monetary expansion will increasingly be less effective in stimulating aggregate demand, hence unlikely to achieve job-creation. Central banks’ actions buy time for governments to enact economic reforms better suited to address the crisis’ underlying causes. Alas, fiscal policy is paralyzed by partisan politics or deficit-reduction needs. Ideally, the US, EU and Japan should go beyond the electoral cycle and launch a five-year fiscal strategy: more stimulus (high-return investments to jump-start growth) over the next two years and credible medium-term austerity, accompanied by structural reforms. Unfortunately, this is politically arduous.

Fifth but not least, demographic decline is weakening growth prospects across the world; Japan and Southern Europe are ahead of the trend, but Eastern Europe, Russia, and Asia are following behind. Lack of demand will hamper economic activity over both the short and medium term.

[1] US Fed, People’s Bank of China, European Central Bank (ECB), Bank of Japan (BoJ), Bank of England (BoE), Germany’s Bundesbank, Banque de France, and Swiss National Bank.

[2] These include: a) deficit at 8 percent; b) debt (including social security) up from 66 percent of GDP in 2006 to 104 percent in 2012; c) benchmark interest rate at 0.25 percent; and d) Federal Reserve balance sheet expansion.

[3] These include $98 billion in federal spending cuts and the expiration of: a) $280 billion Bush-era tax cuts; b) $120 billion payroll-tax holidays; and c) $40 billion unemployment insurance.

One Response to "Is This a Lost Decade for Growth?"

  1. Aegean1972   September 27, 2012 at 4:04 am

    Theres no doubt that we are facing a lost decade. If you think of it, the first five years have already passed (in the places were the crisis has started since 2008).
    Just stimulous packages wont "cut it" (long term). We need a combination of :
    1) political-will for change and real problem solving, along with stimulous packages
    2) investment from cash-rich corporations for job creating in their countries of origin (US & EU)
    3) Gradually bring jobs back from Asia and EM's to the US and Europe. This is key for another 20 years of growth.

    Globalization of the last 30 years is what eliminated the low to middle class jobs in the West and this is the main reason the masses stopped spending, which is a major factor why money stopped flowing and the crisis started. Unless this analogy rapidly starts to change, dont expect growth in the Western world (europe/US). No matter how many trillions you throw in the "bucket" as stimulous money.