In the coming year, “divergence” will be a major global economic theme...
In the coming year, “divergence” will be a major global economic theme, applying to economic trends, policies, and performance. As the year progresses, these divergences will become increasingly difficult to reconcile, leaving policymakers with a choice: overcome the obstacles that have so far impeded effective action, or risk allowing their economies to be destabilised.
The multi-speed global economy will be dominated by four groups of countries. The first, led by the United States, will experience continued improvement in economic performance. Their labour markets will become stronger, with job creation accompanied by wage recovery. The benefits of economic growth will be less unequally distributed than in the past few years, though they will still accrue disproportionately to those who are already better off.
The second group, led by China, will stabilise at lower growth rates than recent historical averages, while continuing to mature structurally. They will gradually reorient their growth models to make them more sustainable—an effort that occasional bouts of global financial-market instability will shake, but not derail. And they will work to deepen their internal markets, improve regulatory frameworks, empower the private sector, and expand the scope of market-based economic management.
The third group, led by Europe, will struggle, as continued economic stagnation fuels social and political disenchantment in some countries and complicates regional policy decisions. Anaemic growth, deflationary forces, and pockets of excessive indebtedness will hamper investment, tilting the balance of risk to the downside. In the most challenged economies, unemployment, particularly among young people, will remain alarmingly high and persistent.
The final group comprises the “wild card” countries, whose size and connectivity have important systemic implications. The most notable example is Russia. Faced with a deepening economic recession, a collapsing currency, capital flight, and shortages caused by contracting imports, President Vladimir Putin will need to decide whether to change his approach to Ukraine, re-engage with the West to allow for the lifting of sanctions, and build a more sustainable, diversified economy.
The alternative would be to attempt to divert popular discontent at home by expanding Russia’s intervention in Ukraine. This approach would most likely result in a new round of sanctions and counter-sanctions, tipping Russia into an even deeper recession—and perhaps even triggering political instability or more foreign-policy risk-taking—while exacerbating Europe’s economic malaise.
Brazil is the other notable wild card. President Dilma Rousseff, chastened by her near loss in the recent presidential election, has signalled a willingness to improve macroeconomic management, including by resisting a relapse into statism, the potential benefits of which now pale in comparison to its collateral damage and unintended consequences. If she delivers, Brazil would join Mexico in anchoring a more stable Latin America in 2015, helping the region to overcome the disruptive effects of a Venezuelan economy roiled by lower oil prices.
This multi-speed economic performance will contribute to multi-track central banking, as pressure for divergent monetary policies intensifies, particularly in the systemically important advanced economies. The US Federal Reserve, having already stopped its large-scale purchases of long-term assets, is likely to begin hiking interest rates in the third quarter of 2015. By contrast, the European Central Bank will pursue its own version of quantitative easing, introducing in the first quarter of the year a set of new measures to expand its balance sheet. The Bank of Japan will maintain its pedal-to-the-metal approach to monetary stimulus.
Of course, there is no theoretical limit on divergence. The problem is that exchange-rate shifts now represent the only mechanism for reconciliation, and the divide between certain market valuations and their fundamentals has become so large that prices are vulnerable to bouts of volatility.
For the US, the combination of a stronger economy and less accommodative monetary policy will put additional upward pressure on the dollar’s exchange rate—which has already appreciated significantly—against both the euro and the yen. With few other countries willing to allow their currencies to strengthen, the dollar’s tendency toward appreciation will remain strong and broad-based, potentially triggering domestic political opposition.
Moreover, as it becomes increasingly difficult for currency markets to perform the role of orderly reconcilers, friction may arise among countries. This could disturb the unusual calm that lately has been comforting equity markets.
Fortunately, there are ways to ensure that 2015’s divergences do not lead to economic and financial disruptions. Indeed, most governments—particularly in Europe, Japan, and the US—have the tools they need to defuse the rising tensions and, in the process, unleash their economies’ productive potential.
Avoiding the disruptive potential of divergence is not a question of policy design; there is already broad, albeit not universal, agreement among economists about the measures that are needed at the national, regional, and global levels. Rather, it is a question of implementation—and getting that right requires significant and sustained political will.
The pressure on policymakers to address the risks of divergence will increase next year. The consequences of inaction will extend well beyond 2015.
Mohamed A El-Erian