The May 1992 World Economic Outlook examined the role played by balance sheet adjustments in the nonfinancial sectors of the economy in constraining the pace of recovery in the United States and the United Kingdom.1 It also examined in less detail similar adjustments in Japan and in the smaller industrial countries. This annex updates the earlier work and then focuses on the corresponding adjustments in the financial sectors of Japan, the United States, and several of the Nordic countries.
The pace of global economic activity is projected to moderate to 2 percent in 1990, reflecting a slowdown in growth in both industrial and developing countries and a contraction of output in Eastern Europe and the Union of Soviet Socialist Republics (Table 1). The staff projects that the growth of world output will increase to 2½ percent in 1991, about the same as the average rate of growth in the 1980s. The rate of expansion of world trade is expected to continue to decline, averaging about 5½ percent in 1990–91. As noted above, these projections are based on the assumption that world oil prices will average $26 per barrel for the remainder of 1990 and decline gradually to $21 per barrel in the fourth quarter of 1991.
World economic activity showed signs of revival in the first half of 1992 as some major economies slowly began to emerge from the cyclical downturns of 1990–91. During the next 12 months, world growth is expected to continue to recover at a moderate pace: following stagnation in 1991, world output is projected to expand by 1 percent in 1992 and by 3 percent in 1993, close to the average growth rate during the past two decades but somewhat less than experienced after the two previous—and more pronounced—recessions in 1974–75 and 1981–82 (Chart 1). Recent progress in reducing inflation is likely to continue in most countries. The growth of world trade is forecast to rise from 2¼ percent in 1991 to 6¾ percent in 1993.
The recovery of global economic activity after the 1991 downturn remains hesitant and uneven. Although some industrial countries have emerged from recession, growth has declined sharply in many other countries because of extensive balance sheet restructuring, persistently high short-term real interest rates, considerable financial tensions, and depressed levels of consumer and business confidence. As a result, the growth of world output picked up only modestly, from ½ of 1 percent in 1991 to 1¾ percent in 1992, which was the third consecutive year of below-trend performance (Chart 1). World output is projected to grow by 2¼ percent in 1993 and then to strengthen by 2½ percent in 1994, but the outlook remains unusually uncertain. On the positive side, inflation has continued to abate in most industrial and developing countries.
Recent months have been characterized by flagging consumer and business confidence, weaker-than-expected economic activity—especially in Europe and Japan—and considerable tensions in foreign exchange markets. Despite encouraging signs of increased growth in the United States, these developments have cast new doubts on the prospects for recovery in the industrial world after what has already been two years of weak growth or recession in many countries. There are two main reasons for the pervasive sluggishness of growth. The most important is the deflationary impact in a number of countries of balance sheet adjustments by the private sector following the recent correction of inflated asset prices. An additional factor is the negative effects of high interest rates in Europe, stemming from the strong fiscal expansion that accompanied German unification, and inadequate progress toward inflation convergence and budgetary consolidation in a number of countries. The persistent currency turbulence since September, growing tensions over trade, and other indications of a reduced commitment to international policy cooperation in the major industrial countries have contributed to increased uncertainty. In these circumstances, there is a critical need for confidence-building economic policies to strengthen the prospects for growth without jeopardizing financial market stability or the considerable progress that has been achieved in reducing inflation.
The current macroeconomic difficulties of the industrial countries can, to a large extent, be attributed to the failure to achieve key medium-term policy objectives during the past decade. This failure has both contributed to the imbalances that led to recent turbulence in the exchange markets and considerably narrowed the scope for policymakers to respond effectively to the sluggishness of growth. On the positive side, a major accomplishment has been the widespread reduction of inflation to levels not experienced since the 1960s. But large fiscal imbalances continue to overburden monetary policy and are adversely affecting business and consumer confidence and financial markets. In many countries these problems are compounded by disequilibria in private sector balance sheets. This chapter examines three important areas where macroeconomic imbalances are giving rise to serious strains in financial markets and are contributing to the weakness of activity.
Developments in financial markets during the past eighteen months and signs of a softening of growth in the industrial countries since the beginning of 1995 have highlighted the sensitivity of financial markets to economic imbalances and the downside risks to the outlook. However, although economic performance has been adversely affected in some countries, there are many reasons to expect that the global economic expansion will proceed at a satisfactory pace. Fears of a pickup in inflation in the industrial countries have largely abated, long-term interest rates have again fallen substantially in most countries following the sharp increases in bond yields during 1994, coordinated foreign exchange market intervention by leading central banks and supportive policy developments have helped to correct the misalignment of key currencies that had emerged earlier in the year, contagion effects from the financial crisis in Mexico have been contained, and growth in most of the emerging market countries in the developing world and among the transition countries has remained robust. While the short-term projections for the industrial countries have been marked down somewhat, the forecasts for many developing countries are now even stronger than expected in the May 1995 World Economic Outlook (see Table 1).
Following two years of slow economic growth, the recovery for the world economy in 1993 is projected to be sluggish (Table 1). A protracted slowdown in Europe and an unexpectedly sharp weakening of activity in Japan have contributed to significant downward revisions to the output projections for many countries for 1993.1 Against this background of recent setbacks there are, however, some encouraging developments: strengthening recoveries in North America; continuing progress and resilience in many developing countries; indications in some central European economies that reforms are starting to bear fruit; and significant reductions in inflation in a number of countries. There is also scope for improving economic prospects in 1994 and beyond through a cooperative growth strategy.
The world economy, following the third major slowdown since the early 1970s, is expected to recover gradually during 1992 and 1993. Although the forces at work should on balance support a resumption of stronger growth, many of the uncertainties in the outlook involve downside risks, suggesting that the recovery may well be modest compared with previous cyclical upturns. This chapter discusses the global economic situation and the short-term outlook. Subsequent chapters analyze the role economic policies could play in improving conditions for sustained growth in the future.