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Updated: October 2, 2011 22:15 IST

Global economy ‘in a dangerous new phase'

C. R. L. NARASIMHAN
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A general view of the Bundestag (German Parliament) at its session on
eurozone rescue in Berlin last week.
AP A general view of the Bundestag (German Parliament) at its session on eurozone rescue in Berlin last week.

The pressing issue has been the Europe's sovereign debt crisis

In its recent biannual publication, World Economic Outlook, the International Monetary Fund warned that the world economy was “in a dangerous new phase.” That warning was issued just days before the annual IMF-World Bank meeting of finance ministers and central bank governors in Washington.

With the World Bank and other international agencies more or less endorsing the IMF's view, it was hoped that the high-level meeting (on September 24 and 25) would come out with a more tangible statement of intent if not a credible action plan to tackle the euro debt crisis and other pressing concerns than what it eventually managed.

The most pressing issue has been the sovereign debt crisis in Europe. Despite considerable pressure from other countries, leading European economic powers failed to reach an agreement on a specific bailout plan that would stave off a default by one or more eurozone countries. A press release at the end of the IMF-World Bank meeting merely asserted that the eurozone along with other member nations was committed to fixing the problem.

Such inaction can be costly. More than anything else it shows a lack of political will without which no solution to the euro crisis is possible. On their part, the richer countries in the eurozone, notably Germany, have argued that strong political opposition at home has made their task of funding a rescue plan extremely difficult. Already the idea of “throwing hard earned money for the benefit of profligate neighbours'' has cost the ruling German coalition dear in some recent elections.

In the last fortnight, financial markets around the world, which had witnessed a sell-off, were bracing for a major meltdown. If that happens, the prospects for a recession will increase. Granted that the eurozone's sovereign debt crisis has assumed menacing proportions, is the panic reaction of the stock markets justified?

Tail wagging the dog?

Or is it because the markets are aware that there are other significant risks? Such as those emerging from the U.S. where apparently investors have lost faith in the Federal Reserve's ability to stave off a recession?

Even in more normal times the financial markets are not a good barometer of economic health. Certainly in the present situation, the biggest danger is of the tail wagging the dog, with the markets tipping the economies into recession. Even companies with strong balance sheets hesitate to invest amidst all the market turmoil. Consumers are loathe to spend for the same reason.

Around the world, stock markets are showing signs of distress. German and French stock markets have shed a third of their value since their peaks this year while U.K. and U.S. shares have lost a fifth. Normally such steep declines are associated with recessions.

Is there a way out of this gloom? The euro debt crisis has major ramifications and downside risks.

A worst case scenario will unfurl as under:

Investors will start worrying as countries, besides Greece, are pushed to the edge. Already Italy and even France have come under stress. The maximum adverse impact will be on the banking system.

If investors start taking their money out, the banks will react by deleveraging and reducing their exposures as quickly as they can by selling sovereign bonds. They will also be less eager to lend to the private sector. Such acts can lead to tensions in the U.S., a potential recession in Europe and possibly a global recession.

The worst case scenario may not come to pass however. A much more hopeful scenario is possible even if Greece defaults. The Greek government pulls out of the eurozone and devalues its currency to regain competitiveness. Eurozone banks holding Greek debt suffer, but the EU and strong countries such as Germany help in recapitalising banks. The financial system gets back some stability. Funds not spent on Greece are used to bolster other countries, including Spain and Italy. Germany leads the eurozone's drive towards greater fiscal unity. Markets stabilise and the world economy is saved from a double dip recession.

Europe is finally taking steps to calm its financial markets and prevent its economy and that of the world from tipping over. The European Financial Stability Facility, the main weapon in the armoury, is sought to be expanded on a massive scale. Its corpus is $440 billion and at the moment efforts are on to use it to derive the maximum benefit. Leading European countries are trying to overcome domestic opposition to their efforts to support bailouts. Greece and other countries, which have come under stress, are trying to push through unpalatable austerity measures.

Even as the world is glued to the sovereign debt crisis, other problem areas in the global economy cannot be ignored.

Needless to add, these compound the gravity of the sovereign debt crisis. Perhaps the biggest cause for worry outside Europe is American politics.

There is plenty of rancor still in the political debates in the U.S., which unlike in the past is in no position to provide leadership to a crisis-ridden global economy. Only a rational and determined U.S. policy can steady the nerves in the global economy. Recent happenings on Capitol Hill and a looming presidential election that promises to be bitter do not offer much hope of that.

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