Thursday, September 29, 2011

Bad policy decisions could push the US into a 'lost decade'

Bad policy decisions could push the US into a 'lost decade' and put the eurozone into recession, warns IMF
Philip Aldrick, Economics Editor
20 Sep 2011

Cutting its global forecasts sharply, the world's economic watchdog said the global economy had entered a "dangerous new phase" and urged policymakers to tread a careful line between aggressive deficit reduction and growth. Central banks should stand ready to restart the printing presses to aid the recovery, it added in its twice-yearly World Economic Outlook.

"The recovery has weakened considerably. Strong policies are needed to improve the outlook and reduce the risks," Olivier Blanchard, the IMF's chief economist, said. "Markets have clearly become more sceptical about the ability of many countries to stabilise their public debt. Fear of the unknown is high."

Europe's leaders came under scathing criticism over the escalating debt crisis. "Europe must get its act together," Mr Blanchard said, adding that there was "widespread perception policymakers are one step behind the action". Urging a speedy implementation of the July 21 agreement to bolster the single currency area's €440bn bail-out fund, he said: "The eurozone is a major source of worry. This is a call to arms."

The warning came as Portugal's prime minister Pedro Passos Coelho said his country may need fresh aid if Greek defaults.

"In the case of a default of Greece, this aid could be necessary and it is important that our partners are convinced that it is worth helping Portugal, and in this case, Ireland, too," he said.

Weaker than expected growth in the US, the persistence of Europe's "sovereign debt and banking sector problems", high oil prices and the Japanese tsunami conspired to dramatically worsen the outlook since June. Global growth for this year has been revised down from 4.5pc to 4pc in the past three months – led by a one percentage point downward revision in US growth for this year to 1.5pc.

The UK was downgraded sharply, from June's 1.5pc prediction to just 1.1pc for this year and from 2.3pc to 1.6pc for 2012. Canada and much of Europe saw even bigger downgrades.

However, the forecasts were based on the assumption that President Barack Obama's $447bn jobs plan is approved and the eurozone crisis is resolved with no more than the small voluntary default on Greek debt already agreed. A worse outcome is a "distinct possibility", the IMF warned.

Under the IMF's "downside scenario" – a "shock" to European banks' capital, higher bad debts in the US and Asia, and slower US growth – "the US and the euro area would fall back into recession, with output in 2012 more than 3pc below projections".

Such a devastating hit would drag the UK back into recession, as the US and the Euro area are Britain's major trading partners. "It would be very difficult to see why the UK should be exempt from that as we don't have any ammunition to withstand it," J├╝rgen Michels, European economist at Citi, said.

Departing from its previous deficit-cutting mantra, the IMF stressed that countries must be careful not to choke off the recovery by cutting too hard too fast. Even the UK should consider back-ending George Osborne's £110bn austerity plan, by delaying spending cuts, if growth turns out to be "substantially" less than the 1.1pc expected this year, the IMF said.

"Countries with more fiscal space could choose a more back-loaded profile should the macroeconomic environment deteriorate substantially," it said. "In the systemically-important advanced economies, activity and confidence are still fragile. If fiscal consolidation were suddenly stepped up further at the expense of the disposable income of people with a high marginal propensity to consume, these economies could be thrown back into stagnation."

In the US, the IMF warned, if income tax relief and unemployment benefit are not extended and if Capitol Hill cannot agree a longer-term strategy for dealing with the $14.3 trillion public debt, "the result could be a lost decade for growth".

In Europe, policymakers must deal with the mushrooming banking crisis by "injecting new capital and restructuring weak but viable banks while closing others". If banks cannot raise funds privately, politicians "must make the case for injecting public funds". Allowing banks time to shrink their loan books would only further damage the recovery by prolonging the credit crunch, Mr Blanchard warned.

To keep the global ship afloat, the IMF called on central banks – particularly the Federal Reserve in the US – to restart money printing and keep interest rates low for longer. "Unconventional policies should continue until there is a durable reduction in financial stress," it said.

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