# Stronger Growth Remains Elusive: Urgent policy response is needed

Date February 29, 2016 Catherine L. MANN (Chief Economist, OECD) TASHIRO Takeshi (Consulting Fellow, RIETI / Deputy Director, Macro Economic Affairs Division, Economic and Industrial Policy Bureau, METI) 12:30-13:30 (Registration desk and seminar room open at 12:00)

## Summary

### Introduction

Catherine L. MANN

Our interim economic outlook shows that stronger growth remains elusive. I would like to talk about the evidence supporting that statement and why we think that an urgent policy response is needed. I will show you evidence that stronger growth is not around the corner and that collective policy action is needed using all three instruments available to policymakers--fiscal, monetary, and structural policies--synergistically in order to get us out of a low-growth equilibrium track.

Weak trade, weak investment, and low commodity prices all weigh on global growth, and we see structural reasons as to why these may remain for some time. We have revised our forecast from our November 2015 report downward because of disappointing incoming data that do not underpin stronger growth and a lack of wage growth. In addition to the real-side concerns, we also worry about the substantial risks associated with financial instability. This can be seen by the recent steep declines in global equity markets, volatile capital flows, and high-debt exposures, particularly in emerging markets. While monetary policy is mainly appropriate, by itself alone, it is insufficient to boost the economy. This is why we believe collective policy action is urgent.

Most people think of investment-led spending as hard infrastructure. That is appropriate for some countries, but for others, there are plenty of roads and bridges in place, and soft infrastructure (e.g., expanding social safety nets) is where fiscal expenditures should take place.

Lastly, fiscal and monetary policy will not achieve faster sustainable global growth unless productivity and growth-enhancing structural reforms are also deployed.

### Evidence

Global growth has flat-lined and has remained stagnant for the past three years after the post-financial crisis uptick. We project this weak growth to continue into 2017 as well. China is slowing down, dropping to 6.2% growth by 2017. The data for Japan indicate a bit of a rebound, but not a particularly robust one. Policy concerns exist going forward along with concerns about whether the current monetary policy will be appropriately accompanied by the needed structural reforms.

Fourth quarter gross domestic product (GDP) data for the United States were released after our forecast. However, even though GDP growth for 2015 was revised upward slightly, I am still comfortable with our 2016 and 2017 forecasts of 2% and 2.2%, respectively, because the revisions have been mostly due to inventory accumulation.

Regarding the euro area, growth might appear to be gaining speed, but there are two caveats. Growth was very low in 2015 (1.5%). Going into 2016 and 2017, we project a slight uptick to 1.7% in 2017, but there are many risks to this outlook. There are important negative tail risks, events that we cannot quantify but would have a significant impact for the euro area. For example, we do not know who will win the referendum in the United Kingdom and we do not know whether there will be a final agreement between the Greek authorities and the institutions. At the same time, if Europe can maintain its forward momentum, the euro area may be doing somewhat better by 2017.

We have two comprehensive forecast rounds per year, usually in May and November, and two interim forecasts where we undertake a top-line, less detailed analysis. For 2016, we have downgrades in forecasts across the board, particularly in Germany, United States, and Canada, and for the global outlook a three-tenths downward revision. All of the major players have been downgraded across the board for 2017 as well, although the picture is a little different.

This has not been our first downgrading of growth forecasts. In recent times, every time we thought that the global economy was starting to accelerate, we had to go back and revise them down in the next forecast round. Many of the factors that we think of as underpinnings of an upturn do not seem to be falling into place. For example, even in economies where labor markets are tightening, e.g., the United States, which has now reached a very low unemployment rate, there is still no wage growth. The underpinnings of robust consumption are not in place. The same is true for Japan: a pretty tight labor market yet no systematic wage increases. The relationship between labor market tightness and wages that we have seen historically and on which we base our standard theories and econometric models does not seem to be present.

Oil prices have dropped dramatically, from approximately $100 to approximately$40 per barrel over the past two years. This should create a tremendous boost to consumers and businesses, and that should translate into consumption and investment. That is our standard story: oil prices falling translate into global growth. However, that does not seem to be happening.

