Strengthening recovery, new risks

Growth is picking up in the OECD area–at different speeds across regions–and at a faster pace than expected in the previous Economic Outlook (November 2009). Strong growth in emerging-market economies is contributing significantly. However, risks to the global recovery could be higher now, given the speed and magnitude of capital inflows in emerging-market economies and instability in sovereign debt markets.

Keeping markets open has been a strong positive factor in the upturn. The rebound in trade, while incomplete, has been substantial and is proving to be a major force pulling the global economy out of recession. The ongoing recovery in activity could surprise on the upside, with a policy-driven expansion giving way to self-sustained growth. Fixed investment could bounce back more robustly and household consumption could recover more rapidly with household savings rates having risen more slowly than previously anticipated, especially in Europe. The spillover from growth in non-OECD Asia could be stronger than expected, especially in the United States and Japan. From this point of view, the overall economic environment is relatively auspicious.

As activity gathers momentum, global imbalances are beginning to widen again. However, in some emerging-market economies, notably China, strong domestic, policy-driven demand is keeping a large external surplus from rising to the levels seen prior to the crisis. This does not obviate the need to tackle global imbalances through appropriate policies. As discussed in this Economic Outlook, strong, sustainable and more balanced growth can be achieved through a combination of macroeconomic, exchange-rate and structural policies, while delivering fiscal consolidation. Identifying and implementing such a combination of policies is a major goal of international collaboration, most notably within the G20. Progress in financial market reform will also require international collaboration. Internationally agreed rules and regulations will need to be established to strengthen the stability of the global financial system. Articulating more clearly the roles of monetary and prudential policies in dealing with future credit and asset-price developments is also a priority.

This otherwise moderately encouraging outlook could be jeopardized by significant risks. A first substantive risk is related to developments in sovereign debt markets. While originating in some euro-area economies, instability has spread to other euro-area members and sovereign debt markets in other parts of the world.

Overheating in emerging-market economies also poses a serious risk. A boom-bust scenario cannot be ruled out, requiring a much stronger tightening of monetary policy in some non-OECD countries, including China and India, to counter inflationary pressures and reduce the risk of asset-price bubbles. Growth would slow down as a consequence, with negative effects on other regions. Exchange-rate flexibility could alleviate some of the pressure on Chinese monetary policy and allow more scope for addressing domestic inflation.

These risks indicate that policy challenges are substantial and more demanding than appeared to be the case a few months ago.

Bearing in mind these risks, monetary policy must be normalised. Support is already being removed in several countries. Exit strategies must take into account concomitant fiscal consolidation so as to facilitate it without putting undue pressure on interest rates. The outlook for inflation remains benign in the OECD area due to considerable economic slack, but inflationary expectations may become unanchored. As mentioned earlier, emerging-market economies are having to deal with inflationary pressures and to absorb sizeable capital inflows. Strong growth in those economies is pushing up energy and commodity prices, which in turn will lead to further inflation.

Exit from exceptional fiscal support must start now, or by 2011 at the latest, at a pace that is contingent on specific country conditions and the state of public finances. Many countries are facing very unfavourable government debt dynamics, as rising indebtedness raises risk premia, which adds to the debt burden while holding back growth, with further adverse consequences on debt sustainability. A related challenge is that several countries are having to embark on fiscal consolidation simultaneously. Given the magnitude and synchronicity of fiscal consolidation, international spillover effects could further bear down on the growth in demand in individual countries.

Prompt and massive response by euro-area governments and the European Central Bank have calmed financial market turbulence. But the region’s underlying weaknesses are far from settled. Fiscal consolidation has been stepped up and front-loaded in some countries. But fundamental structural adjustment programmes will have to be implemented, as announcements alone may not be enough to secure credibility in consolidation strategies.

The sovereign debt crisis has highlighted the need for the euro area to strengthen significantly its institutional and operational architecture to dissipate doubts about the long-term viability of the monetary union. At a minimum, surveillance of domestic policies needs to be strengthened, taking on board broader competitiveness considerations. But these efforts alone may not be enough. Bolder measures need to be taken to ensure fiscal discipline, along a continuum that ranges from stronger surveillance and more effective sanctions for non-compliance, to external auditing of national budgets, all the way to de facto fiscal union.

In all countries, there is a need for sustained and sustainable economic growth also in support of fiscal consolidation. This calls for an articulated strategy linking together – and exploiting synergies among – macroeconomic, financial and structural policies. Fiscal consolidation must be designed and implemented to support growth to the extent possible. Spending cuts must be made to preserve, and indeed increase the cost-effectiveness of growth-friendly programmes, including innovation and education. Revenue-raising measures, where needed, must focus on the instruments that are least harmful to growth, such as consumption and carbon taxes. Fiscal rules can help to enhance the credibility of fiscal consolidation. Growth-enhancing structural reforms must be part of consolidation strategies.

This differentiated, yet synchronised, pattern of normalisation across policy domains and countries underscores the importance of domestic policies in one area taking due account of policy settings in other domains and countries. It also raises the possibility of exchange-rate movements and exposure of vulnerabilities in the financial sector.

Labour and product market reforms need to be implemented to raise potential output, support innovation and prevent high unemployment from becoming entrenched. These reforms can yield concomitant dividends in terms of facilitating fiscal consolidation and reducing global imbalances on a durable basis. The development of social security and services in China and other Asian economies with large current-account surpluses fulfils an important social goal in its own right and would reduce the need for precautionary saving, thereby further promoting domestic demand. In other surplus countries, different types of structural reforms would unleash opportunities for investment, while pension reforms and the removal of tax incentives that encourage consumption would increase household saving in deficit countries.

In the autumn of 2008 the peak of the financial crisis led to unprecedented and coordinated policy responses that prevented the recession from becoming more severe and long lasting. Recent action taken by euro-area countries, also in coordination with other major economies, is of comparable dimension and momentum. Both have been welcome and necessary, and have been taken under the pressure of rapidly evolving circumstances. The fact that the second set of actions has been taken eighteen months after the first is a reminder that the period of significant financial instability that began in August 2007 is not yet over.

The scale and scope of these two episodes has also highlighted the fact that short-term policy responses are not without long-term consequences. Above all, rising indebtedness and widespread moral hazard will reduce room for policy action, if needed in future to cope with new emergencies. Dealing with such consequences, while returning to strong, sustainable and balanced growth, will require coordinated, decisive and sustained efforts at the international and country levels.


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This article is based on the editorial of OECD Economic Outlook N° 87, June 2010. Order the full edition at www.oecd.org/bookshop


©OECD Observer N° 280 July 2010




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