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Global Economy: Continuing Recovery But Clouds on the Horizon

The macroeconomic forecasts in the IMF's latest  World Economic Outlook update reflect two opposing forces. Looking back, say over the first half of the year, numbers about economic activity have come in strong, indeed somewhat stronger than we had forecast. These would give reasons to be more optimistic than we were earlier.

Looking forward, however, strong clouds have appeared on the horizon.  They present real dangers and serious policy challenges, and give reasons to be less optimistic than we were earlier.

Assessing the balance of these two forces is a difficult exercise. Our forecast for world growth in 2010 is about 4½ %, a bit higher than our April forecast of around 4¼ %. This revision largely reflects the stronger activity during the first half of the year. Our forecast for 2011 is broadly unchanged, at about 4¼ %.

As always, these world growth rates hide a large difference between and within advanced and emerging and developing economies. Our growth forecast for advanced countries is 2.6% for 2010 and 2.4% for 2011. These low growth rates imply that high unemployment will remain a central issue for some time to come. Our growth forecast for emerging and developing economies is much higher, 6.8% in 2010 and 6.4% in 2011, an upward revision of 0.5% for 2010 and a small downward revision of 0.1% for 2011.

Let me develop these two themes, a continuing recovery, but clouds on the horizon.

The world economy expanded at an annualized rate of over 5 % in the first quarter of 2010. Growth was stronger than expected in most countries, including the United States, Europe, Japan, Brazil, and India. And, in most cases, it has reflected stronger private demand, which is a good sign for the future. The most recent indicators suggest some slowdown of demand, but it is too early to assess how significant this slowdown may be.

The clouds started building over Greece, but quickly extended to Europe, and threaten to cover the entire global economy. Worries about fiscal solvency in Greece turned into worries about fiscal solvency elsewhere. Worries about fiscal solvency have triggered worries about the solvency of banks. These in turn have led to financial turbulence, disruptions in market financing and a freeze in the interbank market in Europe.  Our baseline forecasts are constructed under the assumption that policy responses will be adequate, and will limit the effects on the real economy.

Even in this case ,however, they are likely to have four main macroeconomic implications. The first, which we have already observed, is a depreciation of the Euro. The second is a tightening of bank lending, especially, but perhaps not only in Europe. The third is the need for fiscal consolidation, which, even if well executed, is likely to affect demand and growth adversely in the short run. The fourth is a near-term reallocation of capital flows.

For the rest of these remarks, let me focus on the last two implications, fiscal consolidation, and capital flows.

The current policy focus in advanced countries is to put in place fiscal consolidation plans. While fiscal stimulus was necessary to stem a potentially catastrophic collapse of output in 2008 and 2009, countries must return to a sustainable fiscal path. The question is when, and at what speed.

We believe that the key here is to put in place a credible roadmap”to stabilize the ratio of debt to GDP over the medium term, with the goal of decreasing it substantially over the longer term. In fact, at the recent G-20 Summit in Toronto, advanced economies committed to fiscal plans that will stabilize or reduce government debt to GDP ratios by 2016, which is in line with our recommendations.

We believe that credibility can be achieved in two ways: First by passing reforms which improve the medium and long term outlook, such as increases in the retirement age in line with higher life expectancy. Second, by putting in place fiscal rules, such as limits on the growth of spending over time.

The adjustment should start soon, but too much front-loading, too sharp a cut in deficits this year or next year, would be counterproductive. The recovery in advanced economies is still fragile, and monetary policy (already very accommodative) cannot yet be used to significantly offset the adverse short run effects of fiscal consolidation. Current plans for 2011, which imply an average decrease in the cyclically adjusted deficit in advanced G-20 countries, of about 1.25% strike us as roughly appropriate. However, what is still missing in many countries are ambitious reform to entitlement systems and, in many cases, better fiscal rules.

Let me finally turn to capital flows. Before problems in Europe came to the fore, capital flows to emerging market countries were steadily increasing. Events in Europe have led to a partial reversal. While fiscal worries in advanced countries have made emerging market countries relatively more appealing, higher risk aversion on the part of investors has led them to repatriate funds, leading to a decrease in capital flows to emerging markets. We expect this reversal to be temporary, and we see the trend as one of continuing strong capital flows to emerging market countries.

These inflows present emerging market countries with a difficult challenge, namely how to best deal with them. Two considerations are important here.

The first is that these flows are largely driven by good fundamentals, and likely to be long lasting: limiting their overall size through controls, or fighting their effect on the exchange rate through reserve accumulation, may prove difficult and eventually self defeating.

The second is that many emerging market countries would benefit from a shift from external to internal demand. This would allow them to maintain growth in the face of lower exports to advanced countries, and to better satisfy domestic needs. To achieve this requires both structural reforms and exchange rate appreciations. In this respect, the decisions by China to boost internal demand and allow for more flexibility of the yuan are welcome.

To summarize, while we remain cautiously optimistic about the pace of recovery, there are clear dangers and policy challenges ahead. How Europe deals with fiscal and financial problems, how advanced countries proceed with fiscal consolidation, and how emerging countries rebalance their economies, will determine the outcome.