The world economy: bottoming out or a respite before the next crunch?

• Author: Prasad, Eswar

In early 2009, the world economy seemed to be headed into an irreversible decline. But a strong dose of stimulative monetary and fiscal policies--perhaps with an assist from the natural resilience of the market economy--seem to have done the trick in stabilizing the financial system and setting the stage for global recovery. Flows of private capital to emerging markets have revived and world trade has begun to rise back to levels seen before the crisis hit. Consumer and business confidence are back on the rise.

While the overall sense of doom has been replaced by one of hope, the recovery has been highly uneven. The U.S. economy, which was at the epicenter of the crisis, still faces a long hard slog in returning to decent growth. The continental European economies, especially France and Germany, have bounced back with surprising alacrity but are unlikely to record high growth. The emerging markets are another story altogether, with China and India in particular returning to remarkably high growth rates after their economies had seemed to hit the wall at the end of 2008. Many other emerging market economies that were hit hard by the crisis, especially those in eastern Europe, are still in the doldrums.

This leaves three questions on the table for policymakers of the Group of 20 countries, the group that has become the de facto agenda-setting body for the world economy. What needs to be done in the short run to secure the recovery? What are the medium-term risks that such policy stimulus measures could create? What does all this bode for global macroeconomic and financial stability?

This Is a Recovery?

The global economic recovery is tepid mad far from assured. The U.S. economy still faces enormous headwinds, including weaknesses in the commercial real estate sector, a rising unemployment rate, and weak consumer demand. On the plus side, there is still a great deal of stimulus wending its way through the economy; inventory rebuilding has begun mad confidence indicators are up. A few other advanced economies are in better shape but domestic demand still remains weak in most of them. While the major emerging markets are growing strongly, they are not capable of pulling in large volumes of net imports from the rest of the world and thereby serving as engines for world growth. Even while industrial production and GDP are beginning to bounce back from their lows, employment growth continues to remain weak even in the fast-growing economies.

Despite all the concerns about the efficacy and dangers of the stimulus measures, withdrawing monetary and fiscal stimulus prematurely is a greater risk at this stage, when economies, markets, and sentiments remain fragile. An important question to ask is whether the measures taken to stanch the crisis might be steering the global economy toward the edge of another...