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Financial Turmoil and Global Growth

The turmoil in world financial markets is impeding global economic growth, according to the International Monetary Fund (IMF) (seehere and here). The major advanced economies are teetering on the brink of recession, and many developing and emerging-market countries are experiencing a sharp slowdown in their growth rates. The world is likely to experience a fairly prolonged period of subpar growth, since the process of rebuilding bank balance sheets will take a long time. Moreover, risks to the outlook are weighted to the downside, as financial institutions remain vulnerable to the negative feedback effects of slower economic growth.

Financial crises do not always spell disaster for economic growth. The IMF studied 113 episodes of severe financial stress occurring in 17 advanced countries over the past 30 years and found that a significantly slower pace of economic growth or a recession followed in only about one-half of the incidents. These economic slowdowns and recessions, however, were longer and substantially deeper than otherwise tended to be the case. The likelihood of a slowdown in economic activity following severe financial stress increased when the economy had previously experienced a rapid expansion of credit, a run-up in housing prices, and heavy household and corporate borrowing. Financial crises involving the banking system were more likely to produce a slowdown in economic activity or a recession than financial crises largely contained to either the securities market or to the foreign-exchange market. Financial systems heavily dependent on arms' length financing - securities and investment banks - as opposed to financing through commercial banks, experienced more procyclical leveraging, which amplified financial shocks. Unfortunately, almost all of these conditions currently hold for the United States.

World GDP Growth

2006 2007 2008 2009
World 5.1 5.0 3.7 2.2
Advanced economies 3.0 2.7 1.4 -0.3
United States 2.9 2.2 1.4 -0.7
Euro area 2.8 2.6 1.2 -0.5
Japan 2.4 2.1 0.5 -0.2
United Kingdom 2.9 3.1 0.8 -1.3
Canada 3.1 2.7 0.6 0.3
Emerging and developing economies 7.9 8.0 6.6 5.1
China 11.6 11.9 9.7 8.5
India 9.8 9.3 7.8 6.3
ASEAN-5 5.7 6.3 5.4 4.2
Western Hemisphere 5.5 5.6 4.5 2.5
Note: GDP growth is measured as year-over-year percent change.
Source: International Monetary Fund, World Economic Outlook Update, November 2008.

According to the IMF, the ongoing financial turmoil is causing the global economy to undergo a serious reversal of the extraordinary growth rates that it experienced over the past few years. Between 2004 and 2007, overall global economic growth was near 5 percent. Emerging and developing countries - notably China and India - led this growth, but nearly every country on earth shared in the expansion. The IMF, which recently marked down its projections, now expects global growth to moderate from 5 percent in 2007 to 3.7 percent in 2008 and to 2.2 percent in 2009. A gradual recovery will likely begin sometime in late 2009, but output growth will remain relatively weak until well into 2010.

The IMF expects that most advanced economies will bear the brunt of the slowdown. Advanced economies grew in a range of roughly 2.5 percent to 3.0 percent between 2004 and 2006. Growth will likely slow to around 1.4 percent this year and fall by 0.3 percent in 2009. This would be the first out-and-out drop in the overall output of advanced countries in the post-World War II period. The IMF expects all of the key advanced economies, except Canada, to experience a contraction in 2009.

Emerging-market and developing countries will experience a slowing in economic growth during the last half of 2008 and early 2009. While the expected slowdown marks a sharp deviation from the countries' recent growth trend, it will nevertheless leave their economic growth fairly high relative to their history. While these countries have not decoupled from the advanced world, they seem to have acquired a bit of their own momentum. Of course, the prognosis masks sharp disparities among individual emerging-market and developing countries; those that depend heavily on external financing may experience particularly rough going.

Economists, even in large groups, are not very precise forecasters, especially when faced with one-off economic events. Despite the revisions, the IMF acknowledges that the risks to its forecast are weighted somewhat more to the downside than the upside. Credit market conditions are likely to remain weak through 2009, as financial institutions in advanced countries go through a prolonged period of deleveraging, during which lending standards will remain tight and risk spreads will stay high. Emerging and developed countries will face difficulty in finding external financing, and consequently, those with large current-account deficits - or who otherwise seem high risk - will remain under pressure. Many currently believe that deleveraging will proceed only through 2009, but the financial sector could take longer to recover, particularly if the housing contraction in the United States proves deeper or if the global feedbacks from slow economic growth appear stronger than currently expected.

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