Further Reflections on Challenges to the United States and the World Economy¹

Lorenzo L. Perez²

The world economy has been subject to unusual shocks in recent years. The Covid-19 pandemic which erupted in 2020 (and is still not completely eradicated) caused a strong global economic contraction triggered by the anti-Covid measures that needed to be taken.  Inflation rose its ugly head, fueled by accommodating monetary policies, supply disruptions, and the expansionary fiscal policies adopted to limit the economic contraction and diminish its negative impact.  The Russian invasion of Ukraine in February 2022, in addition to the horrors that brought to Ukraine, aggravated the economic situation for the whole world by disrupting grain trade and energy supplies, the latter in part as a result of the Western sanctions imposed on Russia.  The large trade surplus that China enjoys with the US has been a source of trade friction between the two largest economies in the world. The potential for trade disputes has also increased as the U.S. and similar governments have taken measures to promote clean energy without taking into adequate account the impact in other countries and existing international trade rules. The increasing evidence of climate change, with its implications for the severity of natural disasters and the disappearance of various species threatening the biodiversity in developing countries, is another worrisome challenge to the world economy.

This article discusses the implications of these developments for both, the developed and the developing countries. The discussion of these economic challenges is relevant to this issue of El Ignaciano, which is dedicated to the family, because a failure to address these challenges appropriately could have dramatic negative impacts on the welfare of families all over the world. The article does not pretend to offer a thorough technical discussion of these topics or to advocate for specific policies to address these problems. Its aim is just to call attention to these problems to persons of goodwill and to identify reasonable positions regarding these issues, in the belief that well-informed citizens can do a better job holding their political representatives accountable.

¹For an initial discussions of these issues, see Lorenzo L. Perez:  Post Pandemic Challenges to the World Economy and Desirable Policy Responses, El Ignaciano, September 2022.
²The author wants to thank Lorenzo J. Perez for once again giving excellent editorial comments.

Developed Countries
In 2022, normalization of monetary and fiscal policies that delivered unprecedented support during the pandemic cooled demand as policy makers in developed countries aimed to lower inflation back to the central banks’ price targets. As a result, there has been a growth slowdown or outright contraction in many countries. Global growth is estimated by the International Monetary Fund (IMF) to have slowed down from 6 percent in 2021 (when many Covid restrictions were lifted, resulting in an economic rebound) to about 3 percent in 2022. Global growth is expected to be less than 3 percent in 2023.³  This is the weakest world growth profile since 2001 – except for the global financial crisis in 2007-2008 – and reflects significant slowdowns for the large economies.  

The employment picture, up to the beginning of 2023, has been more satisfactory. The unemployment rate is back to about 3.5 percent in the United States, showing the effectiveness of the policies adopted to restraint labor dismissals. The unemployment rate in the Euro Area declined from about 8.5 percent in 2020 to 6.5 percent towards the end of 2022.  Global inflation is estimated to have risen from 4.7 percent in 2021 to 8.8 percent in 2022. The IMF projects a decline to 6.5 percent in 2023 and to about 4 percent in 2024. But these inflation numbers should be viewed with caution because upside inflation surprises have been widespread among advanced economies.  

All in all, risks to economic activity and inflation expectations remain unusually large. Monetary policy could miscalculate the right stance to reduce inflation, thus generating a larger than necessary economic slowdown. More energy and food price shocks also might cause inflation to persist longer. Global tightening in financial conditions could trigger distress in non-bank credit markets in developed countries which had grown sharply after 2008 during a period of low interest rates. Tightened financial conditions could also cause distress in emerging markets, which could reverberate in a deterioration in the financial strength of key financial institutions in the developed world. Halting gas supplies from Russia could depress output in Europe, and resurgence of Covid-19 might further stunt growth. However, central banks around the world need to keep a steady hand, with monetary policy firmly focused on taming inflation.

³International Monetary Fund, World Economic Outlook, October 2022.  The World Bank and private sector analysts have also recently lowered their growth projection for 2023 to less than those of the Fund.

