LONDON, Jan 4 (Reuters Breakingviews): In 2025, the global economy will be in a much better place than at any time since the outbreak of Covid-19. Growth will be solid, and inflation will finally abate. Those are ideal conditions for central banks to lower interest rates. But the virtuous circle of an easier monetary policy feeding faster expansion will hit a big snag: governments' inability, or unwillingness, to reduce their huge debts.
Barring a major external shock - and there are plenty of candidates to supply one - 2025 could be a placid year for the world economy. Global GDP will expand by 3.2 per cent - keeping pace with 2024 and faster than the 2.9 per cent recorded in 2019, according, opens new tab to the International Monetary Fund. Advanced economies are on course to grow by 1.8 per cent in 2025, not far from the 1.9 per cent cruising speed they had reached in the nine years prior to the pandemic.
Admittedly, world growth will still be below its long-term average, largely because China's days as an economic locomotive are behind it. And developed economies' performances will vary widely, with yet another strong showing by the United States offsetting weakness in Europe and Japan. Still, the relatively benign outlook should also be accompanied by subdued price growth. Inflation will be around the 2 per cent level targeted by major central banks in all advanced economies in 2025, the IMF reckons.
This economic environment is usually blissful for central bankers. After playing the Grinch for a couple of years, squeezing living standards with sharp hikes in interest rates, the likes of US Federal Reserve Chair Jerome Powell and European Central Bank President Christine Lagarde should be in a position to dole out presents to citizens and businesses by lowering borrowing costs. Indeed, the Fed, the ECB and the Bank of England have all begun cutting rates and markets expect them to continue doing so in the next 12 months.
In normal times, steady growth, low inflation and falling rates would have another positive outcome: encouraging governments to cut public debt. But politicians, especially in developed countries, will squander the chance to tighten their belts.
That's not because the world's fiscal house is in order. In fact, it resembles a family home after teenage kids staged a party while their parents were away for the weekend. The IMF calculates, opens new tab that global public debt is on course to hit 100 per cent of GDP - 10 percentage points above the 2019 level - by the end of the decade. Countries accounting for 75 per cent of world GDP, including the United States, Japan, France, Italy, China and Brazil, are set to run large budget deficits of more than 3 per cent of GDP until 2026 at least. And their plans to reduce their budgetary shortfalls between now and 2029 are four times smaller than what the IMF recommends.
Multiple line charts showing budget deficits as a percentage of GDP for advanced economies on average, the euro zone, the G7 and the United States
In other words, the political masters of the biggest economies have embraced a near-permanent state of fiscal expansion. And they are not rowing back any time soon, as austerity is a sure-fire vote loser. Alberto Alesina and other economists found, opens new tab that a package of tax increases worth 1 per cent of GDP reduces the vote share of the governing party by 7 per cent on average at the following election.
Belts are already starting to loosen. In the United States, the policies pledged by President-elect Donald Trump would add up to $15 trillion to an already huge budget deficit by 2035, according, opens new tab to the non-partisan Committee for a Responsible Federal Budget. In Britain, the Labour government presented plans to increase public expenditures by almost 70 billion pounds a year until 2029 - and said it would fund half of that through more borrowing. Germany may follow suit, with a February election likely to usher in a freer-spending government. In Europe, seven countries, including heavyweights France and Italy, are in breach of the bloc's budgetary rules.
Politicians' penchant for fiscal expansion, and its inflationary effects, leaves central bankers with two unpalatable options. The first is to simply close one eye to deficits and debt, keep lowering rates and live with inflation above their 2 per cent target.
That's a path few rate-setters will take because they fear that tolerating elevated prices would lead to persistently high inflation, with dire consequences for both their credibility and living standards. Powell, Lagarde and their peers were roundly criticised for letting prices spiral out of control in 2022 and 2023.
The second option is to stop cutting rates much earlier than markets expect and start raising them again at the first glimmer of rising inflation. The United Kingdom is already showing the way: investors reacted to the government's spending plans by betting that the Bank of England would abandon one of its expected rate cuts, according to derivatives prices collected by LSEG. Yet as the global fiscal expansion gathers steam in 2025, investors will have to dial back even further their hopes for looser policy. That will keep markets volatile, and government bond yields will stay elevated, driving up funding costs. As politicians insist on walking towards the fiscal abyss, homebuyers, bond investors and businesses will pay a high price.
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