Tags: US | Europe | euro | crisis

US, Europe Edge Closer to a Once ‘Unthinkable’ Reality

Monday, 28 Nov 2011 12:50 PM

By Hans Parisis

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The Organization for Economic Cooperation and Development (OECD) released its latest World Economic Outlook 20011. The report points once more to two major risks to the world economy.

Firstly, it is of the highest priority to put an immediate stop to the eurozone sovereign-debt crisis from spreading. Concerns about sovereign-debt sustainability are becoming widespread. If not addressed in the short term, recent contagion to countries thought to have relatively solid public finances could massively escalate economic disruption, while pressures bank funding and balance sheets and increase the risk of a credit crunch.

Secondly, the other serious downside risk to the global economy is U.S. lawmakers failing to agree a spending-reduction plan.

With the Federal Reserve already flooding the financial system with liquidity, the U.S. central bank has even less room to act if the world's biggest economy hits a downturn. That prospect was made all the more real by the failure of Congress to agree a deficit-reduction plan, without which deep spending cuts would be triggered.

"The resulting fiscal tightening, which would come automatically, would in our view likely generate a recession in the United States," OECD chief economist Pier Carlo Padoan told Reuters in an interview.

The OECD expects U.S. GDP to rise by 2.0 percent in 2012 and by a further 2.5 percent in 2013, after an expected expansion of 1.7 percent in 2011. Euro area growth is forecast to slow down further from 1.6 percent this year to 0.2 percent in 2012, before picking up to 1.4 percent in 2013.

In Japan, GDP is expected to expand by 2 percent in 2012 and 1.6 percent in 2013, following a contraction of 0.3 percent this year. Chinese GDP is expected to grow at 8.5 percent in 2012, down from 9.3 percent this year, before rising to 9.5 percent in 2013.

Weaker activity in China and other emerging-market economies together with modest falls in commodity prices should put inflation in these countries on a downward trend, allowing some easing of monetary policy. Keep in mind that China needs to grow more than 8 percent for avoiding what’s called a de facto “Chinese recession.” So, long-term investors should keep an eye on that GDP number.

The U.S. economic recovery has lost significant momentum, with mediocre labor-market performance and weak sentiment exerting a drag on domestic demand, at a time when fiscal tightening is beginning to have traction.

Although there have been some signs of healing in financial markets, equity-market losses and declines in house prices have again weighed on household wealth.

All of these factors will continue to restrain demand for some time, but gradual improvements in confidence and accommodative monetary policy should help bring about a little bit more than an uptick in output growth after mid-2012, under the condition the eurozone comes up with a solution that is achievable and can be trusted on financial, fiscal and political level, inside and outside the EU.

Nevertheless, U.S. growth will remain subdued as household budgets continue to be under pressure. Investment growth is set to moderate, the labor market continuous moving sideways and it will take several years before the unemployment rate is anywhere near its pre-recession levels, deficit reduction will need to be calibrated to maintain credibility in medium-term consolidation goals while not forestalling the fragile recovery.

Both headline and core inflation are projected to decelerate and monetary policy should remain accommodative for the foreseeable future. Finally, the OECD expects the level of uncertainty in the U.S. remaining high while weighing risks to the downside.

As for the eurozone, it’s now a fact the recovery has stalled as confidence has weakened and financial conditions have deteriorated as a result of the sovereign debt crisis. The momentum in domestic demand has waned and external demand is slowing sharply. Fiscal consolidation and adjustment of private sector balance sheets will continue to restrain demand growth.

Unemployment is expected beginning to rise again and there will be a wide margin of spare capacity. Inflation will fall, against the background of weak underlying price pressures.

The announcement of the measures agreed at the October Euro Summit failed to restore confidence and is in extremely urgent need to be followed up by swift mobilization of adequate financial resources to ease contagion.

To enhance fiscal credibility, euro countries should pursue consolidation plans set out in their Stability Programs, while further monetary loosening is needed to help support activity. Provided that policy actions are sufficient to restore confidence gradually, activity should pick up somewhat from mid-2012.

The main risks center on the interactions of slow growth, sovereign debt and weaknesses in the banking system, as well as the ability of policymakers to find a credible solution to the debt crisis.

In the near future, a solution to the eurozone crisis will be central to where the world economies will go.

A German exit once was a highly improbable outcome to the crisis. Now, as we still face that same eurozone debt crisis that is now really starting to spiral out of control, it is starting to sound like a rather more credible solution, at least for Germany and its Northern European neighbors.

Don’t forget the fact that European politicians now are effectively admitting it is possible to leave the eurozone, which makes me start thinking which country would be best heading for the door first.

Yes, in my opinion at least, the unthinkable is becoming less and less unthinkable.

Besides what I think, the just released OECD’s report is crystal clear that a continued lack of effective action could trigger a downside scenario on a world scale whereby we should expect worsening of the already existing concerns about the banking system, contagion in euro-area sovereign debt markets or an excessively tight fiscal policy in the United States linked to the current political gridlock.

Under this scenario, a wide range of structural measures to boost jobs and economic activity, all desirable in their own right, will become urgent. Effective labor market policies are needed to tackle unemployment which risks turning from cyclical to structural, thereby sapping potential growth, hitting confidence and weakening public finances.

No, it’s really impossible to become optimistic with such an outlook and the messy situation in the eurozone firmly anchored.

In my opinion, long term investors still have very little risk to err by keeping their distance and wait patiently for much lower prices in most of asset categories before stepping back in. Anyway, my preference remains “risk off.”

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