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ON THE VERGE OF A GLOBAL RECESSION ( Chart 1 )

	Chart 1

GDP is declining in the advanced economies

During the second quarter, the economy defined by the 15 countries that utilize the euro as its common currency was declining at a 0.7% annualized pace. Japan’s Gross Domestic Product (GDP) was plunging at a 3.0% rate. In the United States, economic activity was actually still expanding at a 2.8% pace with the help of big tax rebates.

But the deepening financial crisis is likely to have created contracting GDP for all three regions during the third quarter. Consequently, our forecast for 2008 calls for a modest 2.5% expansion. A continuing financial hangover will result in only a slim 1.8% increase for global GDP next year. A growth rate lower than 2.0% for world output is traditionally considered to constitute a recession. It will not be until 2010 that respectable growth is predicted to return, as shown in the chart below.

Some reasons for cautious optimism

Although the ongoing actions by the U.S. Treasury and the Federal Reserve Board represent the largest government involvement in the private sector, there have been some other major interventions during the last few decades. The most notable was the 1989 bailout of the savings and loan industry, which resulted in a total government tab of roughly $500 billion. More recently, the 1998 rescue of Long Term Capital Management hedge fund by the Federal Reserve was another ground-breaking policy move that was taken because inaction was thought to hold catastrophic consequences.

RECENT FINANCIAL LOWLIGHTS IN 2008

Average finish down 40.3% from the all-time peak reached just a year earlier.

And the beat goes on.

The savings and loan bailout offers some possible economic lessons. The 1989 crisis was followed by a modest, but respectable, 1.8% increase in U.S. GDP in 1990. A short, mild recession unfolded in 1991, but the downturn was probably unrelated to the savings and loan crisis. Furthermore, the global economy skated through the entire period without a recession. In short, it is believed that the ongoing crisis will be resolved without catastrophic consequences.

Forecasting in a financial vortex

The U.S. government is essentially adopting a “whatever it takes” strategy to solve the financial crisis. The treasuries and banking authorities of a growing number of countries are now on board, as evidenced by the coordinated ½ percentage point cut in interest rates implemented on October 8. It is believed that the policy tools for a solution are available. Thus, the 2009 world GDP forecast is relatively optimistic. But it is considerably more pessimistic than the 2.5-3% projections that are still being published.

Housing is key

After the dot.com bust, the Federal Reserve Board (Fed) and other central banks dramatically lowered interest rates to prevent a worldwide recession. But between 2002 and 2007, low interest rates and readily available credit fueled a housing boom in the United States, as well as many other countries, that fed on itself. That is, as the housing bubble inflated, banks were able to use the higher asset values to loan even more money for speculative investments. And because the speculative bubble fattened the banks’ bottom lines, they were able to use leverage of roughly 10:1 to further inflate the bubble. But after the bubble burst, the leverage machine was run in reverse. “Deleveraging” and the start of the financial crisis began in August 2007. As the value of mortgages held by banks began to fall with rising defaults, financial institutions were forced to increase their base capital in order to meet minimum capital requirements. They sold assets to do so, putting downward pressure on similar assets, thereby creating a financial whirlpool. And because there has been a collapse in confidence in the financial integrity of many large banks, inter-bank lending has dried up and loans have become very hard to acquire.

The U.S. Treasury, the Federal Reserve Board and numerous central banks around the world have acted with increasing urgency to unclog the flow of credit. The latest actions included the Fed’s decision to loan directly to U.S. corporations, as captured by the recent history of the financial crisis found in the sidebar on page 2. But until the price of real estate bottoms, the crisis will continue to be with us. And should the therapeutic financial remedies now being applied turn out to fall short, our 1.8% forecast for 2009 global GDP growth may turn out to be optimistic.

Developing economies to the rescue

In the early stages of the ongoing financial crisis it was thought that because the United States was the epicenter of the housing bubble, the fallout would be solely a U.S. problem. However, it soon became obvious that foreign banks were major purchasers of what are now known as toxic securities. Moreover, housing bubbles in Europe and elsewhere were creating similar problems. In short, the developed economies are all being adversely impacted, directly or indirectly, by the credit crunch. And although they are approaching 2009 from somewhat different economic positions, their GDP gains are expected to be very similar in 2009. That is, economic growth will be roughly ½ percent next year for the United States, West Europe and Japan, as shown in ( Chart 2 ). Also see ( Chart 3 ).

	Chart2

	Chart 3

However, the developing economies will do substantially better. The so-called BRIC countries (Brazil, Russia, India and China) will perform relatively well, partially because they are more insulated from the credit crisis. Still, growth rates will descend next year. For example, China’s GDP is forecast to grow by only 7.0% next year, compared to 9.7% in 2008 and 11.6% in 2007. Naturally, China’s export markets will decelerate sharply next year, but the country’s hoard of reserve currencies and its determination to maintain strong growth will motivate policy makers to step up domestic spending for infrastructure and military projects, as well as encourage consumer spending. A moderate recovery in 2010 is envisioned to bring global GDP growth up to 3.6% that year.