With world output expected to expand by some 4 to 4½ percent in both 1997 and 1998, the strongest pace in a decade, the global economy is enjoying the fourth episode of relatively rapid growth since the early 1970s (Figure 1). The expansion is underpinned by continued solid growth with low inflation in the United States and the United Kingdom; strengthening recovery in Canada; a broadening of recovery across continental western Europe, notwithstanding persistent weakness in domestic demand in some of the largest countries; robust growth trends in most of the developing world, particularly in China and much of the rest of Asia even though some countries are likely to experience a setback associated with recent turmoil in financial markets in Southeast Asia; and evidence of an end to the decline in output, and perhaps of a beginning of growth, in Russia and in the transition countries as a group. It is worth recalling, however, that each of the three previous episodes of relatively rapid growth was followed by widespread slowdown and even recession in many countries. Taking account of this earlier experience, is there a danger that the present expansion may soon run out of steam and give way to a new global downturn?

Although a moderation of world growth is indeed likely to occur at some point, there are reasons to believe that the current expansion can be sustained, possibly into the next decade. First, there are relatively few signs of the tensions and imbalances that have usually presaged significant downturns in the business cycle: global inflation remains subdued and commitments to safeguard progress toward price stability are perhaps stronger than at any other time in the postwar era; fiscal imbalances are being reduced with increasing determination in many countries, which is helping to contain inflation expectations and real interest rates; and exchange rates among the major currencies, taking account of relative cyclical conditions, are generally within ranges that appear to be consistent with medium-term fundamentals. Second, cyclical divergences have remained sizable among the advanced economies, and there are still considerable margins of slack to be taken up in Japan and continental Europe. Stronger growth during the period ahead in these countries should help support global demand and activity as growth slows to a more sustainable pace in those countries that have already reached a mature stage in their expansions, especially the United States, the United Kingdom, and several of the smaller advanced economies. Third, the recovery that is in progress in the transition countries seems likely to continue to strengthen at the same time as the growing number of successful economies in the developing world are also providing both new markets and increased production capacities; these developments are stimulating trade and growth worldwide while helping to dampen price pressures. Taking into account the combination of the strong catch-up potential of the developing and transition countries and the beneficial effects on productivity of technological advances and increasing globalization, the sustainable rate of world output growth may now in fact be somewhat stronger than in the quarter century since the first oil shock. This view is embodied in the IMF staff’s medium-term scenario, which points to a trend growth rate of world GDP of about 4½ percent between 1996 and 2002 compared with an average rate of expansion of 3¾ percent since 1970.

This generally positive assessment of the global outlook should not lead to complacency because there is a wide range of risks and fragilities that confront individual countries and may affect regional and world economic and financial conditions. The main areas of concern relating to prospects over the short to medium term include the following:

• Risks of overheating. Although world inflation has subsided to the lowest rates seen since the early 1960s, inflationary pressures could reemerge, especially in countries that have reached high levels of resource use. Effective policy to prevent inflation rising requires vigilance not only against overheating in product and labor markets but also in asset markets, and it requires preemptive action when warning signs appear. Problems stemming from large swings in asset prices emerged in the late 1980s and the early 1990s in a number of countries, most notably in Japan but also in Australia, Sweden, the United Kingdom, and the United States, with repercussions on the soundness of financial systems in some cases. More recently, several emerging market countries, especially in Southeast Asia, have experienced similar difficulties in their real estate sectors. Despite some correction in August, there is also reason for concern about the strength of world stock prices, which may to some extent be based on unrealistic expectations about prospects for future profit growth and low interest rates. A more substantial correction in stock prices, were it to occur, could adversely affect confidence and economic activity.

• Uncertainties about the Economic and Monetary Union (EMU) in Europe. The marked convergence of interest rates among the prospective members of the monetary union seems to suggest that financial markets expect the project to go ahead in accordance with the agreed timetable, which calls for the new currency, the euro, to be in place by January 1999. Investor sentiment may still change, however, if the feasibility of the timetable was perceived to be threatened. In that case, interest risk premiums might again widen for some countries, while the currencies of others might be subject to unwelcome upward pressure. Also, should growth prove insufficient to permit progress in reducing record levels of unemployment in much of Europe confidence would remain weak; in some cases there might be a risk of resort to counterproductive fiscal policies incompatible with the requirements of EMU.

• Sustainability of capital flows to emerging market countries. Several factors have contributed to record capital inflows into many emerging market countries and an associated compression of yield differentials in recent years, including the trend toward a more open global financial system and the increasingly successful economic policies pursued in many recipient countries. But the availability of these flows and their costs are also influenced by global cyclical conditions and are vulnerable to higher interest rates in world financial markets as well as to perceptions that large current account deficits—the counterpart to capital inflows—may not be sustainable in all cases. The crisis in Mexico late in 1994 and more recently the financial pressures that have affected Thailand and a number of countries in Southeast Asia underscore the importance of disciplined macroeconomic policies and robust financial sectors. They also have highlighted the risk and costs of potentially disruptive changes inmarket sentiment, including the danger of very strong reactions in financial markets and serious spillovers to other countries when critical policy weaknesses are not addressed in a timely manner.

The rest of this chapter summarizes the IMF staff’s near-term projections and policy assessments and identifies some key policy concerns that need to be addressed in order to strengthen medium-term economic prospects in all countries in accordance with the guidelines set out by the Interim Committee in its September 1996 "Declaration on Partnership for Sustainable Global Growth".¹ Other issues discussed include the prospects for EMU and its potential longer-term implications for Europe and the world economy, the critical need for labor market reforms in Europe, lessons from recent exchange market crises and the trend toward greater flexibility of exchange rate regimes in developing countries, the challenges facing monetary policy in the transition countries in safeguarding progress toward macroeconomic stability, and the need for so-called second-generation reforms to sustain high quality growth in all regions.