FT SPECIAL REPORT

World Economy
Friday October 11 2013
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Confidence takes welcome turn

Unexpected upswing in growth gives rise to ref lection on whether fog of crisis is lifting, writes Chris Giles

Inside
Martin Wolf Recovery has begun but many of the G8 need to take the medicine
Page 2

limmers of hope have begun to light up the world economy. This autumn, for the first time in three years, advanced economies are leading the charge as the emerging world stabilises after a torrid summer. Cautious optimism has yet to translate into a boost to sluggish world economic growth, but so long as the sparks are not just a flash in the pan, 2014 appears set to be a better year. The improvement in the outlook comes with a health warning, however. So much has changed in the global economic environment since the spring that the current snapshot can only give tentative indications of a sustained recovery. In April, the International Monetary Fund talked of a three-speed recovery with emerging economies set fair and growing rapidly, the US and Japan doing reasonably, and Europe still mired in crisis. Last week, IMF managing director Christine Lagarde had to reverse those views in a speech acknowledging that in many of the advanced economies, however, we are finally seeing signs of hope, while momentum is slowing in countries such as China, India and Brazil. These sobering problems in the characterisation of the world economy reflect the fact that there is no longer a simple sound bite to describe who is up and who is down. The increasingly

complicated picture is one in which individual economies are distinct in their performance at the same time as they are mutually dependent. Five years on from the collapse of 2008, the journey is not yet complete, Ms Lagarde said. But the fog of crisis is lifting and we can see that its aftermath leaves us with multiple new transitions. The strength in the world economy

centres on the large advanced economies that have put the worst behind them. Professor Eswar Prasad at the Brookings Institution, says: The US economy continues to push forward at a modest pace and the UK is experiencing surprisingly good growth, while the core eurozone economies and Japan are also turning in positive growth. The unexpected growth upswing in

Full speed ahead? The global economy faces more uncertainty before it matches the performance of Chinas bullet trains Reuters

the second and third quarters raises questions over the cause of the brighter mood and the sustainability of the recovery. Confidence has turned everywhere, with business and consumer surveys showing higher orders and increased production. The US motor industry has been revving faster on the back of improved household finances and a stronger housing market, but rapid recovery has been held back by this years sharp tightening of fiscal policy. This creates a chicken and egg problem, according to Bill Dudley, the president of the New York Federal Reserve. Households are unwilling to borrow and spend, while real incomes are unlikely to grow quickly. In Europe, the bigger difficulty is in understanding why there has been an upswing at all. The eurozone surprisingly emerged from six quarters of contraction in the second quarter of the year, while UK growth powered ahead to 0.7 per cent in the same period despite no let up in its relentless deficit reduction programme. Such is the turnround in Britains economic sentiment that the widely watched PMI indices have moved into boom-time territory. According to Goldman Sachs, the indicators are consistent with annualised growth of 5.5 per cent in the third quarter. Improved confidence is the only clear answer, but that raises the question of why households and companies are suddenly looking on the bright side. In Japan, the march of Abenomics continues with the country growing at its fastest pace in years. The outlook has improved so much that Shinzo Abe, the prime minister, has decided to bite the bullet and raise sales taxes to 8 per cent from
Continued on Page 2

China looks to revive growth Reform is on the agenda as expansion slows

Page 3

Lenders pushed on contagion Making banks safer could conflict with customer needs
Page 4

IMF takes more Keynesian line Richer nations advised to show caution on debt
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Global population upheaval grows No end in sight this century to huge demographic shifts
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FINANCIAL TIMES FRIDAY OCTOBER 11 2013

World Economy

Sound and fury, but signifying nothing yet

Martin Wolf

ix years have passed since the financial crisis in the high-income economies became evident. Five years have passed since the failure of Lehman Brothers unleashed turmoil. Four years have passed since the discovery of Greek statistical malfeasance launched the eurozone crisis. So where is the world economy? Start with a truth too easily forgotten: the state of the highincome economies remains extraordinarily feeble. The four most important central

banks the Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England all have short-term interest rates of half a per cent, or less. These rates have remained extremely low for four years, or more. The Bank of Japans rates have remained ultra-low since the mid-1990s. Since the crisis began, the Feds balance sheet has grown fourfold and is still growing, at a rate of $85bn a month. The supposedly conservative ECB has promised to buy the bonds of troubled governments, if necessary, through the outright monetary transactions programme announced in the summer of 2012. The Bank of Japan has launched a huge programme of balance-sheet expansion under its new governor, Haruhiko Kuroda. What then has all this monetary activism bought? Disappointment. Of the six largest high-income economies, only two the US and

Hot spot: Chinas growth is strong but not the global force that it was

Reuters

Germany were bigger in the second quarter of 2013 than at their pre-crisis peaks five years before: the US economy was 5 per cent bigger, Germanys 2 per cent. The French economy was back to its starting point while the UKs was some 3 per cent smaller. Crisis-hit Italys economy had shrunk by 9 per cent. The combination of aggressive monetary policy with slow growth shows how weak these economies continue to be, despite the healing of the financial sector, corrections in property prices and decline in

private indebtedness. Nor is this weakness expected to disappear soon. The September consensus of forecasts for 2014 indicates growth of 2.7 per cent in the US, 2.1 per cent for the UK (up from a forecast of 1.7 per cent in January), 1.7 per cent for Japan (up from 1 per cent in January) and a mere 0.9 per cent for the eurozone. The ECBs interventions and the commitment of policy makers in troubled countries have brought a degree of stability inside the eurozone. Many weaknesses remain,

