67221 POVERTY THE WORLD BANK REDUCTION AND ECONOMIC MANAGEMENT NETWORK (PREM) Economic Premise FEBRUARY 2012 • Number 75 JUN 010 • Numbe 18 Ascent After Decline: Challenges of Growth Otaviano Canuto and Danny M. Leipziger This note examines one of the most fundamental questions to emerge from the Great Recession of 2007–9: how to regrow global economic growth going forward? Although all are painfully aware that it may be 2013 or 2014 before the global economy returns to normalcy, no one is sanguine about medium- to long-term growth prospects. For this reason, the challeng- ing task of “regrowing growth� will take center stage for politicians and policy makers alike. One point is clear: without a resurrection of strong economic growth in major economies, the likelihood of rapid economic development in poor developing countries is diminished.1 How various elements will affect growth prospects is less clear, but vitally important. In the termi- nology of Hausmann and Rodrik (2003), this is a process of discovery and we are in somewhat uncharted territory. A sharp cleavage has become evident between the prospects by the European Central Bank. The Greek debt restructuring and challenges facing advanced economies and those facing has done little to calm markets and a Euro-recession is happen- emerging and developing economies. Attention in the ad- ing. Added wrinkles include the urgent need for fiscal consoli- vanced economies has focused on the financial sector, where dation in some countries and proposals to revamp prudential the global crisis originated, and on government balance sheets, regulations and capital adequacy requirements, which could which have been affected by the economic downturn, bailout adversely affect loans extended by banks in the short run even costs, and the need for massive fiscal stimulus. At the same as they reduce volatility and bolster the health of the financial time, to avert another Great Depression, monetary policy has system over the long run. been pressed into service in an unprecedented manner—from a In contrast, with a few exceptions, emerging and develop- coordinated cut in policy interest rates in October 2008 to op- ing economies remained robust sources of growth (Canuto, erations aimed at increasing liquidity in the nonfinancial cor- Garcia-Kilroy, and Silva 2011). In most, the recovery moved porate sector and rounds of quantitative easing (QE) in ad- beyond the replenishment of inventories and toward con- vanced economies. sumption and investment, with large increases in industrial The euro area faces serious difficulty from its dependence production using up excess capacity. Capital flows resumed upon bank credit and a sovereign debt problem in vulnerable and credit growth increased, to the point of leading most euro area countries that has compounded the problems of emerging economies to apply anti-inflation policies last year. banks holding government securities. These problems began However, as highlighted by Canuto and Leipziger (2012), the with the bailout of Greece in April 2010 and spread to Ireland, relatively weak growth prospects in advanced economies and Portugal, and Spain, despite the creation of a €750 billion stabi- the interdependence between the two sets of economies pose lization fund and substantial purchases of government bonds serious coordination challenges, and emerging markets, in- 1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise cluding China, are no longer immune to the prolonged global ancing in advanced countries, with private demand stepping low-growth scenario. into the breach as fiscal consolidation occurs, and (b) external rebalancing, involving a reduction in current account deficits in Obstacles to Global Recovery countries like the United States and a corresponding reduction The main obstacles to recovery include uncertainty in financial in current account surpluses, particularly in emerging Asia and markets, mounting sovereign indebtedness, growing solvency in China. concerns in the euro area periphery, a huge amount of matur- The big questions are, first, to what extent will uncertainty ing bank debt, and exposure of both households and banks to in financial markets, problems in the real estate sector and on stagnation in the real estate sector. The real estate sector will private balance sheets, and the end of restocking impede pri- pose a drag on the recovery and will continue to be a source of vate demand from firing in the advanced economies, and sec- risk to the financial sector for a while (Roubini 2010; Shiller ond, whether the domestic demand in emerging economies, 2010). Damaged balance sheets and lack of confidence have while robust in many, will compensate for weaker aggregate conspired to limit economic recovery in the United States, demand in the advanced economies.3 while Euro-skepticism has hurt European growth prospects. A crucial consideration, as noted above, is that the room Against this background, limited room remains for mone- for fiscal and monetary policy maneuvering in the advanced tary and fiscal policy maneuvering in advanced countries. A countries is now limited. The second round of QE in the Unit- delicate balancing act is called for—in particular, how to manage ed States ignited a fierce debate about a return to currency wars the handoff to private demand as fiscal stimulus fades, while and the perceived negative collateral damage to emerging econ- ensuring that fiscal consolidation itself does not worsen recov- omies as the money created spills over via the carry trade. One ery prospects to the point where sustaining public finances view is that such easing and other subsequent monetary policy slows growth and reduces fiscal revenues. decisions have been