The world’s finance ministers and central bank governors will gather in Washington this week for the twice yearly meetings of the IMF. Though there will not be the sense of alarm that dominated these meetings after the financial crisis, the unfortunate reality is that the global economy’s medium-term prospects have not been so cloudy for a long time.
The IMF in its current World Economic Outlook essentially endorses the secular stagnation hypothesis—noting that the real interest rate necessary to bring about enough demand for full employment has declined significantly and is likely to remain depressed for a substantial period. This is evident because inflation is well below target throughout the industrial world and is likely to decline further this year.
Without robust growth in industrial world markets, growth in emerging markets is likely to subside—even without considering the political challenges facing countries as diverse as Brazil, China, South Africa, Russia and Turkey.
Facing this inadequate demand, the world’s key strategy is easy money. Base interest rates remain essentially at floor levels across the industrial world and central banks signal that they are unlikely to increase any time soon. Though the US is tapering quantitative easing, Japan continues to ease on a large scale and Europe seems to be moving closer to starting it. This all is better than the tight money policy of the 1930s that made the Great Depression great. But it is highly problematic as a dominant growth strategy.
We do not have a strong basis for assuming that reductions in interest rates nominal or real from very low levels will have a major impact on spending decisions. We do know that they strongly encourage leverage, that they place pressure on return-seeking investors to take increased risk, that they inflate asset values and reward financial activity. The spending they induce tends to come at the expense of future demand. We cannot confidently predict the ultimate results of the unwinding of massive central bank balance sheets on markets—or on the confidence of investors. A strategy of indefinitely sustained easy money leaves central banks dangerously short of response capacity when and if the next recession comes. A proper growth strategy would recognise that an era of low real interest rates offers opportunities as well as risks. It should focus on the promotion of high-return investments, rather than seeking to encourage investments that businesses find unworthy at current rock-bottom rates.
This strategy would have a