Lost decade of growth for Western economies

Five years after the credit crisis began, Western economies are confronting the prospect of a lost decade of growth, and international diplomats are warning the damage could get even worse if Europe allows its sovereign debt crisis to fester much longer.

International Monetary Fund chief Christine Lagarde is heading to Berlin on Monday to urge action after the IMF called for member countries to provide the fund with $500 billion for new loans to help out troubled countries.

G20 officials also say Europe must double the size of its rescue fund to $1 trillion as a crucial step to stabilise financial markets and prevent the euro-zone crisis from spreading. Europe finance ministers meet on their debt plan on Tuesday.

The World Bank already sees the damage taking hold as European banks pull back their lending to emerging economies. Last week it slashed its growth forecast more than one percentage point to 2.5 per cent for 2012, a pace not seen since 2008 when the world was last in a global recession.

“The risk of a global freezing-up of the markets and as well as a global crisis similar to what happened in September 2008 are real,” Justin Lin, the Chief Economist for the World Bank, said.

The IMF also is set to cut its growth forecasts this week. Although the United States has shown encouraging signs in recent weeks, the economy remains far too feeble for any upturn to be either strong or sustained. Europe is no better off and already appears to have fallen back into a mild recession.

Goldman Sachs calculates that per capita GDP growth in the United States has shrunk by 0.7 per cent each year between 2007 and 2011, compared with 2.0 per cent growth in the decade prior to the recession. In the euro area, the decline has been similar, 0.6 per cent drop against a 1.8 per cent pre-recession rate.

The concern is that the destruction of skills and capital investment caused by recession and slow growth rates will lead to a structurally lower rate of growth and higher rate of unemployment for a protracted period. If left unchecked, it would make it even harder to handle huge government debt loads, making the growth outlook even less stable.

Jerome Levy Forecasting sees the United States trapped in a low growth cycle throughout the rest of this decade, at least until household debt levels are paid down, businesses have restructured to regain competitiveness and wage growth returned.

“We are not holding our breath for a rapid turnaround. In fact for this year, we are investing in scuba gear in case it worsens,” said economist Robert King.

It is against this backdrop that the Federal Reserve is preparing to unveil an overhaul of its long-run goals and strategy for conducting monetary policy on Wednesday, a move that could lay the groundwork for further steps to support the U.S. economy if needed.

The Fed on Wednesday will begin publishing the interest rate forecasts from its individual members. While seemingly a technical step, it can help shape investor expectations on the outlook and possibly will be used to signal an even longer time period that the Federal Open Market Committee plans on keeping interest rates at extremely low levels.

“The immediate benefit is that it will allow the FOMC to replace the implicit commitment of keeping rates near zero until mid-2013 with more flexible guidance,” said Troy Davig, economist at Barclays Capital.

The Fed also may spell out for the first time a specific inflation target and an employment goal. An inflation target would reassure investors the Fed remains firmly committed to keeping inflation under control, even if it does decide to inject more money into the economy to stimulate growth through asset purchases.

It already has bought $2.3 trillion in bonds, making its balance sheet so large that critics say it is sowing the seeds of runaway inflation.

Any further Fed action, however, is probably months away. Fourth quarter GDP data for the United States due out on Friday is expected to show the fastest growth in 18 months, at 3.1 per cent up from 1.8 per cent in the prior quarter. But analysts doubt that the quickened pace can last.

The bulk of the Q4 gain is expected to come from a rebuilding of inventories and unless final demand for goods and services also has accelerated notably – unlikely when wage growth is flat to declining, consumer debt levels high and export demand weakened – the improvement will prove short lived.

In Europe, the picture looks much worse. The United Kingdom may be sliding into recession. It releases its Q4 GDP data on Thursday, and it is expected to show the economy shrank by 0.1 per cent after growing 0.6 per cent in Q3. The Royal Bank of Canada expects the Bank of England to expand its asset purchases by 50 billion pounds sterling in February to give the economy further help.

In the euro zone, the flash reading on Markit PMI indices on Wednesday will gave a sense of the severity of its recession. The manufacturing index is forecast to contract for the sixth month in a row though at a slower pace of 47.3 in January, compared with 46.9 in December. The services index also is seen remaining just below the 50 mark, which separates growth from shrinkage, little changed from the prior month.

When world leaders and corporate leaders gather in Davos, Switzerland, for the World Economic Forum on Wednesday through Sunday, they will face the most challenging economic conditions the world has seen since the 2008/2009 recession.