IMF wrong for 2001, right for 2002?

Charlotte Denny, Guardian News Service, London

Reminding economists of their predictions last year for the world economy in 2001 is an unfair trick, a bit like reminding friends of their new year resolutions.

But who said life was fair? So let's take a peek back at the International Monetary Fund's October 2000 assessment of the prospects for the world economy in the year now ending.

"Growth is projected to increase in all major regions of the world," it predicted, "led by the continued strength of the U.S. economy." After enjoying the strongest growth for 12 years in the millennium year, the world economy was expected to expand by a robust 4.2 percent this year.

Unfortunately, the world has skidded into its first synchronized downturn since the oil crisis of 1974, led by the U.S. At the end of the year, the three largest economies, the U.S., Japan and Germany, are all in recession.

To cap off 2001, last month the U.S. energy company Enron became the world's largest bankrupt corporation, and this month the Argentine economy finally buckled under the strain of its US$132 billion foreign debts, and became the largest ever bankrupt state.

The IMF did however warn that there were risks to its optimistic scenario, chiefly from the growing imbalances in the U.S. economy. And nobody could possibly have predicted Sept. 11.

Although a lot of corporations have blamed the terrorist attacks for mass lay-offs and plunging profits over the past three months, the downturn was already well under way by the time the hijacked planes crashed into the twin towers of the World Trade Center. The official chronologist of U.S. recessions, the National Bureau of Economic Research, says that the longest ever U.S. economic expansion ended in March.

The IMF was not even right about the causes of the downturn. In October last year it was still warning that the biggest threat to the American economy was that greater than expected inflationary pressures would force the Federal Reserve to raise interest rates sharply, throwing the economy into reverse.

Instead, the year began with an unexpected interest rate cut from the Fed and by its end, 10 further cuts had taken U.S. borrowing costs to their lowest in 40 years. Even the most aggressive easing campaign in 50 years was unable to counteract the deflationary forces that were weighing on the US economy, however.

But it was not inflation that derailed the U.S., but the bursting of the hi-tech bubble in spring of last year, when investors realized that the vast amounts of cash poured into dubious Internet ventures was never going to be rewarded by future earnings. That, in turn, led many to start questioning whether the huge investment in IT was actually going to deliver sustained improvements in the efficiency of the U.S. economy -- the founding myth of the so-called new economy.

What surprised most commentators was how quickly the U.S. malaise spread around the world. Even the IMF acknowledged it as one of the more ironic downsides of globalization. It did not help that the world's second largest economy, Japan, was already in trouble before the U.S. stumbled.

Meanwhile, the European Central Bank exhibited an almost criminal degree of complacency for the first half of the year, refusing to join global efforts to ease monetary policy while still insisting that the eurozone was well protected from the impact of the U.S. slowdown.

Those analysts who expected Britain to be the first to follow the U.S. in a downturn were also comprehensively wrongfooted.

Although Britain has stronger trading and investment links with the U.S. than the eurozone economies have, British consumers continued to spend, insulating the economy from the worst of the downturn, although at the price of a widening trade gap with the rest of the world.

Perhaps the Fund's economists should have paid more attention to the markets. At the end of 2000, investors were clearly not as bullish as the technocrats -- world stockmarkets ended last year in a black mood. As 2001 ends, the position is reversed -- the markets are optimistic that the worst is over, and the IMF is in a gloomy mood, warning that 2002 is likely to be another year of weak global growth.

So who is right this time? The pace of growth over the next two years is likely to disappoint and the recovery when it comes will be weak.

But there is a greater danger than just a weak recovery, according to economist Stephen King of HSBC. For the first time since the 1930s, the major economies face a real threat of deflation. Japan, Argentina, China, Hong Kong, Hungary, Russia and Taiwan are already experiencing falling prices, while in Britain, core goods prices turned negative again last month.

As King notes, low inflation may be a good thing most of the time, but when the economy turns sour it makes a central banker's job harder. "Once prices begin to fall, the transmission mechanism of monetary policy begins to seize up, reducing the ability of the monetary authorities to boost economic activity," he warns.

"If the authorities continue to fight last year's inflationary battle rather than this year's deflationary war, they may find themselves in a position whereby the collapse in private sector expectations for future growth comes through faster than the offsetting monetary and fiscal adjustment."

The question, then, for the world economy in 2002 is whether policymakers will finally admit that inflation is no longer the enemy and that deflation is a real threat. It should certainly feature on some central bankers' new year resolutions.