It was not familiar economic forces that caused the upheavals of recent years, but Covid-19 and the war in Ukraine. This reminds us that the most destructive forces we know are indifferent nature and wicked humanity. In its latest World Economic Outlook, the International Monetary Fund (IMF) stresses the “cost of living crisis” and the economic slowdown in China. Yet the policy response to Covid, the unbalanced recovery from that disease and Vladimir Putin’s war caused the former, while China’s response to Covid caused the latter. Disease and war have indeed shaken our world.
These huge surprises have also reminded us that it is impossible to forecast the economy. Often more illuminating is examination of how forecasts evolve. In this case, one can summarise the changes from previous forecasts quite simply: “Just about everything that could go wrong has.” In “fund speak”, “downside risks” have materialised.
What were those downside risks?
First, inflation has been stronger and far more persistent than previously expected: as the World Economic Outlook notes, “Global core inflation, measured by excluding food and energy prices, is expected to be 6.6 per cent on a fourth-quarter-over-fourth-quarter basis” this year. As a result, monetary policy has been tightened sharply.
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Second, the economic impact of Russia’s war on Ukraine has been greater than feared even six months ago. This is especially true for Europe, after the dramatic reductions in Russia’s gas exports.
Finally, Covid is still able to cause havoc, at least in countries whose policies have not evolved sensibly, such as China, and possibly in Africa too, where vaccination rates are disturbingly low.
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Monetary tightening
An outcome of this combination of events is that the US has at the same time seen a sharp monetary tightening, because inflation has been so strong, and yet is in far better economic shape than Europe or China. This, plus its usual “safe haven” effect in times of trouble, has caused a sharp appreciation of the dollar. That is potentially devastating for borrowers with large dollar-denominated liabilities. There may not be a general debt crisis. But debt crises in vulnerable countries are certain.
The result of all this has been a further downgrade of the forecasts. Neither a fall in global output nor one in global output per head is in the fund’s baseline forecast. But a contraction in real gross domestic product lasting for at least two consecutive quarters is expected at some point during 2022-2023 in economies accounting for more than one-third of world gross domestic product. The recent shocks will, as a result, inflict further losses in world output relative to pre-2020 forecasts.
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Moreover, risks are still on the downside. These include: a worsening of the impact of the war; a resurgence in Covid or some other pandemic; a monetary policy that is too forceful, causing a deep recession, or one that is too weak, allowing persistently high inflation; a huge property crash in China; bigger policy divergences among high-income economies, causing yet more financial stress; widespread debt crises in emerging and developing economies; and a further breakdown in co-operation among powerful countries. The last would further fragment the world economy and make impossible any joint approach to a wide range of global challenges, from debt through to climate.
Russia’s war is beyond the reach of normal policy. Sanctions have been tried, but, predictably, have not changed its course, at least in the short run. China’s Covid policy is equally beyond the domain of global action. One assumes it will be changed at some point. When and how remain a mystery.
So, what can and should be done?
Inflation and the vulnerable
First, defeat inflation. As the fund puts it: “Yielding to pressure to slow the pace of tightening will only undermine credibility, allow inflation expectations to rise, and necessitate more aggressive and painful policy actions later. By reversing course, monetary policymakers will deliver only the pain of tightening, with none of the gain.” Expectations have remained anchored because people trust the central banks to do what they are supposed to do. They must.
Second, co-ordinate fiscal and monetary policy. This is perfectly compatible with central bank independence. It makes no sense for these two aspects of macroeconomic policy to be fighting each other.
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Third, protect the vulnerable. The “cost of living” crisis is the worst possible time to slash spending on the weakest. The fund opposes price caps on energy. I disagree. But they must be aimed at lopping off extreme price movements and be fiscally bearable.
Fourth, develop a better framework for handling debt distress. Particularly important in this regard is close co-operation between China and the West. Systemic financial crises are another risk: frameworks need to be made comprehensive.
Fifth, recognise that managing the world economy will require co-operation. An obvious example is Putin’s war. Is it impossible to persuade China that this disaster may threaten its interests, too?
Finally, there is the biggest one: climate. The fund provides an encouraging analysis of this greatest of collective challenges, pointing out that the economic costs of immediate and decisive action to reduce emissions are small, particularly when set against the benefits. Yet it is already desperately late. What we do (or, more likely, do not do) on emissions in the next decade may determine the future of this planet as a home for our own and other species.
We should not let the urgent prevent action on the important. Nor should we let our differences prevent us from agreeing on what we must do. In the environmental crisis, natural forces combine with human folly. This is a formidable alliance. We must end it. – Copyright The Financial Times Limited 2022