more of attempts to avoid a slide into defla- In the medium term, the return to strong growth is threat- tion than to surreptitiously engineer a devaluation of the dollar; ened by: with monetary policy rates close to zero and a political impasse • Rising debt levels. According to the IMF (2010), if growth is over further fiscal stimulus, those easing policies have been the 1 percent less than in the IMF World Economic Outlook only available option (Dudley 2010; Brahmbhatt, Canuto, and baseline between 2010 and 2015, gross government debt Ghosh 2010). in the advanced economies will exceed 120 percent of The trend of decreasing output growth rates in advanced gross domestic product (GDP), compared to less than 110 economies will have significant negative repercussions for fiscal percent in the baseline. For individual countries, the base- revenues relative to the precrisis situation, with adverse conse- line versus slow-growth scenario in 2015 is eye opening: quences for public debt dynamics unless eventually public ex- 250 percent versus 269 percent of GDP for Japan; 110 penditures are cut or taxes increased. Capital and labor will percent versus 122 percent for the United States; and 86 need to be reallocated from declining to expanding sectors, pos- percent versus 99 percent for the United Kingdom.2 ing major social challenges. This shift also means that the de- • Reduced trade prospects. Whether the movement of nomi- mand for consumer durables and investment-goods imports by nal and real effective exchange rates is enough in magni- advanced economies will be below precrisis trends during the tude and direction to achieve a global rebalancing of de- mand has become a controversial topic. In the absence of transition. Emerging economies that rely heavily on such de- coordinated actions to facilitate global adjustment, pres- mand will have little choice but to augment domestic sources sures for protectionist measures could arise. of demand to achieve growth rates similar to those that pre- • Global imbalances. A related concern is that, after initially vailed before the crisis. shrinking, trade deficits restarted widening in external- All of these trends mean that, globally speaking, emerging deficit countries where significant output gaps exist; that economies will have a difficult time compensating fully for the is, these economies have excess capacity, with GDP in fall in potential output and demand in the advanced econo- some cases significantly below potential. The opposite was mies. Growth in emerging markets and developing countries in then happening in external-surplus countries, and if this general has exhibited some resilience, but the global economic situation persists, it could end up derailing global recovery. growth may remain subpar for longer than it would be the case Doubts remain on whether exchange rate moves and dif- if smart national policies and multilateral coordination were in ferential growth rates will be enough to correct imbalances place. at an appropriate speed. The Changing Landscape for Growth Rebalancing Global Demand Many developing countries were mercifully spared the worst of The “strong, sustained, and balanced growth� sought by the the initial shock because their financial sectors are too poorly G-20 (2010) rests on two feats of rebalancing: (a) internal rebal- developed to take on high-risk transactions. In addition, the 2 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise normally precarious external environment was such that those rency combined with excessively high domestic real interest countries tended to manage their macroeconomic policy more rates makes Brazil appealing. But will this allure last when cautiously. In the case of emerging economies, the previously rates normalize in the Organization for Economic Co-opera- acquired fiscal space for anti-cyclical policies, combined with tion and Development (OECD) countries and when domes- accumulated foreign reserves and a margin to maneuver and tic debt must be financed and yields rise? If not, the new ease monetary policies allowed them to respond well to the for- steady state facing emerging-market and developing econo- midable shocks from advanced economies in 2008–9 (Canuto mies (EMDEs) might be capital shortage, not capital surplus. and Lin 2010). The policy conclusion is that domestic resource mobilization What can the changing landscape mean for medium-term efforts may need to be strengthened because international growth in developing- and emerging-market economies? And flows may be more selective and less inclined toward the short can the talk of delinking, multipolarity of growth, and the rise term. That EMDEs should be wary of volatile short-term of Asia fundamentally alter their policy options? At one basic flows is correct, and some have been proponents of the Chil- level, the domestic policy imperatives remain the same—name- ean disincentives of the 1990s toward hot flows (Perry and ly, to save more, invest better, and derive more value added Leipziger 1999); however, with large infrastructure needs and from exports, while increasing human and physical capital to high social expenditures in many countries, capital may still raise long-term productivity. Those challenges remain, as ever, be in short supply. the basic task of development. Related to capital flows and the need to maintain a com- Still, although the Growth Commission’s Supplemental petitive exchange rate without subsidizing exports (either ex- Report (CGD 2009) left the essential recommendations of its plicitly or implicitly), there is the issue of how far to rely on ex- 2008 Growth Report (CGD 2008) unchanged, the returns ports as the growth engine. The economic environment that once expected