by Marco Zecchillo, Head Researcher MI G.E.O. Economics
Introduction
With growth forecasts being revised downwards in major economies, the risk is present for the global economy to enter a receding phase in the following months. In the context of rising inflation, monetary and interest rate policy intervention to slow down the rise of prices borne by households and the spillovers of the war in Ukraine, prospects are less optimistic. This attitude is shared by the World Bank (WB) and by the International Monetary Fund (IMF), whose reports have expressly pointed at a potential risk for the world economy to spiral downwards. In this case, the u-turn in growth would affect both developed and developing markets. The aim of this analysis is to shed light on the determinants of recessions and a comparison with the current global scenario to assess qualitatively how likely the downturn is. Further attention is to be posed at LDCs (Least Developed Countries), for which a declining output could contribute to enlarge the gap between them and emerging markets, rendering it potentially irreversible. Lastly, a revision of the preventive role in the hands of historical international organisations, the IMF and the WB, is deserving of attention.
Keywords: inflation, recession, interest rates, least-developed countries, divergence
Defining a Recession and Detecting Signals
There are a number of ways to evaluate whether an economy has entered a phase of recession. Conventionally, output (Gross Domestic Product) must have declined for at least two quarters in a row. The two-quarter concept relates more to a general Rule of Thumb, while economists tend to use more sophisticated analytical tools. In other terms, a recession, to be deemed as such, shall not relate to a temporary downturn of a market nor to a negative output growth in one particular sector (say, industrial production). The decline shall be encompassing to the whole country’s economic landscape and, most importantly, be persistent (at least 6 months, according to the previous rule of thumb).
Predicting recessions with absolute certainty is similar to being able to predict earthquakes. However, unlike the former phenomenon, historical experience and real world data can be employed to verify if it is possible to find elements in the world economy that are generally correlated to an incoming recession. A fundamental predictor, which has anticipated by a number of months the past eight recessions, is the inverted Yield Curve. The latter consists of the set of points representing the relationship between interest rates (or, market remuneration rates) and the time remaining to the maturity of the security (European Central Bank, 2022).
The term structure of interest rates is a reflection of the investor’s feelings concerning the future of markets. When purchasing securities, buyers attempt to forecast future inflation, future rates and their variability, which may render them weary towards a given purchase. In normal times, longer term bonds yield more than short term bonds as a reward to the investor, who requires insurance for the risk of inflation. An inversion of this positive relationship between time to maturity and rates (i.e., short term securities with higher yields than long term securities) surely signals a negative perception of the immediate future (European Central Bank, 2022).
Amidst rising inflation, Central Banks try to cool down the economy by increasing rates (i.e., by adopting a contractionary policy). This latter aspect is what is being witnessed in the past few months, with higher rates being adopted by the Federal Reserve and the ECB, to make an example. Higher rates tend to be negatively related to prices. The risk is that behavioural and psychological factors, apart from the economic ones, could play a role in exacerbating unwanted effects. For instance, pessimism spreading amongst consumers could extend or worsen the entity of a recession. The hope is that the current interventions will not result to be as disruptive to induce these consequences.
On an overall level, it is arguable that policymakers face a choice between targeting inflation and compromising growth. In the particular trajectory the economy seems to have taken nowadays, the dilemma takes place in a context in which a narrow room for manoeuvre exists for fiscal policy to be used to stabilise, after the notable expenses undertaken in the darkest periods of the pandemic. The phasing out of fiscal provisions aimed at supporting businesses and consumers in the post-Covid recovery shall be at least coordinated and coherent with the monetary stance of the country.
By comparing the current period to other post-recession recoveries, worrying symptoms can be detected (WB, 2023). For instance, the global economy is seeing its fastest slowdown of recovery in a post-downturn phase since the early 1970s. Specifically, the World Bank reports that the current one is a much more visible decline of consumer confidence with respect to past world recessions. Those were different times, apparently. The resulting stagflation of the late 1970s and the following recessions of the 1980s were characterised by extremely slow growth and high inflation. The current measures aimed at increasing rates can produce cooling effects on inflation, potentially avoiding stagflation. However, interest rate policy, as it is known, takes a long time to be transferred onto the monetary and inflation realm. The only certainty is that we will have to wait to produce judgements on the present policy measures.
