If you see world economists beaming brightly, no, you’re not hallucinating

By Anatole Kaletsky (THE TIMES, 21/09/06):

ALMOST SINCE its inception in the late 18th century, economics has been nicknamed “the dismal science”. Economists are supposed to be cynical about human nature. Finance ministers are supposed to be dour and stingy. Central bankers are supposed to be ascetic and pessimistic.

All this is, of course, bad luck for Gordon Brown. As the Chancellor tries to burnish his public image, he must reflect sometimes on the unattractiveness of the cold, calculating economic worldview. Doesn’t this explain why so few chancellors have ever made a successful transition to No 10? Maybe, but Mr Brown can afford to cheer up: misery in economics is suddenly out of fashion.

At last weekend’s joint annual meetings of the World Bank and International Monetary Fund, the global jamboree of finance ministers and central bankers, such was the change in atmosphere that the IMF chief economist was moved to declare: “I’ve been told to smile more often, but since my natural disposition is to be serious, I might seem a little schizophrenic.”

Why are IMF officials suddenly smiling? Why aren’t they fretting, as usual, about the risks of a global recession and issuing their standard denunciations of profligate governments, unsustainable trade deficits and the crushing burdens of consumer debt? Because, to judge by the forecasts published last week in the IMF’s World Economic Outlook, economically we are closer than ever before to the world of Dr Pangloss.

The world economy is expanding, inflation and interest rates are stable, employment and incomes are rising — and almost wherever we look around the world, even in sub-Saharan Africa, these healthy trends seem set to continue in the year ahead. Moreover, when the IMF’s researchers consider the familiar long-term risks to the global outlook — the trade deficits in America (and to a lesser extent in Britain), the risks of a boom-bust cycle in house prices and mortgage borrowing, the danger from soaring energy prices, the threats to financial stability from speculators and hedge funds — they now conclude that all these trends are far less troubling than they seemed even a year ago.

Should we react to this sudden incursion of Dr Pangloss into the citadels of economic orthodoxy by taking a contrary view? That was my instinct before the summer. Two clouds, in particular, seemed to overshadow the horizon. These were the possibilities either that the US economy would slow more abruptly than expected or that inflation in America would accelerate and force the US Federal Reserve Board to keep raising interest rates until they precipitated an outright recession.

In the past few months, however, both these risks have dwindled, largely because oil prices have fallen. Cheaper oil has boosted global spending power and simultaneously helped to stabilise US inflation, albeit at a higher level than the Fed might have liked. As a result, the US now seems to be heading not for a recession but for a gentle slowdown towards a “Goldilocks economy”, neither too hot nor too cold. Its housing boom looks like deflating gradually instead of causing an economic bust.

It is hard to argue with the IMF’s generally optimistic outlook, even though one might cavil with a few details — for example, the IMF seems to underestimate the chances that Germany will suffer a recession following its VAT increase next year.

But what is more interesting than short-term forecasts is the IMF’s analysis of longer-term trends. This is where the new spirit of optimism among economists really shines through. Most economists have long been enthusiastic about the opportunities created by free trade, globalisation and technological progress, but until recently the benefits of these forces were always hedged about with warnings about concomitant risks of financial instability, job insecurity and so on. In the past few years, however, it has become apparent that the structural changes of the past decade have generated greater benefits than expected and, far from creating instability, have reduced economic volatility.

To understand why this has happened, we have to consider the interaction between the five great structural changes that have powered the world economy since the early 1990s. First, the collapse of communism, which has given three billion new consumers and producers the opportunity to enjoy the benefits of the market system; secondly, the spread of free trade, which has allowed all countries to participate in the global economy for the first time; thirdly, advances in electronic technology, which have slashed communication costs and created opportunities for productivity growth in service industries of a kind previously only enjoyed in the manufacturing sector; fourthly, a revolution in finance, which has offered to consumers the opportunities previously only enjoyed by the biggest multinational companies to borrow against their future income and assets; and finally, the rediscovery of active demand management, which has allowed central banks and governments to avert recessions, minimise unemployment and keep economies growing as close as possible to their long-run productive potential.

While economists have long discussed these structural changes, they have not, until recently, begun to understand how they would all reinforce one another to make the global economy more stable and create the conditions for rapid non- inflationary growth. For example, globalisation has shifted manufacturing employment out of the West to China and created huge trade imbalances. But combined with the other structural forces, globalisation has nonetheless made the world economy more, rather than less, stable. Trade deficits have turned out to be easy to finance because of financial deregulation.

Meanwhile, the loss of manufacturing has made employment in the advanced economies more stable because manufacturingn companies are much more exposed than service businesses to cyclical swings in investment and jobs. This greater employment stability, in turn, has made it prudent for homeowners to take advantage of financial deregulation to increase their borrowings — and that has made consumption and growth more stable in the face of shocks such as the collapse of technology shares or the terrorist attacks of 9/11.

Economists are still a long way from understanding the full implications of all these changes — or of weighing them up against new long-term dangers such as climate change, demographic decline and widening disparities of income. We can, however, say one thing for certain: when economists smile, they should no longer apologise for being schizophrenic.