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Nouriel Roubini

Ta-dah! Stag-deflation Add to ...

The latest macroeconomic news from the United States, other advanced economies and emerging markets confirms that the global economy will face a severe recession in 2009.

In the U.S., recession started in December of 2007 and will last at least until December of 2009 - the longest and deepest American recession since the Second World War, with the cumulative fall in GDP possibly exceeding 5 per cent.

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The recession in other advanced economies (Britain, the European Union, Canada, Japan, Australia and New Zealand) essentially started in the second quarter of 2008, before the financial turmoil in September and October further aggravated the global credit crunch. This contraction has become even more severe since then.

There is also the beginning of a hard landing in emerging markets as the recession in advanced economies, falling commodity prices and capital flight take their toll on growth. Indeed, the world should expect a near recession in Russia and Brazil in 2009, owing to low commodity prices, and a sharp slowdown in China and India that will be the equivalent of a hard landing (growth well below potential) for these countries.

Other emerging markets in Asia, Africa, Latin America and Europe will not fare better, and some may experience full-fledged financial crises. Indeed, more than a dozen emerging-market economies now face severe financial pressures: Belarus, Bulgaria, Estonia, Hungary, Latvia, Lithuania, Romania, Turkey and Ukraine in Europe; Indonesia, South Korea and Pakistan in Asia; and Argentina, Ecuador and Venezuela in Latin America. Most of these economies can avoid the worst if they implement the appropriate policy adjustments and if international financial institutions (including the International Monetary Fund) provide enough lending to cover their external financing needs.

With a global recession a near certainty, deflation - rather than inflation - will become the main concern for policy-makers. The fall in aggregate demand while potential aggregate supply has been rising because of overinvestment by China and other emerging markets will sharply reduce inflation. Slack labour markets with rising unemployment rates will cap wage and labour costs. Further falls in commodity prices - already down 30 per cent from their summer peak - will add to these deflationary pressures.

Policy-makers will have to worry about a strange beast called "stag-deflation" (a combination of economic stagnation/recession and deflation); about liquidity traps (when official interest rates become so close to zero that traditional monetary policy loses effectiveness); and about debt deflation (the rise in the real value of nominal debts, increasing the risk of bankruptcy for distressed households, firms, financial institutions and governments).

With traditional monetary policy becoming less effective, non-traditional policy tools aimed at generating greater liquidity and credit (via quantitative easing and direct central bank purchases of private illiquid assets) will become necessary. And while traditional fiscal policy (government spending and tax cuts) will be pursued aggressively, non-traditional fiscal policy (expenditures to bail out financial institutions, lenders and borrowers) will also become increasingly important.

In the process, the role of states and governments in economic activity will be vastly expanded. Traditionally, central banks have been the lenders of last resort; but now they are becoming the lenders of first and only resort. As banks curtail lending to each other, to other financial institutions and to the corporate sector, central banks are becoming the only lenders around.

Likewise, with household consumption and business investment collapsing, governments will soon become the spenders of first and only resort, stimulating demand and rescuing banks, firms and households. The long-term consequences of the resulting surge in fiscal deficits are serious. If the deficits are monetized by central banks, inflation will follow the short-term deflationary pressures; if they are financed by debt, the long-term solvency of some governments may be at stake unless medium-term fiscal discipline is restored.

Nevertheless, in the short run, very aggressive monetary and fiscal policy actions - both traditional and non-traditional - must be undertaken to ensure that the inevitable stag-deflation of 2009 does not persist into 2010 and beyond. So far, the U.S. response appears to be more aggressive than that of the euro zone, as the European Central Bank falls behind the curve on interest rates and the EU's fiscal stance remains weak.

Given the severity of this economic and financial crisis, financial markets will not mend for a while. The downside risks to the prices of a wide variety of risky assets (equities, corporate bonds, commodities, housing and emerging-market asset classes) will remain until there are true signs - toward the end of 2009 - that the global economy may recover in 2010.

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