Geneva, 15 November 2001

"The short-term economic outlook for the ECE region, and indeed for the world economy as a whole, has become exceptionally uncertain since the terrorist attacks in New York and Washington on 11 September. The current trends are pointing to a worst-case scenario in which the simultaneous weakening of economic activity in the major economies, if allowed to continue, could push the global economy into deep recession" says Paolo Garonna, Acting Executive Secretary of the United Nations Economic Commission for Europe (UNECE) commenting on the new issue of the Economic Survey of Europe, 2001 No. 2.

"One likely consequence of the attacks in the United States and in the world economy at large is an increase in transaction costs due to stricter security measures and higher insurance premiums on cross-border trade and transport services. These could affect business productivity and the volume of international trade although orders of magnitude are difficult to gauge. Also government spending on public security and military defence can be expected to increase. In a context of tight budget deficit targets this would have to be offset by cutbacks of other, mainly discretionary expenditure items, such as public investment, or entail the need to raise taxes," says Paolo Garonna.

Significant downside risks

Predictions of a quick recovery from the cyclical downturn in the United States have so far proved to be wrong. Although many forecasts now assume that a recovery will start in the second half of 2002, there are no definite signs that this will indeed be the case. The main reasons for scepticism about this are the sizeable internal and external imbalances that have accumulated in the United States economy in the period 1995-2000. The orderly unwinding of these imbalances will take time and their presence will tend to reduce the effectiveness of the considerable stimulus from monetary and fiscal policy.

The corporate sector needs to eliminate a large amount of spare capacity before business investment can be expected to respond to the lower interest rates and assume its traditional role of supporting economic recovery. In a similar vein, private households need to restructure their balance sheets and to reduce high debt levels in view of deteriorating prospects in labour markets and significant stock market losses. As a result, the outlook for fixed investment and private consumption is not clear and this leaves the prospects for a recovery in 2002 in doubt.

Global repercussions of the US cyclical downturn

As the United States was the main engine of global economic growth in 1995-2000, it is clear that a prolonged weakness of the United States economy will have serious consequences for other regions, notably the developing countries. This is particularly so for its major trading partners in Asia and Latin America and also Canada. In Japan, real GDP is expected to decline not only in 2001 but also next year as well. These developments will, in turn, further weaken growth prospects for the European economies.

Against this background, there has been a marked lowering of growth forecasts for the United States, Japan and the euro area for both this year and next compared with those made before the attacks in early September (table 1.3.1). The figures for 2002 should, of course, be regarded with caution – they reflect inevitably rough estimates of the impact that the attacks and the steeper downturn in the global economy might have on expectations and confidence, and hence on the spending behaviour of households and enterprises. At the same time, however, they illustrate the considerable downside risks facing the global economy given the possibility of a simultaneous contraction of output in the euro area, Japan and the United States and the ensuing negative multiplier effects.

By far the largest reductions in the forecasts of economic growth are those for the United States, especially for 2002, but expectations have also been reduced substantially for other countries and the euro area as a whole. Although many forecasts now assume that a recovery will start in the second half of 2002, the overall strength of economic activity is seen to remain rather weak for the year as a whole. In the United States, the consensus view predicts a continued decline of business investment and a marked slowdown of consumer spending, which had been the main source of growth until the second quarter of 2001. Business investment has collapsed against a background of deteriorating prospects for sales and profits. Private consumption expenditures can be expected to weaken under the impact of a deteriorating labour market and increasing strains in households’ balance sheets. Both business and consumer confidence will be depressed by the heightened uncertainty and this may lead to a postponement of spending plans. Real GDP in the United States is now expected to increase by only 1 per cent in 2001 followed by only 1¼ per cent in 2002.

Euro area needs a more courageous policy response

In the euro area, the rate of economic growth is likely to be only some 1¾ per cent this year, down from 3.4 per cent in 2000 and a full percentage point less than the European Commission’s forecasts in the spring 2001. On current forecasts, the average growth rate of the euro area in 2002 is unlikely to be much better than this year. The same holds for the aggregate of the 15 European Union countries (table 1.3.2). The average outcome is strongly influenced by the pronounced cyclical weakness in Germany, the largest western European economy. The German government now expects an annual rate of economic growth of only ¾ of a percentage point in 2001, down from 3 per cent in 2000. Growth is expected to strengthen only slightly in 2002, largely a reflection of the continued modest growth of the global economy.

