Prospects for the world economy

Even as the dark clouds envelope the world economy and protectionist rhetoric start rearing its ugly head, the global economy is clearly staring down the abyss with little hope in sight. In many respects, the world economy today resembles like on big market hurtling down the road to abyss, with each one pulling the other on the way down!

Looking around for possible growth engines to provide the ignition spark to get recovery going, most of the traditional sources of global growth look weak. The traditional engines of growth, the US comsumers, businesses and financial markets are in too bad a state to be of any help to global growth prospects. Trade and cross-border capital flows too inspire little confidence.

One can only clutch at the straws and hope that atleast a few among a "portfolio of choices" strike the target, atleast in the medium term. Despite all the problems they face, most emerging economies still have high savings rate, considerable fiscal cushion, massive capacities laid idle by the drop in exports, and huge untapped domestic consumer base. An appropriate mix of policies can leverage these strengths and incentivize domestic consumption to provide the trigger for economic growth. A healthy does of inflation could help boost consumption.

As Paul Krugman has argued fiscal policies have considerable positive policy externalities, "My fiscal stimulus helps your economy, by increasing your exports — but you don’t share in my addition to government debt... this means that the bang per buck on stimulus for any one country is less than it is for the world as a whole." Therefore, "if macro policy isn’t coordinated internationally — and it isn’t — we’ll tend to end up with too little fiscal stimulus, everywhere".

This highlights attention on the need to co-ordinate fiscal policies among the major economies, so as to deliver the biggest cross-border bang for the buck. Further, given the limited fiscal space available in many major economies, it is important that those that have the cushion like Germany, France, and the emerging economies of Asia contribute substantial quantities to stimulating the global economy. But strong legacies of deficits and inflation mean that countries like Germany remain wary of buying this arguement.

In fact, the trans-Atlantic divergence on policies to combat the crisis is so stark that a point of convergence appears remote. While the US, UK, and Japan want a significant fiscal response, European nations, led by France and Germany, oppose fiscal expansion and are fixated on overhauling financial regulation. Charles Wyplosz argues that the differences in opionions across the Atlantic are reflective of the deep divergences in the way economic policies are prepared and understood, "US calls for a coordinated macroeconomic policy reaction to the ongoing recession, France and Germany are calling for microeconomic measures to prevent the next crisis. While the US is concerned about mounting unemployment and the associated distress of millions of households, France and Germany worry about their public debts."

The strong social safety nets and automatic fiscal stabilizers such as welfare payments to the unemployed, which are present in Germany and France means that they and other mainland European economies already have significant fiscal stimuluses already underway. They are therefore naturally averse to further fiscal expansion.

As the G-20 summit beckons in early April, there is an immediate need to substantially "increase the resources available to the IMF, enabling it to increase its lending to prevent the spread of the crisis from corporations to countries, and to provide liquidity support to those emerging markets facing a sudden stop or reversal in capital flows". This assumes significance in view of recent IMF estimates that central and eastern European economies face a financing gap of $100bn in 2009, and the World Bank estimates that 129 developing countries face a financing shortfall of between $270 and $700bn.