Premature exit from fiscal expansion could lead
to deflationary spiral, UNCTAD warns

Report says global recovery is taking on pre-crisis patterns, requiringa rebalancing of current accounts around world

Geneva, 14 September 2010 -- UNCTAD economists warn in this year´s Trade and Development Report (TDR) that a premature exit from demand-stimulating macroeconomic policies in developed countries might cause a deflationary spiral with attendant slumps in growth and employment around the world. Ending stimulus measures too soon in an effort to restore the confidence of financial markets could be counterproductive, the report cautions.

The Trade and Development Report 2010(1), subtitled "Employment, globalization, and development", was released today.

Since mid-2009, the world economy has been showing signs of recovery from what is considered the worst economic and financial crisis since the 1930s. Emerging market economies are leading this recovery, while the upturn in developed countries is weaker and resembles the pre-crisis build-up of global trade and current-account imbalances. With fiscal stimulus measures petering out and systemic shortcomings such as insufficiently regulated financial markets and global current-account imbalances still in place, growth rates in most countries will probably decline again in 2011, the study predicts.

Failure to coordinate policies at the G-20 level carries the risk of such imbalances re-emerging, especially among developed countries, the report says. Moreover, there is a risk of a premature restriction of fiscal policies and the danger of a second dip to the recession.

After a contraction of almost 2% in 2009 -- the first contraction since the Second World War -- global real GDP is expected to grow by 3.5% in 2010, UNCTAD estimates. In line with the upturn, world trade, which had plunged by as much as 23% in value in the first half of last year, has picked up again since mid-2009. Commodity prices, rebounding from their lows of the first quarter of 2009, have boosted national incomes and fiscal revenues, due in part to strong demand from rapidly industrializing emerging economies, but also to the renewed risk appetite of financial investors.

Yet the upturn is fragile and uneven, the report cautions.

Emerging market economies, especially in Asia and Latin America, are leading the recovery; some achieved double-digit growth rates in the first quarter of 2010. They had avoided large external deficits and had accumulated significant international reserves before the crisis. As a result, they were able to contain rises in unemployment during the crisis and were able to achieve rapid recoveries in domestic demand. With trade volumes restored to their pre-crisis levels, Asia´s GDP is expected to rise by almost 8% this year, while Latin America´s is forecast to grow by 5%.

By contrast, recovery has been weak in the transition economies of Central and Eastern Europe. Prior to the crisis, these countries often had run huge current-account deficits and had depended heavily on net capital inflows. This has since been exacerbated by restrictive macroeconomic policy responses to the crisis, often under IMF-led programmes.

African countries were less directly affected by the financial turmoil, since they are much less integrated into international financial markets than other developing regions, the report notes. While the whole of Africa is expected to grow at a rate of 5% in 2010, growth will be closer to 6% in sub-Saharan Africa (excluding South Africa).

In developed countries, as in some emerging market economies, immense financial rescue packages prevented the collapse of the financial system, while supportive fiscal and monetary policies compensated for sluggish private demand. Consequently, most developed countries returned to positive growth rates between the second and fourth quarters of 2009. Yet the pattern of the recovery is very similar to that of imbalanced global demand growth during the build-up to the crisis, the report says. That situation is far from addressing the issue which stood at the heart of the crisis of 2008. The United States has witnessed a stronger rise in domestic demand than the leading current-account-surplus countries - namely, Germany and Japan - where growth and employment dynamics continue to rely heavily on exports. Moreover, in recent months, Europe, due to its mostly home-grown debt problems, has become the centre of the global crisis and a laggard in the recovery, says the report.

"The rebound from recession will not endure if it continues to be based on temporary factors, such as inventory cycles and exceptional fiscal stimulus programmes, and if the shortcomings that caused the crisis, such as unregulated financial systems, income inequality and global imbalances, persist," UNCTAD Secretary-General Supachai Panitchpakdi remarks in the overview to the report.

With fiscal austerity spreading throughout Europe and the G-20 consensus on common crisis responses crumbling, the risk of a double-dip recession, or even a deflationary spiral, arises, the TDR warns. A premature exit from demand-stimulating macroeconomic policies in an effort to reduce budget deficits and regain market confidence means that these countries have to rely on exports for recovery. A "free-rider" problem is the consequence: These nations shift the burden of sponsoring demand stimuli onto others and export unemployment to the rest of the world. Given that not all countries can rely simultaneously on exports, one has to ask where the import demand will come from. As a rule, the report states, "governments should withdraw stimulus only after achieving a full recovery of private domestic demand in their country."

Currently, G-20 coordination is facing such a problem, the TDR says: The Euro area, by adhering to fiscal austerity, might take a free ride on the demand stimuli of other economies, such as the United States, which follow more expansionary policies. Agreement on the appropriate crisis response no longer exists, the report contends.

Despite the recent upturn, many countries are now facing the highest unemployment rates of the last 40 years as the global employment-to-population ratio has been declining since 2008. "A continuation of the expansionary fiscal stance is necessary to prevent a deflationary spiral and a further worsening of the employment situation," Secretary-General Supachai concludes in the overview to the report.