The state of the world economy ahead of Davos

There is anxiety in the global financial system as the
international community of political, economic and business
leaders gather in Davos . It’s only anxiety, however, not an acute
sense of slowdown in growth or a sharp contraction of asset
prices.
The world economy is gradually and slowly moving away from
the Great Recession and the crises in Europe. The United States
is taking the lead. The labour market has improved. The job
engine is working again and employment numbers are slowly
moving upwards. Household debt has been reduced and the
balance sheets are gradually improving.
Having spoken to a large number of people in the financial sector
as a part of outreach activity in the run-up to Davos, my sense is
that there is confidence in US growth. But it’s also clear that few
people expect a normal recovery: productivity and investments
have been slower than usual.
Europe is also in better shape. The fiscal deficit of the eurozone
is likely to land below 3% for 2015. Some of the countries in
crisis, particularly Spain, Ireland and Latvia, have made
substantial progress, both in terms of structural reforms,
restoring public finances and cleaning up the banking system.
Even after the World Bank reduced its global growth forecast for
2015, it still expects slightly below 3.5%, which means that in 20
years global GDP could almost double. Many Asian and African
countries will grow at 7% or more per year, and high-growth
countries will quadruple their GDP over the next two decades.
Growth is cutting back poverty and the emerging-market middle
class is growing into a consumer force to be reckoned with.
Why the anxiety?
With oil prices falling and central banks keeping interest rates
low (and even doing further quantitative easing), there is
certainly potential for global growth. So, why the anxiety? I think
there are a couple of reasons. Firstly, global monetary policy is
not in sync, and that can create a lot of turmoil in currency
markets, and more vulnerable emerging-market economies in
particular.
Secondly, the US is gathering pace. Sooner or later the Federal
Reserve will start unwinding some of the unconventional
measures taken during the Great Recession. At the same time,
growth is weak in Europe; the European Central Bank is
discussing if, how and when its balance sheet should be
expanded. I think both the Fed and ECB are moving in the right
direction.
Some of us remember, however, that policy shifts and policies
that are not in sync can cause turmoil. Back in 1994, when the
Fed started to tighten, that was expected. But it didn’t prevent
large portfolio flows from disrupting markets. Given that we have
been seeing unprecedented monetary-policy action for a long
time, it is impossible to foretell how the market will react if the
ECB heads in a more expansionary direction and the Fed cuts its
quantitative-easing measures.
An uncertain future
This is a challenging environment for emerging markets. Flows
in capital accounts are difficult to manage under normal
circumstances; and the unintended side effects of new Fed and
ECB policies will only add more uncertainty. If there are domestic
political problems (particularly in countries with exposure to oil
prices) the temperature will nudge even further upwards.
If the global economic order is to be legitimate, it’s vital that
everybody feel they count and their interests are part of the
policy equation. The Forum’s Annual Meeting in Davos comes at
a crucial moment, when interaction between all stakeholders is
especially important.
Another reason for anxiety is geopolitics. In the decades after
the Cold War, geopolitics was not high on the economic agenda.
The conflict in Ukraine changed that. Even if there have been few
illusions about President Vladimir Putin’s leadership, the general
perception is that he has tried to modernize Russia. Few leaders
who have transformed countries – Otto von Bismarck, Deng
Xiaoping, Olusegun Obasanjo – have done it for purely
benevolent reasons, or with the patience of Nelson Mandela. To
strengthen a country and make it more united, economic growth
is absolutely necessary; therefore trade and markets have been
opened for all but liberal reasons.
The problem is that nationalistic populism has features similar to
inflation: there is a risk of a self-enforcing negative spiral. So, if
escalating conflict causes an economic contraction and
undermines Putin’s popularity, what will be the answer? Further
escalation?
Clearly, geopolitical risk is high on the world agenda. The conflict
in Syria and Iraq has wrought tremendous human suffering and
unleashed unprecedented refugee flows. It also increases the
general sense of growing troubles. The Ebola epidemic, for
instance, is still not under control. The global community has not
been able to muster the resources to avoid a pandemic, and it’s
not difficult to predict scenarios that are extremely disruptive.
The threat of deflation
Next to geopolitical risk, the ghost of deflation is also hovering.
The sharp reduction of oil prices is definitely good for growth ,
but it adds to the short-term downwards pressure on inflation
expectations. Even if metals, food and other commodities
haven’t moved with the same speed as oil prices, the direction
has been clear. Particularly in the eurozone, the risk of deflation
is significant. Growth is likely to be anaemic (1-1.5%) and wage
increases low. The price pressure from demand and unit labour
costs will also be low. At the same time, the credit channel is still
in bad shape in parts of Europe. There are clear deflationary
risks that central bankers have to take seriously.
To me, it’s quite logical that the global financial system is feeling
anxious ahead of Davos. The financial sector is also going
through a difficult transition. The new regulatory environment
has brought higher capital requirements and tougher supervision,
and the demands of risk-averse counterparties are changing the
banking sector. In the long run, this means a more resilient
banking system, but the transition stage is fraught with
operational uncertainty. In a few years the new structure will be
in place and we will have a clearer understanding of the
unintended side effects and whether regulatory arbitrage has to
be dealt with, but we are not there yet.
Another reason the business environment is changing is the
combination of a growing mobile-banking sector, spearheaded
by m-pesa in Kenya and other emerging markets, and new
innovations in transaction, lending and other consumer services
that will increase pressure on traditional banks. Bitcoins and
other electronic currencies have been slow to catch on, but that
might be changing.
It is genuinely difficult for businesses to navigate a global
environment in which there is slow recovery and clear
geopolitical and economic risks. And given that banking is also
going through an enormous regulatory overhaul, it’s no wonder
there is anxiety. But let’s be clear: it’s an improvement on the
crisis-related depression we have seen in Davos over the past
few years.