Prospects of the global economy after Covid-19

As the world is (hopefully) emerging from the Covid-19 pandemic, major challenges await societies across the world related to climate change (Pisu et al. 2022), inequality (Angelov and Waldenström 2021), digitalisation (Benzell and Ye 2021), and the undermining of democracy (Freedom House 2021). Economists can contribute to this debate, based on historic insights, theoretical models, and analysis of data.

This column launches a new eBook containing three papers presented at the 30th Anniversary Conference of the Korea Institute of Finance (KIF), as well as the contributions of the disccussants and a summary of the panel discussion (Beck and Park 2022). The papers discuss the necessary institutional changes to address societal challenges and the necessary reforms to better manage the global financial commons.

As pointed out by Daron Acemoglu at the start of his chapter, today's world faces four fundamental and existential challenges: the rise in inequality, climate change, demographic change, and the weakening of democracy. These challenges not only require urgent actions, but have also been exacerbated by the pandemic. At the same time, these challenges provide opportunities to make institutions more inclusive, but they also require global cooperation, which has been waning in recent years due to the rising confrontation between the US and China.

Acemoglu argues that the rise in inequality was driven by globalisation but even more importantly, by new digital technologies such as specialised software and robotics that have automated work previously performed by low- and middle-skill workers. These trends have been exacerbated by an increasing focus on corporate profits and weakening of unions, the rise of global BigTech firms without the necessary oversight, and capital being taxed less than labour. These trends are intensifying with the rise of artificial intelligence technologies, which are not just continuing the automation trend but have also contributed to the retreat of democracy and steep falls in trust in public institutions.

To counter these trends, Acemoglu calls for the rebuilding of domestic and global institutions capable of harnessing the power of large corporations and significantly redirecting technological change. At the same time, better regulation of technology is required so that the composition of innovations is tilted away from technologies that pollute the environment and cause climate change, and equally tilted away from Silicon Valley's excessive focus on automation and more towards human-friendly technologies that are capable of creating employment opportunities for a broad range of skills.

Climate change calls for global cooperation and more specifically for a global carbon tax – probably of no less than $150 per metric tonne of carbon, which is in the neighborhood of the level of carbon tax in Sweden today – complemented by aggressive and immediate subsidies to research in renewables and other green technologies, including storage and transport technologies and a smart grid for the allocation of renewable energy.

In his chapter, Maurice Obstfeld chronicles the evolution of the global financial markets since the Global Financial Crisis, focusing on changes in the markets' domestic impacts, the strains that have emerged due to the Covid-19 crisis, and risks that may lie ahead. A key theme of his analysis is reforms that strengthen market resilience for enhancing financial stability.

One of the trends that has shaped the contour of the evolution has been the slowing but upward trend of international financial integration among advanced economies and emerging market and developing economies (EMDEs). The volume of global financial transactions seems disproportional to any fundamental economic need or activity, yet it produces a system prone to fragility.

Another trend is emerging evidence of a global financial cycle in which global asset and commodity prices, capital flows, and bank borrowings move in a synchronised pattern. While high-income economies seem to absorb the resulting shocks relatively easily due to deeper and more fluid financial markets, their wealth, the generally greater credibility of their policy frameworks, and elements of the global financial safety net (GFSN) from which they benefit disproportionately, for emerging markets the close linkage between the global financial cycle and growth raises the important policy issue of the extent to which a flexible exchange rate system can insulate EMDEs from shifts in global financial conditions.

EMDEs could be vulnerable to sudden stops in the near-term future in the next contractionary phase of the global financial cycle, for two main reasons. First, there has been an uneven rollout of effective vaccines across the globe, which might threaten recovery in many EMDEs. Second, EMDE fiscal responses to the crisis have made them even more vulnerable to hikes in advanced-economy interest rates – which may already be setting off a contractionary phase of the global financial cycle. The concentration of new sovereign debt issuance on domestic bank balance sheets in a number of EMDEs presents the possibility of a sovereign-bank doom loop.

What policy reforms are necessary to make the global financial system more resilient? Obstfeld calls for expanding the regulatory perimeter to non-bank financial intermediation, where risks have shifted in the wake of tighter bank regulation; extending the scope of bilateral central bank swap lines as part of the GFSN; revisiting the use of capital flow measures as part of a larger toolbox to enhance stability in small open economies; and a new architecture for sovereign debt restructuring, which might be needed in the wake of rising sovereign debt burdens in many emerging markets.

In the third chapter, Thorsten Beck and Yung Chul Park discuss the shorter- and longer-term challenges for the financial sector, both related to the exit from the pandemic and consequent economic crisis and to the challenges posed by economic transformation, digitalisation, and climate change. As societies emerge from the pandemic, sequencing of exit strategies from government support is important to avoid cliff effects and scarring, but also in terms of how quickly the economy can recover and manage the necessary resource reallocation process. Beyond the exit from direct support measures for corporate and financial sectors are the challenges of monetary policy normalisation and fiscal consolidation, with different countries and regions of the world facing different challenges and needs for policy normalisation.

Beyond the immediate challenges, the banking system has undergone structural changes over the past decades that have changed its role in middle- and high-income countries. While the share of credit to households rather than enterprises has increased, the corporate sector has seen an increasing role for intangible assets, which are harder for traditional banks to finance than tangible assets – a trend that can also explain increased cash holdings by corporates. Banks’ activity mix has expanded towards non-intermediation businesses, while tighter bank regulation has raised the importance of non-bank financial intermediaries. These trends have changed the way we think about the relationship between the financial system and economic growth, but also stress that we have to look beyond the traditional banking system towards other segments of the financial system, including private equity and debt providers.

Digitalisation has been an important disruptive force in banking. Traditional banks face increasing competition from new players, including FinTech start-ups and technology platform (BigTech) companies, with the regulatory response critical for the future structure of the financial system. These potentially decisive changes raise the question of whether the benefits from digitalisation and structural changes outweigh new risks and what the financial sector of the future will look like.

A final challenge that Beck and Park discuss is climate change, which both poses problems for the financial system (climate, regulatory and transitional risks resulting in stranded and non-performing assets) and requires the critical function of the financial system for necessary resource reallocation. However, tentative evidence has shown that banks might have limited incentives to support such a transition (especially when compared to public capital markets), which puts the focus on the regulatory response to the climate change challenges but also raises the question of the relative roles of different segments of the financial system.

The debates around these topics reinforce the critical contribution that economists can and should make to the current challenges that humanity as such and advanced, emerging and developing economies face as they exit from the pandemic. This exit poses many challenges for policymakers across the globe but also the opportunity to address fundamental risks for humanity and move towards a safer and more sustainable world.