The World Economy in Turmoil

Recession is again at the world economy’s door, with confidence plummeting and investors, businesses and consumers lacking the trust in the future that is necessary to create economic growth. In Europe, the euro crisis seemed to have reached some kind of denouement with last week’s deal on a revised second bail-out package for Greece, although the details remained to be worked out, which unsettled financial markets somewhat. However, with this week’s announcement by Greek Prime Minister Papandreou of putting this new bail-out arrangement to the people in a referendum, markets are back in panic mode (since this creates huge uncertainty around any resolution of the debt crisis in Greece). If Papandreou wins his bet, he will have a strong mandate to pursue fiscal and structural reforms and all will be well; however, if he loses, then this will be the end of Greece in the euro and the EU, with almost certain contagion throughout the eurozone. Such an outcome could end up breaking the euro and, ultimately, the EU apart.

But Europe is not the only trouble spot, although it is certainly the most worrisome. Japan and the United States continue to have weak economies, with little macroeconomic margin of maneuver to stimulate their economies, owing to their high levels of indebtedness and already very loose monetary policies. Moreover, both countries are seeing important inflows of capital, because global investors see them as safe havens where they can park their money in times of economic turbulence. Unfortunately, this causes their currencies to appreciate in value, thereby making exports more expensive and hurting growth further. This is why the Japanese government is intervening in foreign exchange markets to try to lower the relative value of the yen. But such beggar-thy-neighbour policies usually end up making things worse for everyone—the reason why some have referred to such actions as “currency warfare”.

And what about the BRIC countries, in which many put their hopes for leadership in pulling the world economy out of its present misery? After experiencing rapid growth in recent years, Brazil’s economy is now decelerating as foreign capital moves out of the country in search of safer havens, and as world commodity markets cool down. The same situation applies to Russia. As for India and China, their rapid pace of economic growth is slowing as their central banks tighten monetary policy in order to prevent inflation, both in goods and assets, from getting out of hand, and as exports to Europe and North America weaken owing to declining demand. Hence, I would not count on the BRIC countries to pull the world economy out of a looming recession.

As for bailing out Europe, I would not count on the BRIC countries either for that. Their slowing-down economies will be their main policy focus for the coming months; and their finances are not as rosy as many seem to think. For instance, China might have trillions of dollars in its foreign exchange reserves, but its level of total government indebtedness is rapidly approaching 100% of GDP if local government debt is included. This has the result of increasing the riskiness of China’s financial system.

We are hence faced with a dire situation for the world economy, a lack of easy solutions from the BRIC countries, and a high risk of governments turning inwards to deal with their troubles by adopting policies that might make sense when taken individually but become hurtful when combined at the global level. Given all this, the task facing the world leaders—that is, to restore confidence among economic agents—becomes all the more difficult as well as crucially important.


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