Is economic recovery likely?

Deep pessimism sweeping through the financial markets has threatened to become a vicious circle. In contrast to earlier complacency, G7 governments have adopted unprecedented measures to stop their banking systems from collapsing.

As well as buying toxic assets on a colossal scale and effectively nationalising major commercial banks, the G7 has flooded money markets with liquidity and cut interest rates aggressively. But recurring failures have engendered a mood of despair. If even mighty governments fail to restore confidence, the consequences could be catastrophic.

How bad?
When exploring the credit crisis six months ago, I identified four potential worst-case scenarios:
• Calamitous 1930s-type financial meltdown, involving slump and massive unemployment;
• Japanese 1990s-type prolonged stagnation;
• Inflationary upsurge, resulting from over-aggressive fiscal and monetary expansion; and
• US dollar collapse, US default and loss of US creditworthiness and global status.

There were worrying signals last spring that the situation was worsening, but extreme scenarios appeared remote. The most likely outcome at that time was relatively benign: 12-18 months of below-trend growth; a mild US recession; and slow improvement starting around mid-2009. This view still seemed realistic until the Lehman Brothers collapse and the effective nationalisation of Fannie Mae and Freddie Mac this September.

Where are we now? We have moved dangerously towards scenarios 1 and 2. A banking sector meltdown, though so far averted, remains a real possibility. Banking threats could re-emerge and in the real economy, the recession is serious, rather than mild. The downturn is not confined to the US. Prospects for Europe and Japan are at least as poor.

Output falls and unemployment increases will be significant in all the major economies. Even after outright recession ends, stagnation and lost growth will persist for much longer than previously envisaged. Bank balance sheets remain burdened with huge bad debts.

Government persuasion or coercion may not be able to unblock banking sector paralysis, and ensure a normal flow of finance. Indeed, sound businesses may be reluctant to borrow and invest in the face of serious recession.

The inflationary upsurge in scenario 3 appears unthinkable in the next one-to-two years, but is a very realistic danger in the longer-term. Recession and plummeting commodity prices will reduce 2009 inflation and may even cause deflation. But over-aggressive fiscal and monetary policy, aimed at alleviating recession pains, will unleash powerful inflationary pressures in the future.

Since the credit crisis originated in the US sub-prime market, and the US economy is badly hit by big job losses and sharp house price falls, many have predicted dollar collapse and loss of US status envisaged in scenario 4. However, the sharp recovery in the US dollar has been a remarkable consequence of the crisis. The longer-term US global status remains uncertain.

There are sound reasons for perceiving the US as the safest and most attractive haven for international capital amongst the G7. The US is still much more powerful than Europe and Japan. The recession will be shorter in the US than in other G7 countries. Global economic power may move towards China, India and other emerging nations. But the US will remain dominant among the G7.

Where next?
It is difficult to be optimistic, but excessive pessimism is unjustified. The recession will be nasty, but we will probably avoid a major depression. Governments have taken essential steps to address the most urgent priority ­ avoiding a banking sector collapse. Higher unemployment and business failures are unavoidable. But governments cannot afford to lose the battle over restoring banking stability. If recent measures prove insufficient, more will have to be forthcoming.

Political fallout
The short-term economic cost of resolving the banking crisis, though high, will not be devastating. But the longer-term political fallout may cause serious damage and result in poorer, less efficient and more regulated societies. In a febrile political environment, many factors are being blamed for the crisis: excessive accumulation of debt; unduly lax US monetary policies; exaggerated booms in house prices; the opaqueness of the “originate and distribute” banking model; and a flawed banking reward structure encouraging greed, disproportionate risk-taking and speculation. The severity of the crisis has prompted strident calls to punish the guilty perpetrators and change the system.

Consequently, there are now attacks against globalisation, free trade and capitalism. Yielding to these assaults will cause immense damage. There is also dangerous clamour for draconian financial regulation. But the banks will have to accept radical reforms.

The least harmful way forward is to separate more tightly between two elements: 1) vital utility banking (i.e. running the payment system and providing finance to individuals and small businesses) that cannot be allowed to fail and must, therefore, accept greater regulation; and 2) more speculative investment banking that can be allowed greater freedom, but where failure will not endanger the whole economy.