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October 14, 2014

Originally published in the October issue of Global Finance

In the midst of widespread geopolitical instability and sluggish economic growth, government officials the world over will assemble in Washington D.C. in mid-October to discuss the way forward at the annual meetings of the International Monetary Fund (IMF) and World Bank (WB). If the 2013 gathering was characterized by cautious optimism and the sense that the world had begun to recover in earnest from the global financial crisis, new clouds hang over participants this year.

Mounting tensions from Ukraine to the Middle East risk undermining progress made not only in the regions affected but also, indirectly, around the world. The performances of the European Union and, to a lesser extent, the United States have been disappointing, especially with regards to employment. Emerging markets, with the exception perhaps of China, have been posting subpar rates of growth. Given this background, the unprecedented monetary policy, from Washington to London to Tokyo, that has been propping up the global economy in recent years may have run its course. The question now is whether fiscal policy is ready to pick up the slack. In the meantime, rumblings about Western dominance of the IMF and the World Bank continue in countries from India to Brazil, who are at work to shape their own vehicles of global economic governance.

“I do think that 2014 can be considered a watershed year in that it represents a departure from the downward trend which began with the fall of Lehman Brothers in 2008,” says Marcos Troyjo, director of the BRICLab at Columbia University. “But the atmosphere won’t be as optimistic as expected, since the pace of recovery around the world is much slower than what was foreseen only a couple months ago.”

Growth in the eurozone flat-lined in the second quarter of 2014, with Italy falling back into recession and even the German economy contracting, if only slightly. At +4.2%, the US posted an unexpectedly positive result in the second quarter, but paired with the dismal -2.1% in Q1, it points to an overall weak performance. But there is great concern about stubbornly high rates of unemployment (respectively at 11.5% and 6.2%, according to the latest data). Finally, the IMF recently lowered its growth forecast for emerging markets from a pre-crisis (2003‒2008) average of 7% to 5% over the next five years.

“Labor markets are still doing dreadfully in Europe,” says Guntram Wolff, director of Bruegel, a think tank in Brussels. As such, it is likely that this year’s annual meetings will see yet another rehash of the debate on austerity versus growth. “My view is that the discussion has been too narrowly focused,” says Wolff. “I would argue that we have an aggregate macroeconomic demand problem, especially an investment demand problem that can be addressed only by big core countries like Germany and France. But we also have a supply-side, structural reform problem.” According to Wolff, some institutions in Germany, like the Bundesbank, are coming see that the pace of growth in the region is not sufficient to effect a real recovery, which might open the door for more intervention. However, other branches of the German government disagree. “There is a strongly held view in Berlin, especially in the Finance Ministry, that Germany needs to reach a balanced budget and should start paying back its debt,” he says. As for the willingness to implement structural reforms in countries such as France and Italy, Wolff believes that the leadership is gradually moving in the correct direction, but it is not clear yet whether they have the necessary political support from voters.

Though things in the US appear to be looking up, policy uncertainty continues to represent a drag on growth. “We have a long-term problem but not a short-term problem,” says Gary Hufbauer of the Peterson Institute for International Economics in Washington D.C. “Short term, we are too fiscally constrained. But it is hard for fiscal hawks to understand that one can take different actions for the short and long term.”

Employment will be front and center at this year’s meetings, since it is the key legacy issue from the global financial crisis that has yet to be resolved. In fact, jobs already dominated the discussion at the traditional Jackson Hole Economic Symposium at the end of August, a gathering of the world’s central bankers, finance ministers and academics that is held annually in the US in Jackson Hole, Wyoming. “One challenge that emerged there is that there is a lack clarity about the rate of full employment, which makes it difficult for central bankers to enact normal monetary policy,” says Chetan Ghate, associate professor at the Indian Statistical Institute in New Delhi.

The fragile recovery around the world will link the discussions at the IMF and the World Bank. “The global economy is operating way below potential, and there is a human cost to this, especially in terms of unemployment,” says Ghate. “Development aspirations in developing countries are not being met.” Adding to the uncertainty, countries like Brazil, India, Indonesia and South Africa are in the midst of an important political transition (having all just recently elected new governments) whose effects will be felt only in the coming months. Narendra Modi, India’s new prime minister, has so far elicited the greatest hopes. “We have had sluggish growth for the past two years, mostly driven by domestic factors,” says Ghate. “The expectation is that the new government will rebuild governance and that growth will return to 7% to 8% in three- to four-years’ time. I don’t think anyone can really know that, but it is fair to say that India’s performance will be positively affected by a stable government.”

Much of the debate at the IMF will cover the role of monetary versus fiscal policy to stimulate growth. “If you look at the world economy, it is still lethargic after all this unprecedented monetary expansion, so I say there may be a change in attitude,” says Hufbauer of the Peterson Institute. He believes that infrastructure could emerge as the biggest beneficiary of this shift in thinking. “Most governments don’t want to increase entitlement programs, because when you do, it’s hard to ever take it back,” Hufbauer says. “So if we are going to talk fiscal expansion, it will be in the context of infrastructure spending, which is below-grade in many countries and has very high social productivity.”

Though now widely anticipated, a full withdrawal, by the US Fed in particular, from the policies of low interest rates and quantitative easing could still be a point of contention in Washington. “International monetary cooperation remains a major issue for emerging markets economies,” says Ghate. “Meaning that monetary policy should be set so that it is mindful of the effects it has on them as well.”  While the Fed has announced it will bring its bond-buying program to an end in October, it remains unclear when exactly it will also turn the switch on interest rates. According to Hufbauer, they are bound to remain low for the time being, with a move not likely until the second quarter of 2015.

In the meantime, international monetary policy cooperation is of concern not only to emerging countries. Having just launched unconventional interventions of its own but still struggling to keep the threat of deflation at bay in the eurozone, the European Central Bank is behind the curve relative to the Fed, the Bank of England and the Bank of Japan. ECB President Mario Draghi is moving toward quantitative easing precisely at a time when his American counterpart Janet Yellen is preparing to take the US in the opposite direction, which might undercut his efforts to reach the ECB inflation target.

Finally, IMF/WB governance issues will be on the table again in October, as the US Congress continues to block long-proposed reforms that, among other things, would see a larger voting share at these institutions going to developing countries. Participants may feel an added sense of urgency, as the BRICS countries join forces to launch their own New Development Bank, modeled after the World Bank, and Contingent Reserve Arrangement (CRA), which will resemble the IMF. Though the project is promising and, in the long run, could complement the Bretton Woods institutions, experts warn not to expect too much from either in the near future. “We are coming to the conclusion that we have a deficit in terms of global economic governance,” says Marcos Troyjo of Columbia University. “So the diagnosis will be there, but I don’t see the political will, the economic capacity or the room for cooperation and maneuvering that would either bring existing institutions up to date or that would allow for the creation of a new architecture.”

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