Prospects for the World Economy in 2012

C.P. Chandrasekhar and Jayati Ghosh

There is a palpable sense of gloom and impending doom in most discussions of the world economy today. Even before, several economists had argued that the excessive optimism about ”V shaped recovery” that was being used to describe the economic revival in 2010 was premature and misplaced, especially as none of the fundamental contradictions of global capitalism that led to the previous crisis had been adequately addressed. But they were once again written off as Cassandras by the financial media, which desperately sought sources of ”good news” and future engines of growth particularly among the emerging markets.

Now even the most stalwart establishment voices are expressing growing concern and pessimism. Oliver Blanchard, Chief Economist at the IMF, has issued what must be an unprecedentedly sombre and even dismal statement at the close of the year, noting that recovery is at a standstill in the advanced economies and recognising that 2012 may face even worse economic conditions than 2008.

Blanchard refer euphemistically to ”multiple equilibria – self-fulfilling outcomes of pessimism or optimism, with major macroeconomic implications” and effectively suggests that unless private expectations are managed better by decisive government policies, negative expectations will become self-fulfilling. But it is harder for governments to ”manage expectations”, because private investors themselves are schizophrenic about government deficits and economic growth. Financial markets effectively appear to demand fiscal consolidation by putting very high spreads on the bonds of governments with high ratios of public debt to GDP or fiscal deficit to GDP. And then investors in these markets are very surprised (and react adversely) when attempts at fiscal austerity reduce economic activity and growth prospects.

This has already created a self-reinforcing cycle of contraction in the eurozone, and as long as European leaders (and incidentally the IMF) continue to press for fiscal austerity, this will continue. Meanwhile the peculiar political configurations in the US make it unlikely that any real fiscal stimulus will emerge to ensure a more broad-based and stable economic recovery. The belief currently expressed by many economic commentators, that a ”big bazooka” in the form of even looser monetary policy of the European Central Bank and the US Federal Reserve, will be sufficient to lift economic activity, is unwarranted.

Chart 1 shows quarterly growth data for real GDP since the trough of the crisis in late 2008. It is evident that Blanchard is completely correct in noting that the recovery in the major advanced economic regions is sputtering if not dying. (Data in all charts is based on IMF’s Global Economic Indicators database.) Output growth in Japan has already turned negative once again in the most recent quarters, while it is sluggish in the US and likely to become much worse in the euro area given the inability to resolve the internal problems of the eurozone.

In the past global recession, many developing countries suffered quite sharp declines in output but then the recovery was also faster and more buoyant. Chart 2 shows a sample of emerging market economies (and does not include China and India about which enough discussion already exists). Real GDP recovered more sharply in the economies that had experienced the biggest slumps, but despite this, since the middle of 2010 there has been a deceleration in almost all of the economies described here.

This sluggish recovery or beginning of renewed recession is of major concern not just in itself, but because even the period of recovery was already not associated with much improvement in labour market conditions. Chart 3 shows that in the three major advanced economic regions, open unemployment rates increased during the Great recession, and since then have remained at these high levels despite subsequent increases in incomes and economic activity. Chart 4 shows that (other than for Turkey and Brazil) a similar process was also under way for the emerging economies considered here.

A September 2011 report from the ILO to the G20 found that in the first quarter of 2011, only a handful of countries (notably, Argentina, Brazil, Turkey and Indonesia) had absolute employment levels that were above the levels of the first quarter of 2008, before the eruption of the global crisis. In some countries both output and employment were still below their earlier levels (including the developed world: European Union, the US and Japan) while in others like South Africa, output had recovered but employment was still lower than in early 2008. So the weakening prospects for the world economy come at a time when labour market conditions are already very fragile across the world.

This is extremely bad news for the developing world. Already, it is evident that it is misplaced and even foolhardy to hope that economic expansion in China, Brazil, Russia and some other countries will be enough to compensate for the slowdown in the advanced economies. In sheer quantitative terms, total incomes and import demand in these countries simply cannot counterbalance the falling net demand from US and Europe. But there are further reasons why developing countries – including those that are currently being expected to save the world economy – cannot expect an easy ride in the coming year themselves.

First, most developing regions are directly affected by the slowdown in import demand from Europe, and to a lesser extent the US. For example, manufacturing exports from developing Asia, particularly China, are already affected by the slowdown in Europe and the process is likely to intensify in the coming months. Second, the reduction in China’s exports affects its own demand, as the complex export production platform it is the centre of in Asia reduces demand for raw materials and intermediates. Third, many developing countries have also been affected adversely by the sudden and rapid outflow of mobile finance capital, as banks and other financial institutions book their profits in emerging markets in order to cover their losses. This has also been associated with rapid depreciation of several emerging market currencies, which causes their import bill for oil and other essential goods to increase, but not necessarily affecting their exporting potential in the current climate.

Fourth, there are reasons to be more concerned than many analysts appear to be, about the immediate prospects for the Chinese economy. As the housing bubble in China is pricked and real estate prices fall, this will have negative multiplier effects on all related activities in construction and so on. The debt deflation associated with falling asset prices may also affect consumption and employment. So there is a serious internal threat to growth, unless the Chinese government takes active measures to revive consumption, without relying on expansion of household debt. In many other emerging markets, the previous boom was associated with credit-driven bubbles, and as these are burst, the prospects for economic expansion will similarly be affected.

So there are good reasons for Blanchard of the IMF and others to be gloomy about global economic prospects. However, unless they and others who have real influence on economic policy making across the world argue for a real change in both economic paradigm and current strategy, things are unlikely to look up in the coming year.

This piece was originally published in the Business Line.