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To the Point, 2010 March


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To the Point, 2010 March

  1. 1. To the Point Discussion on the economy, by the Chief Economist March 30, 2010 Cecilia Hermansson Chief Economist Economic Research Department +46-8-5859 1588 No. 3 2010 03 30 The art of doing it right Our global forecast from March 18th envisaged a slow recovery for the world economy with diverging developments between industrial countries and emerging markets. The outlook for China and India is clearly positive with GDP growth rates of 8-9%, while growth in the US, Europe and Japan more or less stays between 1 and 2.5%. The somewhat faster upturn in the US this year is mainly a result of inventory adjustments and stimulus measures, while underlying demand in most mature economies will remain weak. A slow and bumpy recovery may not be problematic as long as a double dip can be avoided. More important are the many policy challenges facing the world economy in general, and industrial countries in particular. Deleveraging in the private sector, consolidating public finances to deal with sovereign debt, withdrawing monetary policy stimulus, and rebalancing growth in Europe as well as globally are just a few. In addition, structural adjustments to counter increasing competition from emerging markets, climate change, energy renewal, the development of welfare systems and demographics are issues that must be addressed by policymakers. This version of To the Point discusses the art of doing it right over the next few years. We limit the discussion to the following areas: 1. Realistic policy-making 2. Monetary policy and financial regulation 3. Fiscal policy 4. Rebalancing growth 5. Growth policies and structural reforms Realistic policy-making With so many challenges facing policymakers at the same time, policies have to be coordinated at many different levels, such as: 1) between fiscal and monetary economic policies, 2) between countries and regions, 3) between national political parties, and 4) over time. Policymakers have been successful in managing the crisis, but will they also be successful in preventing new ones? The dilemma they face is that as long as there is a risk that the recovery will come to a halt, financial regulation should not be altered nor should austerity measures be put in place, but when the growth outlook has substantially improved the window of opportunity may have closed. Therefore, the lessons learnt from the crisis must be kept alive and policies must be coordinated from a long-term perspective. There are challenges for politicians in developing policies that may come into practice many years after they have left the political scene. In addition, most practices are local or national, even though they are affected by other countries’ policies. Creating policies on a regional or global level – and with a longer horizon – is much more demanding for policymakers than usual.
  2. 2. To the Point (continued) March 30, 2010 2 Chart 1: Inflation in the OECD countries 1972-2010 Source: Reuters EcoWin 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 Percent -2.5 0.0 2.5 5.0 7.5 10.0 12.5 15.0 17.5 Most economic policies announced, for example, in the EU or the US have incorporated optimistic growth assumptions over the next few years. This may prove counterproductive if there is no Plan B. Why not be more cautious on growth assumptions as the crisis in itself may have lowered potential growth and altered economic models used to calculate growth? This would leave room for more realistic policies going forward. At a minimum, worst case scenarios should be created with a Plan B attached. Monetary policy and financial regulation Central banks face challenges on many fronts. Balance sheet policies must be scaled back as the crisis abates, but when government bonds or the housing market are involved it will be much more difficult to phase out the stimulus. Keeping the repo rate low for an extended period of time may be good for the real economy, but the transmission mechanism is not as strong as usual, and instead of supporting companies there is a risk that household credits grow too fast in countries where housing markets have been robust during the crisis. There are tests ahead for central bankers in combining financial stability with price stability. We could see a situation with lingering problems in the financial sector and increasing inflation in consumer prices. Most likely, the goal of price stability will be set aside if financial stability is threatened. There is also a need for more research on how to combine these goals. So far, dealing with asset prices seems to have been asymmetric in the sense that interest rates have been lowered (in particular in the US) when asset prices have fallen, but have not increased when asset prices have risen too fast. Leaning against the wind is one way of taking asset prices into consideration, but more research is needed, not least to understand the impact of often volatile asset prices on monetary policy. Instead of discussing these challenges, there has been unreasonably large focus on the acceptable level of inflation. IMF Chief Economist Olivier Blanchard may have an academic interest when he suggested it would be worthwhile to analyse the pros of raising the level from 2% to 4% so that monetary policy could respond more aggressively to economic shocks. For practitioners it must have seemed like a joke. At a time of growing uncertainty regarding central banks’ and governments’ commitment to keeping inflation low, it is important to stick to the anchor created. It has taken years to develop inflation expectations around 2%, and by altering them the confidence in central banks and governments may be lost. Besides, while the level may be raised in theory, in practice it is not possible to increase inflation “just a bit”. If raised to 4%, why not 6% or 8%? And higher and more volatile real interest rates would clearly be more of a disadvantage to the economy than an advantage. Monetary policy will have to be reformed in the years to come. Inflation targeting focused solely on consumer prices will have to be complemented with a larger focus on asset prices, credit growth and financial stability in the longer term. In the meantime it is important to stick to the inflation targets that have been set up as policy makers’ commitment to keeping inflation low is being questioned. While overregulating the financial sector must be avoided, there is still a need for smarter regulation and supervision. The most important thing is to make the financial sector less procyclical and more macro prudential. Creating incentives to reduce the risk of moral hazard is also important, as is creating a financial sector that can be an intermediary for the capital needed to facilitate growth and structural transformation. As the financial sector will always be fragile, the right level for capital requirements is hard to find. Too high of a requirement will raise capital costs for companies and households, and too low of a requirement could increase instability in the longer term.
