The IMF in its current World Economic Outlook essentially endorses the secular stagnation hypothesisnoting that the real interest rate necessary to bring about enough demand for full employment has declined significantly and is likely to remain depressed for a substantial period. This is evident because inflation is well below target throughout the industrial world and is likely to decline further this year.
Without robust growth in industrial world markets, growth in emerging markets is likely to subsideeven without considering the political challenges facing countries as diverse as Brazil, China, South Africa, Russia and Turkey.
Facing this inadequate demand, the worlds key strategy is easy money. Base interest rates remain essentially at floor levels across the industrial world and central banks signal that they are unlikely to increase any time soon. Though the US is tapering quantitative easing, Japan continues to ease on a large scale and Europe seems to be moving closer to starting it. This all is better than the tight money policy of the 1930s that made the Great Depression great. But it is highly problematic as a dominant growth strategy.
We do not have a strong basis for assuming that reductions in interest rates nominal or real from very low levels will have a major impact on spending decisions. We do know that they strongly encourage leverage, that they place pressure on return-seeking investors to take increased risk, that they inflate asset values and reward financial activity. The spending they induce tends to come at the expense of future demand. We cannot confidently predict the ultimate results of the unwinding of massive central bank balance sheets on marketsor on the confidence of investors. A strategy of indefinitely sustained easy money leaves central banks dangerously short of response capacity when and if the next recession comes. A proper growth strategy would recognise that an era of low real interest rates offers opportunities as well as risks. It should focus on the promotion of high-return investments, rather than seeking to encourage investments that businesses find unworthy at current rock-bottom rates.
This strategy would have a number of elements. In the US, the case for substantial investment promotion is overwhelming. Increased infrastructure spending would likely reduce burdens on future generations. Not just by spurring growth, but by expanding the economys capacity and reducing deferred maintenance obligations. As just one example: Can it possibly be rational for the 21st-century US air traffic control system to rely on vacuum tubes and paper tracking of flight paths Equally important, government could do much at no cost to promote private investmentincluding authorising oil and natural gas exports, bringing clarity to the future of corporate taxes and moving forward on trade agreements that open up foreign markets.
With Tokyos increase of the value-added tax on April 1, Japan is now engaged in a major fiscal contraction. Yet it is far from clear whether last years progress in reversing deflation is durable or a reflection of one-off exchange rate movements. A return to stagnation and deflation could rapidly call its solvency into question. Japan takes a dangerous risk if it waits to observe the consequences before enacting new fiscal and structural reform measures to promote spending.
Europe has moved back from the brink. Defaults or devaluations now look like remote possibilities. But no strategy for durable growth is yet in place and the slide toward deflation continues. Strong actions are imperative to restore the banking system to the point where it can be a conduit for a robust flow of credit as well as measures to promote demand in the periphery nations where competitiveness challenges remain. If emerging markets capital inflows fall off substantially, and they move further toward being net exporters, it is hard to see where the industrial world can take up the slack. So reform measures to bolster capital flows and exports to emerging markets are essential. These include, most importantly, political steps to reassure against populist threats in a number of countries and provide investor protection and backstop finance. In this regard, the US Congresss passage of IMF authorisation is crucial. Creative consideration should also be applied in mobilising the trillions of dollars in public assets held by central banks and sovereign wealth funds, largely as safe liquid assets, to promote growth.
In an interdependent global economy, the collective impact of all these measures is likely to be substantially greater than the sum of their individual effects. In similar fashion, the consequences of national policy failures are likely to cascade. That is why a global growth strategy framed to resist secular stagnation rather than simply muddle through with the palliative of easy money should be this weeks agenda.