The World Bank's latest Global Economic Prospects report says global economic growth will rise in the next two years, yet it recommends public budget cutbacks and structural reforms. Deutsche Welle examines why.
The World Bank's most recent Global Economic Prospects (GEP) report, released this week, says a global economic recovery is underway, underpinned by strengthening output and demand in high-income countries.
Global GDP growth in 2014 will be 2.8 percent and it is expected to rise to about 4.2 percent by 2016, according to the report, which the World Bank publishes twice a year.
Average GDP growth in developing countries has reached 4.8 percent in 2014, faster than in high-income countries but slower than in the boom period before the global financial and economic crisis of 2008.
Demand side stimulus or supply side reforms?
The global economic slowdown that struck in 2008 was caused by a financial crisis that resulted in large part from the bursting of an enormous, fraud-ridden mortgage lending bubble in the US.
The crisis led to varying responses in different countries. The GEP report's authors said that in general, developing countries privileged demand stimulus policies over structural reforms during the past several years.
For example, in 2008 to 2009, China implemented a four trillion-renminbi ($586 billion) stimulus program as a direct response to the slowdown in global trade caused by the global financial crisis.
Critics pointed to over-investment in China as a risk to continued fast growth. The country is now struggling to contain a real estate bubble of its own.
The World Bank wants China and other emerging countries to refocus on structural reforms.
"A gradual tightening of fiscal policy and structural reforms are desirable to restore fiscal space depleted by the 2008 financial crisis," the bank's chief economist, Kaushik Basu, has said. "In brief, now is the time to prepare for the next crisis."
The World Bank's mantra: Fiscal discipline and structural reforms
Yet the World Bank is well known for nearly always prescribing fiscal "tightening" - or cutbacks to government expenditures - and "structural reforms."
What is the rationale for public expenditure cutbacks? And what does the World Bank mean by "structural reforms?"
The World Bank consistently urges policymakers to prevent annual deficits from growing faster than the rate of GDP growth. Rising debt-to-GDP ratios mean that an increasing share of the public budget is devoted to servicing debt, leaving proportionately less money available to pay for government-provided infrastructure and services.
However, sometimes countries fall into recession when households, in aggregate, attempt to pay back previously incurred debt faster than they take up new debt. In the jargon of economists, this is called "deleveraging."
For example, Spanish households have been attempting to "deleverage" on a net basis since the collapse of the country's real estate bubble in 2008.
Ray Dalio, founder and CEO of Bridgewater Associates, the world's largest hedge fund, says there are good ways and bad ways to achieve deleveraging. He calls these "beautiful deleveraging" and "ugly deleveraging."
Dalio explains that deleveraging reduces the circulating money supply and leaves less money available to buy products and services.
Under those circumstances, he says, governments sometimes have to step in to supply missing demand. They do this by raising and spending a great deal of money to make up for cutbacks in household spending and business investment. The aim is to prevent a self-reinforcing recessionary spiral from taking hold.
There are three ways to raise the necessary money: borrowing (generally from large savings pools, such as pension or insurance funds), raising taxes on the relatively wealthy, or getting the central bank to print money.
The World Bank has sometimes been criticized for underestimating the importance of balancing missing private demand with increased public spending during recessions. But the Bank's economists emphasize that once the private sector is again operating at or near full capacity, governments should avoid borrowing and spending at a rate that outstrips the rate of GDP growth.
The bank's GEP report says many developing countries have increased their debt to GDP ratios by about 10 percent during the post-2008 crisis period, and most are already operating at close to full capacity.
In coming years, they should gradually tighten fiscal spending - and try to reduce their aggregate public debt to GDP ratio so as to leave room for new stimulus measures next time there is a recession.
Productivity and competitiveness are key to growth
The specifics of the World Bank's "structural reforms" mantra varies to some extent depending on the country upon which reforms are being urged, but the basic features of the Bank's structural reform agenda stay the same.
They include "efforts to boost productivity and competitiveness," as the GEP report says.
Boosting productivity means increasing output (or GDP) per worker. Improving competitiveness ultimately means reducing the production cost and price per unit output, as well as improving the business climate by reducing frictions like excessive bureaucracy.
To achieve higher productivity, investments are needed in machinery and infrastructure, as well as education and training of workers and managers. Reducing corruption is also crucial. When officials take bribes, they in effect are levying a surcharge on the costs of production, without providing any benefit.
Low corruption and a strong, stable, and fair legal framework are important to competitiveness, since investors shy away from jurisdictions where contracts and agreements cannot be relied on.
Demand side stimulus means paying workers well
A more controversial way to increase price competitiveness is to reduce or restrain wage increases. If a company competes by paying their workers less, it may provide the owners of that company a short-term competitiveness benefit.
If most companies push down wages, however, then most households will have less money to spend.
The poor and middle class have a very high "propensity to spend" - they spend all their income and save little or nothing. Because of this, putting extra money in the pockets of poor folks directly stimulates economic demand.
By contrast, wealthy households tend to hoard, rather than spend, much of their wealth. That's why the net effect of excessive economy-wide wage restraint is to increase inequality and reduce aggregate demand.
Lower demand, in turn, causes reductions in employment, output, and GDP. This is why many economists warn that rising inequality of income and wealth is not only unfair, but also tends to reduce overall economic output.