Risks Of Another Global Recession

By M. Isi Eromosele

Failure of policymakers, especially those in Europe and the United States to address the jobs crisis and prevent sovereign debt distress and financial sector fragility from escalating poses the most acute risk for the global economy in the outlook for 2012-2013.

A renewed global recession may be developing. The developed economies are on the brink of a downward spiral enacted by four weaknesses that mutually reinforce each other: sovereign debt distress, fragile banking sectors, weak aggregate demand (associated with high unemployment and fiscal austerity measures) and policy paralysis caused by political gridlock and institutional deficiencies.

All of these weaknesses are already present, but a further worsening of one of them could set off a vicious circle leading to severe financial turmoil and an economic downturn. This would also seriously affect emerging markets and other developing countries through trade and financial channels.

The Oseme baseline forecast assumes that the set of additional measures agreed upon by the EU in late 2011 will suffice to contain Greece’s debt crisis. The measures include a 50 per cent reduction of Greece’s sovereign debt, steps to recapitalize European banks and deeper fiscal cuts in Greece.

The Oseme baseline assumes this would help engender an orderly workout of the sovereign debt crisis in the Euro zone and prevent the Greek default from spreading to other economies and leading to a major collapse of banks.

For the United States, the Oseme baseline assumes that the Government will put in place a policy package that would provide some minor stimulus in the short run, while cutting Government spending and increasing taxes over the medium run.

The baseline further subsumes the policy commitments made by other Group of Twenty (G20) members at the Cannes Summit in France, held on 3 and 4 November 2011.

These reaffirm by and large existing Government plans, with the main emphasis on moving towards further fiscal austerity while sustaining accommodative monetary policies in most developed countries; and with continued focus on price stability through monetary tightening in major developing economies and those countries who are running large current-account surpluses enacting fiscal policies that promote more domestic-led growth.

The presumption of the Oseme baseline scenario is that the combination of these policies will allow developed economies to muddle through during 2012, but will be insufficient to catapult a robust economic recovery.

The risk is high, however, that these relatively benign baseline assumptions will prove to be overly optimistic. It is quite possible that the additional measures planned in Europe will not be effective enough to resolve the sovereign debt crisis in the region, leading to a disorderly and contagious default in a number of countries which will wreak havoc in the economies of the region and beyond.

The efforts to solve the sovereign debt crisis in Europe failed to quell the unease in financial markets during November of 2011 and fresh warning signs of further problems emerged as Italy’s cost of borrowing jumped to its highest rate since the country adopted the Euro.

Another sign of increasing financial distress was a jump in the Euribor-OIS, Europe’s interbank lending rate from 20 to 100 basis points, not as high as at the onset of the 2008 global financial crisis but high enough to cause concern.

A large number of banks in the Euro zone already stand to suffer significant losses, but contagion of the sovereign debt crisis to economies as large as Italy would no doubt overstretch the funds available in the European Financial Stability Facility (EFSF), put many banks on the verge of bankruptcy and trigger a worldwide credit crunch and financial market crash.  

Such a financial meltdown would no doubt lead to a deep recession, not only in those economies under sovereign debt distress, but also in all other major economies in the Euro zone, possibly with the intensity of the downturn seen in late 2008 and early 2009.

The political wrangling over the budget in the United States may also worsen and could harm economic growth if it leads to severe fiscal austerity with immediate effect. This would push up unemployment to new highs, further depress the already much shaken confidence of households and businesses and exacerbate the beleaguered housing sector, leading to more foreclosures which, in turn, would put the United States banking

sector at risk again.

Consequently, the United States economy could well fall into another recession. The United States Federal Reserve might respond by adopting more aggressive monetary measures, for example, through another round of quantitative easing; but in a depressed economy with highly risk averse agents, this would likely be less effective in terms of boosting economic growth than the measures taken in previous years.

A recession in either Europe or the United States alone may not be enough to induce a global recession, but a collapse of both economies most likely would. GDP of the European Union would decline by 1.6 per cent and that of the United States by 0.8 per cent in 2012.

This would constitute about one third of the downturn experienced during 2009. The scenario assumes that financial conditions would not escalate into a full-blown banking crisis with worldwide repercussions, but it also assumes some overshooting of the impact into the real economy, as was the case in 2009, allowing for a mild recovery in 2013, albeit with GDP growth remaining well below the baseline forecast.

Developing economies and the economies in transition would likely take a significant blow. The impact would vary as their economic and financial linkages to major developed economies differ across countries.

Asian developing countries, particularly those in East Asia, would suffer mainly through a drop in their exports to major developed economies, while those in Africa, Latin America and Western Asia, along with the major economies in transition would be affected by declining primary commodity prices.

In addition, all emerging economies would have to cope with large financial shocks, including a contagious sell-off in their equity markets, reversal of capital inflows and direct financial losses due to the declining values of the holdings of European and United States sovereign bonds, which would affect both official reserve holdings and private sector assets.

As a result, GDP growth in developing countries would decelerate from 6.0 per cent in 2011 to 3.8 per cent in 2012, that is, to almost half the pace of growth (about 7 per cent per year) achieved during 2003-2007 and about 3 percentage points below the long-term growth trend.

This growth deceleration would not be quite as big as in 2009 when the pace of developing country growth dropped by almost 4.5 percentage points), yet various regions would suffer negative per capita income growth, likely causing renewed setbacks in poverty reduction and in achieving the other Millennium Development Goals

(MDGs).

Growth of WGP would decelerate to 0.5 per cent in 2012, implying a downturn in average per capita income for the world.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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