Wednesday, June 24, 2009

The worst is over

So concludes the OECD

Here's the "editorial" in its just released June Economic Outlook, by acting chief economist Jorgen Elmeskov:


OECD activity now looks to be approaching its nadir, following the deepest decline in post-war history. The ensuing recovery is likely to be both weak and fragile for some time. And the negative economic and social consequences of the crisis will be long-lasting. Yet, it could have been worse. Thanks to a strong economic policy effort an even darker scenario seems to have been avoided. But this is no reason for complacency; the need for determined policy action remains across a wide field of policies.

The downturn has been global in scope, even though its financial epicentre was in the OECD area. Indeed, trade and financial linkages prompted a synchronised collapse in activity and trade after financial markets froze in the second half of 2008. De-coupling turned out to be a mirage on the way into the recession. But on the way out it looks as if recovery will take hold in a staggered manner across countries reflecting, not least, the extent of policy stimulus and the force of headwinds coming from the need for balance-sheet repair.

More specifically:

 A recovery already appears to be in motion in most large non-OECD countries. This is particularly so in China, against the background of substantial monetary and especially fiscal stimuli. At the same time, these countries do not suffer from the kind of balance-sheet damage that afflicts many OECD countries.

 Signs have multiplied that US activity could bottom out in the course of the second half of this year. Such a recovery would reflect tremendous policy effort. However, as the growth impulse from fiscal stimulus fades and the need for balance-sheet repairs continues to hold back growth the recovery could be uncharacteristically weak and insufficient to bear down on unemployment at around 10% of the labour force.

 Japan's economy is also showing signs that the trade-induced contraction is close to the end, thanks not least to fiscal stimulus. Again, however, the recovery is likely to be slow and huge economic slack is likely to further entrench deflation.

 Signs of impending recovery in the euro area are not yet as clearly visible, reflecting country-specific combinations of bursting housing bubbles, export set-backs and damage to financial sectors. The eventual recovery may also be slow in this region, including because rising unemployment makes consumers more reluctant to spend...

Overall, this Economic Outlook is the first in two years to revise up the growth projections compared with the previous version -- most clearly for the non-OECD and the United States but also to some extent for Japan. But more significant than the upward revision to growth is the change in the distribution of risks around the projections. These are now more balanced than before. Indeed, the projections are built on the assumption that conditions in financial markets stay broadly unchanged for the remainder of this year before normalising in the course of 2010 and this assumption could prove too conservative. But new tremors in the financial area cannot be excluded either, and adverse bond market reactions to the sharp increase in government indebtedness also represent a downside risk.

The recession has already led to a substantial rise in unemployment, with more to come before recovery is sufficiently strong to reverse the trend. The weakness in product and labour markets is likely to put downward pressure on inflation over the projection. But, as in other periods of sustained large slack, its disinflationary impact may be limited and most countries are projected to stay clear of sustained deflation.

Concern has been expressed about potential inflationary impacts of central bank injections of liquidity. As long as slack is large, this risk is likely to be modest. Moreover, many of the instruments for liquidity injection are expected to be self-correcting as financial conditions improve. Nonetheless, discretionary action will at some point have to be taken to withdraw liquidity as financial markets normalise. The timing and calibration of such action will be tricky, requiring central banks not only to exercise good judgement but also to have at their disposal flexible instruments to perform these operations.

With a nascent recovery hopefully in sight it would be tempting to relax the extraordinary policy effort of the past nine months. Tempting, but wrong. Not only because post-crisis policy strategies need preparing but also because there is still more policy can do to ensure a faster and more robust recovery. Some countries have taken action to remove the uncertainty associated with impaired assets on bank balance sheets but others may have to follow. Likewise, and especially in conditions where the picture of bank balance sheets provided by existing accounting rules is hazy, stress testing has a role to play in providing confidence. Getting the full benefit out of stress testing requires that the tests be seen as challenging, be made public, and be associated with demands for recapitalisation where needed.

Eventually, however, the panoply of government interventions to stabilise the financial system should be rolled back. This will likely call for some degree of co-ordination across countries to avoid fear of competitive disadvantage blocking progress. Crucial for the future, regulatory and supervisory changes will have to be brought in to limit the risk of new financial crises. Some of these changes are likely to hurt profitability and be unpopular with regulated firms. And some may face resistance because they alter existing bureaucratic structures. Hence, such reforms need to be undertaken before the memory of the crisis has faded too much.

Government budgets also provide a very important cushion for economic activity in the downturn, principally through the workings of automatic stabilisers and discretionary fiscal easing. The result has been a dramatic, but unavoidable, run-up in government deficits. Indeed, with the incipient recovery likely to be weak, it is important that decided fiscal stimulus actually be implemented in a timely manner and that the fiscal impulse not be withdrawn at a pace that jeopardises recovery.

But very substantial fiscal consolidation will eventually be required in many countries. Some governments have already announced medium-term consolidation plans and others will have to follow. Early announcement of such plans, even if their implementation is conditional on actual economic developments, will help to anchor medium-term expectations of savers and investors and thereby keep down the cost of financing much higher debt levels. Consolidation requirements clearly differ across countries, but analysis in the special chapter of this Outlook on “Beyond the crisis: Medium-term challenges relating to potential output, unemployment and fiscal positions” shows that even countries with large deficits in the near term can reach fiscal balance over the medium term, or at least get a good part of the way, provided that consolidation measures are taken which are strong but not without historical precedent.

Consolidation, when recovery is sufficiently firm, should aim to avoid collateral damage to economies‟ long-term growth prospects. That means relying as far as possible on rolling back public expenditure that is not growth-enhancing, and when tax hikes are necessary to concentrate on broad-based taxes that involve minimal distortion to economic decisions of producers, consumers and investors.

Avoiding negative impacts from consolidation on long-term prospects is particularly important because the crisis itself is likely to have such effects. Some of the increase in unemployment is likely to turn structural and the capital stock could be durably lower as a result of the crisis. It is to be hoped that past reforms in labour markets will limit the extent to which unemployment turns structural.

But even so, further labour market reforms aimed at keeping the unemployed in contact with the labour market and prepared to take emerging new jobs will be crucial. At the same time, it is essential to guard against crisis-driven intervention in product and financial markets undermining the long-run health of the economy. And the pressures for protectionist measures, which can take many forms, must be withstood. Indeed, moves towards liberalisation such as through the Doha Development Agenda would not only benefit long-term growth but would also provide a very helpful boost to confidence in the current situation.

More generally, as the acute crisis abates, it may be time to reflect on the overall economic policy paradigm. One ingredient that will be crucial is structural reforms to foster long-term growth and make economies more resilient in the face of shocks. But the role of macroeconomic policies in the run-up to the crisis will also need to be analysed and appropriate changes to macroeconomic policy frameworks made.

In particular, it will need to be understood whether and, if so, how monetary policy can contribute to avoiding the build-up of financial and asset price vulnerabilities; what role macro-prudential policies can play in this regard; and how fiscal policy can best be set in ways that allow margin for response when crisis hits.

In summary, it looks as if the worst scenario has been avoided and that OECD economies are now nearing the bottom. Even if the subsequent recovery may be slow such an outcome is a major achievement of economic policy. But this is no time to relax -- ensuring that the recovery stays on track and leads towards a long-term sustainable growth path will call for major policy efforts going forward.

17 June 2009
Jorgen Elmeskov
Acting Head, Economics Department