In the euro area the virtual stagnation of economic activity in the second quarter of 2001 increases the probability of a contraction in the third quarter. The sharp fall of the ifo business climate index, a key cyclical indicator, in September 2001 signalled a rapid deterioration of business prospects in Germany. This is likely to be the case in other member countries as well. Given the weak economic conditions in the euro area and the global economy at large and forecasts of rapidly declining rates of inflation, the ECB has room for a further loosening of monetary policy. As regards fiscal policy, at minimum the automatic stabilizers should be allowed to operate fully in order to avoid procyclical effects. The ECB has argued in favour of continued fiscal discipline in the three larger economies of the euro area in line with the letter of the Stability and Growth Pact. But it is difficult to reconcile the two policies – demanding fiscal discipline in a cyclical downturn and at the same time pursuing an overly cautious monetary policy – either with each other or with the current needs of the European economy.

It was accepted in the early years of EMU, that countries with large budget deficits – i.e. close to 3 per cent or above – would need time to achieve the desired medium-term fiscal position of "close-to-balance or in surplus" and that in the event of a severe cyclical downturn in the early years of EMU they could therefore be forced into a procyclical fiscal stance by the rules of the Stability and Growth Pact. The probability of such a risk was, of course, unknown but it was assumed that a sustained cyclical upturn would enable the medium-term fiscal targets to be reached. But actual developments have not turned out that way. The euro area is now on the edge of recession in a very worrisome global context. One of the major principles of the Pact, namely that fiscal discipline is a precondition for eventual fiscal flexibility, is therefore hardly adequate for the current economic situation, which was not envisaged when the Pact was designed. It can, of course, be argued that countries have not done enough to consolidate their fiscal positions, although this is not only a matter of choice but also of economic circumstance. But there is no point in crying over spilt milk. "What is required now in view of European and global economic conditions is a more flexible interpretation of the Pact and the national stability programmers to allow fiscal policy to offset the weakening of private sector demand" stresses Paolo Garonna.

The costs of a further weakening of global growth and a failed recovery in the United States are potentially so high that governments should take measures to avoid such an outcome. In view of the increasingly large downside risks to the global economic outlook, there is now an urgent need for a coordinated policy response, including multilateral measures, to ensure a sustainable recovery, avoid disruption to the liquidity needs of developing countries and guarantee the inflow of other funds to support their economies as advocated by UNCTAD and the IMF.

Europe leading global growth?

The current situation is especially worrisome because of the presence of factors that have been posing serious risks for the world economy for quite some time but which have become more acute in a context of sharply diminished growth expectations. Apart from the fragility of the financial sector in Japan and the risk of emerging market crises, this refers especially to the considerable domestic and external imbalances in the United States economy. The reduction of these imbalances is a necessary condition for a new sustainable upswing. There is now a much greater risk that the inevitable adjustment costs to be borne by the rest of the world (mirrored in the reduction of its current account surplus) will be abrupt rather than gradual: sudden and large changes in exchange rates and in the direction of international capital flows would greatly increase the risk of international financial turmoil and of even larger disruptions to global economic activity.

In the United States, both monetary and fiscal policy has shifted to a significantly more expansionary stance. It can be expected that the Federal Reserve will lower interest rates further if there are no definite signs of a recovery emerging in the near future. Hopes for a rapid and strong rebound of economic activity in the United States in the course of next year (the so-called V-shaped recovery) – with concomitant benefits for the rest of the world – are pinned on the potential stimulus to domestic demand associated with the expansionary stance of fiscal and monetary policies. But such a domestic demand-led recovery in the United States economy could turn out to be a mixed blessing for the world economy because it would only postpone the inevitable reduction of the large domestic and external imbalances and actually increase the risk of abrupt and disruptive adjustment referred to above.

Sustained growth in the rest of the world, especially in western Europe, would create the best environment for a smoother adjustment in the United States. The orderly reduction of economic imbalances in the United States requires sustained growth in the rest of the world, especially in western Europe and Japan. In Japan, huge fiscal imbalances and official interest rates close to zero have left economic policy with little room for manoeuvre, although there is still some scope for further monetary easing to reverse deflationary pressures and stimulate domestic demand. "More generally, western Europe needs to face the fact that the strengthening of global economic growth forces cannot be left to the United States alone. In western Europe, the need for greater reliance on domestically generated growth now requires the maintenance of an expansionary stance of economic policy. Such a stance, which would support the United States economic policy, has now become crucial to sustain the global economy" concludes Paolo Garonna.

TABLE 1.3.1

Changes in the consensus forecasts of economic growth in 2001 and 2002

(Percentage change over previous year)