The G20 can grow faster, but only if the advanced countries—beginning with the United States and Germany—address their own demand deficits. G20 developing countries, which are straining capacity and at risk of inflation, cannot do much more than they are doing already.
Moreover, the correlation between countries that can stimulate demand and those that run current account surpluses is weak, suggesting that setting current account targets (even if countries were prepared to adapt policies so as to meet them, which we doubt) misses the point. Instead, leaders at the G20 summit in Seoul should agree that each participant will grow domestic demand in 2011–12 at the fastest sustainable pace. The IMF should be mandated to work with each country to develop an appropriate plan for growth that reflects its conditions.
Where Is The Demand Deficit?
Global growth is high and is well above what was expected a year ago. The IMF, for example, projected a 2010 growth rate of 3.1 percent in October 2009, but now estimates growth of 4.8 percent for 2010, 1.2 percentage points above the ten-year average.
This positive picture, however, hides a large discrepancy between advanced and developing economies. Demand remains low in advanced G20 countries, where GDP levels are, on average, 7.4 percent below the levels predicted by pre-crisis growth trends. By contrast, G20 developing economies are straining capacity—output is 4 percent above the trend—and most are, or are at risk of, overheating. Unemployment in the developing countries is actually down by 0.8 percent relative to the ten-year pre-crisis average.
Moreover, trends are also diverse among the advanced economies. While unemployment rates in most advanced countries is no more than 1 percent above the pre-crisis ten-year average, unemployment in the United States is of particular concern. Its rise has been almost without precedent in the post-war period, and the share of unemployed workers who have been out of work for more than six months nearly doubled from 2006 to 2009; in the rest of the advanced G20 countries, the average share actually fell.
Furthermore, social safety nets in the United States are weaker than those in other advanced countries, making unemployment politically less tolerable. For example, the income replacement rate of unemployment benefits is much lower in the United States than in Germany and France, and most U.S. workers lose health care coverage if they lose their jobs, whereas German and French workers continue to be protected by national medical insurance schemes. As a result, the United States most strongly perceives the need to revive demand.
But unemployment is not the only concern: the slow recovery in developed economies is contributing to reduced tax revenues, large public deficits, and rising debts. From 2007 to 2010, government debt in advanced G20 countries is expected to have risen by nearly 20 percent of GDP. In developing economies, by contrast, debt will have declined by 1 percent.
To bring down unemployment and reverse the increase in debt, advanced G20 countries need faster economic growth. But with nearly all of the G20 emerging markets already straining their capacity, where can the extra demand come from?
Sources of Additional Demand
There are, in principle, two additional ways to stimulate global demand in 2011 and 2012. The first is for G20 advanced countries—which represent 55 percent of world GDP (in current dollars)—to deploy additional stimulus to close their large output gaps. The second is for the developing G20 countries—which represent 23 percent of world GDP—to stimulate demand while allowing exchange rate appreciation, thus increasing their net imports from the advanced G20 countries while aiming to contain domestic inflationary pressures.
Increasing Demand in the Advanced Countries
The advanced G20 countries exhibit very large output gaps and are borrowing at record low interest rates, yet are set to withdraw fiscal stimulus in 2011 at a rate equivalent to about 1 percent of their aggregate demand. In most of these countries—Japan and Italy are notable exceptions—public debt remains near or below the 90 percent level above which Reinhart and Rogoff (2010) find that debt begins to adversely affect long-term growth. Though there is no hard and fast benchmark of the level of public debt that is sustainable, persisting with fiscal stimulus appears to remain an option for all of the advanced G20 countries except Italy and, possibly, Japan. Germany, which conditions the adjustment in the debt-stricken European periphery, has among the strongest fiscal and external positions in the G20 and stands out as a country which could grow domestic demand more rapidly.
Opponents of fiscal stimulus—whose hand in the United States has been strengthened by the Republican gains in the midterm elections—point to two risks. The first is that additional fiscal stimulus may do little to increase output because the aggregate output gap conceals structural overcapacity in some sectors (for example, housing and household products) and near-full capacity utilization in most others (for example, services). Rather than increasing overall demand, stimulus would cause prices and wages to rise in the latter sectors. So far, however, there is no evidence of high or accelerating inflation or wages in the advanced countries.
The second risk associated with stimulus is that markets may demand higher interest rates as they lose confidence in the country’s capacity to repay its debt. However, continuation of stimulus for another year will add to long-term debt only marginally. Moreover, to mitigate this risk, countries could simultaneously undertake aggressive medium-term fiscal consolidation reforms, which are needed anyway.
Take the United States, for example. It could continue stimulus targeted to help the unemployed, and states and local authorities which are retrenching rapidly, while also enacting medium-term fiscal consolidation measures. These would aim in part to encourage households to save and to reduce the chronic U.S. current account deficit. Such reforms include means-testing Social Security and Medicare, raising the retirement age and the years of contribution required for full benefits to accrue, eliminating the mortgage interest tax credit, introducing a value-added tax, raising the gasoline tax, and embarking on a major efficiency drive, including reduced defense spending.
