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The shadow of war darkens on the global economy

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The decision by Iran to escalate its conflict with Israel by launching a barrage of armed drones and missiles brings the risks of open war between the two countries, possibly involving the US, yet closer. It is no secret, after all, that Benjamin Netanyahu, Israel’s embattled prime minister, has long wished to destroy Iran’s nuclear programme. Some in the US feel similarly. Is this not the hawks’ chance?

In a column published in October 2023, I argued that such an escalation was the principal danger to the world economy posed by the murderous attack on Israel by Hamas. Even though the oil-intensity of the world economy has more than halved over the past 50 years, oil remains an essential source of energy. Severe disruption to supply would have large adverse economic effects.

Moreover, the Gulf region is far and away the world’s most important energy-producer: according to the 2023 Statistical Review of World Energy, it contains 48 per cent of global proved reserves and produced 33 per cent of the world’s oil in 2022. Worse, according to the US Energy Information Administration, a fifth of world oil supply passed through the Strait of Hormuz, at the bottom of the Gulf, in 2018. This is the chokepoint of global energy supply. A war between Iran and Israel, possibly including the US, could be devastating.

The policymakers responsible for the world economy gathering in Washington this week for the spring meetings of the IMF and World Bank are spectators: they can only hope that wise counsels prevail in the Middle East. If disaster were indeed avoided, what might the world economy look like?

On this issue, as usual, the IMF’s World Economic Outlook, offers clarification. This is not because its forecasts will necessarily prove correct. If anything big were to happen, they definitely would not. But they provide a systematic overview of where the world is now.

Briefly put, as Pierre-Olivier Gourinchas, the IMF’s chief economist, explains in his introduction, the recent performance of the world economy has been notably better than feared, despite the shocks to output and inflation caused by the pandemic, Russia’s assault on Ukraine, the surge in commodity prices and sharp tightening in monetary policy. As he notes, “despite many gloomy predictions, the world avoided a recession, the banking system proved largely resilient, and major emerging market and developing economies did not suffer sudden stops” in finance. Notably, the inflation surge did not trigger uncontrolled wage-price spirals. In all, the world economy has proved more flexible and inflation expectations better anchored than many expected. This is all good news.

It is noteworthy that cumulative output growth in 2022 and 2023 exceeded the IMF’s October 2022 forecasts for the global economy and every significant grouping within it except, crucially, for low-income developing countries (LIDCs). The same was true for employment, except in the LIDCs, again, and China. The US economy has been particularly buoyant, though that of the eurozone very much less so.

An interesting question is why the monetary tightening has had so little effect on output. One explanation is that fiscal policy was supportive, notably in the US. Another explanation is that real interest rates fell, rather than rose, because inflation went so high. That is now changing. Another is that a high proportion of mortgages are at fixed rates: there has been a particularly big increase in the share in the UK. Moreover, the surge in savings in the pandemic helped finance spending. Yet this is now ending. Tight monetary policies might still have a sizeable lagged impact.

While the short-term performance of the world economy has been surprisingly good, the longer-term performance has been the opposite. Marked declines in growth of real GDP per head have occurred across the world since the early years of this century. The collapse in the growth of “total factor productivity” — the best measure of innovation — has been particularly significant. In the LIDCs, the growth of TFP even turned negative between 2020 and 2023.

The slowdown in growth of TFP accounted for more than half of the overall decline in growth. According to the WEO, growing misallocation of capital and labour across businesses within sectors explained a large part of this slowdown. One can change such things. But it will not be easy to do so. One reason for this slowdown is likely to be the loss of dynamism in world trade, which is always a potent source of competition.

The principal lessons of this WEO, then, are surprisingly buoyant recent economic performance, except worryingly among LIDCs, together with a marked slowdown in long-term growth, largely due to the slowdown in economy-wide productivity growth. Yet, needless to say, there are also big uncertainties.

On the upside, we might see a short-term surge in election-related fiscal loosening. Positive surprises, notably in labour supply, might further accelerate the decline in inflation. Artificial intelligence might deliver a positive surprise shock to the generally poor productivity growth. Successful reform might also accelerate the growth in potential output. Yet, on the downside, China’s growth might fall sharply. There are also all too evident risks to global financial, fiscal, political and geopolitical stability. World trade might be battered by protectionism. War between Israel, the US and Iran could blow up the Middle East, with huge consequences for energy and commodity prices. The biggest victims of such mayhem would, as usual, be the poorest.

We may have managed shocks better than expected. But we are walking on eggshells and we must tread carefully.

martin.wolf@ft.com

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