In addition to a continued tight monetary policy, the policy makers in developed countries need to ensure that fiscal policy does not work against the monetary authorities’ efforts to reduce inflation. Doing otherwise will only prolong the fight to bring inflation down, risk entrenching inflationary expectations, and increase funding costs of the government and private sectors. In countries where the pandemic has receded it is time to rebuild fiscal buffers by reducing expenditures in anti-Covid programs. The pandemic has shown that the availability of fiscal buffers is essential for dealing with such crises. There is also an internationally growing consensus that fiscal policy should instead aim to protect the most vulnerable through targeted and temporary transfers. 

Fiscal policy can also help economies adapt to a more volatile environment by maintaining a credible medium term fiscal framework and investing in expanding productive capacity. The latter would involve actions to improve human capital, green energy, and supply change diversification. Finally, history shows that price signals are essential to help curb demand and stimulate supply. Price controls, untargeted subsidies, and export bans are fiscally costly and lead to misallocation of resources and black-market premiums.

The weakening of U.S. support for free trade and the increased importance of China in world trade (which frequently operates at the margin of multilateral trade rules) also present significant challenges to the world economy. The Trump administration, under the pretext of national security grounds, imposed tariffs on steel and aluminum and tariffs on Chinese imports due to the growing bilateral trade deficit with China. The Biden administration has not taken down these tariff increases and has not tried to join the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP) that the Obama administration had negotiated for the Pacific region before getting rejected by the Trump administration. The CPTPP has eliminated tariffs among its members in key sectors like the automobile industry and opened the agricultural market in Japan, something that would had been a great opportunity for the U.S. if it had decided to join.⁴  

Another article in El Ignaciano examined why these protectionist measures do not promote the common good and why they can produce results opposite to the intended ones.⁵  In addition, taking these trade measures outside the World Trade Organization (WTO) framework weakens the organization to the detriment of the world economy.

⁴The CPTPP members are Canada, Mexico, Chile, Peru, Australia, Japan, and 5 other Asia Pacific countries.
⁵Lorenzo L. Perez: The Common Good and Trade Policy:  Does Support for Free Trade Still Make Sense? El Ignaciano, August 2021.

The supply disruptions that occurred during the Covid pandemic and the more belligerent behavior in Asia by China have also led the US to reassess its trade policies in some key sectors.  In October 2022, the Biden administration imposed new restrictions on the sale of semiconductor chips and manufacturing equipment to China in a major effort to impair Beijing’s military and technological capabilities. The new rules require manufacturers to receive a license from the Commerce Department to export semiconductors and chip-making equipment to Chinese companies. In addition, international companies are banned to export chips built with US technology to China. The decision follows recently devised plans to increase investment in the U.S. semiconductor manufacturing.  In August 2022, the $280 billion Chips and Science Act was passed, providing $52 billion in subsidies to boost companies choosing to build chip manufacturing plants in the U.S. Following the passage of the law, multi-million-dollar investments have been announced in Ohio and Idaho. Unfortunately, these new measures are being taken at a time when they could feed a looming semiconductor supply glut. 

As part of its overall economic agenda, the Biden administration is also emphasizing the reliability of trade sources. U.S. Secretary of the Treasury Janet Yellen has noted that any economic agenda must consider the potential for regional and global shocks to impact supply chains, including those shocks driven by the policies of certain foreign governments.⁶ Yellen advocates a friend-shoring approach to maintain the efficiencies of trade while promoting economic resilience for the United States and its partners. The approach recognizes that concentration of sources for key manufactured products can sometimes lower costs but also leaves supply chains vulnerable to cascading disruptions that hurt workers and consumers.

Efforts to promote clean energy through electric cars in the United States also has implications for trade policy. The misnamed Inflation Reduction Act of August 2022 provides tax credits to consumers who purchase electric cars produced in the US. The EU has complained strongly that this action discriminates against their electric car industry. This subsidy will also negatively affect the United Kingdom, Japan and South Korea, all strong U.S. allies.  From the perspective of foreign political leaders, the auto industry is too economically important for them to standby and do nothing in the face of what they perceive as unfair trade practices.  French President Emmanuel Macron made clear to President Biden during his recent state visit to the United States at the end of 2022 that U.S. protectionism risks triggering a broader trade war.⁷

⁶Secretary Janet Yellen: Resilient Trade, Project Syndicate Quarterly, December 2022.
⁷Anne Krueger:  Sleepwalking into a global trade war, Project Syndicate, January 11, 2023.

