Downside risks to global growth have risen markedly. We take a look at the factors which in the past tended to lead to a recession. Since the classical causes do not apply this time round, the economy will likely only dip into recession if the euro zone sovereign debt crisis were to escalate and spark a Lehman-style uncertainty shock. It will thus be of critical importance whether euro zone finance ministers are able to reach a common position. In our baseline scenario, we assume that the USA and the euro zone will narrowly escape a recession and that the anaemic recovery will remain in place.
Fears are mounting that the industrialised countries are poised to slip back into recession. Tumbling equity markets indicate that fears of a sharp downturn have risen markedly of late. However, as suggested by past evidence, an economy does not slide into recession without due cause but only if preceded by a shock. Are we presently teetering on the brink of such a shock?
Monetary Policy in the Industrial Countries Still Accommodative
In the past 40 years, all recessions in Germany were preceded by significant rate hikes (chart 1). The same holds for most other industrialised countries. But even though the ECB has raised its target rate twice of late, monetary policy is far from being restrictive. On the contrary, short-term real interest rates are still near zero and in many countries – including the USA – they remain negative. Therefore, rate hikes or a restrictive monetary policy simply cannot be the factor prompting a recession in the industrialised countries.
The emerging markets are a different story, though. In an attempt to curb strongly rising inflation, the central banks in some of these countries have hiked rates substantially, which should act as a damper on economic activity. Nonetheless, with real interest rates remaining fairly low, it is unlikely that central bank rate moves will tip many of these countries into recession, let alone the overall global economy.
Oil Price Set to Retreat
At least two previous recessions – in the early and the late 1970s – were to a large extent the result of rising oil prices. In this cycle, oil has also climbed sharply; in the first half of the year Germany’s gas and oil import bill rose by 1% of GDP compared to the same period a year earlier (chart 2). In many countries – including the USA, but also Germany – this has left deep scars on private consumption.
However, it is highly unlikely that this will spark a recession, given that purchasing power has been eroded much more moderately than in the wake of the 1970s oil crises. What is more, unlike during the two oil crises of the 1970s, the present up tick in prices does not constitute an external shock, but can to a large extent be attributed to buoyant global growth. In any case, in recent weeks the price has fallen again due to the deteriorating economic outlook. Finally, the economy only slid into recession in the 1970s after the central banks started hiking rates aggressively, which is not the case this time.
Euro Likely to End Up Weaker Rather Than Stronger
Unlike some analysts, we do not see the risk that the euro’s strength might hamper economic growth.
| Chart 1: Germany – No headwind from monetary policy
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Chart 2: No new oil crisis
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Firstly, no recession has ever been sparked by an appreciation, at least not in Germany, nor, due to the zero-sum effect of currency moves, will the strengthening of the euro drive all industrialised countries into a severe downturn. Secondly, while the euro has appreciated versus the US dollar, it has lost ground against almost all other currencies. Thus, the euro’s trade-weighted effective exchange rate has inched up only marginally in recent months. Its real external value, which takes into account price trends in the euro area versus its trading partners, has fallen to a lower level than was experienced through much of the past ten years (chart 3). With this in mind, we argue that the economy is unlikely to come under pressure from this front, at least not in the euro zone.
Correction of Bubbles is Well Advanced
Although during the last two recessions, central banks hiked rates at a far more moderate rate than in other downturns, the economy nonetheless registered a sharp plunge. This was due to the formation of bubbles during the upswing which were the result of expansionary monetary policies, and which had to be corrected in the face of deteriorating financing conditions. At the beginning of the new millennium the recession was driven by the IT bubble and, in particular in Germany, an upsurge in corporate debt levels. During the last recession, it was furthered by the housing bubbles in many countries and a sharp rise in private household debt.
However, in the last two years, no new bubbles have emerged in the industrialised countries and the imbalances which preceded the past recession have, at least in part, been corrected. In the USA, the household savings ratio has backed up to the level recorded during the latter half of the 1990s, while residential construction investment relative to GDP is now significantly below pre-boom levels (chart 4). In Europe, the correction of previous imbalances has not made as much headway as in the USA. In Spain, for instance, residential construction investment has declined to pre-crisis levels relative to GDP, but, as US experience shows, needs to drop much further in order to reduce the housing overhang. Still, the previous recessions were not the result of ongoing corrections but could be attributed to the bursting of bubbles and the subsequent corrections. With bubbles already having burst, the risks from this front should be limited in the industrialised countries.1
| Chart 3: Euro weaker rather than stronger
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Chart 4: Housing boom largely corrected
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Key Risk: Uncertainty Shock from the Sovereign Debt Crisis
Thus, the sole possible catalyst for a recession would be a Lehman-style uncertainty shock. In 2008, with equity markets collapsing and the interbank market virtually grinding to a standstill, companies and private households lost faith in economic fundamentals. As a result, they postponed spending wherever possible for as long as possible, turning a modest downturn into a deep recession.
There is some risk that a similar outcome might be looming this time. Equity markets have already collapsed and rumours that several banks are facing funding problems could once again set off a spiral of distrust among financial institutions. And, with ever more people in the euro zone concerned over the long-term intrinsic value of their money, there is a rising risk that the foundations of economic activity could once again be undermined, which would induce companies and private households to assume a considerably more cautious stance.
Risk perception in the financial markets has risen visibly of late, as suggested by our ARPI Index, though it has not yet reached post-Lehman levels (chart 5). However, contagion has not (yet?) spread to the real economy. Although business sentiment is on a downward trend, pointing to weaker economic growth, it has so far not recorded a collapse comparable to that observed after the bankruptcy of Lehman Brothers (chart 6). Nonetheless, in the event of an escalation of the sovereign debt crisis in which a euro zone country was unable to service its debt, we would certainly expect to see such an uncertainty shock.
| Chart 5: ARPI
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Chart 6: Germany – Companies in a state of shock again?
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Continued Growth or Recession, No Stagnation!
Thus, at present, the two most likely scenarios are the two extremes: Provided no uncertainty shock materialises, the global economy is likely to remain on a growth path. In retrospect, slowing economic activity would in this event be nothing more than the usual soft patch that follows the initial strong upward movement in a cycle. However, with many countries embarking on austerity measures and some corrections of previous bubbles still underway this would occur earlier in the cycle than usual. If, however, a default of a euro country were to occur, putting the European Monetary Union as a whole at risk, there is a strong probability that the financial system would be destabilised, throwing companies and private households into a spin and sending the global economy into a sharp recession, both in Europe and the USA.
With developments in the months ahead largely hinging on the answer to one single question – uncertainty shock or no uncertainty shock – we do not attach a strong likelihood to a middle way scenario such as the longer-term stagnation envisaged by an increasing number of analysts. In our opinion, the global economy will either lapse into recession or the anaemic recovery in the USA and the euro zone will remain in place.
We stick with our view that European governments will go to great lengths to avert the default of a euro country and thus the escalation of the sovereign debt crisis. If necessary, the finance ministers would most likely increase the effective lending volume of the EFSF to EUR 700 bn. This should help to curb the economic risks from the debt crisis, although the monetary union would ultimately be transformed into a transfer and liability union. This, however, would encourage lax fiscal discipline and is likely to meet with political resistance sooner or later.
Notes:
1 In the emerging markets, the picture is less clear. While many analysts believe that in China, for example, a housing bubble is emerging, we do not expect any acute risks to global growth from this front. See “Is China a bubble”, EM Country Briefing of 29 April 2011.