There’s an old joke that economists like to tell about how to spot the differences between a slowdown, a recession or a depression. It goes like this: when other people lose their jobs, it’s an economic slowdown; when you lose your job, it’s a recession; and when the economists themselves are out of work, well, then it’s a depression.
Based on this rationale, it’s probably unlikely that economists will find themselves among the ranks of the unemployed in 2008. But whether or not the global economy hits a rough patch — and how rough it will be — in large part depends on what happens in four nations: the United States, Russia, China and India. The first will be closely monitored for signs of how weakly its economy performs, the latter three for whether their collective strength will be enough to keep the world out of an overall slump. And if a slump is coming, the big question will be whether it will hit the level of recession, formally defined as two consecutive quarters of contraction.
Even the economic crystal-ball gazers admit they’re a bit stumped predicting what the world will look like in 2008, though they’re certain it won’t be as good as in recent years, when annual economic growth has hovered around 5%. Deutsche Bank, Germany’s largest, even managed to obfuscate things by using a term that conjures up both the positive and the negative: in a November report, it wrote that chances of a “growth recession” — where world growth dips below 2% — are about one in three. Using a predictive model based on financial indicators such as currencies, bond yields, short-term interest rates and housing prices, the bank said there’s a 33% chance of a “serious” growth recession, similar to those in the early 1970s and 1980s. The recent housing and credit bubbles, along with the banking crisis that ensued, have “elevated the level of uncertainty about the economic outlook to an unusually high level,” it noted. Still, Deutsche Bank didn’t throw in the towel on the world economy just yet, adding it is “cautiously optimistic” that a growth recession may not be coming. Despite hedging its bets, it’s sticking to its estimates of a 4.6% increase in world economic growth, compared with 5.1% in 2007.
“The world economy has entered an uncertain and potentially difficult period,” says Simon Johnson, economic counsellor and director of research for the International Monetary Fund, in his preface to the organization’s latest World Economic Outlook report, published in October. The situation is one in which “threats outweigh actual major negative outcomes,” Johnson notes, and the factors that may affect potential economic activity are “on the downside for growth.” He suggests “unexpected developments are more likely to push growth down rather than push it up.”
During an October press briefing on the IMF outlook report, Johnson started off optimistically enough, telling journalists that the “underlying fundamentals remain sound and global growth should remain strong.” The IMF calculates global GDP will increase by 4.8% — a figure that is lower than its projection of 5.2% in July. But then Johnson went on to note there might be trouble ahead, given that so much of this growth is attributed to emerging economies and not the developed world. The IMF estimates the U.S. economy, seen as the world’s primary economic engine, is projected to grow by only 1.9% in 2008. That’s the same rate as in 2007 — and almost a full percentage point lower than the IMF’s forecast in the summer.
The IMF growth numbers for other advanced economies have also been downgraded since the spring outlook: Canada, 2.3%, compared with 2.9%; euro countries, 2.1% from 2.3%; Japan 1.7% from 1.9%. China, India and Russia made up about one-half of global growth in 2007, with rates of 11.5%, 8.9% and 7%, respectively, and are expected to continue showing strong figures in 2008. The projected growth rates for these countries, down slightly from the IMF’s July forecast, are: China, 10%; India, 8.4%; and Russia, 6.5%.
Johnson said that the emerging-market and developing countries are “providing the basis” for continued strong overall growth for the world in 2008. He pointed out that for the first time, China and India are making the largest country-level contributions to world growth, on the basis of purchasing power parity. But then he emphasized that much of the forecast could change if things don’t go as predicted. “There are serious risks ahead,” he warned, most of them stemming from the potential of prolonged disruptions in global financial markets and a weakening in prices for assets such as real estate. “Like a forest that has not seen a fire in many years,” Johnson said, a benign financial environment during recent years, one that included low volatility and narrow risk spreads, “had built up a sizable underbrush of risky loans, relaxed lending standards and high leverage in certain areas.” So when the first fire — the problems in the U.S. sub-prime mortgage market — finally ignited this past summer, Johnson said it quickly spread to other areas. The first jump was to instruments such as “jumbo mortgages,” which traditionally involved less risky borrowers; the second was to banks, following revelations about their exposure to the U.S. sub-prime mortgages; the third, and most surprising, he said, was to the commercial paper markets. The result of all this has been a major global liquidity crisis, and the accompanying tightening of credit, which slows economic growth.
While the action taken by major central banks to restore liquidity in the markets has helped to stabilize the situation, according to Johnson “the smoke has not yet cleared” and “money market conditions have definitely not yet returned to where they were before the turmoil began.” Going forward, central banks in these advanced economies, he argues, must be careful about distinguishing between actions to restore liquidity and “setting their policy stance to control inflation and support growth.”
The IMF admits it is basing its relatively rosy growth projections for 2008 on the assumption that market liquidity is gradually restored. But it underscored the very real possibility that the recent financial turbulence could end up having a deeper impact on credit availability than previously envisaged. Mortgage lenders are already tightening lending standards, and if financing becomes less readily available, it could lead to a sharp downturn in housing markets, which in many parts of the world are “richly valued.” Not only would a downturn “affect consumption and residential investment spending, but as delinquencies rise, it would also hurt the balance sheets of mortgage lenders themselves.”
