Calm surface, turbulent underneath

Calm surface, turbulent underneath

by The Economist online | WASHINGTON

AT FIRST glance, all would seem well in the International Monetary Fund’s latest global forecast. It thinks the world will grow a bit faster this year than it thought in April: by 4.6%, instead of 4.2%. It puts growth next year at 4.3%, unchanged from April, reflecting a modest upgrade to the American outlook, and a tiny downgrade everywhere else, even Europe.

But beneath that placid surface the IMF sees a snake pit of threats. Among these “downside risks”: banks could curtail lending because of their exposure to impaired government debt; consumers and businesses could spend less because their confidence has been dented; deficit cutting could suppress growth; new financial regulations could damp bank lending; American property prices could fall further; and exchange rates could go haywire. And the upside risks? The IMF doesn’t proffer any.

Most of these threats stem from the rising risk of default by some countries in the euro zone and the knock-on damage to the European banks that hold their bonds. The IMF ran a scenario in which the world repeats the financial shocks it experienced in late 2008. For the world, GDP would be 1.5 points weaker–not enough to tip the world economy back into recession. However, the estimated three percentage point hit to euro-zone growth would easily do the job there.

Given that skewed balance of risks, what can policy makers do? The IMF says policy actions must be “concerted,” “rapid,” “credible,” and “swift,” especially on fiscal policy. The IMF has not joined the hair-shirt brigade; advanced countries shouldn’t actively try to trim their deficits before 2011 because that would threaten the recovery. But “they should not add further stimulus,” either and medium to long-term plans to lower deficits are, it says, “of utmost importance.” These should be designed to boost productive potential, by reforming entitlements and making taxes more growth-friendly.

The IMF notes governments face enormous refinancing needs in the coming year as short-term debts mature. Weaker euro-area governments must refinance 300 billion euros ($380 billion) maturing in the second half of 2010, at a time when other advanced countries will be rolling over $4 trillion. Banks, especially in the euro area, also face a “wall of maturities in the next few years.”

With fiscal policy constrained, the IMF recommends that monetary policy remain loose and prepare to be looser. How can it, when most major central banks have already cut interest rates to, or close to, zero? The answer, the IMF says, is more quantitative easing: “central banks may need again to rely more strongly on using their balance sheets to further ease monetary conditions.” That means buying bonds with newly printed money or making bigger loans on easier terms to banks.

This is easier said than done. The European Central Bank has reactivated some of its longer-term lending operations, but its purchases of government debt, designed to supplement the new European Financial Stability Facility, to date amount to only 59 billion euros. Doing more could make Germans unhappier than they already. The Federal Reserve faces similar internal resistance to more quantitative easing, although the hurdles are lower. Yet even if it could buy another $1.75 trillion of bonds, it would deliver less oomph than the first $1.75 trillion. Liquidity traps apply to long term as well as short term rates. With Treasurys yielding only 3%, it’s not clear how much more demand the Fed will spur by getting them down to, say, 2.5%. But it’s better than doing nothing.