Prepare for a global economic downturn but not a disaster

By Wolfgang Munchau

FINANCIAL TIMES - January 2 2008

North America remains the global economy's hub. Any assessment of the world economy in 2008 depends on the likelihood, depth and length of a US economic downturn and the magnitude of a global spillover. Any forecast is thus contingent on how we answer the following three questions. Will the financial crisis continue in 2008? Will inflation expectations rise further? Last, will there be a disorderly process of global rebalancing? If we answer all three questions with Yes, we should prepare for a global depression. If the answer is No, the world economy will have another good year. There are many intermediate scenarios as well.

I would answer the first question with an unqualified Yes. The financial crisis will probably linger on for most of the year and may get worse before it gets better. This is not really a "subprime" or "credit" crisis, as it is frequently called. This is a banking crisis. Economic history has taught us time and again that banking crises do not simply go away.

This banking crisis has proved persistent because it interacts with the real economy and with other parts of the financial market - the mortgage market, the money markets and various pockets of the bond markets. Furthermore, this is not a liquidity crisis at its core, even though a lack of market liquidity appears to be one of its many symptoms. What has made it so severe and immune to monetary policy is that financial actors no longer have blind faith in the solvency of their counterparties.

Nor will this crisis be over the minute that all subprime-related junk has been fully accounted for. There are many other parts of the credit market that were subject to hype similar to that of subprime mortgages, for example leveraged loans. The risk of contagion is particularly great if the US falls into a recession. In this case corporate bankruptcies would rise sharply and this would immediately hit the market for credit default swaps, complex financial instruments that offer insurance against non-payment of bonds. In this market, too, exposure risks may have been greatly underestimated.

US house prices

The macroeconomic effects of a financial and banking crisis of such scale are not trivial. Economic forecasters frequently underestimate the importance of credit and financial channels. What saved the US economy during the 2001 recession was a booming housing market and the availability of cheap consumer credit. This time many of those mechanisms work in reverse. The housing markets in the US and several other economies are headed for a severe downturn. In fact, it is a testimony to the innate strength of the US economy that it has produced positive growth rates until recently.

The second risk is inflation - for two reasons. First, persistent high inflation could destabilise global government bond markets, a rare pillar of stability in an uncertain financial environment. Second, high inflation places constraints on monetary policy. This in turn could make the downturn harder and longer, and the banking crisis more severe. The problem for central banks is not the rise in headline inflation rates, but the rise in inflationary expectations. A sharp economic downturn would almost inevitably reduce headline inflation rates, owing to lower oil and food prices. But it would not necessarily reduce expectations of future inflation.

Inflationary expectations went up worldwide during 2007, partly because of rising headline inflation, but possibly also because central banks may have lost a part of their credibility as they appeared torn between conflicting objectives of price and financial stability. In the eurozone, for example, five-year inflation futures show that the financial markets expect medium- term inflation to be about 2.5 per cent. Markets obviously distrust the European Central Bank's medium- term inflation target of close to 2 per cent. In the US, the markets have little faith in the US Federal Reserve's comfort zone for core inflation, either.

But this also means central banks will be cautious. In the US, some market participants may be disappointed when they discover that the Fed may not be in a position to cut the Fed funds rate to much below 4 per cent, unless and until the economy contracts sharply. A fall in short-term nominal rates to 1 per cent, as happened in 2003, is very unlikely.

The third risk is a disorderly unwinding of global imbalances, in particular a collapse in the exchange rate of the dollar against the euro and the yen. That could occur if central banks in Asia, Russia and the Middle East were to shift reserve assets out of dollars on a large scale. On this score, I am more optimistic.

The decision by China Investment Corporation to take a $5bn stake in Morgan Stanley is a sign that China is not about to shift investments out of dollar assets into euros. Also, the latest US Treasury International Capital system data show that capital flows were returning to the US in October, after a few months when it appeared that the US capital account surplus was disappearing.

Taken together, I would expect the credit crisis to get worse before it gets better, that persistently high inflationary expectations will place constraints on central banks and that there will be no dollar crisis.
This hypothetical scenario would almost certainly produce a serious slowdown in US economic growth and quite possibly a recession.

What about the rest of the world? Can it decouple? The answer is No. Both Asia and Europe should expect to see a significant reduction in economic growth, too. Asia will be mainly affected through the trade channel, given its reliance on the US as consumer of last resort. The biggest crisis transmission mechanism to Europe is the financial market.

But Asia and Europe are in a relatively strong position to avoid recessions. Asia's economic health will rest crucially on continued financial stability. The biggest current risk to China, for example, would be an implosion of overvalued stock prices. In the eurozone, there are already signs of an economic downturn, but fiscal policy could prove to be an important counter-cyclical stabiliser this time. One of the most vulnerable economies in Europe is the UK, which is heavily dependent for its economic performance on housing and credit, and where the scope for fiscal policy is more limited.

The bottom line is that this year marks the start of an asymmetric global economic downturn that is likely to persist for some time and will probably be quite unpleasant, but which will be well short of catastrophic.

Copyright The Financial Times Limited 2008

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