among them still worsening public debt, costly credit and vulnerable banks. All the crisis-hit economies remain deeply depressed. Emerging economies confront headwinds of their own. The consensus of forecasts has lowered the prospects for Chinese growth to 7.6 per cent in 2014, while India is forecast to achieve 6.6 per cent. Yes, by the standards of other significant economies, these remain stellar figures. But both economies confront structural difficulties in sustaining fast economic growth. Most important are the challenges facing China, already the worlds second-largest economy. In the immediate aftermath of the crisis, China kept up rapid growth by forcing a huge credit expansion. The share of investment in gross domestic product jumped from 42 per cent in 2007 to an incredible 48 per cent in 2012. Shifting away from reliance on investment towards more balanced and slower growth creates a real possibility of discontinuities in economic growth. If Chinas growth were to tumble, the consequent fall in commodity prices might cause substantial difficulties to commodity-exporting countries. Many economies around the world are likely to be adversely affected by sharp shifts in financial conditions as the ultra-easy monetary policies of the high-income economies reverse. Signs of such turmoil emerged with the possibility of tapering by the Fed. Extreme monetary easing has created a multitude of carry trades, with investors borrowing cheaply in low-

interest currencies, notably the dollar, and investing in riskier assets. The unwinding of such trades is usually disruptive. Yet there remain bigger long-term questions. One concerns what might be described as the world economys credit-boom addiction. A related query is how the necessary rebalancing of demand and supply across the world economy will proceed. A big difficulty here is the transformation of the eurozone into a huge Germany, with a shift from a current account deficit of 1 per cent of GDP in 2008 to a likely surplus of 2.5 per cent of GDP in 2013. This is a beggar-my-neighbour policy in a world economy suffering from a savings glut. Yet perhaps the biggest economic questions concern the likely growth rates of the high-income economies in the years ahead and the feasibility of continued convergence between emerging and high-income economies. On the first, the question is whether high-income economies can return to pre-crisis growth rates or even regain pre-crisis output levels. On the second, the concern is whether the growth rates of emerging and developing economies can continue to exceed those of highincome economies by a large margin as the latter recover. The answer to the first question is: we do not know. The answer to the second is: probably. The balance of economic power will continue to shift. But the world economys near-term future is full of risks.

Confidence takes welcome turn

Continued from Page 1

5 per cent in 2014 in a bid to reduce the budget deficit. Beyond the large and richer economies, the early autumn has witnessed some stabilisation of the other big global players. Chinas growth rate dipped from 7.8 per cent in 2012 to an annual rate of 7.5 per cent in the second quarter of 2013, its worst performance since 1990 when China was subject to sanctions in the aftermath of the Tiananmen massacre. Although financial and economic reform is urgently required in the worlds second-largest economy, the deterioration in growth appears to have been checked and some stability has returned. The same modestly optimistic story does not apply to the eurozones periphery or to other emerging economies. While a sense of imminent doom has passed and the eurozone periphery is stemming its losses and improving its trade balances, fiscal positions remain weak and unemployment is too high for comfort. Vulnerability to economic or political shocks remains. Mario Draghi, president of the European Central Bank, said recently that the recovery was weak, fragile and uneven and from low levels. The improvement in Europes current account has a downside. Its increased surpluses over the past few years have been matched by deteriorations elsewhere, mostly in emerging economies. This has created new vulnerabilities that were exposed over the summer. Capital flight from countries such as Brazil to India, after the US Federal Reserve hinted that it was considering scaling back its monetary loosening, led to rapid currency depreciation, inflation and a greater burden of foreign currency debt. Growth slowed, leaving the dilemma of whether to loosen monetary policy with associated currency risks, or to tighten it and hit growth further. HSBC chief economist Stephen King said the developments were not so much a disaster, but a short-term

constraint on growth. In a multi-speed world where the grounds for optimism are as diverse as the causes for concern, simple policy recommendations are tough to make. Everyone understands the validity of the IMFs spring warnings of the difficulties and dangers of removing extreme monetary stimulus in the US, Europe and Japan, but this knowledge has few practical applications. In September, the Fed declined to begin a taper of its asset purchase programme, citing a still too weak recovery. There are no imminent signs of monetary tightening in other advanced economies. After the summers turmoil, Ms Lagarde says the US has a special responsibility to normalise its monetary stimulus very carefully and should do so after dialogue with other countries. Fiscal policy is just as fraught. The US is standing again on the edge of a fiscal precipice. The government

7.5%
Chinas growth rate over the second quarter of 2013

shutdown in early October has a limited effect on the US and global economy but if it were to be followed by a failure to raise the government debt ceiling, the threat of a US default would be a real one. In Europe, the improved outlook and a slightly looser fiscal stance should reduce some immediate tensions over fiscal policy but will not help create a durable fiscal pact for the single currency area. The key task for countries is to seek ways to improve productivity to boost the longer-term outlook. As the Organisation for Economic Co-operation and Development regularly states, painstaking and persistent structural reform over many years is the proven way to boost the longer-term performance of economies. If the world moves out of the emergency ward in the months ahead, the need for growth-enhancing reform will become all the more important.

Contributors
Jamil Anderlini Beijing bureau chief Daniel Ben-Ami Freelance journalist and writer Chris Giles Economics editor Robin Harding US economics editor Claire Jones Economics reporter Brooke Masters Companies editor Michael Steen Frankfurt bureau chief Martin Wolf Chief economics commentator Hugo Greenhalgh Commissioning editor Michael Crabtree Picture editor

Steven Bird Designer Russell Birkett Graphics Rachel Savage Research For advertising details, contact: Ceri Williams, [Link]@[Link], 0207 873 6321, or your usual FT representative. All FT Reports are available on [Link] at [Link]/reports Follow us on Twitter at [Link]/ftreports All editorial content in this supplement is produced by the FT.

