Look beneath the surface of World Bank's rosy economic report

Look beneath the surface of World Bank's rosy economic report
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The World Bank’s report that the global economy is now operating at close to full capacity would seem to be a mixed blessing.

On the one hand, there is certainly reason to celebrate that we are now at last enjoying a synchronized global economic recovery and that the world economy is operating at near its potential.

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On the other hand, there is reason to fear that approaching global full employment could very well be a precursor to aggressive monetary policy tightening by the world’s major central banks as they become forced to make efforts to avoid inflationary pressures.

 

That in turn could lead to the painful correction of financial market excesses and to the bursting of asset price bubbles around the globe that could very well derail the world economic recovery. 

Almost a decade after the world’s worst economic recession in more than 70 years, the World Bank is now reporting that the world economy finally appears to be firing on all cylinders. At long last, the European and Japanese economies appear to be catching up with the long-standing U.S. economic recovery.

Meanwhile, it appears that emerging market economies like Brazil, China, India and Russia, are now regaining their earlier economic momentum. As a result, world employment is increasing and slack in the global economy has been all but used up.

Surprisingly, in its analysis of the current world economic recovery and of the present global economic outlook, the World Bank glosses over the artificial way in which the global economic recovery has been achieved. In particular, it pays no attention to the unduly heavy burden that has been placed on monetary policy to get the global economy moving.

By the same token, it makes no mention of the serious and dangerous distortions in global asset market prices that ultra-unorthodox monetary policy has created, which could very well have set up the global economy for a hard landing.

One measure of the undue burden that has been placed on monetary policy is the fact that the world’s major central banks have been forced to maintain their policy interest rates at close to zero for several years. Another is that these central banks have had to resort to government bond buying on a massive scale to generate an economic recovery.

As a result of that bond buying, it is estimated that since 2008, there has been a staggering $10 trillion increase in the combined balance sheets of the Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan.

While very unorthodox monetary policy has succeeded in producing the synchronized global economic recovery to which the World Bank refers, it has done so at the cost of creating serious financial market risks.

Global equity valuations now are at lofty levels that have only been experienced three times in the last 100 years. Meanwhile, government bond yields have declined to record-low levels, risk premiums on high-yield and emerging market bonds have been substantially compressed, and bubbles now characterize the Australian, Canadian, Chinese and United Kingdom housing markets.

Past experience would suggest that asset price bubbles burst and financial market excesses get corrected when monetary policy starts to go into a serious interest rate increasing cycle.

For which reason, one would think that if the World Bank is right that the world economy is now at its potential and that inflationary pressures are on the horizon, we should be bracing ourselves for disruptive financial market corrections.    

It is well to recall that the World Bank, along with the other multilateral lending institutions singularly failed to anticipate the 2008-2009 Great Recession. Judging by its latest Panglossian assessment of the global economy, it would seem that the World Bank will once again be flat-footed by the next major global economic downturn.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.