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Deteriorating economic outlook for North Atlantic economies

By Saul Eslake - posted Thursday, 15 September 2011

The chances of the major North Atlantic economies slipping into a second recession seem to be increasing.

The US economy grew at a feeble 0.8% annual rate over the first half of the year and is yet to regain the level of output it had on the eve of the global financial crisis, in the final quarter of 2007. To be sure, the US economy had to contend with a number of ‘headwinds’ during the first half of 2011, including a spike in energy prices (which took the share of personal disposable income consumed by energy costs to its highest since mid-2008), and the supply chain effects of the Japanese earthquake and tsunami (which were particularly apparent in the motor vehicles sector).

Even with those ‘headwinds’ now abating, however, hours worked (which is a crude proxy for real GDP, abstracting from fluctuations in labour productivity) grew at an annualized rate of just 0.3% in the first two months of the September quarter, which on the face of it suggests that there has been no subsequent pick-up in the pace of economic growth. Manufacturing, which was one of the stronger areas of the US economy earlier this year, has clearly slowed (although at least it isn’t contracting); housing (which in more normal circumstances would have been at the forefront of any cyclical recovery in economic activity) continues to decline; and consumer confidence deteriorated sharply in August (indeed, one of the two principal gauges of US consumer confidence is now lower than it was in all but one month during the darkest days of the financial crisis).


On the other side of the Atlantic, economic growth in the euro area was somewhat faster in the first half of the year, at an annual rate of 1.9%, than in the United States – but this was largely attributable to Germany, which recorded a growth rate of 3.0% over the first half of this year, while the rest of the euro area grew at a more sedate 1.3% pace. Growth was much slower, both in Germany and elsewhere in the euro area, in the June quarter than in the March quarter, and appears to have slowed further in the first two months of the current quarter.

Last week, the OECD lowered its forecasts for growth in the US economy over the second half of 2011 to 0.7% (from 2.9% in its most recent Economic Outlook, published in May), and for the euro area to 0.5% (from 1.8%).

At such anaemic rates of growth, it wouldn’t take much by way of an unforeseen shock to push either economy into another recession. For the euro area, the seemingly growing probability that Greece will default on its debts may well provide just such a shock. This is a scenario that the European authorities have seemed, until very recently, unwilling to contemplate – to the point of excluding the possibility of a sovereign debt default from the round of ‘stress tests’ conducted by European bank regulators earlier this year, even though a sovereign debt default was widely seen by almost everybody else as the most likely source of ‘stress’ in the European banking system. A default by Greece could well bring on another European banking crisis, depending on the extent to which market participants feared that banks holding large amounts of Greek government bonds (and the bonds of other highly indebted euro area governments, whom markets might regard as more likely to default in the aftermath of a default by Greece) might be depleted of capital and unable to fund their own balance sheets.

And given the way in which the US financial markets have reacted to the growing probability of a Greek default (even though American banks appear to have very limited exposure to Greece, or to other highly indebted European governments), were such an eventuality to come to pass, it’s by no means impossible that the US economy could also slip back into recession as a result (although at least the possibility of the US Government defaulting on any of its obligations has been forestalled for now).

Perhaps the most worrying thing about the possibility of simultaneous recessions on both sides of the North Atlantic is that, were they to eventuate, governments and central banks would have very few options for ameliorating them, in the way that they sought (and were able to) moderate the length and depth of the recessions induced by the financial crisis of 2008.

The US Federal Reserve can’t cut interest rates any more: all it can do (as it has done) is promise to keep them at near-zero, and perhaps undertake another round of ‘quantitative easing’ (although there’s no compelling evidence from their first two rounds of that to suggest that it would do anything to promote an upturn in the economy, even if it might do something for share prices). The European Central Bank could, and should, reverse the two increases in interest rates which it prematurely undertook in April and July, but that wouldn’t achieve very much.


Nor do governments on either side of the Atlantic seem willing to do anything significant by way of providing renewed fiscal stimulus. This is unintentionally highlighted by President Obama’s promise that ‘everything’ in the ‘American Jobs Bill’ that he proposed in his speech to Congress last Friday morning ‘will be paid for – everything’. Although he is yet to say how ‘everything will be paid for’, if everything in it is to ‘be paid for’ then there will be no net fiscal stimulus arising from it. It won’t boost economic activity, and it won’t create net new jobs.  And of course in Europe, governments are responding to each twist of the on-going sovereign debt crisis by tightening fiscal policy further.

In fact, governments could provide more fiscal stimulus in the short-term if they were also willing to lay out credible and enforceable plans to put their finances on a sustainable footing over the medium term, including through measures that would boost productivity and economic growth – such as raising retirement ages, and eliminating loopholes and concessions in their tax systems that distort investment decisions in ways that detract from productivity and economic growth. But the courage to lay out such plans seems to be in critically short supply.

Hence the risk is that any new recession in Europe or the United States could turn out to be a protracted affair, similar in some ways to the ‘depressions’ that occurred during the 19th century, before it became the accepted political and economic wisdom that governments and central banks could and should do something to ameliorate them.

In that case there would be bound to be adverse implications for Australia, even though the chances of China (whose fortunes matter far more to us than those of the United States or Europe) experiencing a sustained downturn still appear very remote.

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This article was first published in The Age on September 14, 2011.

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About the Author

Saul Eslake is a Vice-Chancellor’s Fellow at the University of Tasmania.

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