And once this group of twenty plus economies enters into a recession there will be a sharp growth slowdown in the BRICs (Brazil, Russia, India and China) and other emerging market economies. The IMF defines a global recession as a global growth rate below 2.5% as emerging market economies usually grow much faster (6%) than advanced economies where growth averages about 2%. For example, a country like China – that even with a growth rate of 10% plus has officially thousands of riots and protests a year – needs to move 15 million poor rural farmers to the modern urban industrial sector with higher wages every year just to maintain the legitimacy of its regime; so for China a growth rate of 6% would be equivalent to a recessionary hard landing. It now looks like that, by the end of this year or early 2009, the global economy will enter a recession.
Let’s detail why we a global recession is now likely…
This global recession is being fed by a variety of factors: the bursting of housing bubbles in many economies (US, UK, Spain, Ireland and other. Eurozone memebers); the burst of massive credit bubbles in countries where money and credit used to be too easy for too long and supervision and regulation of credit too loose; the severe credit and liquidity crunch following the US morgage and debt crisis; the most severe financial crisis since the Great Depression (not as bad as the Great Depression but second only to that episode); the negative wealth and investment effects of falling stock markets (that have already fallen globally by a bearish 20% plus); the burden of high oil and commodity prices for commodity importing economies; the global effects via trade links of the US recession (as the US still counts for about 30% of global GDP); the weakness of the US dollar that is reducing the competitiveness of countries exporting a lot to the US; the stagflationary effects of high oil and commodity prices forcing central banks to increase interest rates to fight inflation at a time when there are severe downside risks to growth and to financial stability.
In the US data suggest that the economy entered into a recession in the first quarter of this year as the five indicators used to define a recession (GDP, employment, production, income and sales) all peaked and then contracted between October 2007 and February 2008. The economy rebounded – in a double-dip W-shaped recession – in the second quarter boosted by the temporary effects on consumption of $100 billion of tax rebates. But those effects will fade out by late summer while the more persistent factors hitting a shopped-out, saving-less and debt-burdened US consumer will remain: falling home values; falling stock prices; credit crunch in mortgages and consumer debt (credit cards, auto loans, student loans) ; rising debt and debt servicing ratios as mortgages and other consumer debt interest rates are resetting higher; high gasoline and food prices; collapsing consumer confidence; and, most important, a fall in employment for seven months in a row.
Similar factors are at play in the UK, Spain and Ireland where housing bubbles are going bust together with a bust of excessive consumer debt thus leading to a recession. But even in Italy, France, Greece, Portugal, Iceland and the Baltic economies frothy housing markets are starting to deflate. More broadly and ominously all of the Eurozone is now headed towards a recession including the three largest economies and G7 members: Germany, France and Italy. Bursting of housing bubbles; the effects of the liquidity and credit crunch that has also hit European financial markets and limits the ability of European firms to borrow, hire and invest; the fall of exports to the slumping US; high oil and commodity prices; the loss of competitiveness of Eurozone exports with a super-strong Euro; and the hawkishness of the ECB that – unlike the US Fed that aggressively cut policy rates – first kept rates on hold and has recently raised them to fight inflation. So no wonder that production, sales and consumer and business confidence are all falling in the entire Eurozone. And thus second quarter Eurozone GDP growth will be even worse – and close to zero – than the US while the future growth ahead looks even worse.
Of the remaining G7 economie Japan is already contracting. Japan used to grow modestly for two reasons: strong exports to the US and a weak yen. Now the exports to the US are falling while the yen is not as weak as before. On top of these two negative shocks two other shocks are pushing Japan into a recession: high oil prices for a country that imports all of the oil that it consumes; and falling business profitability and confidence.
The last of the G7 economies, Canada, should have benefited from high energy and commodity prices; but its GDP has already contracted in the first quarter. With a quarter of its GDP exported to the US and such exports being three quarters of its exports Canada’s economy is totally dependent on a sick US economy that is contracting.
So literally every single G7 economy is now headed towards a recessionary hard landing. And now other smaller economies (mostly the new members of the EU that all have large current account deficits) are at the risk of a sudden stop of capital and reversal of capital inflows that could trigger a hard landing; such hard landing is already occurring in Latvia, Estonia, Iceland and New Zealand. This G7 recession will next lead to a sharp growth slowdown in emerging market economies and likely tip the overall global economy into a recession. This slowdown in emerging market economies growth depends on a variety of factors. Those economies dependent on exports to the US and Europe and having 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 twenty plus economies in East Europe from the Baltics to Turkey) may suffer from the global credit crunch and a sudden stop of capital; those that are commodity exporters (Russia, Brazil and other such exporters in the Middle East, Asia, Africa and Latin America) will suffer from a large fall in energy and other commodity prices that are likely to fall by 30% from their recent peaks following the G7 recession and global slowdown; those that have allowed their currencies to appreciate relative to the US dollar will now experience a sharp export growth slowdown; those experiencing rising and now double digit inflation (over 30 emerging market economies) will have to raise interest rates to fight inflation slowing down growth; and those that have let – with loose monetary and credit policies – inflation to become too large will experience a loss of export competitiveness as inflation leads to real exchange rate appreciation.
While falling oil and commodity prices – now down 15% from their recent peaks – will somewhat reduce stagflationary forces in the global economy, inflation is for now becoming more entrenched – via a vicious cricle of rising prices, wages and costs – in many emerging markets in a high inflationary expectation trap. So this high inflation will constrain the ability of these central banks to respond to the downside risks to growth. In advanced economies inflation will become by year end less of a problem for central banks as a slack in goods markets will reduce the pricing power of
firms; as slack in labor markets – with rising unemployment – will keep wages and labor costs at bay; and as sharply falling commodity prices will dampen this source of inflation.
Still all G7 central banks are now worried about the temporary rise in headline inflation. So for now they are all on hold or threatening to hike policy rates to fight potential inflation risks. But over time severe recession risks and the risk of a severe banking and financial crisis – with credit losses now estimated to be at least $1 trillion and possibly as high as $2 trillions and hundreds of banks going bust – will force all G7 central banks to cut further policy rates. But this policy easing will be too slow and delayed, especially outside the US, and will occur only when the G7 and global recession will become entrenched. Thus, the policy response to this upcoming perfect storm will be too little too late to prevent it.