Fears for 2023: a World Outlook
The pandemic recovery appeared to be solid, in many analysts’ view. However, latest developments in the world economy have changed the general environment and optimism is waning, especially at the 2023 edition of the Davos Economic Forum (WEF, 2023a). The World Bank has predicted that the global economy could tip into recession in 2023 (Lawder, 2023). A forecasted overall growth level of 1.7% old signals the lowest rate being recorded since 1993, apart from 2009 (the year after the Global Financial Crisis) and 2020 (clearly, the year marked by the disruptions triggered by the pandemic). In October, provisional analyses seemed to point at a 2.7% expansion of global output, pushed forth by EMDEs (Emerging Markets and Developing Economies, with a projected growth of 3.7%), rather than by advanced economies (with a forecaste 1.1% growth) (IMF, 2022a). These data, despite displaying positive numbers, underline the bleak reality of a dissipating recovery after the Covid-19 Pandemic (Aldrick, 2022). The World Economy rebounded back 6.0% in 2021 (IMF, 2022), with higher rates being seen in EDA (Emerging and Developing Asia, with 7.2%) and LATAM (Latin America, with 6.9%). Euro Area and the US fared well, with percent changes of 5.7 and 5.2% respectively. In general terms, the IMF has applied a reduction of its prediction for global growth on a worldwide level, with an exception made for Emerging Asia (driven by the market expansion in ASEAN member states).
However, Euro Area particularly appears to be in dire straits. The IMF has substantially cut its output projection from 1.2 to 0.5%. As the IMF underlines, it could consist of the weakest growth since the turn of the century, not considering the emergency periods of the Financial Crisis and the acute phase of Covid-19. Similarly, the United States’ forecast has been downgraded to 0.5% (IMF, 2022b). The most recent statements at the Davos World Economic Forum by key officials, including ECB President Lagarde and EU’s Commissioner Gentiloni, appear not to directly point towards a high likelihood of recession. January 19th’s statement released by the ECB President mentions the possibility for only a “minor” downturn of the European economy. However, officials including Lagarde agree on the perspective of furthering the interest rate increase, a move which is likely to keep markets away from optimism (Randow, 2023).
Figure 1. Source: IMF World Economic Outlook, 2022
Figure 1 refers to the World Economic Outlook’s estimation for world growth. The shaded area around the average in both scenarios (without adversities and with adversities), statistically known as a confidence interval (in this case, of 90%), shows that there is still a likelihood for growth to fall beneath the black line. The latter represents a stagnant level of income per capita on a global scale (Gourinchas, 2022).
In the real economic landscape of countries, actual businesses, supporting millions of livelihoods, lie behind raw data. January 2023’s Chief Economists Outlook, presented at the Davos Forum, has disclosed the general feelings from business owners. While inflation is, after the period of time required for the transmission mechanism to take place, generally expected to be lower after upper interest rate adjustments, businesses find themselves in the middle of two threats. Higher inflation on finished goods prices dissuades purchases by consumers, but, at the same time, it makes input prices soar. This, on the one hand, weakens demand.
If anti-inflation action is taken, interest rates increase, raising the cost of borrowing, a factor detrimental for innovation. WEF’s surveys express the expected businesses’ responses, were the global GDP situation unfold in an adverse manner. Almost 9 in 10 businesses would be ready to cut operational expenses, 8 in ten would attempt to reduce costs by laying workers off (Markovitz and Feingold, 2023). The risk is that these general feelings could turn into self-fulfilling prophecies and initiate a vicious cycle that endangers all agents at play.
