IMF predictions prove a fund of fallacy Reading the economic runes proves too tricky even for the world experts
Charlotte Denny Monday December 31, 2001 The Guardian Reminding economists of their predictions last year for the world economy in 2001 is an unfair trick, a bit like reminding friends of their new year resolutions. But who said life was fair? So let's take a peek back at the International Monetary Fund's October 2000 assessment of the prospects for the world economy this year. "Growth is projected to increase in all major regions of the world," it predicted confidently, "led by the continued strength of the US economy." After enjoying the strongest growth for 12 years in the millennium year, the IMF expected the world economy to expand by a robust 4.2% this year. Unfortunately, things did not go entirely according to plan. Instead of the strong growth forecast, the world has skidded into its first synchronised downturn since the oil crisis of 1974, led by the US. At the end of the year, the three largest economies, the US, Japan and Germany are all in recession. To cap off 2001, last month the US energy company Enron became the world's largest bankrupt corporation and this month, the Argentine economy finally buckled under the strain of its $132bn (£91bn) foreign debts and became the largest ever bankrupt state. Optimistic Economists have a terrible track record at predicting recessions and to give the IMF some credit, it did warn that there were risks to its optimistic scenario, chiefly from the growing imbalances in the US economy. And nobody could possibly have predicted the events of September 11. Although a lot of corporations have blamed the terrorist attacks for mass lay-offs and plunging profits over the past three months, the downturn was already well under way by the time the hijacked planes crashed into the twin towers of the World Trade Centre. The official chronologer of US recessions, the National Bureau of Economic Research, says that the longest ever US economic expansion ended in March. The Fund was not even right about the causes of the downturn. In October last year it was still warning that the biggest threat to the American economy was that greater than expected inflationary pressures would force the Federal Reserve to raise interest rates sharply, throwing the economy into reverse. Instead, the year began with an unexpected interest rate cut from the Fed and by its end, 10 further cuts had taken US borrowing costs to their lowest in 40 years. Even the most aggressive easing campaign in 50 years was unable to counteract the deflationary forces that were weighing on the US economy, however. The IMF got it wrong - it was not inflation that derailed the US, but the bursting of the hi-tech bubble in spring of last year, when investors realised that the vast amounts of cash poured into dubious internet ventures was never going to be rewarded by future earnings. That, in turn, led many to start questioning whether the huge investment in IT was going to deliver sustained improvements in the efficiency of the US economy - the founding myth of the so-called new economy. What surprised most commentators was how quickly the US malaise spread around the world. Even the IMF acknowledged it as one of the more ironic downsides of globalisation. It did not help that the world's second largest economy, Japan, was already in trouble before the US stumbled. Meanwhile, the European Central Bank exhibited an almost criminal degree of complacency for the first half of the year, refusing to join global efforts to ease monetary policy while still insisting that the eurozone was well protected from the impact of the US slowdown. Those analysts who expected Britain to be the first to follow the US in a downturn were also comprehensively wrongfooted. Although Britain has stronger trading and investment links with the US than the eurozone economies have, British consumers continued to spend, insulating the economy from the worst of the downturn, though at the price of a widening trade gap with the rest of the world. Perhaps the Fund's economists should have paid more attention to the markets. At the end of 2000, investors were clearly not as bullish as the technocrats - world stockmarkets ended last year in a black mood. As 2001 ends, the position is reversed - the markets are optimistic that the worst is over, and the IMF is in a gloomy mood, warning that 2002 is likely to be another year of weak global growth. So who is right this time? The market's expectation of a quick V-shaped recovery looks like wishful thinking. The pace of growth over the next two years is likely to disappoint and the recovery when it comes will be weak. Falling prices But there is a greater danger than just a weak recovery, according to Stephen King, chief economist at HSBC. For the first time since the 1930s, the major economies face a real threat of deflation. Japan, Argentina, China, Hong Kong, Hungary, Russia and Taiwan are already experiencing falling prices, while in Britain, core goods prices turned negative again last month. As Mr King notes, low inflation may be a good thing most of the time, but when the economy turns sour, it makes a central banker's job harder. When inflation is high, policymakers have plenty of room to cut rates - and even engineer negative real interest rates - adjusted for the effects of inflation. But with inflation low and interest rates at their lowest in decades in most countries, there is much less room for them to manoeuvre. If prices start falling, real interest rates will remain stubbornly positive no matter how low actual borrowing costs go. Moreover, a little bit of inflation makes it easier for economies to adjust - workers are resistant to taking wage cuts even when lay-offs are the alternative. Deflation is a worse threat than stable but moderate inflation, according to Mr King. "Once prices begin to fall, the transmission mechanism of monetary policy begins to seize up, reducing the ability of the monetary authorities to boost economic activity," he warns. "If the authorities continue to fight last year's inflationary battle rather than this year's deflationary war, they may find themselves in a position whereby the collapse in private sector expectations for future growth comes through faster than the offsetting monetary and fiscal adjustment." The question, then, for the world economy in 2002 is whether policymakers will finally admit that inflation is no longer the enemy and that deflation is a real threat. It should certainly feature on some central bankers' new year resolutions.
