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BlogSpot - The economic outlook: Brighter tomorrow, mediocre the day after

warningsignals
Apr 22, 2015
5 min read

The IMF released its World Economic Outlook (and chapters 3 and 4 on private investment and potential output), with a gloomy picture for the medium-term outlook, dominated by legacies from the crisis (weak banks and indebtedness) and lower potential output (associated with population aging and lower productivity growth, and slower capital accumulation due to the crisis). In the short-term, growth is uneven, firming up in advanced economies, but slowing in major emerging markets.

European forecasts were revised up slightly, on the back of recent growth surprises (see for example Morgan Stanley’s outlook—but analysts are critical of the role of Germany.

Questions about the recent growth upturn—EuroIntelligence, however, notes that not all statistics are confirming the upturn—German industrial orders experience its second consecutive monthly slowdown (hat tip DW), driven by foreign orders; eurozone retail sales feel (Eurostat); in Spain, private sector deleveraging continues (Bank of Spain) with credit to the resident nonfinancial sector showing rates of contraction still above 3% annually. Jan Zilinski (Peterson Institute) looks at prediction mistakes in the European Economic Forecasts from February 2014. Further, Philippe Legrain (Project Syndicate) finds that the improvement in Europe is modest, probably temporary—especially as external shocks are unwinding, with oil prices bouncing back in euro terms, and the impact of the lower euro being smaller due to reliance on global supply chains. And the effects of QE could be muted by already low interest rates and bank-based private sector financing. To overcome its balance-sheet recession, Legrain argues that the eurozone needs to clean up its banks, reduce the crushing overhang of mostly private debt, redress the huge shortfall in investment, eliminate barriers to enterprise, and tackle the deflationary drag of German mercantilism.
The negative contribution from Germany—Michele Tejada (EconoMonitor), based on work by Roubini (referenced in Bloomberg) shows that German investment is low when measured against its current ability to invest, and is unlikely to significantly increase in coming years, capping output growth. German structural and policy justifications are not irrational, although they are short-sighted; and current trends represent a missed opportunity to stimulate the economy, while limiting growth potential possible positive spillovers to the rest of the Eurozone. Ben Bernanke (hat-tip EuroIntelligence) adds to the debate that Germany's trade surplus is not due to the quality of goods produced, but the undervaluation of Germany's real exchange rate, and excessively tight fiscal policies—which will ultimately lead to financial imbalances and unbalanced growth. He says Germany has policy tools available to rebalance, like investing in public infrastructure, increasing wages of German (public sector) workers, and through targeted economic reforms, like tax incentives for private domestic investment.

The Secular Stagnation debate is back with a new twist. RBS’s Silver Bullet looks at the issue from a market point of view and reports that low yields are here to stay. RealTime Economic Issues report on the argument (following on its latest Global Economic Prospects session) that a chronic shortfall in demand is causing and will continue to cause low growth, low inflation, and low interest rates: (i) Jacob Funk Kirkegaard argues that for Europe, there is still vast potential for productivity growth that remains untapped while euro area leaders drag their feet on regulatory reforms; (ii) and the same goes for China, according to Nicholas R. Lardy, with vast potential in the public and services sectors; (iii) David J. Stockton expects productivity growth in the US and other advanced economies to return to their historical averages, noting that over the past hundred years the United States has had periods of above and below average growth; (iv) following Stockton, Adam S. Posen warns against confusing a run of subpar growth and medium-term drag on growth from underinvestment with a trend. FreeExchange develops Ben Bernanke’s argument that unless one assumes that the entire world is in secular stagnation, secular stagnation should not really be much of a long-term problem, thanks to exports and capital flows—except if systemic countries are saving to boost their exports. Ben Bernanke questions the assumption that real interest rates can be negative indefinitely, as this would mean that any investment is profitable—though Larry Summers writes that negative real rates are a phenomenon that we observe in practice if not always in theory, because of a chronic excess of saving over investment. The policy response then is global rebalancing rather than deficit-financed demand stimulus (the argument). Tyler Cowen adds to Bernanke’s argument that in “non-secular stagnation” countries, corporate sectors should offer nominal expected rates of return which are relatively high, attracting capital flows—even after correcting for exchange rate movements. Europe is increasingly the source of the demand drain, according to Paul Krugman, and falling into a Japan-like trap. The debate revolves around the issue of the nature of imbalances between saving and investment (too much saving and too little investment? Or mis-allocation?). FreeExchange argues that policy response range from more US monetary easing rather than less; deficit spending in rich countries; or much more immigration in rich countries to address the geographic dimension of imbalances. Jeremie Cohen-Setton, in a Bruegel BlogSpot, presents the various sides of the debate.

Are structural reforms really the magic wand?

Short-term impacts—Alessia Terzi, in Bruegel, looks at whether structural reforms might have a dragging effect in the short-run, despite lack of empirical support (Rodrik, 1996). The IMF (2012), the OECD (2012), and the ECB (2015) provided evidence of positive effects even in the short-term. Looking at the main channels identified in the literature, he finds that in the short-term, reforms dampen consumption but boost investment. To identify which effect dominates, Terzi notes that sequencing and packaging of reforms matters (Cacciatore et al., 2012 and IMF, 2006), as well as access to credit and fiscal policy.
Structural reforms and deflationary risks—Matthew Dalton (WSJ) challenges the prevalence of economic reforms as the be-all-and-end-all the economic debate in Europe, asking whether this works at the zero bound of interest rates, given the deflationary impact of some reforms, and hence the resulting rise in real interest rates. Jérémie Cohen-Setton, in a blog review on Bruegel, reviews specifically the literature about the benefits of structural reforms when economies are stuck at the zero lower bound—i.e., when there is a risk that they reinforce deflationary forces. Gauti Eggertsson, Andrea Ferrero, and Andrea Raffo note the importance of monetary policy accommodation—difficult when at the ZLB.
The political economy of structural reforms—Carlos Cantú, KeyYong Park, Aaron Tornell, in a VoxEU article, look at the example of the Mexican 1980s debt crisis for lessons on the implementation of structural reforms. What they note is that, while Mexico did not receive a haircut until seven years into the crisis, it did when structural reform was already underway, as a result of domestic policies rather than outside conditionality. They suggest that lack of leniency from international organizations can induce deep structural reforms.

The Short View: Stress tests and deferred tax credits

The Financial Times (hat-tip EuroIntelligence) reports the European Commission is readying an investigation into whether the conversion of banks' Deferred Tax Assets (DTA) into tax credits constitutes illegal state aid. Silvia Merler (Bruegel) develops the argument that DTCs may become substantial troubles for banks in Greece, Portugal, Spain and Italy. The conversion strengthened the link between the banks and their sovereigns. RBS Silver Bullet provides a comprehensive review of the issue.