Photo by Dave Ginsberg.

The state of the world

29 June 2014

The fragile state of the world economy makes reform a must, writes Warwick McKibbin.

There is an eerie stability in global financial markets. Given the fragile state of key parts of the global economy this is both reassuring and puzzling.

Perhaps markets are rationally looking many decades into the future at the benefits of successful economic development in China, India and other major emerging economies.

Continuation of the trends in growth in emerging economies that were experienced over the past decade will transform the global economy in future decades.

However, in the near term there are many issues which should make markets nervous. One major concern is the apparent wide spread disconnect between market valuations and actual economic performance. Also the need for sustainability in public and private debt in many countries will inevitably have to be addressed.

Global growth is unevenly distributed across countries and within regions. China continues to grow at just below 7.5 per cent. One major concern for China in the short term is how financial reform will progress and what happens when interest rates in China begin to be driven by market forces.

With interest rates expected to rise within China there is some vulnerability particularly in the shadow banking system however stimulus measures now in place appear to be supporting economic growth. It is likely at least in the near term China will continue to grow and generate income for Australian exporters, particularly in the mining sector. It is not impossible but it is difficult to see a crisis emanating from China soon.

Inflation threat in US

The IMF recently downgraded the forecast for US economic growth to 2 per cent for 2014 down from 2.8 per cent. The Fed also downgraded its growth forecast for 2014.

Although fragile, the US recovery is continuing partly due to loose monetary policy and partly due to an energy boom but events in the Middle East and fiscal drag could easily slow the economy over the next year.

However recent economic growth data is less concerning than the possible re-emergence of inflation. The latest US CPI was 2.1 per cent for May, which is the third month of rising inflation outcomes for both the CPI and producer prices.

Despite this higher than expected inflation reading, Janet Yellen described it as ‘noisy’. The Fed will be focused on the personal consumption expenditure deflator due this week. It would not be surprising to see an inflation bulge emerge in the US and a realisation that the Fed is behind the curve in withdrawing from the extremely loose monetary policy. Energy price shocks from the Middle East will not help.

Much of the success of Central Banks globally in managing the aftermath of the 2009 crisis has so far has come from loose monetary policy in a world where inflationary expectations are well anchored. Any sense that this is not the case (i.e. through bond markets pricing in higher inflation in the yield curve) will result in a spike in global volatility. There are many balance sheets, both private and public, that will be stressed under higher interest rates. The Fed is continuing to reduce the taper by $10billion a month but this is a critical time for the Fed as data emerges on the trend of inflation.

Euro zone conflicted

Europe is an economic mess everywhere except Germany. The continued economic weakness and disastrous levels of unemployment are driving political shifts to the right and towards anti-European Union political parties. The ECB has moved to negative interest rates in an effort to fight off deflation.

The problem is that deflation and weak growth is a problem for European periphery countries but not in Germany so Germany will resist any real loosening of European monetary policy. Fiscal adjustment is necessary in periphery economies but this will likely be very contractionary for countries that are locked into the Euro currency.

Together with systemic problems in European banks and the need for substantial fiscal reforms, it is hard to see how the Eurozone can resist the many existing contradictions within Europe.

In summary the world economy is very fragile with the indicators of volatility and riskiness seemingly inconsistent with the real risks that exist. It is hard to believe that there will not be a significant adjustment in some major markets in the second half of 2014.

Australia is vulnerable to this highly uncertain world. This makes the implementation of real economic reform in Australia all the more critical.

Are you interested in studying with Warwick McKibbin? He teaches Modelling the Global Economy: techniques and policy implications (IDEC8127).

This article was first published in The Australian Financial Review.

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