Developing countries
The external environment has been very challenging for many emerging markets (middle income developing countries with access to capital markets) and other developing economies. Trade tensions, the pandemic, supply-chain snarls, and inflation and war together have dealt them serious blows. Emerging markets growth prospects are well below the 5 percent average annual rate of the decade preceding Covid-19. The increase in interest rates in the United States has generated a sharp appreciation of the dollar, which has added significantly to domestic price pressures in developing countries. Capital flows have not recovered, and many developing countries are in debt distress.  

The World Bank’s latest Poverty and Shared Poverty Report notes that the Covid-19 pandemic dealt the biggest setback in global poverty in decades. The Bank estimates that more than 70 million people were pushed into extreme poverty (per capita income of less than $1.90 per day) by the end of 2020, increasing the global total to over 700 million. 2020 also marked a historic turning point: an era of global income convergence between developed and developing countries gave way to global divergence. Income in the poorest countries fell much more than incomes in rich countries during Covid-19, and the richest economies have recovered from the pandemic at a much faster pace than emerging and developing countries. There has been also a rise in food insecurity in developing countries, caused in great part by the grain trade disruptions from Ukraine and Russia. Countries need to prioritize food security, and, in many cases, binding financing constraints make the trade-off very painful for countries. Coordinated global action to address this problem is thus urgent.  

Debt levels were already high in developing countries before the Covid-19 pandemic. The fiscal policy efforts to protect the population from the effects of lockdowns in 2020 and 2021 resulted in debt increases of 16 percentage points of GDP in 2020 in emerging markets (excluding China) to a level close to 138 percent of GDP. The increase in low-income developing countries (which protected their population less from the effects of Covid-19) increased from 8 percentage points in 2020 to about 85 percent of GDP.⁸ The increase in debt ratios elevates sovereign debt risks, which, combined with budget and financial constraints, put the finances of developing countries under stress. The Economist magazine has identified 53 vulnerable countries that have either defaulted on their debts or are at high risk of debt distress. According to the World Bank, nearly 60 percent of all emerging and developing countries have become high-risk debtors. In these circumstances, policymakers need to take a cooperative approach to ease the debt burdens of the most vulnerable countries, foster greater debt sustainability and balance the interests of debtors and creditors.

⁸Vitor Gaspar and Ceyla Pazarbasioglu, Dangerous Global Debt Burden Requires Decisive Cooperation, IMF blog, 2022.

In 2020, the G20 (a group of the largest economies of the world, including China, that meets periodically to address economic issues) in response to the liquidity crisis caused by the pandemic, implemented a Debt Service Suspension Initiative (DSSI). With support from the IMF and the World Bank, the DSSI suspended $12.9 billion in payments owed by 48 low-income countries between May 2020 and December 2021.⁹ This initiative provided only temporary relief and did not reduce the level of the debt. Since it expired, access to financial markets has tightened. and many of the DSSI’s beneficiaries are now at risk of debt distress. 

At the end of 2020, the G20 and the Paris Club (a group of countries, most of them in the G20, that meets to reschedule the bilateral debt of developing countries under the leadership of the French Ministry of Finance with the support of the IMF and the World Bank), endorsed a Common Framework for Debt Treatments (CFDT). This framework is meant to coordinate and provide debt relief to DSSI-eligible countries. The rise of China as a major lender to developing countries during the last two decades has major implications for debt relief efforts. According to a May 2021 brief of the Peterson Institute for International Economics, China accounts for more than 50 percent of all debt owed by poor countries to official creditors. Prior to the CFDT, China refused an invitation to join the Paris Club. Paris Club members share information about the amounts owed to them, and China does not. 

It remains to be seen how effectively China’s participation in the CFDT process will be. Only a few countries have applied so far for the CFDT: Chad, Ethiopia, Somalia, and Zambia. Ghana is posed to officially request debt relief under the CFDT, and it is further along with a successful negotiation of an IMF-supported program. But several countries that require debt relief are not among those eligible for DSSI/CFDT. The middle-income countries of Lebanon, Sri Lanka, and Suriname have already defaulted, and Egypt, Pakistan and Tunisia face severe debt distress.   

