Global Economic Growth Is Fragile – Here’s Why
The gradual strengthening of the global expansion that we projected in the February 2017 Economic Review , following the seven-year low for world GDP growth reached in 2016, seems to be materialising. Recent data have remained mixed, but suggest on balance that global growth is strengthening moderately and becoming more broadly based, including among the members of the Euro Area and among emerging market economies that have suffered severe recessions in recent years. We are thus forecasting that the growth of world GDP strengthens from 3.1 per cent last year to 3.3 per cent in 2017 and 3.8 per cent in 2018. However, our new forecast has been constructed at a time of unusual uncertainties, which imply several risks to the forecast.
One uncertainty concerns the interpretation of recent economic data in the advanced economies. In recent months, ‘soft’ data obtained from surveys of purchasing managers, businesses and consumers in several of these economies have become markedly more positive, while ‘hard’ data obtained from actual spending and production have generally been more subdued. This divergence may be resolved by an acceleration of economic growth or by a disappointment of expectations. In the latter case, there is a risk of a reversal of recent gains in asset markets.
Second, there is unusual uncertainty about how economic policies will evolve in the United States. In the area of fiscal policy, the administration has outlined proposals for spending and taxes beyond the current fiscal year, but support for them in Congress is unclear. In the area of international trade, there have been promises of dramatic protectionist action but policy changes thus far have been relatively cautious. In the area of monetary policy, the unusually high turnover that is in prospect at the Federal Reserve Board in the coming months gives the president an opportunity to reshape the Fed in a relatively short period. On all these fronts, our forecast assumes no change in established policies, pointing to significant risks.
Third, there is unusually high political uncertainty in Europe associated with the elections taking place, or due to take place in the coming months, in all of the Euro Area’s three largest economies.
In the context of these uncertainties, the following risks stand out.
First, expectations of stronger economic growth indicated in survey data may be disappointed, leading to a reversal of recent gains in asset markets, especially equity markets, which a number of indicators suggest are richly valued. Sharp equity market declines would be likely to damage both private consumption and investment.
Second, the Fed may increase interest rates faster than we assume in our forecast, for example if US fiscal expansion increases prospective inflationary pressure in the economy, which is already operating close to full employment. Such additional increases in US interest rates would tend to crowd out not only private domestic spending, partly by reducing asset prices, but also net exports, partly through appreciation of the US dollar. The US external current account deficit would therefore tend to widen, contrary to the administration’s objective that it should be reduced in order to boost US economic growth. This could lead to increased protectionist pressures, and the widening of global payments imbalances could also jeopardise international financial stability.
The rise in US interest rates and appreciation of the dollar would also have repercussions for emerging market economies, including increases in the debt burdens of countries with liabilities denominated in the US dollar (for more detailed discussion see Box C in the current Review).
Financial pressures from expansionary US fiscal policy could be exacerbated if the administration’s budget plans were to incorporate over-optimistic assumptions about US economic growth. One of the main objectives of the administration’s fiscal (and other economic) policies is to raise the rate of US economic growth, with officials referring to objectives of 3 or even 4 per cent annual GDP growth. It is difficult to see how such goals could be reached in the short to medium term, given the recent trend growth rate of about 2 per cent, roughly composed of 1 per cent employment growth and 1 per cent growth of labour productivity. Given that the economy is close to full employment, policies can raise output growth significantly and in a sustained way only by boosting either the growth rate of the labour force or the growth rate of labour productivity. Both of these have slowed in recent decades (see figure 1). Significantly faster economic growth thus seems a dangerous assumption on which to base fiscal policy.
Figure 1. US GDP growth decomposition
Third, given the unusually large turnover in prospect on the Fed Board in the coming months, there is a risk that the Fed’s independence may be diminished and that upward pressure on inflation may not be resisted by monetary policy. Confidence in macroeconomic stability and longer-term growth prospects could then be severely damaged.
Fourth, there are the risks arising from US-led protectionism. Protectionist or defensive trade policies damage economic efficiency and productivity growth by weakening competitive forces, raise domestic costs and prices, reduce real incomes, and risk a downward spiral of economic activity through successive international retaliatory measures. Thus far, the administration’s actions in this area have been limited (see Box A in the Review for more detailed discussion), but preparatory work is in train on a number of questions, which may lead to counter-productive actions in the months ahead. The risks from increased protectionism are discussed in Box B of the Review.
Fifth, there are risks that the reviews of financial sector regulation being conducted by the administration could lead to more lax regulation and supervision of financial institutions, with adverse consequences for the danger of future financial crises.
Finally, the unusual concentration of national elections in the EU in the coming months poses substantial upside and downside risks for the future of the Euro Area and the EU. An upside risk is that the European project could be re-energised by needed reforms. A downside risk is that the project could collapse as a result of resort to nationalistic economic policies.