FINANCIAL TIMES FRIDAY OCTOBER 11 2013

World Economy

US forecast for next year points to significant headway at last

Growth Outlook brightens for households, business and housing, writes Robin Harding
he tale of the US economy during the past four years has been of the struggle between the engine of an increasingly strong recovery and a succession of headwinds caused by the financial crisis. Will 2014 be the year when the recovery finally makes headway or will it stall once more in the face of yet more economic squalls? Fallout from the turbulence has led to a remarkably consistent pattern since the recession ended in the summer of 2009: no matter what happens, and no matter what anyone predicts, US growth ends up being 2 per cent or a little bit more. The concern now is whether anything has happened to break the trend. The US Federal Reserve is wrestling with precisely this issue, as it tries to decide whether to reduce its third round of asset purchases from $85bn a month. The scenario it set out in June of a tapering later this year was predicated on an acceleration in growth heading into 2014. When the Fed surprised markets by not tapering in September, the reason it gave was the lack of evidence of any acceleration. Central bankers often seem in two minds on the growth outlook. Their need to talk up an economy to boost confidence is at odds with the need to talk it down to explain stimulative monetary policy. But shortly after the September meeting, William Dudley, president of the Federal Reserve Bank of New York, gave a speech that seemed even more conflicted than usual. On the one hand, Mr Dudley pointed

to improving fundamentals as a sign that the economy is slowly healing, On the other, he set out a long list of problems. As a result, we have yet to see any meaningful pick-up in the economys forward momentum, he said. Much is better now than it was four years ago. The most obvious area of recovery is in the health of household balance sheets. According to the latest data, household debt is back to down to its 2003 pre-bubble level relative to the size of the economy. The net worth of households is hitting new highs. The housing sector is recovering. All across the US, the excess of houses built during the bubble seems to have been absorbed, and the number of homes in foreclosure is in rapid decline. The underlying fundamentals supporting business investment are also good, said Mr Dudley in his speech. Profit margins have been high and cash flows strong for some time. Credit availability has been gradually improving. With a brightening outlook for households, business and housing together a large share of the economy all should be set fair for a strong years growth in 2014. The trouble is those problematic headwinds, the biggest of which is fiscal policy. While the US managed to delay a fiscal squeeze for longer than most industrial economies, austerity arrived in 2013, with combined tax rises and spending cuts that the nonpartisan Congressional Budget Office estimated would knock 1.75 percentage points off economic growth this

The sun also rises: the US economy is expected to move into recovery in 2014, but faces challenges along the way, particularly in terms of fiscal policy

Reuters

year. Many analysts regarded the degree of fiscal drag in 2013 as an optimistic sign for 2014. The point is that if the economy was managing to trundle along at 2 per cent growth given this big a fiscal squeeze, then surely, when the squeeze starts to fade next year, the economy will surge. Optimism is tempered with reality, not least as sequestration namely, across-the-board public spending cuts take hold. The recovery of household finances is also not all it seems. It is unevenly distributed: the households that have gained the most are the richest, especially those with large holdings in the stock market. If debt-fuelled consumption is out, households will have to spend from income and, as Mr Dudley noted, that will be tricky. Real disposable income growth has grown at less than a 1 per cent annual pace since March, he said. Furthermore, the recent data do not yet clearly indicate a firming in the income growth rate or the two important components of

labour income growth hours and compensation. Nor will businesses necessarily start to invest in a big way, regardless of profits, with government and consumers cutting back and no obvious shortage of manufacturing capacity. Putting all these factors together, I still conclude that there is a basis for a pick-up in growth as fiscal restraint lessens, said Mr Dudley. He added that the impetus would be limited without a solution to the chicken-egg problem of low consumer demand giving businesses little reason to spend more, with this in turn leading to low demand. Hence he was ready to support a delay in Fed tapering in order to keep mortgage interest rates down and boost the economy. A possibility for 2014 is that this might not happen, with the curse of 2 per cent growth continuing. That said, for the first time in some years, there is the chance of very positive 2014 developments and, finally, perhaps, an end to those headwinds.

GDP growth
Selected countries (annual % change) 2008 10 8 6 4 2 0 -2 -4 -6 -8 Brazil 6 4 2 0 -2 -4 -6 -8 Indonesia
Source: World Bank

2009 2010 2011 2012

China

France

Germany

Greece

India

Japan

Mexico

Russia

UK

US

Anticipation rises of reforms to put China back on growth track

Planning

The old model for expansion is running out of steam, writes Jamil Anderlini
With great pomp and ceremony, the Chinese government unveiled its new pilot free trade zone in Chinas commercial capital Shanghai last month. The project has been touted as the successor to the special economic zone set up in Shenzhen, across the border from Hong Kong, in the 1980s by Deng Xiaoping, Chinas leader of the time, as he embarked on a series of market experiments. Optimists predict Chinas current leaders will use the new 28 sq km zone to introduce their own ambitious reforms and point the worlds second-largest economy back to sustainable growth for decades to come. After more than three decades of rapid expansion, which owes much to the policies of Mr Deng, the growth model he introduced is running out of steam. Chinas economy grew 7.8 per cent last year, its slowest pace since 1999. If it declines to less than 7.6 per cent, this year will see the worst growth performance since 1990, when China was subject to sanctions in the aftermath of the Tiananmen massacre. Despite the fact that one broad measure of credit expanded at its fastest pace ever in the first half of this year, growth continued to decline. It was 7.5 per cent in the second quarter, down from 7.7 per cent in the first. Activity picked up in the third quarter, thanks in large part to the credit expansion, but not even the most bullish analysts or officials believe Li Keqiang, the premier, and his colleagues can maintain rapid growth without major financial and economic reforms. For many China observers and market participants this is the make or break moment. After three dec-