It must be noted, however, that the debt distress of emerging and other developing countries is not due only to negative external shocks. The management of their public finances have been poor, and corruption have deviated billions of dollars from their legitimate destinations. Developing countries need to formulate a consistent medium-term policy framework. Prioritizing policies and programs is vital as governments operate within tighter budgets. Top priorities include ensuring everyone has access to affordable food and a minimum of public services and protecting low-income households from rising inflation. But the highly indebted countries need international assistance to address their debt problems. Without international help, these highly indebted countries will be confronted with ongoing shortages of essential goods, leading to economic stagnation or decline, and sharp increases in poverty. It is thus in the interest of the world economy to ensure debt restructuring along with the necessary economic policy reforms for countries of dire need.  

⁹Jose Antonio Ocampo, Minister of Finance and Public Credit of Colombia, A Pandemic of Debt, Project Syndicate  Quarterly, December 2022.

Climate Change
This is the last challenge discussed in this article, but it is the development that poses the more serious risks to humanity. Climate change events are strongly intertwined across all countries. Recent months and years have offered a series of extreme weather events on every continent, bringing home the consequences of the build-up of greenhouse gases in the atmosphere. 

The effects of rising sea levels are already evident in West Africa (e.g., Senegal), in some Pacific islands and in other parts of the world.  According to The Economist (The World Ahead 2023 issue), average global temperatures are now 1.1 to 1.3 °C (degrees Celsius) above pre-industrial levels, and these temperatures are expected to make hurricanes, floods, droughts, wildfires and heat waves worse than in previous years.¹⁰

Despite this evidence, there are still people and policy makers who adopt an ostrich’s head in the sand approach to climate change; others display an aggressive pessimism regarding the troubling impact of climate change, fueling their belief that climate Armageddon is inevitable and that the world population would have to come down from 8 billion to 1-2 billion to make possible human life sustainable on Earth. This second group advocates for anti-growth economic policies, while the first group see little reason for considering climate change in public policy formulation.

The most prevalent international view regarding climate change is somewhere between the two views as evidenced by the objectives of international climate negotiations. The latest round of such climate negotiations was held in Egypt in November 2022 (COP27 meeting). It appears that goals set to reduce the amount of warming are not being met, however, and no new significant commitments were made at the conference. There was also disagreement on how much financing developed countries could provide to developing countries to address climate change problems. 

Complicating matters, climate politics, which have often been treated somewhat separately from other geopolitical issues, has had to face the short-term energy security emergency brought out by the war in Ukraine. All in all, it seems likely that some fossil fuels will still be burned in mid-century, even if global net-zero emission goals (which by no means is guaranteed) are reached. Electrifying cars and trains is relatively technically simple (not considering the politics), but decarbonizing aviation and shipping will be harder. The Economist, op. cit., argues that using some fossil fuels and balancing the resulting emissions with carbon capture elsewhere, may be the least bad option. But limiting warming to 1.5 to 2.0 °C (degrees Celsius) as set in the Paris agreement will require a dramatic reduction in fossil-fuel use that oil and gas will end up playing a marginal role in the global energy sector.

As for the major polluters, the initiatives taken by China and the United States to reduce the use of fossil fuel are crucial. In the U.S., the Biden administration passed a substantive clean energy package as part of the Inflation Reduction Act. But, if climate change cannot be prevented, policies can be adapted to lessen its worst impacts. Examples of adapting can be found in the Netherlands, which is building vast hollow metal barriers mounted on even bigger steel arms to prevent river flooding from sea-level rise; Indonesia, meanwhile, is drilling vertical drains through which rainy-season floodwater can recharge the aquifer; in the United States, California is working to reduce the vegetation that could feed large wildfires. 

¹⁰The Paris Agreement (COP21) set a goal of limiting warming to 1.5-2.0 centigrade by 2025-2030.

On a positive note, success stories can be found in the realm of agriculture.  Improved farming methods, better inputs, better access to inputs and new seed strains, all continue to deliver improvements.  But the reality is that a lot more is needed to address the threat of climate change. The United Nations Environmental Program (UNEP) has estimated that the level of adaptation spending needed in developing countries will be $140 to $300 billion a year by 2030, with half of that spent in two areas: agriculture and infrastructure.  Currently, less than $50 billion a year globally is being invested in adaptation.¹¹ Subtracting the amount spent in developed countries, UNEP estimated that investment in developing countries is at most a fifth of what is needed.¹² 

The sad reality is that the resources probably needed are much larger than those currently available. In this context, at COP27, the “the polluter pays” principle of environmental regulation applied to the entire world gained more traction. In short, the proposal is that rich countries would pay poor ones to help them deal with damages caused by climate-related disasters, such as floods and desertification. 