from the export-oriented, outward-looking faced the Republic of Korea and original East Asian Tigers strategy may have declined. This is an important finding. It is served them well, and they in turn have benefited from the in- revealing because countries have increasingly found that the credible growth performance of China. But how do new devel- standard prescriptions attached to the basic growth paradigm opments affect newer entrants into global markets? Specifically, do entail variations, especially concerning the role of govern- what is the impact of China’s thirst for raw materials and its ment in the development process. Moreover, if the landscape slowly rising labor costs, which retains its manufacturing mar- has fundamentally changed, policies need to adapt further as ket, at a time of slow world growth? well (box 1). China’s rise has been unprecedented, and along with its The issue of policy formation revolves around a number of dramatic export performance has come a new scale of demand questions whose answers are not yet totally clear. How funda- for natural resources from poorer countries. This is beneficial mentally, for example, has the economic landscape changed? overall, but when will China relinquish its dominance of low- El-Erian (2009) describes a “new normal� in which fiscal im- end manufactures and allow what Cline (2010) referred to as balances and rising debt will take their toll and raise the cost of the “adding-up problem� to absorb new producers? The an- borrowing. According to Chinn, Eichengreen, and Ito (2012), swer: as soon as China can move up-market and capture further we can expect imbalances between China and the United higher-value-added export markets. States to reemerge. Others point to the continuing rise of in- This is where the problem becomes dicier, because devel- come inequality as a major threat to the open trading system oped economies, faced with an unprecedented combination and also cite the strong asymmetries between job creation and of joblessness and offshoring (Blinder 2005, 2007, 2009), job destruction that drive global externalities of national poli- may not be politically able to maintain open markets for cies (Leipziger 2012; Spence 2011; Stiglitz 2011). Aghion and countries that run persistent imbalances while also subsidiz- Cagé (2012) examine how the role of government in the pro- ing their exports. Hence emerges (a) the argument that poor- duction of innovation must fundamentally change as well. er countries need open markets more than do emerging-mar- How might these new trends play themselves out? Will existing ket economies that can actively promote shifts to what Rodrik multilateral institutions retain sufficient support to help re- (2010) calls “modern tradables� to gain a foothold in global strain a new economic nationalism? And will the multilateral markets, and (b) the concern that poorer countries’ turn in system be under greater stress? the queue may be jeopardized by China’s ambitious export On the side of fiscal imbalances, debt, and capital flows, goals. If what Chinn, Eichengreen, and Ito (2012) predict is there have been bouts of short-term enthusiasm for emerging accurate about the lack of adjustment by the two great imbal- markets because of the abnormally low yields in the United ancers (China and the United States), and if these persistent States and the precarious state of the euro. This situation has imbalances lead importers to push back trade openness, then prompted some countries, like Brazil and several others, to im- the prospects for poorer developing countries may become pose capital import taxes. Still, the lure of an appreciating cur- dimmer. 3 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise Box 1. Policy Responses as Suggested by Ascent After Decline: Regrowing Global Economies After the Great Recession Rebalancing Global Growth: To insulate growth from the pernicious • Worker retraining—subsidies are likely to be needed to re- effects of slowly declining current account imbalances, combined train workers as part of a liberalization of trade or entry with capital flows searching for yield, there are several venues for strategy. action: • Research and development (R&D) spending—R&D are • Financial regulation—regulatory reform, particularly cross- critical to firms’ long-run growth, and could be useful for boundary coordination. macroeconomic stabilization. • Central bank policy—consider imbalances and asset pric- • Climate-related innovation—a two-pronged approach es in formulating monetary policy and minimizing threats to might work best: carbon pricing to discourage dirty tech- growth. nology, combined with subsidies to simultaneously encour- • Fiscal policy—tighten fiscal policy proactively. age clean innovation. • Cross-border coordination—countries must coordinate ac- • Industrial policy—consider a policy that targets subsidies tions, and countries with large deficits urged to consoli- to several firms in a given sector, spurring innovation as date. firms compete against each other, leading to higher pro- • International financial architecture—access to emergency ductivity and stimulating new product creation. financing through pooled reserve arrangements, bilateral Financial Shocks and the Labor Markets: Save first financial institu- swap lines, or from a special facility at the IMF would be a tions or jobs? The usual answer is that saving jobs might require plus. saving financial institutions first. But so far, despite vast sums spent Fiscal Policy and Growth: The pressing question of how to adjust fis- to bail out and shore up the financial sector, unemployment remains cal policy while maximizing the positive benefits for growth has no high. Yet, there are still