Chance to exit era of crises must be seized

The consensus view of the world economy has become more optimistic, for good reason. The high-income economies seem at last to be taking off; this is particularly true for the United States and United Kingdom. But significant challenges lie ahead, notably for the euro zone. For emerging countries, stronger growth in high-income countries brings benefits but also costs. If euphoria is among the dangers to stability, 2014 should not see too much of it.

The International Monetary Fund set the mood at the annual meeting of the World Economic Forum in Davos. In its update of the October 2013 World Economic Outlook, it slightly upgraded global growth this year to 3.7 per cent (up by just 0.1 percentage points). But it upgraded UK growth by 0.6 points; Japanese and Spanish by 0.4 points; and German and US by 0.2 points.

Nevertheless, forecast growth in high- income countries remains quite low: 2.8 per cent in the US; 2.4 per cent in the UK; 1.7 per cent in Japan; and 1 per cent in the euro zone. If this is right, these economies will not reduce shortfalls in output relative to pre-crisis trends: in the euro zone that shortfall is some 13 per cent; in the US 15 per cent; and in the UK 18 per cent. The high-income economies are achieving modest recoveries from devastating slumps, despite extraordinarily accommodating monetary policy. That remains the depressing truth.

Could the outcome be better than forecast by the IMF? Yes, with the US the strongest candidate for faster take-off: energy costs are low; fiscal tightening has slowed; the financial sector is in decent shape, at least relative to before; the household debt burden has fallen significantly from its peak; and house prices are rising. The work of Harvard's Carmen Reinhart and Kenneth Rogoff suggests it takes seven years to recover from big financial crises. If so, the US may be due faster growth.

Downside risks

The forecast for the euro zone is grim: the 1 per cent growth this year would follow a decline of 0.7 per cent in 2012 and 0.4 per cent in 2013. Spain and Italy are forecast to achieve only 0.6 per cent growth this year. A strong reversal of mood might produce a better than expected recovery in the euro zone. Unfortunately, the euro zone also faces clear downside risks. One is of a decline in expected inflation to ultra-low levels, or outright deflation. Falling prices in high-debt economies increase the burden of debt and so the chances of further debt crises. Another risk is that the forthcoming evaluation of European banks might reveal significant capital shortfalls. If these were met by bailing in creditors, further disruptions of bank funding would be possible, particularly in the more vulnerable economies.

In aggregate, the growth of emerging economies is still forecast at 5.1 per cent this year, up from 4.7 per cent in 2013. Developing Asia and sub-Saharan Africa are expected to lead the way, as usual. China is forecast to achieve 7.5 per cent growth this year .

Emerging and developing economies are extraordinarily heterogeneous. But big global developments affect all, if in different ways. Early last summer, a signal of coming US tightening generated a "taper tantrum". Now that the tapering of asset purchases by the Federal Reserve is under way we have seen a repeat. Such market movements do not presage a plague of financial crises. Argentina is in a mess but few observers can be seriously surprised – countries with large current account deficits and external debts are vulnerable. Corporate indebtedness has also become high in some cases. But any crises should link to country-specific weaknesses. They should not be another pandemic.

Adverse shifts for emerging economies

Nevertheless, even if unaccompanied by crises, the combination of a more challenging external environment with domestic weaknesses could lower growth in many economies. In a recent blog, Zhu Min, a deputy managing director of the IMF, lists four adverse shifts for emerging economies: the tightening in global financial conditions; the decline in China's growth; the fall in commodity prices; and the weakness of international trade. I would add the adjustment in the euro zone, which is occurring via a large swing in the current account towards surplus, matched by an opposite swing in the rest of the world. Such shifts and consequent increases in net capital inflows make emerging economies vulnerable to "sudden stops" in capital inflows.

Mr Zhu also notes that over the past five decades growth of incomes per head in emerging countries has not on average been faster than in high-income countries. On the contrary, while growth of incomes per head in emerging countries was indeed faster in the 1960s and 1970s, that ceased to be true in the 1980s and 1990s, before becoming true again in the 2000s.

Failed convergence

Depressingly, average real incomes per head in Latin America are lower now than they were in the early 1960s, making its history one of five decades of failed convergence. Some fear that a prolonged period of relatively weak performance might now recur. Sustaining convergence is tough.

Perhaps the biggest question of all concerns what is going to happen to China. Since 2008 its growth has become increasingly dependent on soaring credit. This cannot be sustainable, any more than investing half of gross domestic product will make sense in an economy growing at three-quarters of its historic rate. Beijing may face a choice between radical reform and so a bigger than planned slowdown now; and postponed reform and a far bigger disruption to growth later on.

What, then, is to be done? Nurture recovery and promote reform is the answer. In the US this means eschewing idiocy in the debate over raising the debt ceiling. In the euro zone it means determined action to expand demand and raise inflation at the very least to the 2 per cent target. In Japan it means the same thing, though there the central bank seems determined to meet the target it has agreed. In emerging countries it means another round of radical reforms, notably so in China, Brazil and India. Not least it means avoiding geopolitical calamities, such as a conflict between China and Japan. Co-operation and communication should be the order of the day.

The chances of an exit from an era of crises do seem bigger than before. They should be seized.

Copyright The Financial Times Limited 2014