The World Economy: how did we get here and where are we going?

On Wednesday 26 October 2011, I attended a fascinating lecture at the LSE by Nemat Shafik, Deputy Managing Director of the IMF.

She started with outlining the role of the IMF as a cooperative of 188 countries (the newest member being South Sudan), who poor their resources and finances in order to support each in times of difficulty. She then went on to talk about the current slowdown, its causes, the risks involved if the slowdown was to continue and the potential policies needed to aid a recovery.

Causes of the Current Slowdown.

The causes are twofold.

Firstly, it’s due to ‘balance sheet repair’ occurring across the globe, which is governments and households attempting lowering their debts.

The imbalances have been caused by over spending in advanced economies and low domestic spending in emerging economies, particularly China. She explained how households save 40% of what they earn.

This is primarily due to the fact that there are no public pensions or healthcare provision. Once these two areas are addressed in China, households will be able to increase their domestic spending, lowering the surpluses they currently have.

Secondly, there is a ‘crisis of confidence’ across the developed world which has stemmed from high political uncertainty, highlighted by the debate that US Congress had in raising the US debt ceiling and the political wrangling’s occurring in Brussels and Cannes this week.

Expectations of wage growth have fallen to nearly zero pc, leading to a fall in consumer confidence. The markets have also shifted to buying safer assets, such as gold, 10 year bonds and the Swiss franc.

Confidence has also been influence by the €300bn debt exposure faced by European Banks.

The ‘crisis of confidence’ has also impacted emerging economies. She stated how data has shown ‘decoupling’ between emerging and advanced economies to be a myth. The world is too interconnected for any country not to be influenced by the slowdown in the advance economies.

Risks if the slowdown was to continue

The first risk is the adverse feedback loops which exist from having low growth. This leads to less credit available for banks, leading to less lending to households and businesses, higher unemployment and less tax revenue for the government.

The second risk comes from the paradox of thrift. If all households save at the same time, there is no spending in the economy; aggregate demand falls, causing a recession.

Thirdly the size of the EU sovereign debt and the large US debt.

Finally the statistics have shown that level of income inequality has increased. Shafik stated how it’s been proven that the more equitable a country, the more sustainable growth will be. Thus improving income inequality should be a key driver for all economies.

Policies to aid recovery

The overriding message in terms of what policies should be used to combat the slowdown, was the need for collective action in order to preserve stability and sustain growth.

Firstly, Shafik outlined, those countries with balance of payment surpluses need to start importing more and increasing demand domestically and those deficit countries need to boost their exports. Access to public pensions and healthcare in China, along with an appreciation in the Roubini would help boost domestic demand and imports into China.

Secondly, advance economies need to restore their public finances. She emphasised, however, that this needs to be done at the right pace, not too fast and not too slow and that all countries are different. Some countries, such as the US, can afford to be slower, whereas Greece has to cut its debt a lot quicker.

Thirdly, advanced economies should not worry about inflation and focus on increasing growth and should be prepared to use unconventional policies to get there (e.g. QE). Emerging economies need to keep an eye on their inflation rates and be prepared to tighten their monetary policy.

Finally, some structural policies need to be implemented by different countries. The large about of mortgage debt in the US needs to be addressed, while in the EU, the banks need to be recapitalised to improve confidence. The weaker economies, such as those in sub-Saharan Africa have fared well so far, but need to now rebuild their ‘policy buffers’, which have been used to soak falling demand for exports.

The current climate was succinctly summarised by the chair, Professor George Gaskell, “this current situation is a little like climate change, we all know what we should be doing, but we need to get everyone to agree to it.”

Q&A

I selected some of the questions and answers most relevant for A level and IB students:

What have been the main causes of inequality?

The shift to higher skilled labour economies.

What policies should be used to improve inequality?

The emphasis is on the need to invest in HUMAN CAPITAL in order to provide workers with the higher skills needed to take advantage of the rapidly improving technology.

What is the IMF’s view on the need for a financial tax?

The IMF believe that the financial sector is under taxed as it is not subject to VAT. The IMF believe that a ‘Financial Activity Tax’ would be the most appropriate financial tax to implement. This would be a tax on profit and wages, which is seen as more efficient than a tax on financial transactions.
More detail here: http://blog-imfdirect.imf.org/2010/04/25/fair-and-substantial—taxing-the-financial-sector/

Where is the leadership going to come from for global cooperation that is needed?

The G20, who make up 80% of the world economy.

What policies should the Italian Government being implementing?

The main issue is that the Italian economy hasn’t grown in capital terms in 10 years. They have an inflexible labour market and too much regulation, which is holding back firms.
Further details can be found in the IMF report. http://www.imf.org/external/np/ms/2011/051111.htm

Are the current austerity measures being implemented by many advance economies, too much?

The stimulus required is country specific, but what all countries need to show the markets is that they have a ‘plan’ in the medium term.