Cautious economic optimism is back

Prospects for the global economy seem good overall these days. But it wouldn’t be the first time since the recession of 2008 that official forecasts proved to be too optimistic. What could go wrong?

Growth forecasts for the global economy have turned decidedly more optimistic in the past few months. The International Monetary Fund, for example, predicts that the growth in world output will increase from a disappointing 3% last year to 3.6% this year and 3.9% next year.

This is a significant improvement, representing more than US$400 billion in additional annual incomes and 24 million additional jobs distributed around the world, relative to last year’s growth performance. In a world where hundreds of millions remain involuntarily unemployed, this is big news.

In this scenario, large emerging economies — such as China, India and Brazil — are experiencing a relative slowdown, but the rich industrial economies are finally doing better.

In the US in particular, after a lousy two years marred by uncertainty over the ability of the US Congress to deal with the massive fiscal deficit, businesses and consumers are now seeing some light at the end of the tunnel, in the form of a revival of oil and gas production and improved international trade performance.

Meanwhile, the European Central Bank has managed to persuade market players that it will be able and willing to backstop bond markets that would otherwise be weighed down by fear and uncertainty about the ability of the PIGS countries (Portugal, Italy, Greece and Spain) to repay their public debt. ECB backing helps these countries avoid impossible interest rates — and large odds of social unrest — while trying to bring their finances in order.

Even Japan’s relatively new government has managed to give an impression of dynamic reform in an economy weighed down for two decades by high public debt, a rapidly aging population and heavy regulation.

And many smaller emerging markets continue to register exciting growth. Most of sub-Saharan Africa, those parts of Latin America working together to form a Pacific Alliance of market-friendly economies, and some southeast Asian nations such as Vietnam that now benefit from more open trade, and a diversion of Japanese investment away from China, will help sustain global growth.

Good news overall, then. But it wouldn’t be the first time since the great global recession of 2008 that official forecasts proved to be too optimistic. What could go wrong?

In both the EU and Japan, the current policies stimulating the economy mainly help to buy time until the planned reform of regulatory, labour market and other anticompetitive barriers that have stifled growth for too long are carried through. Unless and until these reforms are instituted, business will have reason to remain very cautious.

Similarly, future resumption of fast growth in China and India depends on how well governments there are able to pull off painful reforms: China is trying to clean up dubious assets from the balance sheets of state-owned financial institutions propped up by the state, but this risks a dangerous credit contraction there; India needs to resume, beyond this election year, moving on the path to reform of key sectors such as energy, finance and trade in order to return to its strong pre-2012 growth. And in too many otherwise promising economies, deep-seated problems ranging from civil strife to corruption and old-fashioned dirigisme will hold the middle class back.

Finally, the real global economic stress test is yet to come: rising interest rates. As long as inflation remains subdued, central banks will be cautious about reversing the extraordinary measures they have put in place to keep credit from collapsing. But many believe inflation is only in abeyance, and when it returns and rates rise again, some sovereign and private borrowers may not find the going so easy.

So, rough waters lurk. But for now at least, let’s latch onto all the reasons to be optimistic. Enjoy the summer.