Global Growth The Tied Hands of Economic Policy

The world may be sliding into a deep recession and this time around, neither monetary nor fiscal policy may be enough to get growth back on track, warns Handelsblatt Research Institute boss Dirk Heilmann.
Current fiscal policies, like the ECB's QE, are not working.

Amid nervous financial markets, economists are beginning to speculate whether the U.S. economy is merely cooling off or is already in a cyclical downturn. Pessimists like Willem Buiter of Citigroup see the world's biggest economy at risk for sliding into a recession soon.

They cite worsening financing terms, declining investment, especially in the oil sector, and foreign trade problems stemming from the strong dollar. The optimists, on the other hand, stress that deleveraging the private sector is well underway, the labor market is in good shape and the oil sector is not large enough to drag down the entire U.S. economy. They do not see anything worse on the horizon than a 1-2 percent decline in growth.

One thing is clear: No other region could currently make up for the loss of the United States as the engine of the world economy. According to the International Monetary Fund, the euro zone economies will grow by 1.7 percent this year, but they may already have passed the peak of their cyclical recovery. Political turbulence also fuels the risk of a downturn.

Japan is on the verge of its next recession, the situation in China is unclear, and commodities-exporting countries are in crisis mode because of sharp declines in prices.

A cocktail of risks is brewing that could lead to a global recession. The IMF defines a global recession as a decline in annual per-capita real world GDP, adjusted for purchasing power parity. The last time that happened was in 2009.

Banks, companies and citizens have become accustomed to relaxed monetary policy and hardly react to new incentives anymore.

A new global recession would be happening in an environment in which the monetary policy of all major central banks is more expansive than ever before. For years the U.S. central bank, the Fed, the Bank of Japan, the Bank of England and the European Central Bank have been engaged in a race to bring their interest rates and currencies to the lowest possible levels. As a result, they are in an extreme crisis mode before an economic downturn has even begun.

The central banks have little left in their arsenals. The Bank of Japan is beginning to have trouble finding bonds to buy. The European Central Bank threatens to have the same problem unless it makes other types of securities eligible for the bond-buying program it launched in March 2015, such as corporate bonds, bank bonds or shares in equity funds. In its meeting on Thursday, the ECB Governing Council can push the base rate further into negative territory, extend the bond-buying program or launch additional liquidity programs for the banking sector.

The only problem is that the marginal benefit of monetary policy is declining. This is because banks, companies and citizens have become accustomed to relaxed monetary policy and hardly react to new incentives anymore. A possible, radical step is the direct monetary financing of governments, as some economists already proposed, but the European Central Bank is expressly forbidden from doing so. And the Fed's problem is that it embarked on a rate hike in December and would have to prepare how it communicates a reversal.

If monetary policy is no longer capable of stimulating the economy, the hour of fiscal policy may have come. But the problem here is that government debt has grown in recent years to a level that would already have been disconcertingly high before the financial crisis.

As a result, there are only few countries with any fiscal latitude. One of them is Germany. In the case of a global recession Germany, as a major exporting power, should attempt to offset the decline in demand from export markets with higher demand in the domestic market. In that case, it would be difficult to defend the fiscal policy goal of a balanced budget.

But even much higher government spending in Germany and the few other countries whose government finance are still in relatively good shape would not be enough to pull the world economy out of the next recession. The finance ministers and central bank heads in the G20 group recognized this at their latest meeting in Shanghai, and therefore proposed structural reforms to boost economic strength and increase confidence among businesses.

Still, it is highly questionable whether the governments of the Western world, in light of a growing populism on the right and the left that promotes a nationalist economic policy that is hostile to the market economy, can still bring about structural reforms. That window may already have been closed. 


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