  3. 3. To the Point (continued) March 30, 2010 3 Chart 2: Fiscal position in selected OECD- countries 0 50 100 150 200 250 -16 -14 -12 -10 -8 -6 -4 -2 0 Japan USA UKIreland Greece Spain France Portugal Eurozone Belgium Italy Germany Finland Sweden Public debt, % av GDP Budget balance,% av GDP Fiscal policy As central banks unwind their balance sheet policies and keep repo rates low, governments must deal with rising sovereign debt causing turbulence on financial markets and negatively affecting growth. In countries like Ireland, Greece, Portugal and the Baltics, budget consolidation has already begun. In the Baltics especially, there is an awareness of the need for austerity, but in many other EU countries this awareness is still lacking. For the US, UK, France and other large economies, there is also a need to create awareness. It will no longer be possible for them to live beyond the means, as it most likely will become harder to find financing in the future. Because banks may also have to raise more capital, the combination of high sovereign debt and tighter financial regulation may increase interest rates going forward. Budget consolidation will most likely start during the next year in most larger economies. Still, there is lack of detail in the austerity plans, and most growth assumptions are too optimistic. How to raise taxes and lower expenditures when voters are not ready can certainly be a challenge. In the EU, there is still a vision of expanding the welfare state, lowering working hours, and further reducing taxes. Add the demographic challenge, and the equation will be hard to solve. After the high inflation of the 1970’s and 80’s, new institutions were set up in many countries, such as inflation targeting, an independent central bank, etc. Efforts to create lower inflation expectations were successful, and inflation targeting served its purpose for many years (but became too narrow-minded when asset bubbles started to blow up more frequently). Now it is time to strengthen institutions that create budget discipline in both good times and bad. Sweden is a case in point. After the financial and property crisis in the early 1990’s, expenditure ceilings and budget goals were established, improving fiscal discipline since then. The fact that most EU countries allowed budget deficits during the good times points to the need for such institutions, including independent fiscal councils and fixed targets. Rebalancing growth Germany should not become less competitive, as has been suggested as a solution to rebalancing growth within the Euro zone. Of course, countries like Greece, Portugal and Spain must become more competitive. The agenda for 2020 rightly points to reforms to increase competitiveness in Europe as a whole. As these countries must improve their external balances, however, there must be increasing demand from outside of Europe to absorb the larger European export volumes. Where is this demand going to come from? Countries with high surpluses today (e.g., China, Japan, Germany, Arab countries, Singapore, Norway and Sweden) will be the ones best able to absorb most of the rebalancing of growth. They have more leeway to increase demand among companies and households. The problem is that it takes time. In China, for example, the social security system must be developed in order to lower the need for savings, and that is a slow and complicated process. The US congress is pressing the Obama administration to declare China a currency manipulator on April 15th, when a report is due to be presented by the Treasury. If this happens, the US may take the issue to the World Trade Organisation (WTO) or start raising tariffs on Chinese products. As China will not succumb to foreign pressure, there is a risk that declaring China a manipulator will develop into a trade war. If anything, this would be devastating to global economic growth going forward.
  4. 4. To the Point (continued) March 30, 2010 4 Chart 3: GDP Growth according to Swedbank’s forecast -8 -6 -4 -2 0 2 4 6 8 10 12 USA EMU Japan China India Global GDP 2009 2010 2011 2012 Economic Research Department SE-105 34 Stockholm, Sweden Telephone +46-8-5859 1000 Legally responsible publishers Cecilia Hermansson +46-8-5859 1588 China has increased imports during the crisis and become a growth engine in the world economy, although perhaps not sufficiently so. The rebalancing must continue, as the US and the UK can no longer be consumers of last resort; other countries must slowly take over. For Europe to take greater responsibility, the key is to continue with growth-oriented policies and structural reforms that increase domestic demand, for example, by integrating service markets. Growth policies and structural reforms The best way to reduce sovereign debt in industrial countries is not by increasing inflation. A recent IMF study by Carlo Cottarelli shows that with 6% inflation (instead of 2%), public debt as a share of GDP would be 8 percentage points lower in 2014 in the OECD countries. Therefore, inflation would have to be much higher for several years to have a substantial impact on debt ratios, and then there would be significant disadvantages for the real economy. Raising taxes and cutting expenditures considerably could cause anaemic growth for years. So despite the need, there also have to be structural reforms and growth-oriented policies that at the same time enhance growth. Notwithstanding the stimulus measures used to boost demand, the recovery in the industrial economies has been less than convincing. Supply side measures must be added, such as improvements to education and research systems, better rules for entrepreneurship, and micro-oriented reforms that improve efficiencies in labour markets, housing markets and product markets. The EU in particular has much to gain by increasing competition and better integrating the service sector. Further, climate change could create incentives for investments in green infrastructure, including energy. Without bold measures, there is going to be a long period of slow growth in many industrial countries. This will make it much more difficult to face growing competition from emerging markets, where there is no need for austerity measures and credit markets are functioning better. With so many challenges facing our policy makers, a lot of credit must go to those who make the hard decisions. Who said the art of doing the right thing was easy? Cecilia Hermansson To the Point is published as a service to our customers. We believe that we have used reliable sources and methods in the preparation of the analyses reported in this publication. However, we cannot guarantee the accuracy or completeness of the report and cannot be held responsible for any error or omission in the underlying material or its use. Readers are encouraged to base any (investment) decisions on other material as well. Neither Swedbank nor its employees may be held responsible for losses or damages, direct or indirect, owing to any errors or omissions in To the Point.