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From BaselineScenario website. I did not paste all points from B and C, since that would make this post too long, but you can read them via the link.
Caution: this is a long post (about 3,000 words). The main points are in the first few hundred words and the remainder is supportive detail. This material was the basis of testimony to the Senate Budget Committee today by Simon Johnson.
A. Main Points
1) In recent months, the US economy entered a recovery phase following the severe credit crisis-induced recession of 2008-09. While slower than it should have been based on previous experience, growth has surprised on the upside in the past quarter. This will boost headline year-on-year growth above the current consensus for 2010. We estimate the global economy will grow over 4 percent, as measured by the IMF’s year-on-year headline number (their latest published forecast is for 3.9 percent), with US growth in the 3-4 percent range – calculated on the same basis.
2) But thinking in terms of these headline numbers masks a much more worrying dynamic. A major sovereign debt crisis is gathering steam in Europe, focused for now on the weaker countries in the eurozone, but with the potential to spillover also to the United Kingdom. These further financial market disruptions will not only slow the European economies – we estimate growth in the euro area will fall to around 0.5 percent Q4 on Q4 (the IMF puts this at 1.1 percent, but the January World Economic Outlook update was prepared before the Greek crisis broke in earnest) – it will also cause the euro to weaken and lower growth around the world.
3) There are some European efforts underway to limit debt crisis to Greece and to prevent the further spread of damage. But these efforts are too little and too late. The IMF also cannot be expected to play any meaningful role in the near term. Portugal, Ireland, Italy, Greece, and Spain – a group known to the markets as PIIGS, will all come under severe pressure from speculative attacks on their credit. These attacks are motivated by fiscal weakness and made possible by the reluctance of relatively strong European countries to help out the PIIGS. (Section B below has more detail.)
4) Financial market participants buy and sell insurance for sovereign and bank debt through the credit default swap market. None of the opaqueness of the credit default swap market has been addressed since the crisis of September 2008, so it is hard to know what happens as governments further lose their credit worthiness. Generalized counter-party risk – the fear that an insurer will fail and thus bring down all connected banks – is again on the table, as it was after the collapse of Lehman.
5) Another Lehman/AIG-type situation lurks somewhere on the European continent, and again G7 (and G20) leaders are slow to see the risk. This time, given that they already used almost all their scope for fiscal stimulus, it will be considerably more difficult for governments to respond effectively if the crisis comes.
6) In such a situation, we should expect that investors scramble for the safest assets available – “cash”, which means short-term US government securities. It is not that the US has anything approaching a credible medium-term fiscal framework, but everyone else is in much worse shape.
7) Net exports have been a relative strength for the US economy over the past 12 months. This is unlikely to be the case during 2010.
8) In addition to this new round of global problems, the US consumer is beset by problems – including a debt overhang for lower income households, a soft housing market, and volatile asset prices. The savings rate is likely to fall from 2009 levels, but remain relatively high. Residential investment is hardly likely to recover in 2010 and business investment is too small to drive a recovery.
9) On a Q4-on-Q4 basis, the US will struggle to grow faster than 2 percent (the IMF forecast is for 2.6 percent). This within year pattern will likely involve a significant slowdown in the second half – although probably not an outright decline in output. The effects of fiscal stimulus will begin to wear off by the middle of the year and without a viable medium-term fiscal framework there is not much room for further stimulus – other than cosmetic “job creation” measures.
10) The Federal Reserve will start to wind down its extraordinary support programs for mortgage-backed securities, starting in the spring (although this may be delayed to some degree by international developments). The precise impact is hard to gauge, but this will not help prevent a slowdown in the second quarter.
11) On top of these issues, there is concern about the levels of capital in our banking system. The “too big to fail” banks are implicitly backed by the US government and for them the stress test of early 2009 played down the amount of capital they would need if the economy headed towards a “double-dip”-type of slowdown; the stress scenario used was far too benign. In addition, small and medium sized banks have a considerable exposure to commercial real estate, which continues to go bad.
12) Undercapitalized banks tend to be fearful and curtail lending to creditworthy potential borrowers. This may increasingly be the situation we face in 2010.
13) Emerging markets are also likely to slow in the second half of the year. Twice recently we have assessed whether these economies can “decouple” from the industrialized world (in early 2008 and at the end of 2008). In both cases, emerging markets – with their export orientation and, for some, dependence on commodity prices – were very much caught up in the dynamics of richer countries’ cycle.