Market experiment: China hopes the project will repeat the success of the special economic zone in Shenzhen Reuters

ades of rapid growth the economy is running out of steam but more importantly there are deep-rooted structural issues that threaten sustainable growth and even social stability, says Wang Tao, chief China economist at UBS. If the new government does not launch sweeping reforms now, many people believe Chinas economy is heading for ruin. As well as Mr Dengs reforms in the early 1980s, many people are comparing the new reform agenda with the late 1990s, when premier Zhu Rongji set out to overhaul state-owned enterprises in the face of the Asian financial crisis. The reforms Mr Zhu implemented included the firing of around 40m state employees who had come to expect lifelong iron rice

bowls from their state factories and relied on their work units to provide them with everything from housing to healthcare. Mr Zhu also began housing reforms that resulted in a transfer of wealth from the state to households and created, virtually overnight, the commercial property sector that is now the single most important driver of the Chinese economy. Last but not least, Mr Zhu steered China into the World Trade Organisation, setting the country up for an export and investment boom that allowed it to become the worlds largest trader of goods and the worlds second-largest economy after the US. All of these powerful drivers have begun to falter and are no longer enough to keep the economy growing

Michael Spence 2001 Nobel Prize for Economics

The US is in a steady but slow recovery led by private sector adjustment and extensive deleveraging. But growth is below potential and the non-tradeable sector is short of aggregate demand. Europe is not in recovery. It remains in a fragile situation. Japan may be beginning a recovery, but it is too soon to tell.

at the rates to which it has become accustomed. Especially since the global financial crisis, when China saw its exports fall dramatically and its fledgling property sector slump for the first time, growth has become increasingly reliant on credit. Many warn that Chinas own financial crisis could lie ahead. Fundamentally, we believe the challenges facing the Chinese economy have not been addressed, namely industrial overcapacity, high corporate and local government debt intertwined with risks associated with a rapidly growing shadow banking sector and a latent property bubble, says Jian Chang, an economist at Barclays. We cut our 2014 [GDP growth] forecast to 7.1 per cent [from 7.4] on slower potential growth, significant financial and fiscal risks and an urgent need to adjust the economys structure and make structural reforms. Most analysts agree that Chinas new leaders need to reduce the economys reliance on investment and boost consumption, and that the government also needs to reduce its control over the allocation of key productive resources. As a tool to deal with these various challenges, the free trade zone in Shanghai appears woefully inadequate on its own. Chinas cabinet highlighted six areas for the zone to focus on: financial services; shipping and logistics; commercial trade; professional services such as law and engineering; culture and entertainment; and social services including education and healthcare. Specific intentions were typically vague and, with no sign of big bang reforms from the Shanghai launch, most analysts and investors have turned attention to a major Communist Party conclave scheduled for late November. Many hope that the anticipated reforms needed to give China more sustainable long-term growth will be unveiled at that meeting.

FINANCIAL TIMES FRIDAY OCTOBER 11 2013

World Economy

Big lenders pushed to provide contagion control

Reform Some ideas to make bank operations safer in a financial crisis may conf lict with the needs of customers, writes Brooke Masters

our years ago, when the Group of 20 leading nations met in London, many promises were made. The financial system would be reformed, the leaders said, to prevent a repeat of the chaos that followed the 2008 collapse of Lehman Brothers. How many of those promises have been kept? Reforms have been implemented. Banks have been hit with tighter capital requirements and the first ever global liquidity rules. Derivatives trades seen as a key contributor to the crisis are being pushed on to exchanges and into central clearing where the risks they pose can be more easily monitored and managed. The reform impulse remains strong, in part because regulators and politicians are not convinced that cracking down on banks and trading is enough to make the broader system safe. Some argue that many of the global banks that survived the crisis are so large and complex that they remain too big to fail, and taxpayers could once again be required to come to the rescue. Others point to the growth of shadow banking non-banks that compete head to head with banks to

supply credit but are not as closely monitored or regulated. We expect pressure on firms and regulators to simplify their operations, and their rules, to make these more transparent to one another and to other stakeholders, not least boards, politicians and investors, says Clifford Smout, a former Bank of England regulator now at Deloitte, the professional services firm. To some extent, the global reform effort has fragmented, with some leading financial centres focusing on local safeguards to top up the global Basel III capital and liquidity reforms. But there remain some common threads. The Financial Stability Board, led by Mark Carney, the Bank of England governor, co-ordinates global efforts and has put contagion at the top of its to do list. G20 members that are home to big banks are pushing those institutions to write resolution and recovery plans that would make them easier to shut down or break up in a crisis. The FSB has adopted general principles for these plans, known as living wills, and countries, including the UK and US, are working with banks to write them. The effort is proving complex.

Banks, as structured now, are not easy to dismember, and a key part of the G20 agreement that bank debt investors should take losses before taxpayers do requires a massive change in the kind of bank bonds and other debt that is marketed and sold. Cross-border resolution will need a lot more work, says Barney Reynolds, a lawyer at Shearman & Sterling. This is in part legal coming up with legislative and other arrangements that give comfort that collateral and other assets will be available

Edward Prescott 2004 Nobel Prize for Economics

Much of the developed world is sinking deeper into depression relative to its pre-2008 trend, with the US and southern European countries doing the worst. Moreover, many developing countries, in Asia in particular, are doing well. Growth of 2 per cent in gross domestic product per working age population is healthy.

