Baseline Scenario for 12/15/2008: pdf version
Peter Boone, Simon Johnson, and James Kwak, copyright of the authors
1) The world is heading into a severe slump, with declining output in the near term and no clear turnaround in sight.
2) Consumers in the US and the nonfinancial corporate sector everywhere are trying to “rebuild their balance sheets,” which means they want to save more.
3) Governments have only a limited ability to offset this increase in desired private sector savings through dissaving (i.e., increased budget deficits that result from fiscal stimulus). Even the most prudent governments in industrialized countries did not run sufficiently countercyclical fiscal policy in the boom time and now face balance sheet constraints.
4) Compounding these problems is a serious test of the eurozone: financial market pressure on Greece, Ireland and Italy is mounting; Portugal and Spain are also likely to be affected. This will lead to another round of bailouts in Europe, this time for weaker sovereigns in the eurozone. As a result, fiscal policy will be even less countercyclical, i.e., governments will feel the need to attempt precautionary austerity, which amounts to a further increase in savings.
5) At the same time, the situation in emerging markets moves towards near-crisis, in which currency collapse and debt default is averted by fiscal austerity. The current IMF strategy is designed to limit the needed degree of contraction, but the IMF cannot raise enough resources to make a difference in global terms – largely because potential creditors do not believe that large borrowers from an augmented Fund would implement responsible policies.
6) The global situation is analogous to the problem of Japan in the 1990s, in which corporates tried to repair their balance sheets while consumers continued to save as before. The difference, of course, is that the external sector was able to grow and Japan could run a current account surplus; this does not work at a global level. Global growth prospects are therefore no better than for Japan in the 1990s.
7) A rapid return to growth requires more expansionary monetary policy, and in all likelihood this needs to be led by the United States. But the Federal Reserve is still some distance from fully recognizing deflation and, by the time it takes that view and can implement appropriate actions, declining wages and prices will be built into expectations, thus making it much harder to stabilize the housing market and restart growth.
8) The push to re-regulate, which is the focus of the G20 intergovernmental process process (with the next summit set for April 2), could lead to a potentially dangerous procyclical set of policies that can exacerbate the downturn and prolong the recovery. There is currently nothing on the G20 agenda that will help slow the global decline and start a recovery.
9) The most likely outcome is not a V-shaped recovery (which is the current official consensus) or a U-shaped recovery (which is closer to the private sector consensus), but rather an L, in which there is a steep fall and then a struggle to recover.
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