reasons to focus on financial institutions: easy solution. Public indebtedness, especially in advanced econo- their systemic significance, the difficulty in deciding which sectors to mies, is already so high that merely stabilizing it may have highly pick for saving jobs, and the standard moral hazard arguments, negative consequences for potential growth. Lowering indebtedness which might predispose firms to build up leverage in anticipation of to thresholds that empirical studies indicate are safe, from the growth being helped. Going forward, a strong focus should be on job-creat- perspective, would take a Herculean effort. Reducing public debt in ing competition policies and easing barriers to entry because the li- advanced and emerging economies to 60 percent and 40 percent of on’s share of net job creation is in start-up firms. GDP, respectively, by 2030 would involve a staggering increase in Information Technology, Globalization, and Growth: How can informa- cyclically adjusted primary fiscal surpluses—by 8.25 percentage tion technology (IT) boost growth prospects? The standard channel points of GDP for advanced economies and by 3 percentage points is its positive impact on total factor productivity growth as a result of for emerging economies during 2011–20, with the primary surplus innovation. Three key variables influence economic welfare and kept at this level until 2030. The big question then is whether an growth: terms of trade, economies of scale, and variety. The secular adjustment of this magnitude will have adverse consequences for fall in the quality-adjusted prices of IT products (and hence, a poten- growth because of the aggregate demand effects. tial decline in the terms of trade) would tend to favor consumers and Infrastructure Policy for Shared Growth Post-2008: The infrastructure importers; at the same time, economies of scale combined with the sector attracted attention as a quick fix during the global crisis. In ability to import inputs (which also benefit from scale economies) G-20 countries, infrastructure accounted for 20–30 percent of the could benefit exporting countries. Incentive for businesses to do ex- average fiscal stimulus package: policy makers and politicians be- isting things better is where the real IT benefits lie. A good strategy lieved that public infrastructure projects might be the silver bullet to for a developing country might be to join a global supply chain and create jobs and keep up demand. Although the financial sector and eventually create better conditions for using IT at home, which is its regulation received most of the attention in the aftermath of the where the growth potential of IT lies. global crisis, infrastructure (which accounts for 12–18 percent of Innovation-Driven Growth: One thing is clear: innovation must be a key GDP) warrants a similar level of scrutiny. Policy makers tend to focus component of the new growth strategy—which in itself is not a novel on the benefits of infrastructure, paying little heed to the rents ex- idea. What is novel is that the process of innovation is undergoing tracted by construction firms, bankers, and operators—the burden radical change through open innovation, global innovation chains, of which ultimately falls on taxpayers. Regulation must restore bal- and the facilitating role of new technology platforms such as the Inter- ance among the key stakeholders—namely, operators, users, and net. Key considerations of the new growth strategy include: taxpayers. So far, investors and operators have been the big winners, • An increase in human capital operating through technolo- and there has been increasing political reluctance to get users to pay gy has a bigger impact on GDP than deregulation, which fully. operates through a positive impact on services. Rethinking Growth and the State: No one will seriously challenge the • Although a decrease in regulation and an increase in har- idea that regulation, whether in finance or infrastructure, is a funda- monization have similar effects, harmonization has a big- mental government role that, if anything, needs strengthening. The ger beneficial impact on services, while technology bene- issue is not so much size but smarts when it comes to defining the fits more from deregulation. government’s role, especially after the recent global crisis. Consider • The ultimate driver of growth is technology accumulation, the following aspects of the state’s policy role in knowledge invest- and this is strongly supported by human capital accumula- ment: tion. • Education funding—countries will benefit from increased • Delay in implementing policy change will be costly for pro- research funding. ductivity and growth. Source: Canuto and Leipziger 2012. 4 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise Forging the Link between Medium- and tion of economic powers must also come a renewed commit- Long-Term Growth ment to multilateralism, both by the advanced economies under stress and the emerging economic powers who are as- It is incorrect to assume that all is written in stone: if the crisis cending (Leipziger 2012). has taught one lesson, it is that when fundamental shifts occur, Perhaps there will be a bifurcation of possible scenarios the outcomes will entail new elements that shape future direc- ahead: in the first, advanced economies reacquire the ability to tions and affect policy choices. Given higher debt service costs grow, with a simultaneous global rebalancing of demand and in the medium term, risk capital will be scarcer. This shortage supply, and global growth can facilitate rather than hamper has implications, for example, for inherently risky projects in necessary structural change. In the second scenario, the global developing