Concerns over World Economy

After some postings on concerns over Indian economy, it is time to look at the world economy. BIS Annual Report for 2006-07 has been released.

Unlike most Annual Reports this one is a good review on World Economy and Financial Markets. The summary is here. As it is a pretty long report, it would take time to read and comment.

I read Malcolm Knight’s (General Manager of BIS) speech on the same, which provides a neat summary. His speeches are quite good and the focus on risk in his speeches is exceptional.

  • See Table 1 (page 1 of the speech) for sure. Most economists have underestimated the growth levels in world economy and the consensus predictions have been lower than actual for most of the years. Infact, it is quite amusing that when growth is falling analyst expectations are higher than actual and vice versa. 🙂 So analysts don’t get it wrong just with India but also with World Economy in general.
  • On Inflation front, the actual has been marginally higher than estimates but overall low inflation.
  • Knight says the trend this year further confirms that this is the era of Great Moderation, the period of low volatility of inflation and output.  

What lies ahead? Or in Knight’s words “potential fault lines”. He says  there are 3 :

  1. Inflation outlook: Core inflation (excluding food and energy) has been higher than the comfort levels for much of 2006-07. Globalization effects seemed to be fading away as wages have been increasing in China and this could lead to high inflation.
  2. Features of Financial cycle: The risk premiums have been really low and most asset prices have increased to all time highs leading to concerns that we might have already gone too far and a correction is on the anvil.
  3. Global configuration of country’s external balances: Current account deficits of developed countries continue to be financed and capital continues to flow in emerging markets. Plus there has been a huge increase in foreign exchange reserves of some Asian countries. Knight remarks:

    In current account deficit countries, the positions have largely tended to reflect buoyant consumer spending and associated declines in household saving as opposed to the accumulation of productive capital that could raise future incomes. As regards current account surplus countries, in those economies that have been building up reserves it has proven increasingly difficult to forestall rapid monetary and credit expansion and asset price rises, which could be aggravating vulnerabilities to financial strains and future inflationary pressures.

    The efficiency of domestic financial systems could also be compromised by these developments. Other distortions pertain more to the global financial system. The management of unprecedented volumes of foreign exchange reserves by the public sector, concentrated in a handful of countries, is bound to raise major challenges of an economic and even a political nature. More broadly, the threat of economic protectionism should not be underestimated.

Hmmm… So this is what BIS thinks.

Knight further says, if he has to point out one concern it is the “unusually low level of inflation adjusted interest rates”. He adds that this factor either lurks behind or is a symptom of the above concerns. Very well put Sir.

What are the policy measures to correct?

1. A need to adjust the fiscal policy by bringing reforms in labour and product markets. There is a need to gradually reduce the costs of healthcare and pensions on the fiscal and make it more market oriented. As times are good, these reforms would be easier to implement now.

2. The monetary policy should try and normalize interest rate levels to contain inflationary risks and this would also help in pricing the risks in the financial markets better.

3. Keep strengthening the financial system. After all, in these good times, financial markets can often play the spoilsport by allocating/channelizing resources to not so prudent deficit unit. When times are good, the probability of risks due to moral hazard/adverse selection increases.

Nice stuff. 


One Response to “Concerns over World Economy”

  1. Financial Bubbles « Mostly Economics Says:

    […] should be used for asset prices is gaining ground. This recent article by Leijonhufvud and latest BIS annual report all talk about accommodative monetary policies being responsible for the recent asset price […]

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