Missing growth multipliers

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Missing growth multipliers

In April 2010, when the global economy was beginning to recover from the shock of the 2008-09 financial crisis, the International Monetary Fund’s World Economic Outlook predicted global GDP growth would exceed 4 percent in 2010, with a steady annual growth rate of 4.5 percent through 2015. But that forecast proved far too optimistic.

Global growth has decelerated. In its most recent WEO, the IMF forecasts global GDP to grow 3.3 percent this year and 3.6 percent in 2013. Moreover, the downgrading of growth prospects is remarkably widespread.

The forecast errors have three potential sources: failure to recognize the amount of time needed for economic recovery; underestimation of “fiscal multipliers” (the size of output loss owing to austerity); and neglect of the “world trade multiplier” (the tendency for countries to drag each other down as their economies contract).

For the most part, the severity and implications of the financial crisis were judged well. Lessons from the October 2008 WEO, which analyzed recoveries after systemic financial stress, were incorporated into subsequent forecasts.

As a result, predictions for the United States - where household deleveraging continues to constrain growth - have fallen short only modestly. The April 2010 report forecast a U.S. growth rate of 2.5 percent annually in 2012-13; current projections put the rate a little higher than 2 percent.

By contrast, the fiscal multiplier was seriously underestimated - as the WEO has now recognized. Consequently, forecasts for the United Kingdom - where financial sector stresses largely resembled those in the United States - have been significantly less accurate.

The April 2010 WEO forecast a U.K. annual growth rate of nearly 3 percent in 2012-13; instead, GDP is likely to contract this year and increase by roughly 1 percent next year. Much of this costly divergence from earlier projections can be attributed to the benign view of fiscal consolidation shared by U.K. authorities and the IMF.

Likewise, the euro zone’s heavily indebted economies (Greece, Ireland, Italy, Portugal and Spain) have performed considerably worse than projected, owing to significant spending cuts and tax hikes. For example, Portugal’s GDP was expected to grow 1 percent this year; in fact, it will contract by a stunning 3 percent. The European Commission’s claim that this slowdown reflects high sovereign-default risk, rather than fiscal consolidation, is belied by the U.K., where the sovereign risk is deemed by markets to be virtually nonexistent.

The world-trade multiplier, though less widely recognized, helps to explain why the growth deceleration has been so widespread and persistent. When a country’s economic growth slows, it imports less from other countries, thereby reducing those countries’ growth rates and causing them, too, to reduce imports.

The euro zone has been at the epicenter of this contractionary force on global growth. Since euro zone countries trade extensively with each other and the rest of the world, their slowdowns have contributed significantly to a decrease in global trade, in turn undermining global growth. In particular, as European imports from East Asia have fallen, East Asian economies’ growth is down sharply from last year and the 2010 forecast - and, predictably, growth in their imports from the rest of the world has lost momentum.

Global trade has steadily weakened, with almost no increase in the past six months. The once-popular notion, built into growth forecasts, that exports would provide an escape route from the crisis was never credible. That notion has now been turned on its head: as economic growth has stalled, falling import demand from trade partners has caused economic woes to spread and deepen.

The impact of slowing global trade is most apparent for Germany, which was not burdened with excessive household or corporate debt, and enjoyed a favorable fiscal position. To escape the crisis, Germany used rapid export growth - especially to meet voracious Chinese demand. Although growth was expected to slow subsequently, it was forecast at roughly 2 percent in 2012-13. But as Chinese growth has decelerated - owing partly to decreased exports to Europe - the German GDP forecast has been halved. And, given that this year’s growth has largely already occurred, Germany’s economy has now plateaued - and could even be contracting.

In good times, the trade generated by a country’s growth bolsters global growth. But, in times of crisis, the trade spillovers have the opposite effect. As the global economy has become increasingly interconnected, these trade multipliers have increased.

Indeed, while less ominous and dramatic than financial contagion, trade spillovers profoundly influence global growth prospects. Failure to recognize their impact implies that export - and, in turn, growth - projections will continue to miss the mark. The projected increase in global growth next year will likely not happen. On the contrary, policy errors and delays in individual countries will seriously damage economies worldwide.

Copyright: Project Syndicate, 2012

* The author is a visiting professor of international economic policy at the Woodrow Wilson School of Public and International Affairs, Princeton University.

by Ashoka Mody
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