Thursday, August 10, 2006

The world must prepare for America’s recession

The world must prepare for America’s recession
By Nouriel Roubini
Copyright The Financial Times Limited 2006
Published: August 9 2006 19:49 | Last updated: August 9 2006 19:49

The odds that the US will slide into recession have risen since last month from 50 per cent to 70 per cent by my estimates. The US Federal Reserve took its foot off the brake on the economy this week when it took a pause in tightening monetary policy for the first time after 17 successive interest rate rises in spite of rising inflation. But it is too late. The Fed might have been hoping for a soft landing for the economy but instead it faces recession. The implications will be felt globally. The rest of the world will not decouple from the US economic train, as some analysts predict. When the US sneezes, the rest of the world still gets the cold.

The US recession will be triggered by three unstoppable forces: the housing slowdown; high oil prices; and higher interest rates. The US consumer, already burdened with high debt and falling real wages, will be hard hit by these shocks.

The effects of the housing slump will be more severe than those following the technology bubble implosion in 2001. The negative wealth effect on consumption of falling housing prices – and the related sharp fall in home equity withdrawal – are also larger than the wealth effects of the collapse of tech stocks in 2000. Property, unlike the tech stocks, is a significant part of household wealth. Finally, about 30 per cent of US employment in the latest recovery has been related to housing.

The second-quarter US gross domestic product figures are an ominous signal: consumption of durable goods are already falling; residential investment is in free fall; and inventories are up as still-high production faces falling sales growth. Higher investment in equipment and software, expected to offset lower spending on housing and consumption, is instead falling.

As consumer demand is slowing, profit-rich companies are not finding good investment opportunities to increase capacity, and are thus returning such profits to shareholders in an unprecedented buy-back bonanza.

In spite of still-rising inflation, the Fed will cut interest rates in the autumn or winter in recognition of a looming recession. But its looser stance will not prevent that recession, for the same reasons the pause applied by the Fed in June 2000 failed to stave off the 2001 recession.

Once the housing and consumption slump starts, demand for durable goods becomes interest-rate insensitive. Indeed, the recent housing bubble has led to a glut of housing stock, consumer durables and lingering excess capital capacity in the rest of the economy. Thus, as we saw in 2000-01, the housing and consumption slump will dominate any monetary easing effort by the Fed.

Will the rest of the world decouple from the US recession? The market consensus now sees a divergence in patterns of global growth, between the US on the one hand and Europe and Asia on the other. But this is only wishful thinking. The world will sharply slow down once the US slumps.

Trade links are one important reason why the rest of the world will be affected. But the oil shock will have the same stagflationary effect on the eurozone and Asia as on the US. Monetary policy is being tightened in Japan, eurozone and emerging markets. Global chief executives’ confidence is sharply down and rising geo-strategic shocks are hitting consumer and business confidence.

The fall of the dollar amid the US slowdown will lead to deflationary forces in Europe and Asia, and room for monetary and fiscal easing is much more limited now than in 2001, when the Group of Seven industrialised countries slashed policy rates and eased fiscal policy. There are now serious limits to monetary easing as global inflation is up; and fiscal policy cannot be eased either as almost all G7 countries face serious fiscal imbalances.

Implications for financial markets of this global slowdown will be serious; although we may see a rally in the wake of the Fed’s pause and later easing, one can expect a subsequent slump in the US equity market. When the reality of a recession sinks in, global equity markets will fall with currencies and bonds in emerging markets, especially those with large external deficits. Finally, the dollar risks a disorderly fall as the US current account deficit becomes unsustainable. Central banks and private investors are now concerned about losses on holdings of dollar assets. Thus, US consumer “burn-out” may be followed by the flight of foreign investment amid rising trade and protectionist pressures.

The writer, chairman of Roubini Global Economics, is professor of economics at the Stern School of Business, New York University


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