Policy recommendations

The economic recovery in developed countries has entered a new phase of fragility. Many developed countries, particularly in Europe, have shifted from stimulus to fiscal retrenchment, even though private spending has not recovered and unemployment has remained high. This creates risks of prolonged stagnation or of double-dip recession in some developed economies. Given the lack of growth in employment and wages in Europe, Japan and the United States, their policies should aim at renewed monetary and fiscal stimulus of their economies instead of trying to regain the confidence of the financial markets by prematurely cutting government spending.

 

It is important to understand that there is nothing in balancing the budget that would automatically lead to an absorption of excess capacity as long as the private sector does not increase its spending. On the contrary, balancing the budget, by curtailing the disposable incomes of people with high consumption propensity would decrease demand and increase further excess capacity.

 

The rapid recovery of Asian economies after the crisis, in particular China and India, and the relatively fast recovery of commodity prices have helped developing countries maintain their growth momentum. However, many developing countries continue to face considerable downside risks and the danger of a negative external shock cannot be completely ruled out, given the volatility of commodity prices, the continuous crisis in Europe or their exposure to significant short-term capital flows, which tend to exert an upward pressure on their currencies and damage their export industries. In other words, even though growth in several developing countries has come to rely more on domestic forces rather than on exports, it remains vulnerable. Thus developing countries should aim at maintaining stable macroeconomic conditions domestically and containing external disruptions.

 

Strict re-regulation of the financial sector in developed countries is essential to reduce the possibilities of a new financial crisis. It is a requirement to reduce herd behaviour and eliminate the problems associated with too-big-to-fail institutions. Meanwhile, it should be more orientated towards investment in fixed capital. In parallel, developing countries should use capital controls, foreign reserve accumulation and foreign exchange management in order to reduce the risks of contagion associated with external financial crises.

 

Given the importance of private spending for boosting global demand, incomes policies in the biggest economies could contribute significantly to a balanced expansion, especially when the global recovery is still fragile. An essential element of such a policy is the adjustment of real wages in line with productivity, so that domestic consumption can rise in line with supply. This would also help prevent an increase in unit labour costs, and thus keep the main domestic source of inflation under control. Monetary policy could then reduce its focus on price stability and pay greater attention to securing low-cost finance for investment in real productive capacity, which in turn would create new employment opportunities. Wages rising at a rate that corresponds approximately to the rate of productivity growth, augmented by a target rate of inflation, is the best anchor for inflation expectations.

• Developed countries' policies should aim at renewed monetary and fiscal stimulus instead of trying to regain the confidence of the financial markets;
• Developing countries also face considerable downside risks and should aim at maintaining mildly expansionist macroeconomic conditions domestically, while trying to contain external disruptions;
• Re-regulation of financial markets is a requirement to reduce herd behaviour and eliminate the problems associated with too-big-to-fail institutions;
• Developing countries should use capital controls, foreign reserve accumulation and foreign exchange management to reduce the risk of financial crises;
• Adjustment of real wages in line with productivity to promote domestic consumption is necessary for a sustainable recovery in developed countries;
• Monetary policy could then reduce its focus on price stability and pay greater attention to securing low-cost finance for investment in real productive capacity.