to affiliates in other states in an emergency. In part, it is practical, in as much as many states are likely to be suspicious of placing any reliance on assets held abroad, regardless of the legal regime, and will want sufficient assets to be held locally. Some of the work, which focuses on making individual parts of banks easier to hive off, cuts across what some of their most lucrative corporate customers need because it will make it harder and more expensive to move money quickly around the world. The obvious answer of sorting out too big to fail by simplifying the banks, reducing inter-connectivity and improving the quality of data are, on the face of it, appealing, says Giles Williams, of KPMG. However, it does not recognise what the large end users really want. They need banks that can facilitate trade finance, manage risk, make payments and provide credit which needs global players. We do need banks that can respond to these key corporate requirements to make sure that global trade and investment continues. One of the main thrusts of the global reforms centres on making sure that shadow banks hedge

funds, private equity groups, peer-topeer lenders and other sources of nonbank credit do not become vectors of transmission for instability. The effort is grounded in experience, namely when the freezing of the market for asset-backed securities sent ripples across the system and the Lehman collapse left many creditors grabbing for the same assets. So far regulatory effort concentrates on making sure that individual securities are not reused as collateral for too many transactions and that the valuation of that collateral does not rise and fall too rapidly. The nebulous nature of shadow banking and broad aims of the reform drive are making many people nervous, particularly in the EU, which is moving forward quickly in this area. These non-banks may be in for tough scrutiny if regulators are convinced they mistreat customers. Beware conduct risk, says Stephen Dawson, at lawyers Shoosmiths. When lenders in new consumer credit realise the scope and scale of this concept, we will see a lot of people running for the hills, he adds. Virtually every aspect of a lenders business model can be challenged.

Wages are not the whole story for real incomes

Households

Many variables shape the experience of a downturn, says Daniel Ben-Ami

Beyond the truism that financial crises and recessions are painful, the advanced economies have had widely divergent experiences in recent years. This is clear even at the level of economic growth. At one end of the scale, Australia has avoided recession altogether, while at the other, Greece has suffered a contraction every year since 2007. These two are outliers, but it should be clear many variables shape the way countries experience a downturn. These include unemployment levels, the provision of a social safety net and the performance of financial assets. All have a bearing on income. Although wages are the largest source of income for most households they are far from the full story. Transfers from government (such as social security) and employers (such as in employee health insurance) can be an important part of the picture. So can investment income, including dividends and capital gains. For the poorest, government transfers can play a big role in ameliorating the effects of recession. By contrast, the richest benefit disproportionately from investment returns. It is no surprise that the incomes of the wealthiest Americans are closely correlated to stock market performance. Despite its size, the US is in its own way an outlier, as the squeeze on household income started well before the financial crisis. Median income hit a record high in 1999, according to data from the Current Population Survey (CPS). Despite a dip followed by recovery, the level in 2007 was still slightly below the peak in real terms. Between 2007 and 2012, it fell by 8.3 per cent, according to the CPS data. Wages had been more or less stagnant for the two decades before the peak, but other factors counteracted this. Increased female participation in the workforce meant household incomes could rise even if wages were static, and transfers played a significant role. Despite the longevity of the income squeeze, the recent downturn has particular characteristics. This recession is very different from the last because it is employment-driven, says Richard Burkhauser, a professor of policy analysis at Cornell University. It is the first time that the employment of both men and women has fallen. This is the key factor in

falling household incomes rather than the dip in wages, he adds. This time, government transfers also cushioned the impact of the squeeze on median incomes. They have had a much more palliative effect than in the 1980s recession, he says. In the UK, the squeeze on household incomes predates the financial crisis but does not go as far back as in the US. From 2002-07, household incomes only grew by about 0.5 per cent a year much lower than the long-term average of about 2 per cent. However, a study by the Resolution Foundation, a think-tank, found that average disposable incomes fell in every region but London. Median incomes for the UK as a whole did not start to fall until 2010. When they did, wages were hit first, so those at the top and middle of income distribution felt the greatest effect. More recently, those on lower incomes have started to feel the impact of benefits cuts. Germanys experience differs from others in important respects. For a start, the persistence of a gap between the west and the east of the country, more than two decades after unification, is striking. According to a German
Professor Richard Burkhauser: This recession is different

Socio-Economic Panel Study, a survey of households, real disposable household incomes for western Germany were at about the same level in 2005 as in the early 1990s. In contrast, median incomes in eastern Germany rose in the 1990s before dipping in the subsequent half decade. Its experience since the financial crisis also differs from the US and UK, with median income rising slightly. Much of this can be accounted for by lower unemployment. This is the most important aspect, says Markus Grabka, a researcher associate at DIW Berlin, a think-tank. The German labour market is a very surprising story. In the UK, the IFS, a think-tank, has done a simulation on trends in household income until 2015-16. It concluded that much of the pain is still to come. Many changes to taxes and benefits have yet to take effect. Those at the top and middle have experienced falls and are not likely to enjoy a strong recovery. In contrast, the bottom end looks set to suffer further. As for the US, Lane Kenworthy, a professor of sociology at the University of Arizona, is downbeat: If we dont get back to the rising employment we had in the 1980s and 1990s, median household income will stay flat for the long run.

FINANCIAL TIMES FRIDAY OCTOBER 11 2013

World Economy

Latest fad confuses rather than clarifies

Forward guidance Policy does not always have the desired effect, writes Claire Jones
he staid world of central banking might look immune to fashions whims. But underneath the pinstripes, lurk a group of technocrats keen to stay in vogue. Central bankers are a cosmopolitan crowd. Their global nature has led to them aping each others policy frameworks. The latest fad is for forward guidance. Before guidance became so popular, one of the most common mantras uttered by the worlds monetary guardians was that they never committed themselves to future actions. No longer. The US Federal Reserve, the Bank of England and the European Central Bank have all now experimented with guidance. With rates near zero, it is one way that central banks can signal their willingness to keep monetary policy ultraloose until economies near full health. Put simply, forward guidance involves telling people what you are going to do before you actually do it. Two main forms have emerged. The first involves promises to keep rates on hold for a fixed period of time. This method, known in central bank speak as time-contingent guidance, was popularised by Bank of England governor Mark Carney when still head of the Canadian central bank (see right). The Fed took guidance a step further in December 2012 by introducing the second sort of pledge a commitment to support economies until unemployment, or another economic variable, reached a level commensurate with a well-entrenched recovery. This form of support, often referred to as state-contingent guidance, was adopted by both the Bank of England and the European Central Bank. The policy has, so far, met with mixed results, on occasion leading more to confusion than clarity.

