>GLOBAL ECONOMIC OUTLOOK: Overview — Economic Divergence and Financial Repression

We continue to expect a sizeable slowdown in global economic growth in 2012, with renewed recession in the euro area, growth of roughly 2% in the US, and slowing – albeit still strong – growth in Asia1. Within that broad outlook, we again make more forecast downgrades than upgrades, and we expect that overall global growth will slow from 3.0% in 2011 to 2.3% in 2012 (down from 2.5% in our previous forecast).


We are again cutting our 2012-13 growth forecasts for a range of European economies, with GDP downgrades for the euro area, UK, Sweden, Switzerland, the Czech Republic, Hungary and Norway2. We now expect that euro area real GDP will fall by 1.5% this year and will fall by 0.4% in 2013 (prior forecasts were minus 1.2% and minus 0.2%, respectively). In the euro area, these new downgrades chiefly reflect announced or expected extra fiscal tightening in Italy, Spain and the Netherlands, plus the continued drag from tight financial conditions and the weak banking system. Other European economies are being hit by adverse spillovers from the probable EMU recession and, especially in the UK, internal drag from high private debts. We do not expect that euro area real GDP will regain its prerecession peak until late 2016. Going the other way, the only significant upgrade is Russia, for which we are raising our 2012 GDP forecast to 3.5% from 2.5%.


Our forecasts imply a further marked rise in the GDP growth differentials between the US and Euro Area, with the gap in terms of YoY GDP growth likely to reach 3 ½%-4% in coming quarters, the highest in recent decades – even above the wide late 90s divergence. While the euro area probably already slipped into recession in the final quarter of 2011, we continue to expect sustained economic growth near 2% this year for the US despite unsettled financial conditions. Indeed, for the US, gradual improvement in the labor market and the resilience of activity in the face of negative shocks have introduced upside possibilities. We expect housing investment to rise this year, after six straight years of decline, and we have raised slightly our forecast for payroll employment growth to just shy of 2 million jobs in 2012 with unemployment now expected to dip to 8¼% by year end




Note that our forecast of continued US growth is relatively subdued compared to previous cyclical recoveries. It is consistent with the “Reinhart-Rogoff” (R-R) norm for countries in a post-crisis deleveraging phase, which is not for permanent stagnation, but a deep recession and modest recovery that leaves the actual path of real GDP about 10% below a simple extrapolation of the rising pre-crisis path. By contrast, the euro area and UK are likely to underperform the R-R pattern, mainly because of early fiscal tightening, EMU financial strains and the weaker condition of European banks. Of course, the durability of this wide growth gap rests in part on the US’s ability and willingness to defer significant fiscal consolidation near term, while private sector deleveraging is underway. There are risks that US fiscal policy may turn markedly more contractionary in 2013, depending on the outcome of the late-2012 Presidential election and the evolution of Treasury yields.


We continue to expect a long period of ultra-low policy interest rates across the advanced economies. The ECB is likely to cut its main policy rate to 0.5% by midyear and, flooding markets with extra liquidity, this probably will push overnight rates well below 0.5%. For the US, the Fed has signaled that it will pursue all means to support financial conditions with the immediate focus on communications strategies. New support for the mortgage market is possible in coming months but we think full-blown QE would require new signs that the outlook is deteriorating again (which is not our base case). At this stage, we tentatively forecast the first rate hike to come in 2014 for the US, 2015 for the UK and 2016 for the euro area: but the key point for all three is that withdrawal of monetary stimulus is distant.


We also expect the policy response to the current public and private debt crises will include some elements of financial repression, especially in Europe. Financial repression refers to various measures that seek to constrain the financial sector, in particular ‘Financial repression occurs when governments implement policies to channel to themselves funds that in a deregulated market environment would go elsewhere. Policies include directed lending to the government by captive domestic audiences (such as pension funds or domestic banks), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between government and banks, either explicitly through public ownership of some of the banks or through heavy “moral suasion.” Financial repression is also sometimes associated with relatively high reserve requirements (or liquidity requirements), securities transaction taxes, prohibition of gold purchases, or the placement of significant amounts of government debt that is
nonmarketable’.


Financial repression was the norm for many advanced economies and emerging markets during the post World War II decades, but diminished in significance in advanced economies with the financial deregulation and liberalization initiated by Thatcher and Reagan. It continues to be a routine instrument of economic policy and government funding tool in many emerging markets and developing countries. A key factor is the desire of governments to secure for themselves relatively cheap and stable funding. In addition, financial repression has been consistent with the general political preference for regulation and quantity restrictions as tools of economic management, a desire to reduce the riskiness of banks and to save consumers from the perils of over-indebtedness, plus the aim of extracting political advantage for the government as the arbiter of credit and financial allocation. And in many cases, the captive investor base then had to accept substantial erosion of the real value of their government debt holdings through negative real interest rates caused by controlled nominal interest rates and high inflation.


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