The Road to Recovery Gets Steeper
What is one to make of recent economic data, particularly in the advanced countries? Is the world economy slowing? If so, should policy do anything about it and, if so, what might the alternatives be?
In his FT blog of June 5 2011 Gavyn Davies notes that the "speed and extent of the decline in the manufacturing growth has been unusually severe, especially in the US".
What is even more important politically is an estimate that the US private sector created only 38,000 jobs in May, well below a forecast increase of 175,000.
Mr Davies notes that "if we add together all of the business survey evidence for May, we get a picture of a global economy which is probably continuing to expand, but not at a very rapid rate." In all, he writes, "the decline in business surveys has been greater than occurred in the spring of last year, when the world economic recovery hit a temporary pot-hole." But "they they have not yet fallen to anywhere near the levels which would trigger serious concerns about a double-dip recession." This looks right.
It underlines the fact that in the advanced countries as a whole, this has been a weak recovery, particularly given the depth of the recession.
Of the six biggest advanced economies - the US, Japan, Germany, France, the UK and Italy - only the US and Germany had higher gross domestic product in the first quarter of 2011 than three years before and then only by a little.
I regard the four laggards as being still in recession. The fact that the US had the highest GDP, relative to its starting point, of these six countries may be a surprise to some, given its 9 percent unemployment rate in April.
That reveals the flexibility of the US labor market. It also suggests that demand and so output remain depressed.
By the standards not of other rich countries today, but of its own past, the US recovery is extremely disappointing.
So what is going on? The broad answer is that to the long-standing and powerful headwinds of post-crisis recovery have been added a number of more or less temporary ones.
Recessions that have their origin in the collapse of credit-fuelled bubbles are usually more severe and longer lasting than ones generated by attempts to curb inflationary overheating.
It normally takes years for asset prices, above all property prices, to stabilise and excess leverage to be brought down through mass bankruptcy and the slow paying down of excess debt.
During that time, private spending tends to be weak as is the case now in the US, the UK and Spain.
The result also tends to be a huge increase in fiscal deficits, as revenue collapses and spending rises relative to far lower than expected GDP.
This output shock is a more important source of huge fiscal deficits in countries most affected by the crisis than the much maligned and modest fiscal stimuli. This, then, is the structural headwind.
But to this have been added rising commodity prices, notably of fuel, and the impact on global supply chains of Japan's earthquake and tsunami of March 11 2011. The latest surge in oil prices, itself a tax on consumers, partly reflects the "Arab spring".
But more important is an enduring structural shift: the rising impact of emerging giants on global commodity demand. The big question is what policy can do in response to these difficult circumstances.
In its May Economic Outlook, the Organization for Economic Co-operation and Development focuses on fiscal consolidation, moves towards "normalisation" of monetary policy and, above all, on structural policies.
In justifying this, it asserts that "the global recovery is becoming self-sustaining and more broad-based".
Yet the envisaged recovery implies a high degree of economic slack for years. This is very far from "normal".
Second, an array of downside risks exists, among them further commodity price jumps, renewed weaknesses in asset prices and financial or fiscal shocks.
Is structural policy the magic bullet? The OECD argues that "concerns about high unemployment becoming entrenched and a permanent post-crisis reduction in potential output, together with the need to strengthen confidence in the sustainability of public sector debt dynamics.
raise the urgency of enacting well-designed, growth-enhancing structural reforms". This is right.
The OECD stresses that "labor market policies have a key role to play in preventing cyclical unemployment from turning structural".
In the euro zone, increased nominal wage flexibility is needed, in the absence of exchange rate adjustment.
Finally, as the OECD argues, policies that control the growth of long-term fiscal obligations, particularly those associated with ageing, are needed, though it is worrying that many of these hurt the most disadvantaged.
Yet structural policy is not enough. In the post-crisis predicament, demand matters, as well.
Structural policies that raise the incentive to invest are twice-blessed, since these raise demand and potential supply at the same time.
They need to be a priority in designing tax and spending plans. Yet also crucial is getting the withdrawal of fiscal and monetary policy right.
It is far more likely, in current circumstances, that support will be withdrawn too soon than too late, undermining the recovery and generating a prolonged stagnation, with malign long-structural effects.
Three considerations need to be borne in mind. First, the yield on US and German government 10-year bonds fell below 3 percent this week. The US position is striking given the hysteria.
Second, despite the expansion of the monetary base, growth of broader aggregates is well-contained in the US and euro zone.
Further quantitative easing would be perfectly manageable and, if the economy lost momentum, perfectly sensible.
Finally, core measures of consumer price inflation are very low in both the US and eurozone. Targeting volatile and unpredictable headline inflation is quite sure to destabilise the economy.
Since the object of inflation targeting is to stabilise it, instead, that is senseless.
In short, the case for combining structural measures to improve long-run potential output and fiscal positions with continued strong monetary and fiscal support for recovery seems to me, at least, overwhelming in countries with room for manoeuvre.
The biggest danger remains prolonged semi-stagnation in the post-crisis era, not excessive growth and high inflation.
That is, of course, a judgment. But judgment is what we have. Use it.