Fears for LDCs and Smaller Countries
Least Developed Countries have always been under the deep analysis of international organisations such as the IMF and the World Bank. Especially, the International Development Association (IDA), a branch of the WB, is entitled to provide funds to LDCs. Funded countries do not need to be credit-worthy to receive the benefits. A diffused contraction of world’s output felt in LDCs is an option to take into consideration by policymakers. In a similar fashion, some studies have noted how recessions have a tendency to produce worse effects for small countries (i.e., those with a population lower than the world average). On average, however, as stated by Kose et al., (Kose et alia, 2020a), data across decades and historical experience tell that recessions are worse in advanced economies rather than in Emerging Markets and Developing Economies, with subsequent recoveries being stronger in the latter nations (Kose et alia, 2020b). EMDEs are, however, of a different category from Least Developed Countries. These trends may, therefore, not hold. The recent pandemic experience could tell the exact opposite story. While EMDEs show signs of being better equipped, for a variety of factors, to re-emerge and recover to pre-crisis levels in a fast time, late UNCTAD analyses have ascertained that this is not applicable to Least Developed Countries. Since its creation, UNCTAD (the UN Conference on Trade and Development, founded in 1964 and backed by the UN) has been paying attention towards developing countries, in furnishing them with the elements to access international markets without being damaged (for, say, competition reasons). Their May 2021 estimates (UNCTAD, 2021) emphasise how LDCs were struggling to bounce back to the pre-pandemic GDP per capita levels (i.e., the figures of 2019). Most of the countries in this category were deemed likely to take several years to return to pre-Covid figures. Nevertheless, the most worrying projection involves around 15 of the 46 countries classified as LDCs, which were predicted to take more than 5 years to recover. The post-pandemic period is defined, by UNCTAD, to have materialised into the worst socio-economic performance in 30 years as far as this group of countries is concerned (UNCTAD, 2021). Amongst them it is possible to observe nations struggling with internal conflicts, quasi-failed or full-blown failed states, including Yemen, Sudan, Haiti and Somalia. Particularly, the situation in Haiti has alarmingly worsened in the past few years. UNCTAD commentators are concerned that this direction could widen the divergence with EMDEs and lead LDCs into a “lost decade” for their development (UNCTAD, 2021b).
This volatile setting endangers and weakens the position of some nations in facing another potential global downturn, or, worse, a recession and an erosion of the purchasing power and actual per capita income.
International Organisations’ Reactions
These two main global institutions have contributed in furnishing researchers and policymakers with their analytical reports. Their functioning, however, is known to be substantially different. The IMF’s intervention is triggered after a country demands to be helped. By being an almost universal forum, it plays a higher role than this and works on preventing instability rather than tackling it ex post. Instead, the World Bank, through the IDA (International Development Association) branch, is strongly focused on the poorest countries. In the scenario of a serious global recession, these two institutions may be invoked to work at a greater pace than normal. The IMF, so far, has warned about the risk. By publishing reports, it raises the publicity and the awareness of potential disruptions. Ms Georgieva, the head of the fund, has been clear in saying that a third of the world’s population may live through a period of recession (Tewari, 2023).
In playing its preventive role, IMF analysts have stated that fiscal and monetary policies will have to be fine-tuned to avoid being dissonant (El Yaakoubi, 2023). Moreover, the danger they detected is that excessive contraction (contractionary fiscal or monetary policies) may end up producing harmful effects. The cure shall not be worse than the disease. Conversely, being too loose in tackling inflation and halting the interest rate rise could, as previously discussed, make history repeat itself and plunge the world into a state of stagflation. Surely, to conclude, the next period of world history will be a hard challenge to test if international organisations and their coordinating power is effective. Countries taking advantage of each other in times of crises, like in the beggar-thy-neighbour times of the post-WW1 period, is an example that cooperation should prevail to avoid even worse outcomes, including socio-economic crises and political upheaval.
The world is, in this respect, on a razor’s edge. Policymakers are, hopefully, well aware of the danger.
Sources Ranking
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4 | Incerta | Non confermato; possibile ma non logico in sé; non ci sono altre informazioni sull’argomento |
5 | Improbabile | Non confermato; non logico in sé; contraddetto da altre informazioni sul soggetto. |
6 | Non giudicabile | Non esiste alcuna base per valutare la validità dell’informazione. |
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