A perilous journey to full recovery

“We have avoided collapse, but we need to guard against any relapse. 2013 will be a make-or-break year.” These were the words of Christine Lagarde, managing director of the International Monetary Fund, at the World Economic Forum last week. She was right. The business people, policymakers and pundits in Davos breathed a sigh of relief. For the first time since 2007, the focus of the discussion was not upon financial calamity. Yet the fact that the economies of the high-income countries have not fallen off their rickety bridge does not guarantee a swift return to growth. That may well come. But it is not yet ensured.

Confidence has improved. One indicator is the spread between the London interbank offered rate (Libor) and the overnight indexed swap rate (OIS), which offers a measure of the risk of default in the lending of banks to one another. These spreads have fallen to just 10 basis points in euros and 16 in US dollars. Stock markets have also recovered strongly from troughs in March 2009, particularly in the US. Spreads between the yields on sovereign bonds of vulnerable eurozone sovereigns and those on German Bunds have fallen substantially: in Italy, the spread fell from 5.3 percentage points in late July 2012 to 2.6 percentage points on January 25 2013; in Spain, it fell from 6.4 to 3.4 percentage points. As confidence in sovereigns has improved, so has that in banks. (See charts.)

Improvement in confidence is not limited to high-income countries. In its January Global Economic Prospects, the World Bank notes that “international capital flows to developing countries …have reached new highs”; that “developing country bond spreads …have declined by 127 basis points since June [2012]”; and that “developing country stock markets have increased by 12.6 per cent since June”. This then is a global change.

What explains the rising optimism? One reason is that feared disasters – a break-up of the eurozone or a fall over the US fiscal cliff – have been avoided. Another is that substantial post-crisis adjustment has occurred, above all in the US, where private leverage and house prices have gone through a significant rebalancing: US private debt is back to 2003 levels relative to gross domestic product, for example. Yet another explanation is rising trust in the competence of policy makers. Above all, central bankers have used ultra-expansionary monetary policies to pull the economies for which they are responsible for a long time. The US Federal Reserve’s federal funds rate has been 0.25 per cent for more than four years, with more to come. Even the European Central Bank, the most cautious of the big central banks, has adopted what would have seemed an irresponsibly easy policy in any previous era, with interest rates at 0.75 per cent since last July.

Even so, the future seems far from golden. In an update of its forecasts for the World Economic Outlook, the International Monetary Fund has painted a far from rosy picture: growth of 2 per cent in the US, 1.2 per cent in Japan, 1.0 per cent in UK and -0.2 per cent in the eurozone this year, though the emerging and developing countries are forecast to be far stronger, with growth of 5.5 per cent. The two-speed world economy remains in place.

In time, rising confidence should drive growth, but only if it is sustained. The question is whether it will be. On this there are reasons for both pessimism and optimism.

The big reason for pessimism is that high-income countries remain stuck in a contained depression. The extended period of ultra-loose monetary policy, including both exceptionally low interest rates and huge expansions in the balance sheets of central banks, is one indicator of this. Another is the size of fiscal deficits in a number of high-income countries. Yet another is the weakness of economies, despite the scale of the policy support.

Of the six largest high-income countries, only the US and Germany had higher output in the third quarter of last year than at their pre-crisis peaks and, even then, the rise was small, at 2.5 per cent in the US and 2 per cent in Germany. Output in France, Japan, the UK and Italy was below its pre-crisis peak. Output in France and the UK is stagnant, in Japan erratic and in Italy plunging. This is truly a miserable picture.

In the eurozone, the ECB succeeded in removing the tail risk of a eurozone break-up by gaining German support for a promise to buy sovereign bonds. It was victorious without firing a shot. But that does not tell us what would happen if it had to start firing. The ECB might still be forced to deliver on its promises to buy. Nobody knows what would happen, particularly if countries were not expected to stick to the conditions for support.

It is also possible to envisage big problems arising from managing fiscal and monetary policy. The dangers are of tightening too soon or of tightening too late: too soon and the recovery may be aborted; too late and inflationary expectations may become embedded, once again.

Some argue that an inflation upsurge is already around the corner. Now that Japan has joined the party with its “Abenomics”, that seems a bigger risk than before. Yet I doubt that these hitherto false prophets will be proved right – I fear premature tightening far more. But the uncertainty is great. The ability of policy makers to manage these risks successfully is doubtful, as Gavyn Davies noted in a comment on the contribution of Mark Carney, next governor of the Bank of England, to a panel in Davos.

But there are also reasons to be optimistic about the future. Emerging economies have shown sustained dynamism, even if there have been disappointments. With the rebalancing that has occurred, as well as an energy revolution, the US might surprise on the upside. Japan might escape deflationary doldrums. Finally, the return of private capital to the eurozone periphery might initiate a virtuous upward spiral of confidence and spending. A key to success everywhere will be timing the exit from exceptional policies.

Policy makers responded successfully. In the case of the eurozone, they were almost too late. But, in the end, the ECB promised action. That promise has proved stunningly effective, so far. A chance of a return to sustained growth is now emerging, though least of all in Europe. Substantial fiscal and monetary support is still essential. If policy makers sustain the effort, the world could be far closer to full recovery a year hence.

martin.wolf@ft.com