Prospects for the world economy

We are living in interesting times. And for many these times are not just interesting but are also dismal. With pessimists predicting that there may be a ‘lost decade’ or two for the global economy. The implication is that there will be little or no economic growth for the world economy – with living standards stagnating and businesses struggling to survive. Is this a reasonable prognosis – or are there better times ahead?

Reasons to be gloomy
There are good reasons for pessimism. Amongst the advanced countries, the main focus is on austerity and reducing public deficits and debts. But one of the main structural problems that led to the financial crisis was the accumulation of private sector debts – by businesses, financial institutions and households. For instance, by 2007 private sector debt in the UK was approximately 450% of GDP and in the USA it nearly 300% of GDP – levels that have no historical precedence. Since the financial crisis, many private sector institutions and individuals have been ‘de-leveraging’ by repaying some part of their debt – the counterpart to this, is reduced expenditure on consumption and investment reducing demand for goods and services.

UK debt from FSA

This reduced demand has depressed economic activity, which means Governments should step in to deal with the problem. But many have been reluctant to do so because of concerns about the size of public debts and deficits.

In the Eurozone, the focus on austerity reflects the constraints of a single currency and German paranoia about inflation. If a country has control of its own currency it can use monetary policy (such as interest rates) or exchange rate policy to influence its economy. With a single currency, these policy levers are lost leaving only fiscal policy – Government expenditure, taxation and borrowing – which many European governments used before the crisis – often beyond what was allowed by EU rules. When the financial crisis hit many European countries were hit by a triple whammy: Governments had to bail out the banks, in effect nationalising private sector failures and debts; they could not use monetary and fiscal policy because of the constraints of the EURO; and they had to reduce public expenditure to assuage financial markets that the EURO would not collapse and to placate the electorate in Germany who are concerned that they will pick up the tab.

The UK is also in the midst of austerity economics despite having control over both monetary and fiscal policy and not being hampered by a single currency. Here politics dominate economics: the British economy would be much stronger with a looser fiscal policy and the level of public debt is not high by historical standards and is easily fundable. The problem is the Government’s aversion to the public sector – the usual refrain is that the private sector creates wealth which is then taxed and spent by the public sector. This is simply wrong headed – and arguing that teachers, doctors, nurses and the police do not create wealth contravenes the logic of macroeconomic measurement.

One country that has eschewed the dogma of austerity is the US. Despite threats of fiscal cliffs and political log-jams it has used fiscal policy to help boost the economy. And it has worked – since the onset of recession; the US has had much faster economic growth than either the Eurozone or the UK.

Reasons to be cheerful
Although growth in the Eurozone and the UK are dismal there are parts of the world economy where growth is rapid. Much of world economic activity is now being driven by the BRICS (Brazil, Russia, India, China and South Africa). For pessimists, world economic grow is a zero sum game – if some countries grow they will poach or destroy jobs from slow growing economies. This is wrong: fast growing economies are good for the rest of the world – increasing prosperity abroad will drive up demand for goods and services from the advanced countries.

The most important driver of long-run economic growth is the development and exploitation of new ideas. And since the industrial revolution, the world has been inventive is developing new products and processes. And here, we can be grateful that countries such as China and India and investing in science and technology. This is not a race where we will be left behind – as long as we are open to ideas that are developed abroad. And even in many rich countries there has been an increase in new ideas by Governments through more R&D since the crisis – only in the UK has investment fallen since 2007.

The role of the State
Many countries – such as the UK and those in the Euro zone – are likely to have very low economic growth in the next few years. But growth will eventually resume – particularly when demand starts to return to something like normal and as new ideas are developed. And the role of the state will be important in this process. As economies grow, consumers want more and better education and healthcare – and many of these services are provided by the state. And many of the new ideas that will lead to economic growth are expensive and uncertain and require investment by the state. If we are to ensure future prosperity, the state should not be seen as the problem but as part of the solution.

About mk242013

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