Failure to lift the debt ceiling would, however, be a major event. Prolonged failure would lead to an extreme fiscal consolidation and almost surely derail the U.S. recovery. But the effects of any failure to repay the debt would be felt right away, leading to potentially major disruptions in financial markets both in the United States and abroad. We see this as a tail risk, namely a low probability risk, but were it to happen, it would have major consequences.
Now, fiscal risks in the United States, as worrisome as they are, should not, however, lead us to lose sight of a bigger picture, and this is what you and we should be focusing on. It is difficult to do this week, but we have to try.
Looking to the bigger picture,advanced economies are slowly strengthening, more or less as we forecast in the past. At the same time, emerging market economies have slowed down and they have slowed down more than we had forecast last July.
So, let me give you the basic numbers here. We forecast growth in advanced economies to be 1.2 percent this year and 2 percent next year, so this is actually more or less the same as our July forecast. We forecast growth in emerging markets and developing economies to be 4.5 percent this year, 5.1 percent next year, and that is a downward revision of 0.5 percent and 0.4 percent, respectively, relative to our July forecast.
These two evolutions, strengthening recovery in advanced economies and a slowdown in emerging market economies, are leading to tensions. In particular, emerging market economies are facing the challenge of slowing growth in the context of tougher global financial conditions.
In the U.S., private demand continues to be strong. On the assumption that fiscal accidents are avoided, which is the underlying assumption of our forecast, recovery should strengthen. Growth will be higher next year than it is this year. It is, therefore, time to make plans for exit from both quantitative easing and zero policy rates, although it is not time yet to implement these plans.
Moving on to Japan, the recovery in Japan continues. Whether it can be sustained depends very much on Abenomics, as it is called, meeting two major challenges. The first, reflected in the debate, about the increase in the consumption tax is the right pace of fiscal consolidation.
The second is a credible set of structural reforms to transform what is now a cyclical recovery into sustained growth.
Let me turn to core Europe. Core Europe is at last showing some signs of recovery. This is not due to major recent policy changes but partly to a change in mood, I would say, which could be self-fulfilling or at least partly self-fulfilling. Now, I have talked here about core Europe. South and periphery countries are still struggling. Definite progress on competitiveness and exports is not yet strong enough to offset depressed internal demand.
Now, the major news, as I said at the start of this press conference, comes from emerging markets, where growth has declined often more than we had forecast in July. So, the obvious question is whether this reflects a cyclical slowdown or a decrease in potential growth. That is a very hard question to answer and we will know the answer only in time. Based on what we know today, the answer is both.
On the first, while some decrease in growth relative to the 2000s is probably inevitable, structural reforms can help and are now becoming more urgent:rebalancing toward consumption in China to removing barriers to investment in India or Brazil.
On the second challenge, which is the cyclical adjustment, then standard advice also applies. Countries with large fiscal deficits, of which there are a few, should consolidate; countries with inflation running persistently above target should tighten; and more importantly than what they do to interest rates, they should put in place a credible monetary framework, which some countries still do not have.
Now, the increase in U.S. long rates makes the advice even more relevant than it was, say, six months ago. Normalization of interest rates in advanced economies is likely to lead to a partial reversal of the earlier capital flows, and this is where the tensions come in. As investors repatriate funds, countries with weaker fiscal positions or high inflation are particularly exposed. The right response for emerging market economies faced with these issues must be twofold.
First, where needed, they have to put their macro house in order to clarify the Monetary Policy Framework to maintain fiscal sustainability. Second, in response to the capital outflows of a slowdown in capital inflows, they should let the exchange rate depreciate in response to these flows.
FMI Olivier Blanchard, Economic Counsellor and Director of the Research Department.