14) The IMF projects global growth, 4th quarter-on-4th quarter within 2010 at 3.9 percent, i.e., the same as their year-on-year forecast. We expect it will be closer to 3 percent.
15) Over a longer time-horizon, we will probably experience a global economic boom, based on prospects in emerging markets. With our current global financial structure, this brings with it substantial systemic risks (see Section C below).
B. From Greece to the US: The Globalized Financial Transmission Mechanism
1) The problems now spreading from Greece to Spain, Portugal, Ireland and even Italy portend major trouble ahead for the US in the second half of this year – particularly because our banks remain in such weak shape...
--- several more points in section B at website...
C. Longer Run Baseline Scenario
1) In terms of thinking about the structure of the global economy there are three main lessons to be learned from the past eighteen months.
2) First, we have built a dangerous financial system in Europe and the U.S., and 2009 made it more dangerous.
4) Third, the crisis has exposed serious cracks within the euro zone, but also between the euro zone and the U.K. on one side and Eastern Europe on the other. Core European nations will spend a good part of the next decade bailing out the troubled periphery to avoid a collapse. For many years this will press the European Central Bank to keep policies looser than the Germanic center would prefer.
5) Over the past 30 years, successive crises have become more dangerous and harder to sort out. This time not only did we need to bring the fed funds rate near to zero for “an extended period” but we also required a massive global fiscal expansion that has put many nations on debt paths that, unless rectified soon, will lead to their economic collapse.
6) For now, it looks like the course for 2010 is economic recovery and the beginning of a major finance-led boom, centered on the emerging world.
7) But this also implies great risks. The heart of the matter is, of course, the U.S. and European banking systems; they are central to the global economy. As emerging markets pick up speed, demand for investment goods and commodities increases –countries producing energy, raw materials, all kinds of industrial inputs, machinery, equipment, and some basic consumer goods will do well.
10) Good times will bring surplus savings in many emerging markets. But rather than intermediating their own savings internally through fragmented financial systems, we’ll see a large flow of capital out of those countries, as the state entities and private entrepreneurs making money choose to hold their funds somewhere safe – that is, in major international banks that are implicitly backed by U.S. and European taxpayers.
12) We saw something similar, although on a smaller scale, in the 1970s with the so-called recycling of petrodollars. In that case, it was current-account surpluses from oil exporters that were parked in U.S. and European banks and then lent to Latin America and some East European countries with current account deficits.
13) That ended badly, mostly because incautious lending practices and – its usual counterpart – excessive exuberance among borrowers created vulnerability to macroeconomic shocks.
15) This is the scenario that we are now facing. For example, savers in Brazil and Russia will deposit funds in American and European banks, and these will then be lent to borrowers around the world (including in Brazil and Russia).
17) The big banks will initially be careful – although Citigroup is already bragging about the additional risks it is taking on in India and China. But as the boom progresses, the competition between the megabanks will push toward more risk-taking. Part of the reason for this is that their compensation systems remain inherently pro-cyclical and as times get better, they will load up on risk.
18) The leading borrowers in emerging markets will be quasi-sovereigns, either with government ownership or a close crony relationship to the state. When times are good, investors are happy to believe that these borrowers are effectively backed by a deep-pocketed sovereign, even if the formal connection is pretty loose. Then there are the bad times – remember Dubai World at the end of 2009 or the Suharto family businesses in 1997-98.
19) The boom will be pleasant while it lasts. It might go on for a number of years, in much the same way many people enjoyed the 1920s. But we have failed to heed the warnings made plain by the successive crises of the past 30 years and this failure was made clear during 2008-09.
20) The most worrisome part is that we are nearing the end of our fiscal and monetary ability to bail out the system. In 2008-09 we were lucky that major countries had the fiscal space available to engage in stimulus and that monetary policy could use quantitative easing effectively. In the future, there are no guarantees that the size of the available policy response will match the magnitude of the shock to the credit system.
22) We are steadily becoming more vulnerable to economic disaster on an epic scale.
By Peter Boone, Simon Johnson, and James Kwak
http://baselinescenario.com/2010/02/...010/#more-6335
Caution: this is a long post (about 3,000 words). The main points are in the first few hundred words and the remainder is supportive detail. This material was the basis of testimony to the Senate Budget Committee today by Simon Johnson.
