The broad contours of the global economy are generally well known. Global growth overall remains modest, with the projections of most international organizations having been revised down over the past six months.[1] In the United States, economic expansion has been steady, reflecting a pickup in private sector demand, but fiscal drag continues to exert itself and growth has been insufficient to make any significant headway in absorbing excess capacity. The euro zone remains mired in recession, with its economic and governance problems still far from resolved. Growth in Japan, in contrast, appears to be on the rebound, at least over the near term. Among the major emerging market economies, growth, while more rapid than among advanced economies, has slowed, with a shift to a lower underlying growth trend than previously thought, especially in China, and with significant regional differentiation. Against this economic backdrop, the political landscape has been changing, with elections and transitions of power taking place in a number of G20 countries with more still to come — notably in Germany in September.
In financial markets, we have recently witnessed considerable volatility, reflecting shifting market expectations about monetary policies, especially in the United States. Looking through this volatility, however, there has been significant improvement in global financial conditions. This is evident in the euro zone, where yields in peripheral economies have come down and, so far, stayed down. In the United States, equity prices have reached new highs, housing prices have started to recover and corporate bond issuance has been robust. Similarly, markets in Japan showed an initial euphoria in response to the dramatic change in policy direction.
The improvement in financial conditions has been strongest in advanced economies, largely in response to policy actions of central banks. Essentially, markets have keyed off those central banks pursuing unconventional policies, particularly those involved in bond-buying programs — the Federal Reserve and the Bank of England, and, most recently, the Bank of Japan.
Central Bank Balance Sheets and Beyond
A phenomenal expansion of central bank balance sheets has taken place in the aftermath of the financial crisis, as central banks have aggressively pursued several types of unconventional monetary policy measures. In virtually all cases, it has involved liquidity and credit facilities, as well as outright asset purchases. In some cases, it has also involved forward guidance; that is, policy commitments conditional on future economic developments.
The Fed, early on, undertook both dollar liquidity and foreign-currency liquidity swaps, and then began to engage in quantitative easing (QE), which became known as QE1, QE2 and QE3. In terms of asset purchases, the Fed has been active in the market for mortgage-backed securities, while the Bank of England has expanded its balance sheet primarily through purchases of UK gilts. In contrast, the European Central Bank’s focus has been on refinancing operations rather than outright asset purchases. Its Outright Monetary Transactions mechanism has yet to be triggered, but the announcement alone had a significant impact on spreads. And the Bank of Japan has committed to doubling the monetary base by the end of 2014, primarily through the purchase of long-term Japanese government bonds, to help end almost two decades of stagnation.
The effectiveness of these unconventional measures has been hotly debated. Central banks have presented evidence that bond yields have come down, estimating the cumulative effect to have been from around 50 to 120 basis points at 10 years, and have argued that portfolio rebalancing, wealth effects and signalling have all been positive for growth. Those on the other side of the debate, however, have argued that these estimates are greatly overstated, and worry about the ability of central banks to unwind unconventional policies without generating significant uncertainty and volatility in markets, along with expressing concern about the risk of asset price bubbles or generalized inflation from prolonged monetary accommodation. These concerns have even led to constitutional challenges about the legality of some central bank actions.
Doing the counterfactual — what would have happened in the absence of these unconventional policies — is difficult, given the limited experience we have had with such measures. The balance of evidence, however, appears to support the view that the global economy would be worse off today if central banks had not taken these extraordinary actions. Financial markets are certainly of this view.
All indications point to the likelihood that we will be living with unconventional monetary policies for some time to come. While Federal Reserve Chairman Ben Bernanke has raised the possibility of a slowing in the pace of asset purchases, it would be conditional on a steadily improving US labour market and economy (that is, data determined), and it would still involve an expansion of the Fed balance sheet. Financial markets, being naturally forward looking, have nonetheless already begun to critically assess and react to what some are calling “the beginning of the end of easy money”; we have seen US treasuries back up sharply in response. In the United Kingdom, the continued commitment to fiscal consolidation almost certainly rules out any unwinding of unconventional policies any time soon, with forward guidance becoming the preferred tool. The European Central Bank seems to have also embraced forward guidance. And in the case of Japan, an aggressive expansion of the Bank of Japan’s balance sheet has just recently been launched.
Given the state of the global economy, unconventional monetary support should continue to be an important part of the policy mix to promote global economic recovery and growth. But is it enough? While the risks and concerns about the prolonged use of unconventional policies cannot be ignored, the more serious issue comes from a much broader policy perspective: that sustained global economic growth, sufficient to absorb economic slack, has not yet been firmly established.