Another important relationship is that between low interest rates and capital equipment investment. We have had low interest rates for a very long time, but no across-the-board investment is going on. Again, the historic relationship which drives our econometric relationships and models does not seem to be working.

Furthermore, a number of countries, including Japan, have experienced exchange rate depreciation, but this has not translated into export growth as strongly as we would expect based on the historical relationships.

### Locomotives of global growth

The United States has traditionally been the global locomotive of growth. Dollar appreciation tends to lead to increased imports, which serve as a foundation for GDP growth in export-oriented economies.

In 2014, we had the traditional composition of growth: a strong contribution of consumption and pretty strong fixed investment. Net exports are usually a big drag because the appreciation of the dollar reduces U.S. exports. Going into 2015, a few elements of the locomotive have petered out, in particular, investment. In the United States and other countries, investment simply does not have the systematic relationship to low interest rates as seen in the historical data. Although investment performance is much better in the United States than in other countries, it is still not as strong as it should be.

For example, with regard to investment performance in the current cycle compared to previous cycles, the United States is still 10-15 percentage points below where it should or normally would be in the business cycle under normal circumstances. This suggests a lot of aging capital stock, which should lead to a stronger desire to invest, but we do not see it happening. Q1 2015 was what we would expect to see, with net exports taking a lot off of the U.S. GDP growth, but benefitting the rest of the world. It is true that Q4 2015 took half a percentage point off, so there is some transmission of U.S. growth to the rest of the world, but it does not really add up to what we might have seen in other episodes where the United States came out of the global business cycle first and helped everybody rise up. Part of this is because the U.S. economy is not as large in terms of global GDP as it was in the past--30% instead of 50%. But it is also the case that U.S. consumers, even though they have made a big contribution to U.S. growth, are not really back to where they were. Another part of this is the lack of wage gains in the United States. The spending power of the middle class has not rebounded, and the middle class as a whole has about the same real spending power now as it did about 20 years ago.

China has been a locomotive for global growth for many years. It constructed many buildings and moved many workers from agriculture into cities, into factories, and into a higher-income, developing middle class. However, China's growth has recently entered into a transition from manufacturing to services. The services sector looks like it is actually picking up and taking over with a growth rate in the 8% range. However, we like to look at services excluding the financial sector. The reason is that we are concerned that the extent to which financial transactions being undertaken in China are supportive of real estate and state-owned enterprises (SOEs) are not the kind of services that create new types of jobs and spur new consumption patterns. Looking at services without the financial sector, it is hard to tell if a growth transition is really taking place. Movement is underway from manufacturing to services and from commodity-intensive investment to consumption, but it has not been smooth. Rather than being a global locomotive, the rebalancing in China is currently a global drag through commodity price declines and their implications for commodity exporters. Exporters lose purchasing power and trade less, and so it ends up being a drag, especially when we see that commodity price declines are not feeding through in a normal way in commodity-importing economies.

Another reason why China is perhaps no longer a global growth locomotive lies not just on the real side but also on the financial side. The contribution of China to financial volatility is also a drag on global markets. Although the renminbi (RMB)-U.S. dollar exchange rate is not the only important factor, the decisions to have a mini-depreciation in August 2015 and then to try to transition to a basket of currencies have discombobulated the financial markets, and that uncertainty has been transmitted to equity markets generally. Declining reserves also make it difficult to understand what the objections of the Chinese authorities are, and that is transmitting quite a bit of volatility to the market.

Another indicator of the extent of the changes in the commodity space is the Baltic Dry Index, the cost of transiting across the ocean in large carriers. Some of the decline in 2015 is the result of many new carriers coming online that were built back in 2011, which was the last time prices were high, but it also indicates low demand.

### Structural factors

Another factor that underpins our view that global growth will remain elusive is based not just on cyclical but also structural factors. We have concerns due to the significant slowdown in global trade growth. Global trade growth has lagged behind world GDP growth on only five occasions since 1973. All five episodes have been associated with significant slowdowns in the global growth environment. The downward trends in global trade growth and in global GDP growth are operating hand-in-hand. The change in the global value chains is one reason for this as is the lack of investment, and we see those two as having some structural components.

