The world economy enters this year with more uncertainty (and anxiety) than at any time in recent memory. Although the financial crisis appears to be contained in the US and Europe, its full repercussions will not be clear for some time. The advanced countries are in for the worst economic downturn since the Great Depression. But how long and deep will this recession be, and how badly will it affect emerging and developing nations?
We don’t have the answers to these questions in part because the consequences will depend on what actions policymakers take. The right responses will ensure that the world economy can begin to recover by late this year. Poor policy choices, on the other hand, will at best delay recovery and at worst do permanent damage. Here is a list of things to watch for.
Will the US response be “bold” enough? US President Barack Obama has promised that it would be, echoing at least part of former US president Franklin D. Roosevelt’s (FDR) famous call for “bold, persistent experimentation” at the height of the Great Depression in 1932. Obama has a first-rate group of economists on his side, which ensures that he will not do anything silly. But the US’ circumstances are sufficiently exceptional that he will need advisers who are willing to try new, untested ideas — in other words, experimentation a la FDR.
In particular, he will need to go beyond Keynesian fiscal-stimulus policies to heal the deep wounds to economic confidence that lie at the root of the current crisis. So far, confidence-building measures have been limited to financial markets, through public guarantees, liquidity support and capital injections.
But workers who worry about being laid off are unlikely to go spend, regardless of how much money fiscal stimulus puts in their pockets. Just as banks are hoarding cash, households will try to preserve wealth by increasing their savings. So incentives targeted directly at preserving employment will have to be part of the solution.
Will Europe get its act together? This could have been Europe’s moment. After all, the crisis originated in the US and left US policy focused on its domestic troubles, opening up room for global leadership by others. Instead, the crisis demonstrated the deep divisions within Europe — on everything from financial regulation to the requisite policy response.
Germany has dragged its feet on fiscal stimulus, stymieing what should have been the second leg of a globally coordinated fiscal action plan. If Europe wants to pull its weight on the global stage, it will have to act with greater unity of purpose and shoulder a greater share of responsibility. Alas, the best that can be hoped for at this stage is that Europe will not undermine the global fiscal stimulus that even the IMF, the guardian of fiscal orthodoxy, regards as absolutely essential.
Will China hold together? Even though a weak US response is the biggest risk on the economic side, what happens in China may well have deeper and more lasting consequences on the broader historical canvas. For China is a country of enormous hidden tensions and cleavages, and these may erupt into open conflict in difficult economic times.
Experts on China differ on the rate of economic growth needed to create employment for the millions of Chinese who flock into the country’s cities every year. But it is virtually certain that China will fall short of this threshold this year. This explains the almost continuous stream of measures that emanate from Beijing these days: increased public spending, monetary easing, pressure on state enterprises to expand activity, subsidies to exporters, partial convertibility of the Chinese yuan to spur trade with neighboring countries, and so on. But will this do enough to stem the slowdown in an economy that has become hooked on external demand in recent years?