The Need for More Than Just Monetary Policy
The challenges the global economy faces require far more than just a continuation of unconventional monetary policies. While more can, and in some case should, be done by central banks, the limits of monetary policy need to be recognized. The time these policies have offered for other policies to be put in place and take hold may be running out.
In advanced G20 economies, we have a deficiency of demand, with unemployment remaining unacceptably high, and still going up in some jurisdictions. Balance sheets remain impaired with pressures of deleveraging and unsustainable debt levels still very evident. Implementation of financial sector reforms is far from complete. And there is a pressing need for real sector structural reforms, ranging from product and labour market reforms to tax reforms to address the challenges of today’s global economy.
In the euro zone, the degree and pace of austerity measures needs to be recalibrated and combined with a more concerted effort to recapitalize banks. Any realistic strategy for dealing with the euro zone crisis must involve substantially more private and sovereign debt restructuring. If the right policy mix is not put in place soon to support recovery, a protracted period of sub-par growth will continue, and the stated objective to establish a more effective euro zone governance structure, such as a banking union, may never materialize. In the United States, the pace of fiscal consolidation must be calibrated so as not to undermine the recovery that appears to be taking hold. At the same time, a clearer path of fiscal consolidation must be laid out if markets are to support the recovery and the private sector is to have confidence in the policy path going forward. When the Fed deems it appropriate to begin pulling back on the pace of its asset purchases, a durable expansion, underpinned by more than just monetary policy, must be a prerequisite if the inevitable portfolio rebalancing that comes with such Fed action is to be absorbed smoothly. Similarly, in the United Kingdom, care must be taken not to overweight what monetary policy can accomplish alone. Restoring the health of the UK banking system must take on renewed urgency. For Japan, a premium must be placed on clear and effective communication to avoid market missteps about the size and timing of its bond-buying program. We have already seen some reversal of initial market euphoria due to a lack of transparency about the plans of the government and the Bank of Japan.
What about advancing G20 economies? As the engine of global growth since the onset of the crisis, their main near-term task is to continue to adjust the macroeconomic levers of policy to support sustained growth. Given the differentiation across countries, these policy responses vary. A complicating factor has been the spillovers from the policies of advanced economies, including the market gyrations surrounding recent Federal Reserve communications about its pace of asset purchases. Still, key variables such as exchange rates have broadly reflected medium-term fundamentals.
The other critical challenge for advancing economies is to engineer key structural changes in recognition of underlying, longer-term global forces at play, including their own rising presence and importance. These policies include those to support a shift of resources to growth-oriented sectors, promote sound and transparent regulations and encourage more reliance on the price mechanism as a way of doing business. In China, recent concerns about the rapid rate of credit expansion and the growing presence of a shadow banking system underscore the importance of placing priority on moving in the direction of interest rate and exchange rate market reforms, even if these are deemed among the hardest to do. Success in all these areas of structural reform also, critically, requires policy platforms with clear roles and responsibilities. It is when there is a lack of clarity, or a perceived vacuum, about policy objectives and frameworks that problems arise.
The Need for Collective Political Will
In his report prepared for the 2011 Cannes G20 Summit, “Governance for growth: Building consensus for the future,” UK Prime Minister David Cameron said that what was needed above all was “political will” to overcome the obstacles to global growth. Political will is needed at the national level where tough decisions are made and core public policies are carried out. But equally critical, the interdependencies of the global economy, which became even more apparent from the fallout of the financial crisis, demand collective political will if we are to put the failures that led to and propagated the “Great Recession” behind us. Indeed, the challenges facing G20 countries (described above) in sustaining economic recovery and growth can only truly be met if we act together.
More than ever, how individual countries fare in today’s global economy rests on having global governance that works. This is what we expect from G20 leaders — to drive international policy cooperation for the benefit of all. It is always easier to be inward looking, point the finger at others and act unilaterally. At the peak of the global financial crisis, G20 leaders showed political will, as well as good will, to act collectively. That need for collective action has not disappeared.
For St. Petersburg, with some leaders, notably Chinese President Xi Jinping, attending their first summit, the world will be watching for three priority outcomes:
- a clear and focussed message reinforcing collective G20 recognition of the importance of international economic cooperation for effective management of the global economy, and a commitment to achieving such cooperation;
- policy actions to promote global economic recovery and growth, where individual country strategies recognize and incorporate the interdependencies, spillover effects and externalities that tie G20 economies together; and
- political direction to achieve full implementation of agreed regulatory reforms to the global financial system.
[1] In its July World Economic Outlook, the International Monetary Fund revised down its projection of global growth for 2013 to 3.1 percent and for 2014 to 3.8 percent. Both advanced and emerging economies shared in this downward revision. The Organisation for Economic Co-operation and Development has also revised down its most recent projection for global growth in 2013.