In most advanced G20 economies, monetary policy is the most direct policy option available to enhance domestic demand. Current output gaps and inflation rates suggest that monetary policy in many advanced economies, particularly Japan, Italy (part of the Euro zone), and the United States, is actually too tight.1 With policy rates close to zero, unconventional measures such as balance sheet expansion (quantitative easing) could be used to increase liquidity and enhance private demand, as the Federal Reserve has advertised it intends to do under its QE2 program.
There are, however, serious questions relating to quantitative easing that argue for caution. These include doubts about its effectiveness in affecting long-term interest rates—and about the effectiveness of even lower interest rates in stimulating demand. Quantitative easing could also make carry trades and other risky investor behavior easier to engage in, and would raise further questions about the ability of central banks to withdraw large liquidity injections without wreaking havoc on exposed investors. A policy of quantitative easing in the major advanced economies could also be read as an attempt by these countries to devalue their currencies. These risks are of special concern to emerging markets, to which we now turn.
Increasing Demand in the Emerging Economies
Developing G20 economies are already straining capacity and trying to stem large inflows of foreign capital. Some are enacting capital controls, and most are engaged in sterilized currency intervention (i.e., buying dollars and euros while offsetting the money created by selling bonds or tightening reserve requirements). Indeed, reflecting their negative output gaps and rising inflation, monetary policy in the G20 developing economies should be considerably tighter, particularly in India and Argentina, where inflation has increased most—by 7.6 percentage points and 4.2 percentage points, respectively, from pre-crisis averages.
But could the G20 developing economies simply allow capital to flow in and let their exchange rates appreciate? Could they allow domestic demand to rise, perhaps even engage in additional fiscal stimulus, and let it spill over onto imports, thus mitigating the inflationary pressures?
The answer for most countries is no. Three large risks would be associated with this course. First, several of the developing G20 economies, including Brazil and Turkey for example, have already seen large real exchange rate appreciation relative to their ten-year pre-crisis averages. In other economies, such as India, current account deficits have deteriorated significantly from pre-crisis averages. Second, with international interest rates now at zero, the sustainability of such large capital inflows when rates rise again is questionable, to say the least. Third, even with currency appreciation, the implied increase in domestic demand could not be prevented from spilling over onto non-tradable goods and services, stoking inflation, real wage increases, and housing and asset price bubbles.
Some economies have slightly more capacity to embark on a strategy of domestic demand growth and currency appreciation. These economies may include Mexico and Saudi Arabia. Given its size, low debt levels, undervalued currency, and centralized economic management, China could also handle a gradual appreciation of its currency and may be able to add stimulus. However, it must do this with care since its output is already 2.6 percent above trend, its inflation rate is edging upward, and its urban housing prices are soaring. In addition, the effect on demand in the advanced G20 countries in 2011 would be small. Even if China’s current account surplus were to be cut in half from its current 5 percent of GDP—an unlikely shift in a country where demand is already straining capacity—the addition to advanced G20 countries’ demand might amount to only 0.2 percent of their GDP. The effect on the United States, which exports relatively little to China, would be about half of that.
Policy
The world economy is recovering well but is healing too slowly in the advanced countries to sharply reduce government deficits and to lower unemployment, an especially acute political issue in the United States.
The main possible source of demand growth now lies in the advanced G20 countries, which could aim to at least neutralize the 1 percent of GDP drag implied by their current fiscal plan to withdraw stimulus. Measures targeted at the long-term unemployed and at the hardest hit local governments may have the biggest demand and social cohesion payoff. A few developing countries may also be able to add a little to global demand. (See Table 1 for a country-by-country assessment of capacity to grow domestic demand.)
Moreover, some external deficit countries, such as the United States, France, and Mexico, can still contribute to global demand growth, while some surplus countries, such as Japan and Argentina, can have only a limited impact because they face other constraints.
G20 leaders meeting in Seoul must therefore recognize that a focus on current account imbalances and currencies not only misses the main point, but also risks a resurgence of protectionism or worse. Instead, they should mandate the IMF to work with countries on plans to grow their demand at the fastest possible pace, consistent with their individual macroeconomic constraints. The institution’s attention should focus on the large countries that have the greatest room to act, starting with the United States, Germany, and China.
Uri Dadush is the director of Carnegie’s International Economics Program. Bennett Stancil is a researcher in Carnegie’s International Economics Program.
1. The Taylor rule is often used to estimate appropriate policy interest rate given the current output gap and inflation rate. The Taylor rule rate is calculated as follows:
R = Rneutral + pcurrent+ 0.5y + 0.5 * (pcurrent – ptarget)
R is the Taylor rule suggested interest rate; pcurrent is the average inflation rate in the previous 12 months; ptarget is the central bank's target inflation rate; y is the output gap; Rneutral is the neutral rate, which is assumed to be equivalent to the trend GDP growth rate, when inflation is equal to its trend and GDP is equal to its potential. If the current policy rate of an economy is below the rate suggested by the Taylor rule, it implies that tightening of monetary policy is needed.
Table 1: G20 Potential for Demand Growth
