The world economy is suffering – not from a lack of growth, but from a deficit of confidence.
What’s missing is positive decisions made by investors, businesses and households – driven by the sort of spontaneous urge to act that the economist John Maynard Keynes called ‘animal spirits’.
Looking ahead to 2015, there are plenty of positives. The world economy should improve, with growth picking up to 3.4 per cent from 2.9 per cent in 2014.
But sometimes better indicators are not enough. Confidence is crucial and takes more than better data to improve.
Policy makers can rekindle confidence
Policy makers can play a key role in rekindling the animal spirits, and much depends on their actions in the coming months.
Generally, policy makers prefer to use monetary policy to manage the economic cycle. When activity is robust, central banks raise interest rates to stop economies from overheating, and when a slowdown occurs, they respond with rate cuts to revive the economy.
If companies are not investing and households are not spending, governments should be buying goods and services to boost activity
It’s easier and faster to change interest rates than to alter government spending and taxation. However, monetary policy sometimes reaches a point where it loses its desired effect on economic activity.
In these cases, fiscal policy can and needs to play a role. If companies are not investing and households are not spending – despite interest rates being at a record low – governments should be buying goods and services themselves to boost activity. At least until the economy gains momentum.
Look at Japan where interest rates have been low for years, while the economy has faced the constant threat of deflation and low growth.
Europe plagued by lacklustre growth
Another good example is Europe. Here, interest rates have been kept close to zero and the central bank has taken the first steps toward quantitative easing, with more expected to come in 2015. Yet, the region is plagued by lacklustre growth, and risks losing a generation to unemployment.
Since 2007, the 11 largest euro-area economies have performed even worse than they did during the Great Depression in the 1930s, contracting by an average of 0.2 per cent annually, compared to average growth of 0.3 per cent during 1929 to 1936.
Though we expect growth in the euro area to improve in 2015, it’s important to keep this in perspective.
On a positive note, 2015 should be the year that the US economic recovery finally gains some pace, with the Federal Reserve likely to start hiking interest rates from September. However, the normalisation of monetary policy needs to be carefully timed and managed.
Hiking interest rates too much too soon is a risk. Economic history is littered with examples of central banks hiking rates prematurely and killing off a recovery.
These include the tightening of US monetary policy in the 1930s, the Bank of Japan’s interest rates hikes in 2000 and 2006, the European Central Bank’s hikes in 2011 (despite the meltdown in southern Europe) and, more recently, the rate hikes by Sweden’s Riksbank in 2010 and 2011, which subsequently had to be reversed.
These experiences offer valuable lessons in how not to dampen the animal spirits.
China’s policy makers want to avoid a hard landing
In China, confidence is bound to be affected by structural transformation amid cyclical headwinds. The country is rightly changing its economic model. The old model, which helped China become a middle-income country, was dependent on investment, manufacturing and exports.
But if China is to avoid the dreaded middle-income trap – where developing economies become stuck in a cycle of low growth after a rapid rise in wages – it needs a new model in which domestic consumption and services become more important.
This ongoing transition is likely to lead to lower growth, which the Chinese authorities seem willing to tolerate. We forecast GDP growth at 7.1 per cent in 2015, but it will probably feel slower.
Although China’s policy makers are willing to accept slower short-term growth in exchange for longer-term sustainability, they will want to avoid a hard landing, which could affect the labour market and, in turn, damage private consumption.
2015 is likely to bring improved growth and low inflation in the world economy
A positive surprise for the world economy in 2015 could be India – the one exception to the weaker animal spirits that prevail elsewhere. We expect India’s economic indicators to continue to improve next year.
More importantly, confidence is improving sharply due to changes made by India’s new government to reduce red tape and promote investment. We expect stronger growth and slower inflation in the coming years.
Confidence and positive action are crucial
Taken as a whole, 2015 is likely to bring improved growth and low inflation in the world economy. This should be positive for financial markets, with stronger US growth and resilient emerging markets in Asia, Africa and the Middle East underpinning market conditions.
However, the lack of animal spirits is sobering. Confidence and positive action are crucial if the recovery is to gain momentum, and the risk of a policy mistake remains an important worry in 2015.
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