Editorial managing the global financial crisis and economic downturn

OECD Economic Outlook, Dec, 2008 by Klaus Schmidt-Hebbel

Many OECD economies are in or are on the verge of a protracted recession of a magnitude not experienced since the early 1980s. As a result, the number of unemployed in the OECD area could rise by 8 million over the next two years. At the same time, inflation will abate in all OECD countries and some even face a risk, albeit small, of deflation.

This Economic Outlook represents a substantial downward revision from just a few months ago: many of the downside risks previously identified have materialised. The financial turmoil that erupted in the United States around mid-2007 has broadened to include non-bank financial institutions and rapidly spread to the rest of the world. Following the collapse of Lehman Brothers in mid-September, a generalised loss of confidence between financial institutions triggered reactions akin to a "blackout" in global financial markets. Spreads in credit and bond markets surged to very high levels, paralysing credit and money markets. Prompt and massive policy action to restore confidence and provide liquidity appears to have successfully limited the period of panic, but the need for financial institutions to operate with less leverage and to repair their balance sheets remains. This process of adjustment will take time and impair the flow of credit, and is the key factor weighing on activity going forward.

I would like to emphasise upfront that the uncertainties associated with this OECD Economic Outlook are exceptionally large, especially those related to the assumptions regarding the speed at which the financial market crisis--the prime driver of the downturn--is overcome. Specifically, we assume that the extreme financial stress since mid-September will be short-lived, but will be followed by an extended period of financial headwinds through late 2009, with a gradual normalisation thereafter. On this basis, as well as our usual assumptions that exchange rates and the oil price are maintained at their recent levels, the main features of the economic outlook are the following:

* US output declines through the first half of next year, then gradually picks up as the effects of the credit squeeze abate, the housing downturn bottoms out and monetary policy stimulus takes hold. The recovery, however, is likely to be languid, as consumption is held back by the large losses in households' wealth. Inflation eases significantly, as the recent declines in commodity prices filter through the economy and as economic slack exerts downward pressure on prices.

* Euro area activity also falls over the next six months, as tighter financial conditions, subdued income growth and negative wealth effects from lower equity and house prices damp consumption and investment. Economic activity then gradually recovers as monetary easing gains traction and the effects of global financial market turbulence dissipate. Inflation will ease considerably, to reach a level by early next year that is consistent with the European Central Bank's inflation target.

* Japan has not been at the epicentre of the financial crisis, but after a brief growth spurt in early 2009 due to fiscal stimulus, output is set to stagnate over the second half of 2009, as the global economic downturn and the recent appreciation of the yen curtails external demand. With persistent economic slack and anaemic wage growth, deflation may return by mid-2009.

* Other OECD countries where the economic downturn will be severe include Hungary, Iceland, Ireland, Luxembourg, Spain, Turkey and the United Kingdom. These economies are most directly affected by the financial crisis, which in some cases has exposed other vulnerabilities, or by severe housing downturns.

* The major non-OECD countries are in many cases also slowing due to the combined effect of more difficult international credit conditions, earlier policy tightening, income losses due to lower commodity prices, and weaker demand from OECD countries. However the slowdown in growth is from high levels.

The financial crisis is not the only development shaping the projections. Other important drivers include ongoing adjustments in housing markets, which in many European economies, based on past housing cycles, still have a long way to go. Moreover, they come on top of negative wealth effects from the steep fall in equity prices. Partially offsetting these contractionary forces is the sizeable monetary stimulus, including non-traditional means, recently introduced and built into the projections, and the boost to real household incomes due to sharply lower commodity prices.

The projections carry both upside and downside risks, but they are skewed to the negative side for 2009. The dominant downside risks include a longer than assumed period before financial conditions normalise, further failures of financial institutions, and the possibility that emerging market economies will be hit harder by the downturn in global trade and foreign investor risk re-assessments. The upside risks are less significant, but adjustment in bank balance sheets may advance more quickly in response to the comprehensive and unprecedented policy measures introduced. Also governments may introduce policy stimulus over and above that factored into the projections. For 2010, widespread risks remain, but these are more equally distributed, reflecting the possibility of an earlier economic recovery.