BoE Forward guidance needs time to convince

Mark Carney did not invent forward guidance, writes Chris Giles. But applying the idea after he became Bank of England governor in July showed his commitment to transforming monetary policy. He was an early user of forward guidance at the Bank of Canada in 2009 and convinced of its success. It worked because it was exceptional, explicit and anchored in a highly credible inflation-targeting framework, he told UK MPs in February. It also worked because we put our money where our mouths were by extending the almost $30bn exceptional liquidity programmes we had in place for the duration of the conditional commitment. And it worked because it reached beyond central bank watchers to make a clear, simple statement directly to Canadians. But the policy introduced in the UK in August was only superficially similar to that introduced in Canada four years earlier. Of the three reasons Mr Carney gave for success there, only his desire to communicate with UK households and companies survived. There were three big differences. First, instead of offering explicit guidance regarding how long interest rates would remain at the floor of 0.5 per cent, the UK followed the US Federal Reserves policy of statecontingent guidance, linking exceptionally loose monetary policy to the state of the economy and, in particular, the unemployment rate. Second, the Bank showed reluctance to put its money where its mouth was. This was an exercise in communication rather than a financial commitment. And third, unlike the theoretical writing of academics such as Michael Woodford of Columbia University, the policy was not an attempt to bind the BoE to hold interest rates lower for longer than otherwise, so imparting greater stimulus. Speaking at the policys launch, Mr Carney said: First and foremost [forward guidance] is a clarification. He said it would make stimulus more effective, reduce uncertainty about monetary policy and provide a framework to test the degree of inflationary pressure in the economy. The banks nine-member Monetary Policy Committee threw out its policy of taking a fresh decision on interest rates every month, replacing this with an intention not to raise Bank rate above its current level of 0.5 per cent at least until the Labour Force Survey headline measure of unemployment has fallen to a threshold of 7 per cent. When the unemployment rate fell below this threshold, the MPC would think again about rates, but policy would not necessarily be tightened immediately. Since the target remained keeping inflation at 2 per cent, the MPC introduced three knockouts that, if breached, would remove the unemployment guidance. These would be triggered, the MPC said, if its forecast for inflation 18-24 months ahead ran higher than 2.5 per cent, if market or household expectations of inflation rose to an unacceptable level, or if the Banks Financial Policy Committee advised that loose monetary policy was threatening financial stability. If the BoE thought introducing forward guidance would be easy, the period since August has proved a rude awakening. The central bank has been dogged by an inability to explain whether it thinks the new policy introduces more stimulus to the economy. Mr Carneys response that the stimulus was more effective has failed to reassure inquisitive observers.

Yields in the US and elsewhere shot up when the Fed first announced its decision to taper, with signs that the US central bank was considering pulling back from bond buying, triggering turmoil in the emerging markets that have been among the main beneficiaries of the liquidity that is a byproduct of central banks quantitative easing. Yet the Fed decided to pull back from tapering at least for now and chairman Ben Bernankes apparent refusal to explain why met with much criticism. Economist John Llewellyn, of Llewellyn Consulting, says: As we and most of those to whom we have talked understood it, the primary purpose of increased Fed transparency was to clarify what it was likely to do, and why. It was designed to spell out its reaction function and so manage expectations. If so, this strategy has been compromised. It is now harder to grasp precisely what is motivating the Federal Open Market Committee, particularly where the labour market is concerned. He adds: This retreat threatens to diminish the Feds credibility, and add to financial market volatility. The Bank of Englands and ECBs guidance is, in part, a response to reaction to the Feds tapering schedule. Mr Carney said in August when unveiling the BoEs guidance framework: This is exactly the time when something like this is appropriate. We are at the start of a renewed recovery. This is very welcome, but its after a very sharp recession and a very long period of very weak activity. . . In the relief about the recovery . . . an understandable expectation can build up, that that immediately means pulling back on the exceptional monetary stimulus which is really at the heart of helping to get the recovery

Much of the confusion has centred on how committed to guidance central banks actually are

going. But both the BoE and ECB have found themselves unable to suppress the rise in bond yields triggered by talk of Fed tapering. The BoE has also found its views about when it is likely to need to raise rates out of sync with those of financial markets, which expect official borrowing costs to rise in 2015, while the BoEs forecasts imply rate increases are unlikely to come until the following year. Jens Larsen, economist at RBC Capital Markets, says: If anyone thought you could delink long-term interest rates in the UK and the eurozone from those in the US, then that was always a bit of an illusion. Central banks have managed to refine their message. What makes it difficult is that the Fed is also struggling to get its message across. Much of the confusion has centred on how committed to guidance central banks actually are. They have qualified their commitments by saying any signs of price or financial instability will trigger a review of their frameworks. They have also been at pains to stress that there is great uncertainty about what will happen to their respective economies. Mr Larsen says: The commentary from the Bank of England has been that forward guidance is a way of structuring policy makers uncertainty about the economic outlook, not a way of removing that uncertainty. Markets are struggling with that message. He adds: Theres a real communications challenge here. When youre looking at something like the BoEs or the Feds framework, then it is something thats inherently complicated. [Forward guidance] is an attempt to explain what theyre doing, and as an attempt it strikes me as pretty complicated.

