In the Eurozone, expansionary fiscal policy in the form of aggregate demand support and financial sector balance sheet repair has been absent in the post-crisis period (with a few exceptions) and is unlikely to play a role in cyclical developments next year. The fiscal drag will decline on a sequential basis, but the impact on eurozone growth from fiscal policy inaction will be negligible. As such, large output and employment gaps amid liquidity trap conditions will be treated solely by the medication of monetary policy via the European Central Bank (ECB), which is slowly starting to act in a more concerted manner.
In Japan, policy dissonance is not quite as pronounced as in the eurozone, but the initial conditions of demographic decline and debt deflation are somewhat worse. While we were very encouraged by Japan’s announcements of expansionary fiscal and monetary policies during 2012, the premature reversals of expansiary fiscal policy in 2014 and 2015 are creating significant uncertainty and volatility in the economic outlook there.
Turning to China, and to emerging markets more broadly, we see policy dissonance of a different class altogether. The developing countries do not face the same cyclical pathologies as the developed countries. For most major developing countries, the key cyclical growth challenges involve a developmental transition from easy “low income mercantilist” growth models to more nuanced and diversified “middle income” growth models that involve broadening the economic base via continued investment in higher-value-added production and the introduction of financial and other service sector segments to the private economy.
China, Brazil, India and Mexico are all struggling currently to achieve the right policy mix to overcome these hurdles. Part of the problem is that the external demand environment for developing economies continues to be weak, but a more important part of the problem is that developing countries have wasted the post-crisis period by focusing too much on cyclical policy changes as opposed to structural ones.
China’s policy mix in the post-crisis period has relied more on the tremendous amount of public sector balance sheet flexibility available to policymakers and less on liberalization and development policies necessary to sustain growth for a longer frequency.
The outcomes for other developing economies will be tied to what happens in China next year. While Mexico and India are less tied to China, and recently both show signs of accelerating structural policy changes necessary for growth, Brazil, and Russia will continue to look to China for external demand support.
Russia in particular will face significant challenges in 2015, exacerbated by economic sanctions being placed on its banks and corporations due to the ongoing conflict in Ukraine.