We have a situation where, despite a great deal of monetary easing, no country has reached its core inflation target of 2%. Despite relatively tighter labor markets in the United States and Japan, there has not been much uptake for compensation per employee. For the euro area, there is still quite a bit of labor market slack. Even by the end of our forecast horizon, the unemployment rate in the euro area will be at least two percentage points higher than it was in 2007. If wage gains are to occur in the euro area, they will not be a result of labor market slack. It may result from, for example, a minimum wage hike in Germany. However, if we are looking for tightness in labor markets to translate to increased wages and increasing core inflation, we are missing the central factor: wage increases.

### Financial side problems

The financial side is also a key reason for concern. This matters to policy action which deploys all three policy tools.

Are the declines we have seen so far this year overshooting the true fundamentals, or are they just showing financial markets catching up to the true fundamentals? Financial markets are reassessing prospects. The declines in the August-September-October 2015 period have in part persisted until today. The declines we saw into February 2016, despite a subsequent uptick, have left asset prices below their average level for the first half of 2015. Furthermore, with the concerns about global growth showing up in the various equity indexes, not only does it show up in the share prices but also in the volatility index. There is a lot of uncertainty in the financial markets about where things are going.

We are relatively more concerned about the implications of financial market stability for the emerging markets. Financial instability manifested in equity price movements, in strong effective exchange rate depreciations, and in increases in sovereign bond spreads. The spreads are about one-third of the way back to the time of Lehman Brothers.

When you put together equity financial tightening, exchange rate financial tightening, and sovereign bond spread financial tightening for the emerging markets, it adds up to vulnerabilities in terms of the domestic market and also the external market. For some countries such as China, Turkey, and Brazil, there was a rather substantial increase in credit corporations in recent years.

On the external side--the external liabilities--the key issue there is currency: currency mismatches between liabilities denominated in foreign currency and assets in domestic currency subject to swings in the exchange rate. Looking at internal and external exposures, there are some countries that are at somewhat greater risk than others: Turkey, Brazil, maybe China and South Africa. All of these countries actually have much less exposure now on the external side relative to GDP than they did back in 1997 or 2001. They have much stronger macro prudential conditions in their banking systems, which indicate that there is no negative spiral between the banks and the corporates and the sovereigns.

### Need for collective action

The real and financial sides tell us that we need to do something new as policymakers. We cannot just let the world continue to grow at 3%, or in the case of the Eurozone at 1.5%, or Japan at even less than that. The reason we cannot allow this is that countries that are growing at these slow rates cannot make good on the promises that policymakers have made. They made promises to young people that they are going to have a job and a better life. Well, Europe has 25% youth unemployment; not a promise being kept there. At such low global growth rates, promises to the elderly to continue paying their pensions cannot be kept. For some countries, the rate is insufficient to make good on the debts that they have in place. Collective policy action deploying all three instruments in a synergistic way is crucial to get us to a higher global growth rate. Monetary policy has been pretty much working alone in many countries.

Some view the small increase in the U.S. federal funds rate of 25 basis points in December 2015 as an error. I think 25 basis points were appropriate for the Federal Reserve at the time. It balanced the objectives of support for the real economy against the need to promote financial stability. Even with that small interest rate increase, the expectations in the market for the pathway forward have come down dramatically.

Where are we on the other major policy legs? Almost every country is planning to have a contractionary fiscal policy. Monetary and fiscal policies are not working together in many countries. Why do we think it is a good time to engage in an appropriate fiscal policy? Interest rates are really low. This is a way of thinking about having more fiscal space than might normally be advocated.

Suppose we did have collective fiscal action: a half percentage point of GDP in public investment undertaken by all OECD economies. Public investment means high multiplier projects, which could be hard or soft infrastructure, in various countries. In this exercise, the BRICS countries are not undertaking fiscal expansion--only the OECD countries are--but they would still receive spillover benefits. The collective action is in part to take account of the spillover benefits of everybody working together.

Many countries are concerned that they lack fiscal space. But if the multiplier is greater than one, fiscal sustainability as measured by debt relative to GDP in fact is improved. Deficits today undertaken with the right mix of projects chosen and structural reforms can result in more fiscal sustainability.

