FT.com / Columnists / Wolfgang Munchau - The good, the bad and the ugly scenarios

FT.com / Columnists / Wolfgang Munchau - The good, the bad and the ugly scenarios

The good, the bad and the ugly scenarios
By Wolfgang Munchau

Published: January 2 2007 18:48 | Last updated: January 2 2007 18:48

The past 10 years have proved the economic optimists right. I would expect the pessimists to fare better in the next 10 years. The question is: will the cynics get lucky in 2007?

There is a widespread consensus that the world economy is facing a mid-cycle slowdown in 2007. Rather than trying to make a single forecast for the year, it is probably best to look at three underlying scenarios for the US economy – still the global trendsetter whatever the fashionable decoupling theories may say. The three scenarios are: a soft landing; a hard landing with growth of between 0 and 1 per cent; or recession.

The soft landing is the mainstream prediction. It is endorsed by the US Federal Reserve, countless other central banks around the globe and the vast majority of private and public sector forecasters. No one should bet against it lightly. A soft landing would see US growth falling to an annual rate of about 2 per cent.

This is the scenario on which the world’s central banks and governments have based their current policies. If it prevails, we should expect global economic growth to continue at a respectable pace this year. The eurozone and Japan would be able to grow at rates close to trend – about 2 per cent in real terms. The world’s three largest economies would be perfectly synchronised.

This scenario assumes that the slowdown in the US housing market will have a limited impact on the US domestic economy. Calculating the effect of sluggish house prices on personal consumption is hard at the best of times. When that recession is unusually sharp, when the domestic savings rate is below zero and when there is additional uncertainty about the long-term effect of the boom in mortgage equity withdrawals, the spill-over becomes impossible to forecast.

If the slowdown in house prices is worse than expected, or if the spill-over from property to the rest of the economy is bigger, then we enter scenarios two or three. I would personally consider scenario two – a hard landing short of a recession – to be the most probable.

The most recent data suggests that we have not yet reached the bottom of the property market recession. There has been some conflicting information. Building permits have fallen significantly for two consecutive months, while new homes sales have gone up most recently. But the confidence index of the National Association of Home Builders is near an all-time low (see chart). The widely followed ISM index shows that manufacturing has entered into a recession. If unemployment were to rise as a result of the slowdown in housing and manufacturing, then it would be rational for consumers to increase their savings rates again, just as it was rational to reduce them during the previous upswing.

Scenario two would have important implications for monetary policy. The Fed would start to ease monetary policy in 2007, but may remain constrained by the persistently robust core inflation rates. The European Central Bank has also fully bought into the soft-landing scenario. If the ECB continues to tighten policy during the first quarter, it might end up with an excessively tight policy stance, which would almost certainly have a negative impact on eurozone growth. The Bank of Japan would have been in a similar predicament if it had started, prematurely, to raise interest rates in December.

Under scenario three, US economic activity would decline for a sustained period, usually defined in America as two consecutive quarters or more. It takes a brave forecaster to make such a call. One of the few is Nouriel Roubini, chairman of RGE Monitor, the economics information website, who has been sticking his neck out since July. Recessions happen from time to time, but they are rarely predicted. What would it take to turn the present downswing into a recession? The spillover from the housing market to the rest of the economy would have to be much bigger. Consumers would have to build up savings much faster. There may be financial distress among mortgage lenders. We have already seen some warning signs in the sub-prime mortgage market. If some large hedge funds were to bet their entire wealth – or more – on the soft-landing scenario, the financial system itself could come under strain. While it is relatively easy to construe recession scenarios, it is impossible to predict that any of these events will actually happen this year.

None of the scenarios envisage the world decoupling from the US. In the first, benign scenario, the US, Japan and the eurozone would grow by about 2 per cent. In scenario three, several mechanisms would carry the shock of a US recession around the world economy – a fall in global equity prices, a falling dollar and a fall the profits of multinational companies. There is no way that the eurozone and Japan could withstand such a shock and manage to grow by 2 per cent under such circumstances.

The real problem with scenario three is not the short-term economic effect, undesirable as it may be, but the political fallout. The bigger the downturn, the bigger the anti-globalisation backlash. Depending on exchange rate movements, we could see an outbreak of protectionist pressures in the US or Europe, or both.

US trade relations with China may deteriorate under the Democrat-led Congress. There has also been a swing to the protectionist left in Europe. In France, the two leading contenders for this year’s presidential elections are both exploiting popular fears of globalisation in their campaigns. A consensus has sadly emerged among French intellectuals that it is the job of the government to protect the people against globalisation. In Germany, too, there has been a notable swing to the left in the traditionally conservative CDU, the party of Angela Merkel, the German chancellor.

My own gut feeling is that protectionist pressures in Europe will rise dramatically when the euro’s exchange rate hits $1.40. The trouble is that under scenario three, an exchange rate of $1.40 is highly probable. This is one important reason why the conflagration of a recession and a rising anti-globalisation sentiment could do lasting damage to the world economy. If the optimists are right, again, we can avoid such a confrontation; the world can look forward to another good year. We may still be able to avoid it under scenario two, but probably not under scenario three – the one that few dare to forecast and that all fear the most.

Copyright The Financial Times Limited 2007