by Simon Johnson, Peterson Institute for International Economics
Testimony before the US House Committee on Financial Services, Subcommittee on International Monetary Policy and Trade hearing "Implications of the G-20 Leaders Summit for Low-Income Countries and the Global Economy"
May 13, 2009
The remainder of this testimony will provide background on the current global economic situation and its most likely development over the next 12–24 months. This will be a primary driver of outcomes in low-income countries.
Global Economic Outlook
The global economy remains weak across the board, although the fall in global output may now be bottoming out. Some forecasters are beginning to recognize that growth in 2010 is not a foregone conclusion. The OECD, for example, now forecasts contraction of 4.3 percent in 2009 for the OECD area as a whole, and a 0.1 percent contraction in 2010. This is broadly in line with an "L-shaped" recovery view.
Even that forecast, however, expects quarter-over-quarter growth rates to be positive beginning in Q1 2010. (This is not a contradiction: If growth is sharply negative in early 2009, then quarterly rates can be positive throughout 2010, without total output for 2010 reaching average 2009 levels.) While most forecasters expect positive growth in most parts of the world in 2010, those forecasts seem to reflect expected reversion to the mean rather than any identified mechanism for economic recovery. The underlying assumption is that at some point economic weakness becomes its own cure, as falling prices finally prompt consumers to consume and businesses to invest. But given the unprecedented nature of the current situation, it seems by no means certain that that assumption will hold. In particular, with demand low around the globe, the typical mechanism by which an isolated country in recession can recover, exports, cannot work for everyone.
Like the global economy, the US economy only looks worse than it did two months ago, with some financial-market stabilization but no definite indicators of an incipient recovery. The underlying causes of economic weakness are largely unchanged and widely known:
This combination of reduced spending and reduced credit has sharply depressed aggregate demand, creating a classic vicious cycle where reduced demand leads to reduced economic activity, which leads to reduced spending power via increased unemployment and reduced corporate profits. In addition, concerns about financial-system solvency are constraining the ability of financial institutions to supply the credit needed by the economy. There will likely be a rolling wave of defaults and debt restructurings in the United States and around the world over the next couple of years; this is hard to avoid and constitutes a major reason why the recovery will be slow compared with previous recessions.
On balance, we believe that the Obama administration and Federal Reserve Chairman Bernanke are making every effort to combat the financial and economic crisis. However, some aspects of the response, most notably the fiscal stimulus, have been underpowered. And a combination of ideological and political constraints has hampered the administration's efforts to rescue the banking system. For these reasons, we still do not see the mechanism that will cause the economy to turn around.
In this context, we interpret the recent stock-market rally as indicating that the economic decline is slowing; it does not necessarily denote that rapid recovery is just around the corner.
The lead-up to the recent G-20 summit exposed some of the tensions between the United States (and the United Kingdom) and Europe when it comes to economic policy. To generalize, Europe (led by Germany and France) favors less fiscal stimulus spending, more fiscal discipline, and lower inflation risk; the United States favors more stimulus and more expansionary monetary policy, at the risk of higher inflation.
I favor the US position, for a simple reason. Not only is the current global recession very severe, but it is unlike any we have seen before, and therefore we cannot rely on historical patterns to tell us when and how the recession will end. In that context, and with unemployment climbing virtually everywhere, it makes sense to do more rather than less to turn the economy around. The European position is that their more advanced social welfare systems will both limit human misery and provide an automatic fiscal stimulus, both of which are true. However, European economies are just as vulnerable as ours to a prolonged period of deflationary stagnation, a risk that, unlike Ben Bernanke, they seem willing to take.
Given this divide in opinion, there was no chance for a meaningful resolution at the G-20 summit. However, the G-20 did have some notable achievements. First, increasing funding for the IMF to $1 trillion gave it the capacity to actually bail out multiple mid-size economies, which may become necessary as the recession progresses. Second, by eliminating Europe's de facto control over the IMF (and the United States' de facto control over the World Bank), the summit gave other members of the G-20 more of a stake in helping to develop and support concerted international solutions to the economic crisis. While this could take months or years to pay off, it is an important first step.
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