A. Main Points
1) In recent months, the US economy entered a recovery phase following the severe credit crisis-induced recession of 2008-09. While slower than it should have been based on previous experience, growth has surprised on the upside in the past quarter. This will boost headline year-on-year growth above the current consensus for 2010. We estimate the global economy will grow over 4 percent, as measured by the IMF’s year-on-year headline number (their latest published forecast is for 3.9 percent), with US growth in the 3-4 percent range – calculated on the same basis.
2) But thinking in terms of these headline numbers masks a much more worrying dynamic. A major sovereign debt crisis is gathering steam in Europe, focused for now on the weaker countries in the eurozone, but with the potential to spillover also to the United Kingdom. These further financial market disruptions will not only slow the European economies – we estimate growth in the euro area will fall to around 0.5 percent Q4 on Q4 (the IMF puts this at 1.1 percent, but the January World Economic Outlook update was prepared before the Greek crisis broke in earnest) – it will also cause the euro to weaken and lower growth around the world.
3) There are some European efforts underway to limit debt crisis to Greece and to prevent the further spread of damage. But these efforts are too little and too late. The IMF also cannot be expected to play any meaningful role in the near term. Portugal, Ireland, Italy, Greece, and Spain – a group known to the markets as PIIGS, will all come under severe pressure from speculative attacks on their credit. These attacks are motivated by fiscal weakness and made possible by the reluctance of relatively strong European countries to help out the PIIGS. (Section B below has more detail.)
4) Financial market participants buy and sell insurance for sovereign and bank debt through the credit default swap market. None of the opaqueness of the credit default swap market has been addressed since the crisis of September 2008, so it is hard to know what happens as governments further lose their credit worthiness. Generalized counter-party risk – the fear that an insurer will fail and thus bring down all connected banks – is again on the table, as it was after the collapse of Lehman.
5) Another Lehman/AIG-type situation lurks somewhere on the European continent, and again G7 (and G20) leaders are slow to see the risk. This time, given that they already used almost all their scope for fiscal stimulus, it will be considerably more difficult for governments to respond effectively if the crisis comes.
6) In such a situation, we should expect that investors scramble for the safest assets available – “cash”, which means short-term US government securities. It is not that the US has anything approaching a credible medium-term fiscal framework, but everyone else is in much worse shape.
7) Net exports have been a relative strength for the US economy over the past 12 months. This is unlikely to be the case during 2010.
8) In addition to this new round of global problems, the US consumer is beset by problems – including a debt overhang for lower income households, a soft housing market, and volatile asset prices. The savings rate is likely to fall from 2009 levels, but remain relatively high. Residential investment is hardly likely to recover in 2010 and business investment is too small to drive a recovery.
9) On a Q4-on-Q4 basis, the US will struggle to grow faster than 2 percent (the IMF forecast is for 2.6 percent). This within year pattern will likely involve a significant slowdown in the second half – although probably not an outright decline in output. The effects of fiscal stimulus will begin to wear off by the middle of the year and without a viable medium-term fiscal framework there is not much room for further stimulus – other than cosmetic “job creation” measures.
10) The Federal Reserve will start to wind down its extraordinary support programs for mortgage-backed securities, starting in the spring (although this may be delayed to some degree by international developments). The precise impact is hard to gauge, but this will not help prevent a slowdown in the second quarter.
11) On top of these issues, there is concern about the levels of capital in our banking system. The “too big to fail” banks are implicitly backed by the US government and for them the stress test of early 2009 played down the amount of capital they would need if the economy headed towards a “double-dip”-type of slowdown; the stress scenario used was far too benign. In addition, small and medium sized banks have a considerable exposure to commercial real estate, which continues to go bad.
12) Undercapitalized banks tend to be fearful and curtail lending to creditworthy potential borrowers. This may increasingly be the situation we face in 2010.
13) Emerging markets are also likely to slow in the second half of the year. Twice recently we have assessed whether these economies can “decouple” from the industrialized world (in early 2008 and at the end of 2008). In both cases, emerging markets – with their export orientation and, for some, dependence on commodity prices – were very much caught up in the dynamics of richer countries’ cycle.
14) The IMF projects global growth, 4th quarter-on-4th quarter within 2010 at 3.9 percent, i.e., the same as their year-on-year forecast. We expect it will be closer to 3 percent.
15) Over a longer time-horizon, we will probably experience a global economic boom, based on prospects in emerging markets. With our current global financial structure, this brings with it substantial systemic risks (see Section C below).
