The paradox of the world recovery

Juan Carlos Martínez. Professor. IE Business School

27 October 2006

The world economy is growing, despite the high price of crude oil and raw materials. But it also faces other threats that could flare up at any time.

The end of summer has brought the publication of economic forecasts by various organisations, including the IMF (International Monetary Fund), the OECD (The Organization for Economic Co-Operation and Development) and the European Commission. Although their conclusions differ by decimals, they all share a common denominator: the world economy is accelerating despite the increasingly obvious risks it faces. This is not unusual since all positive situations intrinsically carry some latent risks and imbalances.

One of the most positive conclusions from these forecasts is that European economies are on the mend. Although most of the structural reforms remain pending, Germany, France and, to a lesser extent, Italy, seem to be emerging from their economic lethargy. The reasons for this recovery lie in increased investment and growing consumption, as a result of lower unemployment. What is more, this recovery is helping turn around the impoverished public accounts of many countries. Europe’s recovery is good news for Spain; if our economy is cooling as a result of higher interest rates, as the latest economic data show, the foreign sector could replace domestic demand as the engine of growth, helping narrow our huge trade deficit.

The worldwide outlook is also bright. China, India and the economies of Southeast Asia will continue to dazzle. Latin America will maintain economic growth of more than 4% thanks to its improved trade balances and the high price of raw materials. The economic news from Japan continues to be upbeat, as the economy continues to recover from years of deflation. Only the North American economy seems to be slowing, damped by higher interest rates and rising oil prices. But even so, U.S economic growth is predicted to reach 3% in 2007, if inflation is kept under control, enabling the Federal Reserve to loosen its monetary belt.

The paradox here lies in the fact that this world recovery/acceleration has come at a time when it was least expected. Current conditions would appear to be anything but ideal: the price of crude is over $60 a barrel and interest rates in the Euro-zone and the United States are on the rise. If, a couple of years ago, anyone had predicted that the world economy would grow this year by just over 5% (the second-highest figure in the last 30 years) on the back of record high prices for crude oil and other raw materials and tight monetary policies, nobody would have believed it.

However, the increase in oil prices over the last two and a half years has not had the same devastating effect on the world economy as it had in the past. This is due to the growing energy efficiency of western economies, appropriate monetary policies and the deflation exported by China and other emerging economies. What is more, in real terms, crude prices have not actually risen that much, especially for those whose currency has appreciated against the dollar. Even so, inflation has made its mark, albeit generally in very moderate terms. It is the bad memory of past experiences with inflation that has prompted the different central banks to act proactively in order to avoid these pit falls. They seem to have succeeded at stemming inflation, without hurting the economy.

In general, other economic variables and indicators are performing well. Business profits are growing at a good pace and mergers and takeovers are still rampant thanks to the excess liquidity sloshing around the world economy. Indeed, most of the world´s stock exchanges have reported gains this year and some, such as the Spanish market, have reached highs.

However, the geopolitical risks remain latent. Although the conflict in Lebanon seems to have calmed down with the arrival of international troops, the problem of Iran remains. So far, negotiations with Teheran have not been successful in deterring Iran from its uranium-enrichment programme and there seems to be little hope they will do so. Furthermore, it is hard to believe that the United States and, above all, Israel will remain indifferent to this possibility. Who knows how high oil prices might go should another conflict break out in the Persian Gulf.

The other imbalances that threaten the world economy are like those of a chronic disease. They are always there, and can rear their ugly head at any moment, but you get used to living a more or less normal life with the threat. In economic terms these would be the bursting of the real estate bubble, the risk of emerging economies and the US current account deficit. Everyone knows these threats can flare up at any moment, but in the meanwhile, we continue to party.

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