Standard Life Investments

Published Article

Professional Adviser - November 2012


The Darkest hour ………

The IMF recently adjudged that the global economy was at heightened risk of falling back into recession. It identified major fault-lines in the US authorities’ failure to address its fiscal challenges, the European authorities’ failure to reach a resolution to its financial and economic woes and the dangers surrounding the Chinese economic slowdown. Just how real are these areas of stress, and do they pose a threat to the global economy?

Pressure points

The US certainly faces a challenge in what to do about the impending ‘fiscal cliff’ around the turn of the year when a number of tax rises and spending cuts are scheduled to take effect. The Congressional Budget Office (CBO) estimate that the size of the fiscal changes would be around $800bn in the 2013 calendar year, or around 5% of GDP.

That 5%, however, does not represent the likely hit to the economy – that will depend upon assumptions about the appropriate multipliers to apply. Without getting into specifics, it is generally accepted that changes in spending will have a multiplier of greater than one, as they directly affect spending levels and, therefore, will have a further feed-through to incomes. Changes in taxation, in contrast, don’t have a direct impact on spending, and hence have a multiplier of less than one. With tax changes representing 75% to 80% of the ‘cliff’, the CBO estimate a multiplier of around 0.8%, and a likely full year impact of 4% of GDP.

Even then it is not inevitable that the US would tip back into recession. Yes 4% would represent a sharp fiscal drag, but it says nothing of the positive push coming from monetary policy. Credit is beginning to flow again, and the housing market has been a major beneficiary. The gradual pick up in house prices has contributed to a $700bn improvement in household wealth over the first half of this year. Whilst not ‘ready’ money, it would help to offset the fiscal drag.

That will especially be so if the ‘cliff’ turns out to be a lot lower than the aggregate numbers suggest. The general feeling is that a compromise will see the hit to GDP in the range 1-1½%, which is unlikely to derail the recovery. Nevertheless, the IMF is right to highlight the lack of progress towards a credible medium-term solution to the US debt situation. While the near-term ‘cliff’ looks surmountable, pressures are building further out.

The IMF’s concern about Europe centres on the continuing financial crisis and the severe austerity response. It’s true that the region’s financial system is far from fully functional despite many attempted initiatives. Nevertheless, the ECB’s Outright Monetary Transactions (OMT) initiative appears to have dampened fears of another near-term crisis, whilst the European Stability Mechanism (ESM) is now up and running. Although neither has been put to the test as yet, their presence seems to have discouraged over-aggressive speculation. Both Spanish and Italian bond yields have fallen sharply, and even a further credit downgrade of the former was insufficient to lure large-scale sellers – the greater the downgrade, the greater the likelihood of a bond-buying programme being triggered. So, IMF fears about near-term risks look overdone.

The IMF’s concern about austerity measures surrounds just what fiscal multiplier applies, and the potential social and political tensions that the measures may generate. IMF research suggests that the multiplier has become greater in the post-2008 world, although it is unclear why this should be so, and whether other factors are at play. Certainly, the CBO in the US believes that the fiscal multiplier surrounding the fiscal cliff is around 0.8. The IMF are perhaps overly gloomy in their assessment.

However, it is not being overly gloomy about the risks that social and political tensions could jeopardise deficit reduction plans. The substantial rise in unemployment in many countries and the sharp hit to growth is making progress difficult. The IMF chief Christine Lagarde hazarded that Greece should be given an extra two years to achieve the necessary deficit reduction. That would mean a higher interest payment burden, but better economic performance would partially offset that, and should lessen tensions.

The third pressure point was the cooling of the major developing countries’ economies, particularly China, the world’s second largest economy. Back in 2008 these economies held up much better than the developed industrial economies. China, then, launched a substantial stimulus package to support the economy. It succeeded, but at the cost of rising inflation, bad loans and overcapacity in many sectors. The last two years have seen the authorities battling to contain inflationary pressures. That battle having been won, a measure of policy easing subsequently followed.

Despite some fears that the economic slowdown in China was gaining momentum, the worst does appear to be over. GDP growth has picked up through 2012, from 1.5% in Q1 to 2.0% in Q2 and 2.2% in Q3. That latter figure probably overstates the pace of expansion (over 9.0% annualised), but it does question whether cooling growth in China is really a threat to the global economy.


The IMF was right to identify these potential pressure points for the global economy, and to alert the various decision-makers of the consequences of failure to meet these challenges. But perhaps it was a bit melodramatic to assert that ‘the risks of a serious global slowdown were alarmingly high’. A key difference from 2008 is that global trade has held up much better, with little of the disruption to trade finance that hit trade then. Further, apart from government finances, the degree of leverage has been greatly reduced. Where risks do lie are in the vastly reduced policy options should a serious slowdown occur.

Douglas Roberts, Senior International Economist, Standard Life Investments

First Published in Investment Week on 1st November 2012