Why the Global Economy is Stuck and How It Can Recover

Metal globe sitting on world currency
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There is little doubt that the global economy has failed to fully recover from the 2008 financial crisis. While low interest rates and quantitative easing helped in the immediate aftermath of the crisis, developed economies have seen growth rates slow to an anemic pace since 2015 despite extraordinary measures. The lack of a recovery is particularly concerning given the few options left for central banks and the lack of willpower to implement fiscal reforms.

In this article, we will take a look at why the global economy has experienced problems and some options being considered by policymakers to help it recover.

Monetary Policy Reaches Its Limits

Central banks around the world responded to the 2008 financial crisis by cutting interest rates and implementing quantitative easing programs. These actions were designed to stimulate the economy by lowering borrowing costs to incentivize businesses to invest. Despite these policies and negative interest rates in some countries, low growth and inflation have plagued developed countries and frustrated economists looking for solutions.

Monetary policy may have reached its limits when it comes to cutting interest rates with very low natural rates and inflation, according to San Francisco Federal Reserve President John Williams. In an August 2016 statement, Mr. Williams urged governments and central banks to consider new measures like setting higher inflation targets and tying monetary policy directly to economic output in order to predictably boost an economy during a downturn.

Other economists worry that an aging population in the developed world and a lack of productivity gains could permanently lower growth rates. According to McKinsey Global Institute, productivity would need to accelerate 80% from its historical rate to keep global GDP growth from slowing due to a shrinking labor pool.

The bad news is that productivity is actually slowing as technological breakthroughs of the past may have reached their limits.

Fiscal Policy Reform Remains Elusive

Many central bankers and economists argue that fiscal policies haven’t evolved to meet the new economic reality. These policies leverage national budgets to boost an economy through stimulus spending, tax cuts, and other measures rather than relying on interest rates and currency manipulation to encourage or discourage borrowing. They work hand-in-hand with monetary policy by further incentivizing businesses to actually borrow and invest.

Mr. Williams outlined a number of different fiscal policy changes that could help the global economy escape its current crisis. For instance, he suggested that tying tax rates or government spending to unemployment rate could create a predictable, systematic adjustment of fiscal policy that supports the economy during recessions and recoveries. These kinds of programs could help boost economic growth through structural rather than behavioral changes.

Fiscal policy has started to change in many developed markets, but greater government spending hasn’t led to higher bond yields yet. The U.S. Presidential candidates seem ready to pursue expansionary fiscal policies, while European leaders seem to be changing their tune when it comes to austerity — particularly in the U.K.

following the ‘Brexit’ vote. The success of these changes when it comes to spurring growth to be seen, however.

The Bottom Line

The global economy has been struggling to grow since the 2008 financial crisis. With record low interest rates and aggressive bond-buying, equity markets have rallied without any strong underlying GDP growth over the last few years. Monetary policy may have reached its traditional limits, which has some economists calling for more extreme measures. At the same time, fiscal policy may finally become more expansionary as governments look to spur growth.

International investors should keep these factors in mind when making their investment decisions. For instance, the lower bound on interest rates could cap a rally in bond prices, while renewed stimulus spending could bolster earnings at many publicly traded companies.

The announcements of these programs can also have profound single-day effects on major equity indexes given changing investor expectations for the future.

The two most important central banks to follow are the U.S. Federal Reserve and the European Central Bank, while the Bank of Japan and Bank of England may also move the markets with their announcements.