B. From Greece to the US: The Globalized Financial Transmission Mechanism
1) The problems now spreading from Greece to Spain, Portugal, Ireland and even Italy portend major trouble ahead for the US in the second half of this year – particularly because our banks remain in such weak shape...
--- several more points in section B at website...
C. Longer Run Baseline Scenario
1) In terms of thinking about the structure of the global economy there are three main lessons to be learned from the past eighteen months.
2) First, we have built a dangerous financial system in Europe and the U.S., and 2009 made it more dangerous.
- The fiscal impact of the financial crisis was to increase by around 30-40 percent points our federal government debt held by the private sector. The extent of our current contingent liability, arising from the failure to deal with “too big to fail” financial institutions, is of the same order of magnitude.
- Our financial leaders have learnt that they can bet the bank, and, when the gamble fails, they can keep their jobs and most of their wealth. Not only have the remaining major financial institutions asserted and proved that they are too big to fail, but they have also demonstrated that no one in the executive or legislative branches is currently willing to take on their economic and political power.
- The take-away for the survivors at big banks is clear: We do well in the upturn and even better after financial crises, so why fear a new cycle of excessive risk-taking?
4) Third, the crisis has exposed serious cracks within the euro zone, but also between the euro zone and the U.K. on one side and Eastern Europe on the other. Core European nations will spend a good part of the next decade bailing out the troubled periphery to avoid a collapse. For many years this will press the European Central Bank to keep policies looser than the Germanic center would prefer.
5) Over the past 30 years, successive crises have become more dangerous and harder to sort out. This time not only did we need to bring the fed funds rate near to zero for “an extended period” but we also required a massive global fiscal expansion that has put many nations on debt paths that, unless rectified soon, will lead to their economic collapse.
6) For now, it looks like the course for 2010 is economic recovery and the beginning of a major finance-led boom, centered on the emerging world.
7) But this also implies great risks. The heart of the matter is, of course, the U.S. and European banking systems; they are central to the global economy. As emerging markets pick up speed, demand for investment goods and commodities increases –countries producing energy, raw materials, all kinds of industrial inputs, machinery, equipment, and some basic consumer goods will do well.
10) Good times will bring surplus savings in many emerging markets. But rather than intermediating their own savings internally through fragmented financial systems, we’ll see a large flow of capital out of those countries, as the state entities and private entrepreneurs making money choose to hold their funds somewhere safe – that is, in major international banks that are implicitly backed by U.S. and European taxpayers.
12) We saw something similar, although on a smaller scale, in the 1970s with the so-called recycling of petrodollars. In that case, it was current-account surpluses from oil exporters that were parked in U.S. and European banks and then lent to Latin America and some East European countries with current account deficits.
13) That ended badly, mostly because incautious lending practices and – its usual counterpart – excessive exuberance among borrowers created vulnerability to macroeconomic shocks.
15) This is the scenario that we are now facing. For example, savers in Brazil and Russia will deposit funds in American and European banks, and these will then be lent to borrowers around the world (including in Brazil and Russia).
17) The big banks will initially be careful – although Citigroup is already bragging about the additional risks it is taking on in India and China. But as the boom progresses, the competition between the megabanks will push toward more risk-taking. Part of the reason for this is that their compensation systems remain inherently pro-cyclical and as times get better, they will load up on risk.
18) The leading borrowers in emerging markets will be quasi-sovereigns, either with government ownership or a close crony relationship to the state. When times are good, investors are happy to believe that these borrowers are effectively backed by a deep-pocketed sovereign, even if the formal connection is pretty loose. Then there are the bad times – remember Dubai World at the end of 2009 or the Suharto family businesses in 1997-98.
19) The boom will be pleasant while it lasts. It might go on for a number of years, in much the same way many people enjoyed the 1920s. But we have failed to heed the warnings made plain by the successive crises of the past 30 years and this failure was made clear during 2008-09.
20) The most worrisome part is that we are nearing the end of our fiscal and monetary ability to bail out the system. In 2008-09 we were lucky that major countries had the fiscal space available to engage in stimulus and that monetary policy could use quantitative easing effectively. In the future, there are no guarantees that the size of the available policy response will match the magnitude of the shock to the credit system.
22) We are steadily becoming more vulnerable to economic disaster on an epic scale.
By Peter Boone, Simon Johnson, and James Kwak
http://baselinescenario.com/2010/02/...010/#more-6335
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