Expect the World Economy to Suffer Through 2009
Some optimistic experts are now saying that though this will be a turbulent year for global markets, the worst of the financial crisis is now behind us. Would it were so. We believe that 2009 will be tougher than many anticipate.</br></br>We enter the new year grappling with the most serious global economic and financial crisis since the Great Depression. The U.S. economy is, at best, halfway through a recession that began in December 2007 and will prove the longest and most severe of the postwar period. Credit losses of close to $3 trillion are leaving the U.S. banking and financial system insolvent. And the credit crunch will persist as households, financial firms and corporations with high debt ratios and solvency problems undergo a sharp deleveraging process.</br></br>Worse, all of the world's advanced economies are in recession. Many emerging markets, including China, face the threat of a hard landing. Some fear that these conditions will produce a dangerous spike in inflation, but the greater risk is for a kind of global "stag-deflation": a toxic combination of economic stagnation, recession and falling prices. We're likely to see vulnerable European markets (Hungary, Romania and Bulgaria), key Latin American markets (Argentina, Venezuela, Ecuador and Mexico), Asian countries (Pakistan, Indonesia and South Korea), and countries like Russia, Ukraine and the Baltic states facing severe financial pressure.</br></br>Policy remedies will have limited effect as insolvency problems constrain the effectiveness of monetary stimulus, and the risk of rising interest rates (following the issuance of a wave of public debt) erodes the growth effects of fiscal stimulus packages. Only when insolvent banks are shut down, others are cleaned up, and the debt level of insolvent households is reduced will conditions ease. Between now and then, we can expect further downside risks to equity markets and other risky assets, given the likelihood that markets will continue to be jolted by worse-than-expected financial news.</br></br>The U.S. twin fiscal and current-account deficits will rise over the next two years as the country runs trillion dollar-plus fiscal deficits. We're all aware that foreign actors have financed most of this debt over the past several years. During the 1980s, the U.S. also faced the burdens of twin deficits, but relied on financing from key strategic partners like Japan and Germany. This time, the situation is more worrisome because today's financing comes not from U.S. allies, but from strategic rivals like Russia, China and a number of relatively unstable petrostates. This leaves the U.S. perilously dependent on the kindness of strangers.