C P Chandrasekhar & Jayati Ghosh

An unbalanced recovery

C. P. CHANDRASEKHAR JAYATI GHOSH | Updated on February 14, 2011





While assessments vary in their detail, the consensus is that the recession that began in December 2007 and lasted 18 months has now, finally, been followed by recovery. The basis for such optimism is not, however, robust.

With 2010 behind us, there has been a spate of updates on the world economy. Led by the International Monetary Fund (IMF), a number of agencies carried their estimates to Davos to cheer business and political leaders who had gathered there.

All these estimates, however, seem influenced by the impatience that comes from having waited three years for the downturn to bottom out and reverse in the direction of recovery.

To recall, the Business Cycle Dating Committee of the National Bureau of Economic Research in the US, which is the standard bearer when it comes to this activity, had dated the recession induced by the financial crisis to December 2007. That recession, estimated to have lasted 18 long months, ended without signs of a robust recovery. It is not surprising, therefore, that the desire for a return to what would be “business as usual” was and is overwhelming.

Capitalism is, of course, not a system that tends to dip relentlessly to its own doom. More so because it is a system that functions in a context of nation-states with national governments that are bound to stretch themselves to correct recessionary trends.

As a result, even when Great Recessions occur, a return to growth is more than likely. This is what did happen over the last three years, particularly the last two, when governments expanded expenditures and central banks pumped in liquidity to save the financial system and restore demand.

Taking the world as a whole, GDP growth, which had dipped from more than five per cent in 2006 and 2007 to 2.8 and -0.6 per cent in 2008 and 2009, had recovered to 4.8 per cent in 2010 (Chart 1).

Elements of concern

However, till recently most analysts were not happy with both the speed and the nature of the recovery for a number of reasons. The first, of course was that, while GDP growth had returned to positive territory, job losses were not being fully recovered and the unemployment rate remained high. Thus, the unemployment rates in the US and France were disconcertingly close to 10 per cent over 2010.

Secondly, growth was extremely unevenly distributed across regions and nations, making the thrust of the recovery appear to be largely restricted to a few emerging market countries.

While developing economies saw their growth rate bounce back to 7.1 per cent in 2010, led by developing Asia, the G7 recorded an indifferent 2.5 per cent growth rate and the EU a 1.7 per cent.

Thirdly, even while the recovery was on average not spectacular, there were signs of overheating and inflation across the world, with the price rise being particularly sharp in countries where rates of growth have returned to high levels (Chart 2).

Govts' debt burden

Moreover, world food and energy prices are threatening to spiral to levels that were characteristic of the period when the world experienced a food and fuel crisis.

And, finally, while it is widely accepted that the financial crisis was generated by the accumulation of debt in the balance sheets of households that had been encouraged to indulge in a debt-financed spending spree, the resolution of the crisis has substantially increased debt on the balance sheets of governments in the developed countries (Chart 3) . This is bound to increase the reticence of governments to substitute public for private expenditure as the stimulus to growth.

With these elements of concern persisting, what seems to be occurring is a shift in the tenor of the discussion on the nature and significance of the recovery. In the effort to restore economic optimism and talk up global growth, the favourite phrases doing the rounds today are “two-speed recovery” (coined by the IMF) and “multispeed recovery”. Unevenness in growth, which was earlier seen as a sign of global imbalance, is now being celebrated as cause for optimism.

Three speeds

These phrases reflect the argument that unevenness arises because all segments of the global economy are on a highway to recovery, even if on lanes that permit different speeds.

There are at least three speeds at which the recovery is expected to proceed during 2011: 6 per cent or more in the emerging economies led by China and India, 3 per cent in the US and less than 2 per cent in the euro area. Put together these are presented as a significantly positive rate for the global economy as a whole.

While the working people in a host of countries, developed and developing, may be short of jobs and incomes, a truly global perspective seems to provide cause for optimism.

This desire to talk up the world economy stems from two sources.

The first is the challenge that high and persisting unemployment poses to the legitimacy of the market mechanism, triggering violent protest first in Europe and now in West Asia, which needs to be addressed. What better way than holding out the promise of growth even if it comes from developments either in distant lands or in the future?

The second reason is that financial markets across the globe, which bounced back using the large volumes of cheap liquidity pumped into the system in response to the crisis, are less confident and seem likely to slide downwards again.

Imbuing the markets with optimism is therefore important as well. Uncertainty regarding the recovery generated by developments such as the sovereign debt problems in Europe is partly responsible. Not surprisingly, institutions and fora geared to promoting the legitimacy of market-driven systems are keen to talk up expectations of growth.

Dark clouds

The reality is less accommodating. In each of the segments of the world economy separated by speeds of recovery there are dark clouds in the horizon.

Take emerging markets, for example. Those recording the highest rates of growth are experiencing symptoms of overheating in the form of inflation in goods and/or asset prices.

In China, where growth exceeded 10 per cent in 2010, annual inflation stood at 5.1 per cent in November, which was the highest in two years.

Housing prices too rose 7.8 per cent over the year by December. In India, the quick recovery in output growth has been accompanied by high and persisting inflation, initially focused on food prices, but now increasingly generalised.

In addition, across emerging markets, the inflow of foreign capital fuelled by the availability of cheap credit in the developed countries is resulting in currency appreciation that undermines export competitiveness and hurts growth. Initially, the surges in capital flows to these markets were seen as signs of strength and confidence.

Even the January 2011 Global Financial Stability Report Market Update from the IMF declared: “Stronger economic fundamentals in some key emerging markets, along with low interest rates in advanced countries, have led to a rebound in capital flows, after the significant drop at the height of the financial crisis. Net inflows to emerging market countries now represent around 4 per cent of GDP in aggregate.

By comparison, inflows prior to the crisis were above 6 per cent of GDP. Capital inflows have been accompanied by a large increase in equity and bond issuance, potentially limiting some of their effects on the price of these assets.”

But not much later came news that over the week ending February 4, , global investors pulled out $7 billion from emerging markets, frightened by food price inflation, the turmoil in Egypt and much else. This flight to safety to developed country markets merely reflects the fact that the recent surge in flows to the emerging markets was nothing more than speculative ‘carry-trade' investments encouraged by the infusion of cheap liquidity.

Shift now to the slowest of the lanes on the three-speed global growth highway: Europe. There is no dispute over the fact that fiscal austerity, whether induced by the possibility of sovereign default or voluntarily adopted, is likely to keep growth low well into the foreseeable future.

What is disconcerting is that all the austerity notwithstanding, the prognosis is that the sovereign debt problem in many countries will just not go away but may have to be addressed with restructuring that could convert slow growth into a veritable decline.

Finally, there is the middle lane through which the world's most important economy, the US, trundles.

Twin dangers

There are indeed signs that the US seems to be recording some improvement in growth, even if that growth is jobless. But there are two dangers. The first is that the recovery once again seems to be financed with debt that makes it vulnerable.

The second is that the growth in US consumer spending might encourage emerging markets to return to relying on export-led growth. That would only see a return to the global imbalances associated with the last crisis.

In sum, while the mood in Davos was to stress that the world's economies had got onto a three-lane highway to recovery, the evidence being ignored suggests that we are approaching toll gates that would slow the traffic. Moreover, the road beyond may be so narrow that it could halt the flow.

Published on February 08, 2011

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