The man with the plan: Mark Carney, Bank of England governor, is a proponent of forward guidance
Bloomberg

The response that stimulus was more effective failed to reassure observers
Andrew Tyrie, chairman of the Treasury select committee of MPs, was withering. Have you ever heard a governor of a central bank come before a committee and say: Do you know, we announced this policy and we are pleased to announce it has made our existing policy less effective? I just do not think that is telling us anything, he complained in September. But the policy is far from doomed. Its introduction came alongside the most surprisingly positive economic data of the past five years. MPC members say it is therefore not surprising that market expectations of the first interest rate rise have been brought forward. Issues around the timing and pace of a tightening of monetary policy will be more pertinent as the recovery gathers strength and rate rises begin to be discussed in earnest. Until then, forward guidance can be summed up as intending to encourage the recovery to strengthen naturally until the MPC begins to worry about inflation. For now, that means no change in policy.

IMF adopts a more Keynesian line on deficits and stimulus

Fiscal policy

Study advises rich nations to be more cautious on debt, writes Chris Giles
A recovery appears under way in advanced economies. Inflation is under control and prospects for companies have brightened. But this good news has done little to still arguments over fiscal policy in Europe, Japan and the US. As for taxes, spending, borrowing and debt, there is as much disagreement and fear as ever. As this report went to press, the US was mired in a vicious debate over its budget, which led to a government shutdown. Even if this spat is resolved, the relief will be temporary, as Republicans and Democrats still have to agree to raise the debt ceiling this month or face the possibility of the US sovereign defaulting on its obligations. Fiscal tensions are almost as deep in the eurozone, which is likely to need additional lending to Greece and Portugal within the next nine months. Agreeing this will be as difficult as ever and that is before the bigger question of official sector debt write-offs is even considered. Japan faces fears that its plan to raise sales taxes from 5 per cent to 8 per cent next year will undermine its fledgling recovery. And, just as the main British political parties had reached consensus in supporting the deficit reduction programme, the Conservative party has tried to recreate division by using its autumn conference to announce a tighter ambition for fiscal policy. Targeting a budget surplus in normal times would require austerity until the end of the decade. With political tension so high, the politics of fiscal policy have remained as poisonous as ever, but this has not been replicated in economics. In fact, there has been

something of a meeting of minds among economists. While disagreements over the best path for deficits and debts still exist, particularly related to applying theory in practice, there is a developing consensus over some of the parameters of the debate. This consensus was best described in an International Monetary Fund research note published in September that attempted to summarise the debate. The paper contained elements the camp supporting fiscal stimulus could cheer and also had something for those of a more austere nature. Significantly, it was endorsed both by Olivier Blanchard, director of the IMFs research department, and Carlo Cottarelli, director of the fiscal affairs department, who have not always seen eye to eye. Perhaps its strongest conclusion is that when things start to return to normal, rich countries should be more cautious than before the crisis about the burden of debt deemed acceptable. The evidence shows that most advanced economies fiscal buffers were not big enough to allow them to easily absorb the severe economic shocks they suffered, with several countries experiencing sovereign debt crises as a result, the paper concludes. The implication is that the deficit reduction programmes in most advanced economies will go on for longer than thought to ena-

ble the burden of debt to fall further and faster than many currently plan. Prolonged austerity raises two other questions: should countries avoid fiscal stimulus in bad times? And should they try to cut big deficits quickly? The IMFs considered answers here will please those of a more Keynesian bent. For decades the received wisdom among policy makers was that fiscal policy was not much use in bad times, because the effects were small, came too late,

Should countries avoid fiscal stimulus in bad times? And should they try to cut big deficits quickly?
were difficult to calibrate and hard to reverse. After gathering evidence from the financial crisis, the IMF rejects these arguments, noting that the downsides to fiscal stimulus are not as large as thought. It goes further and says that when monetary policy is struggling to secure traction in a deep recession fiscal policy is an appropriate countercyclical policy tool. It found that in the crisis, most advanced economies designed and implemented a large fiscal stimulus

Kenneth Rogoff Professor of economics, Harvard University

The developed world is moving towards recovery, and the overall risks to growth are balanced. We have entered a period where political uncertainty weighs more heavily on growth than at any time since the 1970s. Despite these uncertainties, things should get gradually better.

quickly, efficiently and effectively. Most of the policies were also reversed quickly, proving they could be credibly temporary. In another change to precrisis orthodoxy, the IMF says central banks efforts to print money and buy government debt which had the effect of monetary financing of the deficit were not nearly as dangerous as thought in the pre2007 world, so long as the quantitative easing was used to complement deficit reduction efforts rather than as a substitute. When it comes to reducing a deficit, the IMF questioned whether countries should try to front-load their efforts to get the pain over quickly, as had been the conventional wisdom, but decided negative effects generally were too large. Austerity is not expansionary is the message. The fund recommends nations proceed according to the state of the economy, the condition of public finances, and the extent of financial market pressures. This, it added, at a gradual pace within a credible medium-term plan. In another IMF paper, the staff looked at successful deficit reduction programmes to learn what works. The simple answer is fast growth and deficit reduction programmes are best, but the former cannot be guaranteed, so the authors also looked at countries that reduced debt levels amid low growth. It was possible, they said, because there are some episodes where large debt reductions were achieved despite very difficult starting conditions of anaemic growth and a very high debt burdens. The trouble is, the recipe for success was difficult to define. A number of factors were at play, but hard work and a bit of luck played their parts, argue Helge Berger and Justin Tyson, IMF staff members. The conclusion is that policy can tame high deficits and rising levels of public debt, but it is quite an effort and is likely to result in a difficult start with low growth and bad headlines.