As for emerging markets, the IMF says the good news is that they will continue to replace the U.S. as “the main growth engine of the world economy,” though that growth will probably be slightly slower than the heady pace of the past two years. The downside to emerging markets, however, is that problems in global financial markets could disrupt capital flows. “Countries in emerging Europe and in the Commonwealth of Independent States [including Russia] are particularly exposed because of their large current account deficits and reliance on bank-related inflows,” the IMF warns. Inflationary pressures could also have an impact. Rising food prices, dwindling spare capacity, and continuing high oil prices could lead to a tighter monetary policy to contain inflation.
The IMF notes global current account balances also pose a risk, with the potential of leading to a “disorderly depreciation of the U.S. dollar, which could have severe repercussions throughout global financial markets.” As well, large trade imbalances in countries such as the U.S. could prompt protectionist pressures. But the IMF cites signs that these imbalances are moderating: the U.S. current account deficit is projected to decline slightly in 2008 to 5.5% of GDP, and the current account balances of oil-producing countries should come down as they ramp up spending. However, the IMF says China’s current account surplus will likely continue to remain large.
While the IMF points to some of the potential dangers for the world economy in the coming months, Robert Shiller, the Stanley B. Resor professor of economics at Yale University, is even harsher in his assessment, suggesting a hard landing is on the horizon. His warning is based on his interpretation of trends in oil prices, and the U.S. and international stock and real estate markets. Each of these areas, he told delegates attending a weeklong “financial opportunities” conference in Dubai in late November, spearheaded by the Dubai International Financial Centre, reveals speculative pressure that is indicative of financial bubbles. If the pressure and instability persists, the global economy could enter a major recession. “Perhaps we have gotten a little too confident in the global economic growth,” Shiller said at the conference’s opening session. He noted that stock markets in emerging countries such as China, Brazil and India have been up sharply, which is partly, but not fully, justified by underlying growth and earnings. And using the real estate markets in the U.S., the Netherlands and Norway as examples, he said historically high prices represent an “unprecedented” era of speculation. “It’s gotten into our thinking that real estate can only go up,” Shiller noted, adding that the futures markets are predicting a 5% to 10% decline in U.S. prices over the next year or so. All this, combined with continued high oil prices, could spell bad news.
Fellow conference panelist Eric Vergnaud, head of OECD Research at BNP Paribas, however, suggested the global economy is in for a softer landing. He countered that the U.S. is more robust than what Shiller suggested, and that growth in emerging economies will continue to be strong, helped out by further devaluation in the U.S. dollar. So the likely outcome, he predicted, is a slowing of growth, but not a recession.
While there are economists who take this more optimistic line of thinking, the gloomier picture painted by the IMF and Shiller is shared by the Organization for Economic Co-operation and Development, which has also downgraded its growth projections for most of the world’s major economies. In December, it cut its 2008 projection for U.S. GDP growth to 2%, down from the 2.5% it projected last May; for the euro area it reduced its projection to 1.9%, from 2.3% in May. But although projected growth is lower, OECD economics department acting head Jørgen Elmeskov doesn’t see a recession on the horizon. “Although near term growth has been revised down,” he wrote in the outlook, “the baseline scenario…is actually not that bad in view of the recent shocks.”
Some economists have been arguing that the economies of emerging countries have been “decoupling” from the U.S., so that a recession in that country wouldn’t necessarily have the same impact it once did. But others say these “hot” economies would be hurt by any American economic slowdown, given U.S. consumers drive so much of the demand side of the global economy. “If U.S. consumer spending slows in a material way, it is mathematically impossible for China and India to fill the void,” Stephen Roach, chairman of Morgan Stanley Asia told delegates at the Dubai conference. He also noted that U.S. consumption is worth US$9.5 trillion annually, compared with China’s US$1 trillion and India’s US$650 billion. With consumption in the U.S. now representing 72% of the country’s GDP, “this gorilla is as far out on the consumption curve as it has ever been,” Roach said. He added that U.S. consumption has not been income driven, but rather asset-driven, especially through increases in the value of homes. As the housing market slows, he warned, “the housing-dependent U.S. consumer, lacking in support from income, is toast.” The emerging economies, especially in Asia, he said, will be the most affected by slower U.S. consumption, given that so much of their economy derives from the U.S. and other advanced countries. Should there be a U.S. recession and slowdown in other advanced nations, “emerging markets will be in trouble.”
So the picture that emerges from all the crystal-balling by economists for 2008 ranges from cautiously optimistic, to gloomy, to gloomier still — whether it’s called an economic slowdown, “growth recession” or just plain old recession. Whatever the case, it seems that based on the definitions in that old economists’ joke, the one thing we can probably count on is that this time next year, we will find the world’s economic prognosticators still gainfully employed.