Stephen King: Policymakers have their work cut out as the West remains on life support

As 2010 draws to a close, the world's policymakers will be quietly confident that the worst is over. Economic activity is booming in the emerging world and no longer declining in the West. Unemployment has stopped rising in most countries and, for the lucky few, is actually falling. Stock markets have rallied and bond markets have sold off, perhaps indicating a revival of animal spirits. And, whereas a year ago many policymakers were worried about deflation, the bigger concern today in many parts of the world is the return of inflation.

Strangely enough, much the same could have been said about the position a year ago. Back then, there were clear signs of economic recovery. Companies were rebuilding their inventories after an earlier and prolonged period of destocking. Asian policymakers were already fretting about the inflationary implications of an aggressive economic rebound. And financial markets were doing relatively well. Indeed, expectations of recovery were so well-entrenched that, early in the New Year, people began to think the Federal Reserve, America's central bank, was preparing the way for an increase in interest rates.

That never happened. Although the US economy picked up through the course of 2010, the pace of recovery has been disappointing, to say the least. In the first few years of recovery from deep recessions, the US typically grows at a very brisk pace.

Following the Great Depression, annual growth rates hovered around 10 per cent. In the mid-1970s, after the first oil shock, growth rates were up at around 5 per cent. And following the double-dip recession of the early 1980s, growth rates averaged between 4 and 7 per cent for three successive years.

For 2010, it looks as though growth will average around 2.8 per cent. Following the 2.6 per cent decline in GDP in 2009, this is simply not good enough. The pick-up in US growth has not been sufficient to lift inflation from remarkably depressed rates. With interest rates now at zero, the US economy is in danger of behaving very strangely. If inflation continues to fall – or indeed, descends into outright deflation – interest rates will, in real terms, be too bracing.

For an economy awash with debt, this will simply hamper the recovery even further, leaving the unemployment rate too high and policymakers either scratching their heads or wondering whether quantitative easing will be able to weave its debatable magic.

For the emerging world, additional US monetary stimulus is making life more difficult. With global interest rates already very low and with investors sensing that emerging growth is the only game in town, the danger is that capital inflows into emerging markets will lead to overheating, the creation of bubbles and excessive inflation. Indeed, while US inflation heads down, inflation in the emerging world, most obviously in China and India, is heading up.

These nations don't have Western-style debt problems and are not suffering from the associated headwinds. They're mostly unwilling, however, to raise interest rates and to allow their currencies to appreciate, fearing either even bigger inflows to take advantage of currency appreciation or, instead, a severe loss of competitiveness. Instead, many emerging nations are pursuing what can best be described as quantitative tightening; raising collateral requirements on property loans, changing reserve requirements for banks and, increasingly, imposing capital controls. They are throwing sand into the works of global capital markets in a bid to protect their own sovereign interests.

The eurozone has proved to be a curate's egg in 2010. While newspaper headlines have, understandably, focused on the sovereign debt crisis, some parts of Europe have performed a lot better than many expected at the beginning of this year. Germany's reputation as a slow-growing economy with persistently high unemployment perhaps needs to be re-appraised following a year in which activity has picked up nicely (admittedly from a very low starting point) and where unemployment has continued to fall. Indeed, Germany's labour market experience has been almost the polar opposite of America's, helped along by the award of government subsidies to allow workers who might otherwise have lost their jobs to stay on short shifts.

Nevertheless, to put it mildly, the eurozone still has issues. Can the debtor nations repay their debts? Will creditors eventually have to take a hit? Will the eurozone nations eventually have to agree on an act of union, a further strengthening of political ties to allow fiscal transfers to take place across nations in a bid to avoid a repetition of this year's events? Until we have answers to these key questions, the eurozone will be stuck in economic purgatory. Flows of capital from the periphery to the core may help lift activity in Germany and France, but these gains on their own won't be enough to solve the eurozone's huge political and economic problems: it's a bit like robbing Peter to pay Paul. And then, of course, there's the UK. At one point on its knees, with London known as Reykjavik-on-Thames, 2010 has proved to be a better year for the UK than many – me included – had thought likely. Yet, as with the US, can we be sure that this good fortune will be sustained?

One thing we've surely learnt from the past decade or so is that it's foolish to pretend that UK economic developments are somehow independent of events taking place elsewhere in the world. At the moment, policymakers have lots of things to worry about, whether it's the growing protectionist threat from the US, the impact of booming emerging markets activity on commodity prices, or the dangers of a major economic upheaval in the eurozone. Already, the effects of these global challenges can be seen in the UK economic numbers: exports have picked up, but not as much as you'd expect given the support from 2008's sterling devaluation, while inflation has risen, partly because of the impact of higher global commodity prices on UK food and energy bills.

Indeed, while the rise in inflation is routinely regarded by some as a sign that the Bank of England has lost the plot, the rise in prices has, to date, not been matched by any significant rise in wages. This latest dose of inflation is, therefore, not like the inflations of the 1970s, when both prices and wage rose rapidly. Indeed, the bigger worry at the moment is not so much that inflation will continue to rise but, instead, that the higher cost of living will erode real incomes and spending, thereby threatening the pace of economic recovery in 2011 and beyond. Combine that with the ongoing austerity in the public sector and it becomes abundantly clear that the UK economy, like other Western economies, is not yet out of the woods.

Indeed, the Western world remains on economic and financial life support. Nothing has so far happened to suggest that policymakers are in any position to take the economic patient out of intensive care. The risks are still too great.