FINANCIAL TIMES FRIDAY OCTOBER 11 2013

World Economy
Population growth and the labour market
1950 working age populations
Selected countries (m)

Global working age population (15-64)

Billion 3.24 3.86 4.54 5.04 5.47

5.79

6.03

6.17

6.35

6.44

6.50

6.53

2100 working age populations

Selected countries (m)

China

332.9

1.53

1.75

2.11

2.62

India

930.8
Forecasts

Working age populations (15-64)

Selected countries (m) India
1000

223.4
US
800

China

614.6
Nigeria

102.2
Russia

602.0 67.1
600

US Indonesia

Japan

49.1
Germany

261.5

400

183.8
Russia Japan

47.0
Indonesia

41.3
UK Nigeria

200

42.9
Germany

62.5
UK

33.8
0 1950 55 60 65 70 75 80 85 90 95 2000 05 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100

20.9

29.8

42.4
Source: UN

SubSaharan Africa In line for demographic dividend while developed world must count cost of ageing population
The world is going through huge population upheavals with no end in sight this century, writes Rachel Savage. Europe and east Asia are ageing, while developing countries across Asia and sub-Saharan Africa with relatively young populations could reap a so-called demographic dividend. The impact of families in the developed world having fewer children has already started to ripple through society. The working-age population has started to peak, particularly in those countries that have good healthcare provision. For developed nations, the question of how affordable this is has never been so pressing. Yet for countries such as India and Indonesia, whose working age populations are set to climb until the middle of the century, the challenge is to provide their growing workforce with jobs. India will have almost 1.1bn people aged 15-64 by 2050, according to the UN Population Division, 320m more than today. Other nations face the prospect of supporting their ageing citizens. By 2050, more than half of Japans population and 40 per cent of Russias will be over 50. For a multitude of reasons, Russias population has been shrinking since the early 1990s. Meanwhile, sub-Saharan Africas population is booming. The UN predicts Nigeria (see separate report) will be home to more than 900m people by 2100, and could start to rival China as the worlds second most populous country behind India. While Nigerias fertility rate (defined as the number of children born to each woman) is likely to stay above the so-called replacement rate of 2.1 throughout the 21st century, fertility rates are falling across other sub-Saharan African countries.

Eurozone fails to cheer recovery

Reform Is enough being done, asks Michael Steen

hy is no one cheering? Technically, the eurozone exited its 18month recession in the second quarter and is back on the path to growth. Yet its supporters and critics have remained silent. Mario Draghi, president of the European Central Bank, may have the answer. I see a recovery that is weak, that is uneven, that is fragile and that is starting from very low levels, he said this month. Unemployment remains close to record highs, hitting the young and at its worst in the southern countries and Ireland. Spains rate is 26 per cent, rising to 56 per cent among the under-25s. And the growth that has been achieved has been anaemic. The International Monetary Fund expects euro area gross domestic product to shrink 0.6 per cent over the course of this year and grow less than 1 per cent next year. Output is still well below pre-crisis levels. But the mood on financial markets has changed, and this matters because flareups no longer turn into conflagrations affecting all 17 countries. Political crises in Italy, Portugal and Greece have passed without markets panicking. Much of that is thanks to Mr Draghis untested pledge to do whatever it takes to keep the eurozone together by buying the bonds of any country hit by speculation that it will leave. But is enough being done at a fundamental level to address the imbalances and contradictions to allow it to function as a single currency area in future? Officials in Brussels point to the nascent banking union, deficit reduction tar-

gets and structural reforms implemented in member states as tangible signs of progress. Others say the austerity imposed along with deficit reduction targets has set the region back, exacerbating contraction just when more expansionary public spending could have helped kick-start the private sector. Economically, the bloc remains an odd beast. Interest rates are arguably still too high in the countries worst hit by the crisis such as Spain and Italy, slowing their recovery chances, and too low for Germany and Austria, creating the risk of asset price bubbles. So what are the prospects for Europes great experi-

A large part of the puzzle is unblocking weak credit flows from banks into the economy
ment, as it stumbles out of recession and deals with the challenges of a slowdown in emerging markets and uncertainty in the US? A study by the Centre for European Reform, a thinktank, compiles predictions from leading economists on what the European economy will look like in 2020. Paul de Grauwe, the Belgian economist and professor at the London School of Economics, believes the northern creditor countries have failed to offset the austerity forced on the southern debtor nations with budgetary stimulus in the north and debt forgiveness. What is surprising is that [instead of protecting debtor nations] the European Commission has assumed the role of agent of

the creditor nations in the eurozone, pushing austerity as the instrument to safeguard the interests of the creditor nations, he says. George Magnus, UBSs former chief economist, says a symmetric macroeconomic adjustment is needed that implies states such as Germany adopt a more expansionary policy. There also needs to be rapid progress towards a banking union, including joint liability for banks, to sever the link between weak banks and weak sovereigns. Europe might well muddle through, he says, but the combination of the debt crisis, productivity shortcomings, and ageing populations have produced the most significant threats to the European economy and the legitimacy of its institutions since the 1930s. Holger Schmieding, chief economist at Berenberg bank, takes an optimistic view, seeing the absence of automatic transfers between economies as an advantage. Since member states cannot devalue or inflate their way out of trouble, they have had to make tough reforms that will eventually make them stronger. While the big picture is open to multiple interpretations, there are immediate concerns in getting the economy going again. A large part of the puzzle is unblocking weak credit flows from banks into the economy. With ECB supervision of the biggest banks on the horizon, Mr Draghi is clear that he expects improvement. We have strong hopes that credit will recover before [next October], he says. We would be in very bad shape if credit were not to recover by then.

Edmund Phelps 2006 Nobel Prize for Economics

Even structuralists like me can agree that nearly every nation in the global economy needs a strong rise in business investment if we are to regain prosperity. We cannot regain high prosperity until we manage to refresh our economies with innovative visions and ventures.