So far, this year has provided further evidence of a divided and disconnected world economy that faces major policy dilemmas. Europe is imploding, the UK is contracting, the US is stagnating and, while Asia is cooling, it at least has the policy tools to be able to rebound.
The global economy has slowed significantly, from a healthy, policy-induced growth rate of 4.2 percent in 2010 to a much cooler 3 percent growth last year. This year, global growth may be only 2.6 percent. This masks considerable differences, but, as we have seen in recent years, globalization means no region of the world is completely immune to problems in the West.
The good news is that, helped by policy stimulus, emerging economies, led by China, may see a pickup into next year. The trouble is many economies in the West are running out of policy tools to be able to respond if they are hit by another shock. Hence, it is easy to construct a “perfect storm” scenario for next year, in which a combination of problems comes together and things get worse.
The biggest shock would be if energy prices were forced higher following a Western-led attack on Iran. This is not inevitable, but the risk cannot be overlooked. It would come as a major blow to global growth as the recent easing in oil prices has helped many economies considerably.
For now, the biggest shocks are coming from Europe. This is the world’s weakest link, which is remarkable given how wealthy that region is and how strong some of its core economies are, especially Germany. It is staggering how Europe’s political leaders have let it get this bad.
Over the past year, there has been a need for European politicians to act fast, comprehensively and ahead of events. Instead they have been slow, inadequate and, usually, have only acted after problems have emerged. To make matters worse, they are also focusing on the wrong problem — of excessive debt — when the real challenge facing Europe is the lack of growth.
At their recent summit — the 19th in a couple of years — European leaders finally made some progress, but it was not enough to end recession and to address deep-rooted issues at the heart of the euro. However, their actions also led the European Central Bank (ECB) to cut interest rates to a record low of 0.75 percent. In the coming months, a return to unconventional policy may be needed, such as the ECB buying bonds and providing cheap long-term loans to banks.
If only the US was booming, things might not be so bad — but it isn’t. The US economy is as weak as Europe’s, despite increased optimism about low energy prices because of shale gas and despite big firms being in great shape. Thus US interest rates are staying near record lows.
No matter who wins the presidential election, some difficult decisions on tax and government spending need to be addressed and the likelihood is the US faces only steady and far from spectacular growth.
Western economies may be only halfway through their painful adjustment. Gross government debt levels in advanced economies have risen from an already high average of 74 percent of GDP ahead of the crisis to 105 percent by the end of last year. However, one of the main reasons government borrowing is rising is because growth and demand are so weak, as people and firms continue to pay down their debt and deleverage.