IMF: Recovery Will Most Likely Not Be Robust

Olivier Blanchard, an IMF economist, has some interesting thoughts on recovery. His position is that, if history is any guide, economic growth will be permanently impaired as a result of the recession.

All this means that we may not go back to the old growth path, that potential output may be lower than it was before the crisis.

How much has potential output decreased? It is very hard to tell: we do not see potential output, only actual output. The historical evidence is worrisome, however. The IMF’s forthcoming World Economic Outlook presents evidence from 88 banking crises over the past four decades in a wide range of countries. While there is large variation across countries, the conclusion is that, on average, output does not go back to its old trend path, but remains permanently below it.

The possible good news is that the trend itself appears to be unaffected: on average, crises permanently decrease the level of output, but not its growth rate. So, if past is prologue, the world economy likely will return to its past growth rate. But, especially in advanced countries, the period of above-average growth, characteristic of normal recoveries, may be short-lived or nonexistent.

Great! We get to pay for our sins in perpetuity. Sounds like one of Dante’s rings. Anyway, he also has some thoughts on the revival of demand:

Just achieving “normal” growth, however, may be hard because of demand problems. The forecasts now predict that growth will be positive in most countries, including advanced countries, for the next few quarters.

But there are two caveats to this news:

• Growth will not be quite strong enough to reduce unemployment, which is not expected to crest until some time next year.

• These positive growth forecasts are largely predicated on a combination of a fiscal stimulus and inventory rebuilding by firms, rather than on strong private consumption and fixed investment spending. Sooner or later, the fiscal stimulus will have to be phased out. And inventory adjustment will also naturally come to an end.

The question, then, is what will sustain the recovery.

Two rebalancing acts will have to come into play. First, rebalancing from public to private spending. Second, rebalancing aggregate demand across countries, with a shift from domestic to foreign demand in the United States and a reverse shift from foreign to domestic demand in the rest of the world, particularly in Asia.

Mr. Blanchard then goes into a lengthy discussion of the changes in consumption among countries that are going to be needed to accomplish his goal of rebalancing. As I am sure you have already guessed, that rebalancing he envisions rests mostly upon a change in China’s domestic consumption.

If you are a regular reader of this blog you will know that I am highly skeptical of any near-term change in China’s citizens propensity to save. Not only is it ingrained but there are a number of valid reasons why anyone living in China would want to have a significant cash cushion. Mr. Blanchard offers up some reasons that might induce the Chinese to save less and consume more including the oft repeated meme that if only China would adopt more social safety nets then her people would be less inclined to squirrel away so much money.

Easier said than done and even if those safety nets magically appear convincing the average Chinese citizen that they will be there when needed is a tall order. Michael Pettis addressed this point in a post recently. From his view inside the country, he is bearish on any meaningful rise in Chinese domestic consumption.

If Pettis and I are right then Mr. Blanchard’s prognosis becomes a bit more dire. He himself declares that if international rebalancing does not begin to occur the US could suffer a prolonged period of very slow growth or pursue fiscal stimulus to a disastrous end. By that he means a serious loss of confidence in the dollar and a subsequent sell-off of major proportions.

It’s also possible that a prolonged period of subpar growth in the US does not lead to overly aggressive fiscal policy but does impact the value of the dollar negatively. Rather than some cataclysmic run on the currency, it slowly devalues over time with the consequent positive effects on exports and imports. Thus does rebalancing occur via market forces rather than through overt governmental actions.

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