countries: namely, self-financing may become a ne- economy remains trapped in a suboptimal trajectory, consider- cessity rather than merely an option. ably below potential output, with the attendant strains in New opportunities may need nurturing, and whether in terms of political economy that make convergence more disor- the information and communication technology (ICT) area derly. Hopefully Ascent after Decline will be convincing about (Mann 2012) or through technological innovation (Aghion the need to strive toward the first path, and avoid the second. and Cagé 2012), government policy may emerge as vitally im- portant to move growth rates back to their previous levels. With About the Authors the medium-term outlook depressed—namely, with Japan, the Otaviano Canuto is Vice President and head of the World Bank’s eurozone, and the United States considerably below their po- Poverty Reduction and Economic Management (PREM) Network. tential output levels for years—others will need to pick up the Danny M. Leipziger is Professor of International Business and In- slack. And in so doing, if successful, EMDEs may, like China, ternational Affairs at George Washington University’s School of become new growth drivers (Canuto and Giugale 2010). Such Business and is Managing Director of the Growth Dialogue. Previ- a positive outcome requires action not only by developing coun- ously (2004–9), he served as Vice President and head of the tries, but also by major emerging-market economies that need PREM Network, as well as in other managerial positions in the to become custodians, along with OECD countries, of global World Bank. institutions and rules (Leipziger 2012). This note provides a bird’s eye view on Canuto’s and Major new economic players may increasingly see it in Leipziger’s Ascent after Decline: Regrowing Global Economies af- their self-interest to foster more-rapid convergence, not through ter the Great Recession (2012), http://issuu.com/world.bank. the decline of the existing global powers, but by growing faster publications/docs/9780821389423. in a growth-conducive environment (Leipziger and O’Boyle 2009). That environment requires greater commitment from Notes new and old economic powers. 1. Canuto (2010) posits several sources of “autonomous Conclusion growth� in developing countries, through which many develop- The Great Recession of 2007–9 was not simply a severe busi- ing economies will be able to keep growing even if advanced ness cycle; the global economy’s preceding boom, though un- economies remain trapped in their current doldrums. As time balanced and eventually unsustainable, also revealed deep passes, he sees a switchover of global locomotives taking place. structural changes in the global economic dynamic, and these However, a growth differential between developing and ad- are irreversible. Thanks to improved policies in much of the de- vanced economies may still emerge with higher or lower global veloping world and the corresponding opening of avenues to- growth rates, depending on the growth pace of the latter. ward convergence with advanced economies, the former ac- 2. Presumably, the effects would be even more adverse if inter- quired increasing weight and relevance. There is ground for a est rates rise. reasoned optimism regarding the maintenance of such policies 3. There are limits to this phenomenon, however, given that a and thus for the continuation of those changes in the future rebalancing of global demand and supply happens gradually, (Canuto and Giugale 2010). and interdependencies still exist even in a more multipolar eco- At the same time, as mentioned by Leipziger and O’Boyle nomic world. (2009), the emergence of new economic powers also entails References risks if they seek convergence through high growth rates with- out incrementally taking on new responsibilities for mainte- Aghion, P., and J. Cagé. 2012. “Rethinking Growth and the State.� nance of the system. Canuto and Giugale (2010) and Spence In Ascent after Decline: Regrowing Global Economies after the Great Recession, ed. O. Canuto and D. Leipziger, chapter 5. 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Shiller, Robert J. 2010. “Don’t Bet the Farm on the Housing Recov- Leipziger, chapter 3. World Bank. ery.� New York Times, April 10. Dudley, William C. 2010. “The Outlook, Policy Choices, and Our Spence, Michael. 2011. “The Impact of Globalization on Income Mandate.� Speech at City University of New York, October 1. and Employment: The Downside of Integrating Markets.� El-Erian, Mohamed A. 2009. “Europe’s Adjustment to a New Nor- Foreign Affairs 90 (4): 28–41. mal.� Pimco.com article, Pacific Investment Management Co. Stiglitz, Joseph. 2011. “Monetary Policy.� Remarks at the “Macro (PIMCO), Newport Beach, CA. and Growth Policies in the Wake of the Crisis� conference, Estache, A. 2012. “Infrastructure Policy for Shared Growth Post- International Monetary Fund, Washington, DC, March 7–8. 2008: More and Better, or Simply More Complex?� In Ascent af- World Bank. 2011. “Global Economic Prospects 2011: Navigating ter Decline: Regrowing Global Economies after the Great Recession, Strong Currents.� Semiannual report (January), World Bank, ed. O. Canuto and D. Leipziger, chapter 4. World Bank. Washington, DC. The Economic Premise note series is intended to summarize good practices and key policy findings on topics related to economic policy. They are produced by the Poverty Reduction and Economic Management (PREM) Network Vice-Presidency of the World Bank. The views expressed here are those of the authors and do not necessarily reflect those of the World Bank. The notes are available at: www.worldbank.org/economicpremise. 6 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise