A long recession

Managing the global financial crisis and economic downturn
Chief Economist, OECD

Many OECD economies are in or are on the verge of a protracted recession of a magnitude not experienced since the early 1980s. As a result, the number of unemployed in the OECD area could rise by 8 million over the next two years. At the same time, inflation will abate in all OECD countries and some even face a risk, albeit small, of deflation.

This Economic Outlook represents a substantial downward revision from just a few months ago: many of the downside risks previously identified have materialised. The financial turmoil that erupted in the United States around mid-2007 has broadened to include non-bank financial institutions and rapidly spread to the rest of the world. Following the collapse of Lehman Brothers in mid-September, a generalised loss of confidence between financial institutions triggered reactions akin to a ‘blackout’ in global financial markets. Spreads in credit and bond markets surged to very high levels, paralysing credit and money markets. Prompt and massive policy action to restore confidence and provide liquidity appears to have successfully limited the period of panic, but the need for financial institutions to operate with less leverage and to repair their balance sheets remains. This process of adjustment will take time and impair the flow of credit, and is the key factor weighing on activity going forward.

I would like to emphasise upfront that the uncertainties associated with this OECD Economic Outlook are exceptionally large, especially those related to the assumptions regarding the speed at which the financial market crisis – the prime driver of the downturn – is overcome. Specifically, we assume that the extreme financial stress since mid-September will be short-lived, but will be followed by an extended period of financial headwinds through late 2009, with a gradual normalisation thereafter. On this basis, as well as our usual assumptions that exchange rates and the oil price are maintained at their recent levels, the main features of the economic outlook are the following:

  • US output declines through the first half of next year, then gradually picks up as the effects of the credit squeeze abate, the housing downturn bottoms out and monetary policy stimulus takes hold. The recovery, however, is likely to be languid, as consumption is held back by the large losses in households’ wealth. Inflation eases significantly, as the recent declines in commodity prices filter through the economy and as economic slack exerts downward pressure on prices.
  • Euro area activity also falls over the next six months, as tighter financial conditions, subdued income growth and negative wealth effects from lower equity and house prices damp consumption and investment. Economic activity then gradually recovers as monetary easing gains traction and the effects of global financial market turbulence dissipate. Inflation will ease considerably, to reach a level by early next year that is consistent with the ECB’s inflation target.
  • Japan has not been at the epicentre of the financial crisis, but after a brief growth spurt in early 2009 due to fiscal stimulus, output is set to stagnate over the second half of 2009, as the global economic downturn and the recent appreciation of the yen curtails external demand. With persistent economic slack and anaemic wage growth, deflation may return by mid-2009.
  • Other OECD countries where the economic downturn will be severe include Hungary, Iceland, Ireland, Luxembourg, Spain, Turkey and the United Kingdom. These economies are most directly affected by the financial crisis, which in some cases has exposed other vulnerabilities, or by severe housing downturns.

The major non-OECD countries are in many cases also slowing due to the combined effect of more difficult international credit conditions, earlier policy tightening, income losses due to lower commodity prices, and weaker demand from OECD countries. However the slowdown in growth is from high levels.

The financial crisis is not the only development shaping the projections. Other important drivers include ongoing adjustments in housing markets, which in many European economies, based on past housing cycles, still have a long way to go. Moreover, they come on top of negative wealth effects from the steep fall in equity prices. Partially offsetting these contractionary forces is the sizeable monetary stimulus, including non-traditional means, recently introduced and built into the projections, and the boost to real household incomes due to sharply lower commodity prices.

The projections carry both upside and downside risks, but they are skewed to the negative side for 2009. The dominant downside risks include a longer than assumed period before financial conditions normalise, further failures of financial institutions, and the possibility that emerging market economies will be hit harder by the downturn in global trade and foreign investor risk re-assessments. The upside risks are less significant, but adjustment in bank balance sheets may advance more quickly in response to the comprehensive and unprecedented policy measures introduced. Also governments may introduce policy stimulus over and above that factored into the projections. For 2010, widespread risks remain, but these are more equally distributed, reflecting the possibility of an earlier economic recovery.

Against the backdrop of a deep economic downturn, additional macroeconomic stimulus is needed. In normal times, monetary rather than fiscal policy would be the instrument of choice for macroeconomic stabilisation. But these are not normal times. Current conditions of extreme financial stress have weakened the monetary transmission mechanism. Moreover, in some countries the scope for further reductions in policy rates is limited. In this unusual situation, fiscal policy stimulus over and above the support provided through automatic stabilisers has an important role to play.

Fiscal stimulus packages, however, need to be evaluated on a case-by-case basis in those countries where room for budgetary manoeuvre exists. It is vital that any discretionary action be timely and temporary and designed to ensure maximum effectiveness. Infrastructure investment is often mentioned as a desirable instrument for stimulus. While it will boost both supply and demand, provided the investments are well chosen, infrastructure investment typically takes a long time to be brought on stream and, once begun, is difficult to wind down in line with a recovery in activity. Alternatives, such as tax cuts or transfer payments aimed at credit-constrained, poorer households, might prove more effective in boosting demand.

Once there are clear signs of a recovery taking hold, it will be necessary to begin promptly to unwind the macroeconomic stimulus in place to prevent inflationary pressures from gaining a foothold. At the same time, with high public debt in many OECD economies, it will be equally important that a credible fiscal framework is in place to ensure long-run public finance sustainability, especially in the face of spending pressures associated with population ageing.

Although the concerted efforts taken to stabilise financial markets appear to be working, governments must be prepared to modify them in light of evidence on their effectiveness. They must also be ready to expand them if the need arises. Such support should be limited to sectors or firms that are of systemic importance. Moreover, the now global scale of the financial crisis underscores more than before the 3 necessity for international co-ordination to avoid measures that distort competition or effectively shift the problem to other countries. It is equally important that exceptional measures are designed and implemented in ways that allow their orderly removal as conditions in financial markets normalise. Individual countries may find it difficult, acting on their own, to unwind the exceptional measures that are currently needed, again pointing to the need for co-operation. At the same time, steps that encourage mortgage loan workout solutions merit consideration to reduce foreclosures which are costly to all parties involved and thereby lower the risk of further aggravating conditions in financial markets.

Reform of financial market supervision and regulation is clearly necessary to build a more resilient financial system. Here, our efforts need to focus on identifying the market imperfections that gave rise to the incentives for excess risk taking and high leverage, as well as the regulatory failures that together caused this unprecedented global financial crisis. This will involve, inter alia, strengthening and streamlining the prudential oversight of financial and capital markets, and plugging the gaps and inconsistencies in regulatory regimes. It also requires enhancing transparency of market instruments, transactions, and the governance rules that determine corporate incentives and decisions. The tendency for pro-cyclicality of financial markets and macroeconomic policies also has to be corrected and ideally reversed.

The recent G20 meeting initiated an action plan and a process for addressing many of these issues. I welcome, in particular, the commitment of the G20 to continue furthering multilateral co-ordination to overcome the immediate problems facing the global economy and to strengthen the international financial architecture over the medium term. For its part, the OECD will support the global concerted effort to relaunch the world economy. In this context, the OECD drawing on its structural analysis expertise will identify policy reforms that support the functioning and performance of financial markets and policies that promote higher growth.

The reform agenda is comprehensive and the many complex issues involved will take time to address. It will be important, therefore, to remain focussed on the objective of strengthening the global financial architecture. While substantial government intervention to support financial markets has proven necessary because of their systemic importance, back-pedalling on open and competitive markets would prove very costly, and pressures to move in this direction must therefore be resisted. Indeed, the experience of the past year has highlighted the importance of continuing with structural reforms that boost growth and strengthen the resilience of our economies to better withstand and absorb shocks. In this respect, a quick, successful completion of the Doha Round would contribute to supporting world growth, boost confidence, and demonstrate a commitment to competitive and open markets.

©OECD Observer No 270-271 December 2008-January 2009

Read interview with OECD Chief Economist Klaus Schmidt-Hebbel  (full link: http://oecdobserver.org/news/archivestory.php/aid/2754/

UPDATE January 2009: see OECD's strategic response to the economic crisis. (Full link: http://www.oecd.org/general/42061463.pdf)

Links last updated 11 Feb 2019

Economic data

GDP growth: -1.8% Q1 2020/Q4 2019
Consumer price inflation: 0.9% Apr 2020 annual
Trade (G20): -4.3% exp, -3.9% imp, Q1 2020/Q4 2019
Unemployment: 8.4% Apr 2020
Last update: 9 July 2020

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