Structural reform has to be undertaken in conjunction with fiscal and monetary policy. The pace of structural reforms has been disappointing and shows insufficient ambition.

For the last 12 years, we have assessed the impacts of various types of structural reforms undertaken by economies. We can show that for advanced economies between 2007-2010, on average, 20% of the recommendations were implemented and had an effect. During crises, in 2011 and 2014, an average of about 40% of the commitments were undertaken and had an effect. In 2015, countries are being less ambitious in terms of projects and implementing them. To get multipliers greater than one, you have to have structural reforms. All three tools must be used together or they are not going to work.

On the European Union (EU), why do we think we should not hold our breath on the EU being a locomotive? In the EU, investment was the main way in which countries undertook fiscal consolidation. Eurozone investment is about 20% below its 2007 levels, and we foresee essentially no uptick throughout our forecast horizon. Not many projects have been approved. The Juncker plan deployment has been disappointing. The plan focuses on investment in network industries within the EU: telecoms, energy, and transport. The only way that investment could take root and galvanize the private sector is through regulatory harmonization, which is a key element of the Juncker plan but very little progress has been made on that essential element. In addition, there has not been deleveraging in the banking system so the amount of money being pushed out through the European Central Bank (ECB) ends up stopped in the banking system with less deleveraging than what has happened in the United States, for example. Lastly, I would like to mention that we are very concerned about the uncertainties in the Eurozone.

To summarize, global growth has flatlined because of subdued levels of trade, investment, and wage growth. Emerging markets were dependent on commodities and exports which have fallen away. We have seen less of an improvement coming from low oil prices and interest rates than expected. Something is broken in the transmission mechanisms. We are concerned about the downside risks. Collective action and greater ambition are required to raise global growth and reduce risks.

### Q&A

Q1. You focused on the importance of three policy tools in combination. This is a global extension of Abenomics. That's very good. In the context of Japan, what is your view about the lack of growth? What is preventing Japanese economic growth despite the fact that the three policies are being pursued? Also, were you saying that the consolidated effort by Japan has been wrong or needs to change? You also described a multiplier effect, but there were no data on Japan. Could you give us some data on Japan? Also, on China, it is my strong impression that the international market volatility in the past few months has been primarily due to the Chinese changes in the exchange rate, the stock market collapse, etc. If China makes a sufficient effort to contain capital outflows and prevent exchange rate depreciation, greater stability can be imagined in the international market. I'd like to hear your views.

Catherine L. MANN
I will take the last question first. I think there is a correlation between the timing of the movements in the RMB-U.S. dollar rate to the major movements in the global stock market indexes. I agree with you that the uncertainty regarding the exchange rate regime and RMB valuation are important ingredients in global volatility. However, I am not sure I would agree that altering the pace of the opening of the capital account in China is the appropriate direction. The reason is that it might temporarily appear to have improved, but as soon as they opened it up again, the volatility would return. Or, the volatility would manifest itself via a different channel, maybe in the stock market or on bank balance sheets in China. Closing the capital account again may not be the right direction. Having a clearer strategy and communicating that strategy would be helpful.

The fiscal multipliers we have for Japan under our collective action scenario model are quite a bit larger than those of the Bank of Japan. When we first discussed this exercise, it generated quite a bit of model comparison. Our multipliers are larger not only under the Japan-only scenario but also under the Japan-collectively-with-everyone-else scenario, because Japan benefits greatly from collective expansion elsewhere. Under those scenarios, Japan ends up with a really big decline in its debt to GDP ratio because of the enormous debt.

Has the world finally caught up with Japan and Abenomics? I could say that policymakers have caught up with the concept of Abenomics. I hope policymakers around the world and indeed in Japan catch up to the concept of Abenomics. The third arrow has not really been deployed. It has been reconfigured now, in a search for structural reforms that are politically implementable. There is a distinction between what should be done to achieve the best economic outcome and what can be done given political constraints. It is important to keep both of those in mind. What is clear from Japan's case is that fiscal and monetary policy deployed individually, which is what has happened, are insufficient, and it is now time to get the third arrow out of the quiver and into the air, because there is no more room on the other two.

*This summary was compiled by RIETI Editorial staff.