Another approach is to look for innovations in the global finance system. There are financial instruments which have existed for decades where creditors provide debt relief in return for a government commitment to, say, decarbonize the economy, invest in climate-resilient infrastructure, or protect biodiversity forests or reefs (debt-for-climate-swaps and debt-for-nature swaps). Where action would have not been taken without the swap, the arrangement aids climate action or protects nature. And to the extent that debt reductions exceed the new spending commitments, borrowers get fiscal relief through budget savings. Countries such as Barbados, Belize and Seychelles have recently negotiated these types of arrangements, and other are considering following their examples.  

But not all attempts have been successful. In 2007, Ecuador proposed the creation of a fund of about $3.5 billion for the South American country in exchange for keeping in the ground about 1 billion oil barrels. Supporters of the idea said it would have been a win for the climate, for biodiversity and for indigenous rights. It also would have been a precedent-setting moral victory.¹³ But the fund attracted little interest, and now Ecuador, struggling under painful debt, wants to expand drilling in one of the most environmental important ecosystems of the planet, one that stores vast amounts of planet-warming carbon. 

The challenging situation in Brazil will also have a world impact. Most of the Amazon rain forest, known as “the lungs of the Earth” and credited with possessing both the globe’s richest biodiversity and 150-200 metric gigatons of carbon that would otherwise get released in the atmosphere and supercharge climate change, resides within Brazil’s borders. Fortunately, the new government that took over at the beginning of this year has announced plans to reverse deforestation efforts that had been promoted by the previous administration of former president Jair Bolsonaro.

¹¹The Economist, November 5, 2022.
¹²Reuters reported on November 2 that another study commissioned by Egypt and Britain and released prior to COP27 presented larger figures for external financing needed by 2030 for emerging markets and developing countries--$1 trillion-- that would need to be matched by public and private financing from those countries.
¹³New York Times, January 14, 2023.

Key Take Aways
From the discussion of the challenges above, men and women of good faith can derive general key takeaway positions promoting the common good, solidarity across countries and protection of the poor. These takeaways can be used to assess the positions being taken by their political representatives in public policy debates.

The reduction of inflation continues to be paramount for the world economy. It will be important that the focus of monetary policy is maintained in reducing inflation as a defense of the common good and the protection of the poor. 

Fiscal policy needs to be supportive of these efforts by being relatively tight while, at the same time, maintaining a strong safety net and helping to increase clean energy sources. Many developing countries share a concern over of an increase of extreme poverty that needs to be addressed, as well as increased food insecurity for their populations. They need financial assistance in part through debt restructuring, and the international community needs to work toward securing China’s participation as a major creditor in debt-restructuring arrangements in a transparent way. Debt restructuring for developing countries should be subject to the condition of sound economic programs to ensure that resources are not wasted and that the benefits accrue to the majority of their populations.   

The multilateral trading system which has promoted trade and improved the welfare of most of the world’s population for a number of decades is under threat. The Biden administration’s abandonment of free markets in key sectors for an active industrial policy needs to be reexamined. Concerns of foreign allies and strong trading partners need to be taken into account to avoid a dangerous spiral into protectionism worldwide. Unless the U.S. takes a leading role in adopting a more acceptable strategy, there will be additional economic costs in the production of many goods. A friend-sharing trade policy needs to be implemented with caution to ensure that the efficiencies of trade are achieved.

As discussed above, the promotion of clean energy and measures to try to adapt to the inevitable climate change must have priority in public policy stances. More resources need to be mobilized to fight climate change, particularly in those developing countries most in need of assistance in this area. Put simply, the international community needs to continue to work on innovative ways to increase resources to fight the impact of climate change, including through debt-for-climate swaps, debt-for-nature swaps and other mechanisms.

Lorenzo L. Perez, PhD. in Economics, University of Pennsylvania, is a retired economist who worked for over 30 years at the IMF, and prior to that worked at the Agency for International Development and the U.S. Treasury Department.  Member of the Editorial Board and
resident columnist of El Ignaciano.