Monday, August 18, 2008

The perfect storm leading to a global recession

The perfect storm leading to a global recession

The probability is growing that the global economy - not just the US - will experience a serious recession. Recent developments suggest that all G7 economies are already in recession or close to tipping into one. Other advanced economies or emerging markets (the rest of the eurozone; New Zealand, Iceland, Estonia, Latvia, and some Southeast European economies) are also nearing a recessionary hard landing. When they reach it, there will be a sharp slowdown in the BRICs (Brazil, Russia, India, and China) and other emerging markets.

This looming global recession is being fed by several factors: The collapse of housing bubbles in the US, UK, Spain, Ireland and other euro-zone members; punctured credit bubbles where money and credit was too easy for too long; the severe credit and liquidity crunch following the US mortgage crisis; the negative wealth and investment effects of falling stock markets (already down by more than 20 per cent globally); the global effects via trade links of the recession in the US (which still counts for about 30 per cent of global GDP); the US dollar's weakness, which reduces American trading partners' competitiveness; and the stagflationary effects of high oil and commodity prices, which are forcing central banks to increase interest rates to fight inflation at a time when there are severe downside risks to growth and financial stability.

Official data suggest that the US economy entered into a recession in the first quarter of this year. The economy rebounded - in a double-dip, W-shaped recession - in the second quarter, boosted by the temporary effects on consumption of $100 billion (€68 billion) in tax rebates. But those effects will fade by late summer.

The UK, Spain, and Ireland are experiencing similar developments, with housing bubbles deflating and excessive consumer debt undercutting retail sales, thus leading to recession. Even in Italy, France, Greece, Portugal, Iceland, and the Baltic states, frothy housing markets are starting to slacken. Small wonder, then, that production, sales, and consumer and business confidence are falling throughout the euro zone.

Elsewhere, Japan is contracting, too. Japan used to grow modestly for two reasons: Strong exports to the US and a weak yen. Now, exports to the US are falling while the yen has strengthened. Moreover, high oil prices in a country that imports all of its oil needs, together with falling business profitability and confidence, are pushing Japan into a recession.

The last of the G7 economies, Canada, should have benefited from high energy and commodity prices, but its GDP shrank in the first quarter, owing to the contracting US economy. Indeed, three quarters of Canada's exports go to the US, while foreign demand accounts for a quarter of its GDP.

So every G7 economy is now headed toward recession. Other smaller economies (mostly the new members of the EU, which all have large current-account deficits) risk a sudden reversal of capital inflows; this may already be occurring in Latvia and Estonia, as well as in Iceland and New Zealand.

This G7 recession will lead to a sharp growth slowdown in emerging markets and likely tip the overall global economy into a recession. Those economies that are dependent on exports to the US and Europe and that have large current-account surpluses (China, most of Asia, and most other emerging markets) will suffer from the G7 recession. Those with large current-account deficits (India, South Africa, and more than 20 economies in East Europe from the Baltics to Turkey) may suffer from the global credit crunch. Commodity exporters (Russia, Brazil, and others in the Middle East, Asia, Africa, and Latin America) will suffer as the G7 recession and global slowdown drive down energy and other commodity prices by as much as 30 per cent. Countries that allowed their currencies to appreciate relative to the dollar will experience a sharp slowdown in export growth. Those experiencing rising and now double-digit inflation will have to raise interest rates, while other high-inflation countries will lose export competitiveness.

Falling oil and commodity prices - already down 15 per cent from their peaks - will somewhat reduce stagflationary forces in the global economy, yet inflation is becoming more entrenched via a vicious circle of rising prices, wages, and costs. This will constrain the ability of central banks to respond to the downside risks to growth. In advanced economies, however, inflation will become less of a problem for central banks by the end of this year, as slack in product markets reduces firms' pricing power and higher unemployment constrains wage growth.

To be sure, all G7 central banks are worried about the temporary rise in headline inflation, and all are threatening to hike interest rates. Nevertheless, the risk of a severe recession - and of a serious banking and financial crisis - will ultimately force all G7 central banks to cut rates. The problem is that, especially outside the US, this monetary loosening will occur only when the G7 and global recession become entrenched.

Thus, the policy response will be too little, and will come too late, to prevent it.

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