By Fabrizio Carmignani, Griffith University

The World Bank’s Global Economic Prospects report released this week is moderately optimistic about the short-term outlook of the global economy.

World Bank economists anticipate an improvement in most key economic indicators, with growth accelerating in both high income and developing economies and international trade picking up considerably.

In the troubled Eurozone, GDP growth should finally turn positive in 2014 (1.1%) and then consolidate at around 1.5% in the two subsequent years. The United States is expected to grow at least twice as fast as the Eurozone, while growth in Japan is predicted to slow down progressively from 1.7% in 2013 to 1.3% in 2016.

Outside the group of high income economies, East Asia should remain the fastest growing region of the world followed by South Asia, with both China and India partly recovering from earlier weaknesses. All of the other regions are forecast to score positive growth rates.

Certainly, the report also warns about some rather obvious downside risks, most notably the uncertain worldwide market reaction to the end of US program of quantitative easing and the possibility of a sudden, disorderly increase in the interest rates.

But, on balance, the message is positive and even comforting, especially if read with the eyes of a European who has lived for two or more years in fiscal austerity, fearing possible government and banking defaults.

Europe: long term scars will be hard to heal

There are indeed signs of normalisation in Europe. Most of the countries that were in recession at some point in time in 2012 started to recover during 2013, while Italy and Greece are expected to be out of recession in 2014. Concerns about debt sustainability in peripheral countries have somewhat eased as the interest rate spread relative to Germany significantly declined.

Yet, the long recession has left scars that a (still moderate) cyclical upturn will not quickly heal. According to the World Bank report, the income of the average individual in the Eurozone is today 5% lower than five years ago. In countries like Italy, Spain, Portugal, and Ireland, the decrease in per-capita GDP since 2008 amounts to 10%. In Greece, GDP per-capita today is only 76% of what it was before the crisis.

At the rate of GDP expansion currently predicted for 2014-2016, it will take these countries several years to return to their pre-crisis level. In terms of per-capita income, 2008-2018 will be probably remembered as a “lost decade” of Europe.

Similarly, the unemployment rate in the Eurozone went up by five percentage points, from 7.5% in 2007 to 12.3% in 2013. Youth unemployment scored a particularly sharp increase, hitting 24.4% on average in the region and climbing to such heights as 58% in Greece and Spain in the course of 2013.

This severe deterioration of labour market conditions, coupled with the cuts to social welfare imposed by the fiscal austerity program, spurred widespread social discontent in many countries. Again, it will take more than a cyclical rebound to restore individuals’ confidence and to brighten the prospects of the young generations.

Associated with the decrease in per-capita incomes and increase in unemployment is the widening of income inequality. Crises like the one that started in 2007-08 hit the economy as a whole, but some socioeconomic groups are hit even harder than others.

The consequence is that the distribution of income will become more unequal, both across individuals in the same country and across countries. This will in turn foster some more social discontent and also complicate the negotiations on the reforms of the European Union, which are now more necessary than ever.

Moreover, this process of growing inequality is likely to continue for some time after the end of the recession, as the effect of GDP contractions on distribution is typically lagged by a few years.

Keynesianism alone will not suffice

The good news is that these lasting scares can indeed be healed with a robust dose of long-term growth. The bad news is that long-term growth does not just happen automatically at the end of a recession. In fact, long-term growth requires a set of policies and reforms that most countries still seem to be neglecting.

Fiscal austerity in time of recession was (and still is) a bad idea. Austerity did not cause the European crisis or the global financial crisis, but it certainly made the effects of these crises worse. 

Drawing on this observation, many have pushed for the adoption of expansionary monetary and fiscal policies, in line with the Keynesian logic of stimulating the economy from the demand-side. The problem is that this is a strategy for stabilising the business cycle, not for promoting long-term growth.

A counter-cyclical monetary and/or fiscal policy; that is, monetary and fiscal expansions in time of cyclical economic downturn, followed by corresponding tightening in time of cyclical upswing, is necessary to reduce cyclical volatility and to maintain the economy as close as possible to its long-term trend.

But it is not through systematically loose monetary and fiscal policy that a country can hope to generate strong long term growth. Japan tried to do that in the 1990s and lost that decade. The Shinzo Abe government is now repeating the same mistake and growth, which picked up in the short term, is already expected to decline by 2016.

Under Alan Greenspan, the US Federal Reserve pursued a policy of systematic monetary expansions for several years in the 1990s and early 2000s, causing a sharp decline in interest rates which was, together with several regulatory deficiencies, at the root of the financial collapse of 2007-08.

The leadership of Ben Bernanke and now Janet Yellen, instead, is aptly using quantitative easing as a short-term instrument to absorb the contraction and stimulate the recovery. But now that the recovery seems to be underway, quantitative easing will be withdrawn and US monetary policy will move towards a more conservative stance.

One might argue that Keynes himself never developed a theory of long-term growth around expansionary monetary and fiscal policies, but this would be an academic debate. From a policy perspective, the central issue is that Eurozone countries, and more generally high income economies, will need to combine the counter-cyclical approach to macroeconomic policy with a set reforms aimed at re-starting long-term growth.

The recipe may vary from country to country, depending on their underlying structural weaknesses. For instance, Italy (whose full recovery is probably central to the destinies of the entire Eurozone) badly needs a reform of its labour market, policy interventions to ensure that economic rights are fully enforced, an effective spending review, and pro-competition reforms in a number of sectors.

Other countries would have to prioritise interventions in the banking sector. Finally, all European countries will have an interest in the reform of the economic institutions of the European Union.

Without these structural interventions, the current favourable short-term prospects will soon give way to new, much more negative scenarios. And the light at the end of the tunnel will inexorably fade away.

Fabrizio Carmignani receives funding from the Australian Research Council for a project on the estimation of the piecewise continuous linear model and its macroeconomic applications

This article was originally published at The Conversation. Read the original article.