Joint Economic Forecast Spring 2009

Members of the Project team "Joint Economic Forecast":

ifo Institut für Wirtschaftsforschung an der Universität München
in collaboration with:
KOF Konjunkturforschungsstelle der ETH Zürich

Institut für Weltwirtschaft an der Universität Kiel

Institut für Wirtschaftsforschung Halle
in collaboration with:
Institut für Makroökonomie und Konjunkturforschung in der Hans-Böckler-Stiftung und
Österreichisches Institut für Wirtschaftsforschung

Rheinisch-Westfälisches Institut für Wirtschaftsforschung
medium-term forecast in collaboration with:
Institut für Höhere Studien Wien

Summary

In spring 2009 the world economy is in the deepest recession since the Great Depression. The downturn intensified in the autumn fall into an utter collapse that rapidly affected almost all countries of the world. Extensive governmental programmes for the support of the financial sector and for reviving the economy have not been able to restore confidence in future economic developments.

Indications of a cooling of world economic activity were already evident in 2007. At the beginning of last year, the economic weakening was still largely limited to the US. Thereafter, the downturn began also in the other industrialised countries. The dramatic sharpening of the situation on the financial markets in September 2008 that culminated in the bankruptcy of the investment bank Lehman Brothers touched off a drastic downturn in output that also affected the newly industrialised countries, which until then had quite robust economies. The intensity of the downturn in the winter half year 2008/09 is also because output declined almost everywhere in the world simultaneously. Among the industrialised countries, especially Japan and Germany were hard hit -economies with a high export dependency.

Clear indications of an end of the downturn are still not evident even if some indicators suggest that the decline in output and demand will slow in the coming months. According to the members of the forecast group, the downward movement will not bottom out until the winter half year 2009/2010. The subsequent economic recovery will have little dynamism at the start. A key problem remains the continuing uncertainty in the financial markets that is based particularly on solvency of individual banks and that has slowed money flows perceptibly in the economy. This forecast assumes that the situation in the financial markets will remain unstable for a time but that another dramatic worsening of the situation will not occur. Some important countries will also have a real-estate depression whose end is not yet foreseeable and which will increase the write-off requirements of the banks. According to past experience, recessions that are accompanied by real-estate and bank crises are deeper and more difficult to overcome than recessions in which such problems are not prominent.

All in all, the forecast group expects that output in the industrialised countries will decline drastically by 4.2 percent 2009 with a slight decline following in 2010. Unemployment will increase massively, and the output gap will be considerable at the end of the forecast period. This might result in a falling inflation trend. On the whole, the economies of the newly industrialised countries will only shrink slightly in 2009. This, however, is above all the result of the continuing albeit weaker expansion in the two large economies of China and India. In the remaining newly industrialised countries in Asia and Latin America as well as in Russia, GDP will clearly decline. For 2010 a moderate recovery of economic activity is expected in most countries. World output is expected to fall strongly in 2009. The development of world trade is even more dramatic for which a decline of 15 percent is expected. In the coming year global GDP might increase again slightly. In a historical comparison, however, the rate of ca. 0.5 percent is very low, and also world trade will increase very hesitantly at the start.

In spring 2009 the German economy is in the deepest recession since the foundation of the Federal Republic. As a result of the worsening of the international financial crisis last autumn, the global downturn intensified dramatically. Worldwide demand for capital goods collapsed, and this affected the export industry, the driving force behind the last upswing in Germany, extremely hard. Since German industry has specialised in investment goods and consumer durables, it profited over-proportionally from the economic expansion of its trading partners. Now, however, it has been particularly affected because demand for these products has decreased to a very large extent in the course of the world recession.

In the meantime the crisis has spread to the whole German economy. On basis of the present indicators the forecast group expect that the downward dynamic will weaken but they see no stabilisation before mid-2010.

Already in 2008 total output shrank - after an unusually good initial quarter - at an increasing pace, with the braking forces from exports becoming more and more apparent after mid-year. After a declining trend in foreign orders for German industry already in the first half of the year, from September on they plunged downward. As a result production in manufacturing collapsed. In the first two months of 2009 the downward movement became even stronger. Both the speed and the extent of the decline are unprecedented in the history of the Federal Republic.

For the first quarter of 2009 leading indicators confirm that the decline in economic output accelerated. Incoming orders and production in manufacturing declined again dramatically in the first two months and the business situation in trade and industry received increasingly poorer assessments.

In the coming months the difficult world economic environment and the leading indicators point to a continuing decline in production activity. To be sure, the dynamics of the decline may have weakened; the decline in orders slowed somewhat in February and the Ifo business expectations have improved slightly since December 2008. Nevertheless, the basic economic tendency is still pointed downwards. As a result of the continuingly desolate foreign order situation, a further decline of exports is expected. Corporate investments will also be reduced further.

However, construction investments should increase as the public investment programmes begin to take effect. It is also expected that private consumption will provide initial support. With the increasing job-loss risk, however, the propensity to consume will weaken so that private consumption will clearly decline by the end of 2009. All in all, GDP is expected to decline by 6 percent in 2009.

This should lead to an accelerated decline in employment. To be sure, the use of shorter working hours will cushion the decline in employment initially, but firms will be increasingly forced to reduce personnel levels the longer their capacities are underutilised. In the course of 2009 a loss of more than 1 million jobs is expected. In parallel, unemployment will accelerate, surpassing the 4 million mark in the autumn.

For 2010 the forecast group does not expect a dramatic recovery. GDP should decline by 0.5 percent. By the end of the year, unemployment should stand at slightly under 5 million.

The trend in consumer prices is regressive. The reduced prices for crude oil will continue to have a lowering effect on prices for natural gas and electricity. Moreover, the desolate demand situation and the underutilised capacities will put pressure on core inflation. Since these adjustment processes will only take place gradually, however, a slight increase in consumer prices of 0.4 percent is still expected for 2009. In 2010 they will stagnate on the whole.

The economic stimulus programmes, the declines in tax revenues as well as rising labour-market expenditures will be a considerable burden for public budgets. For 2009 the financing deficit will shoot up to 89 billion euros, which corresponds to a deficit ratio of 3.7 percent. Due to further declines in output and increasing unemployment, the forecast group expects a deficit for the coming year of 133 billion euros and a deficit ratio of 5.5 percent.

This forecast is above all based on the assumption of very slow recovery of the international banking system as governmental rescue measures gradually take effect. But this assumption carries high risks. The global banking system continues to struggle with enormous balance-sheet risks and equity problems that could be exacerbated by the recession and the increase in company insolvencies. For this reason another crisis of confidence cannot be ruled out. The result could be a repeat decline in orders and output. Then a slide into a worldwide deflationary downward spiral would not be unlikely.

Upward forecasts risks also exist, however, since it is quite possible that the German economy will recover faster than predicted. If the international banking crisis was resolved rapidly and bank lending soon returned to normal, expansive monetary policies could take full effect. In Germany the rise in unemployment could be considerably slowed because with better sales outlooks firms would tend to avoid dismissals.

In a medium-term perspective, a major consequence of the financial crisis is that capital will be expensive for some time since there will be a lasting change in risk assessment. Real capital formation will be particularly affected. Moreover, the production structure of German industry is presently still geared to a demand boom in the world economy, a situation that is unlikely to return when the recession is over. For this reason production potential and its growth must be currently assessed far lower than only a year ago.

A top priority for economic policy is the restoration of the full effectiveness of the banking sector. Although the German government responded rapidly with a rescue package, this has not eliminated the problems in the banking sector. The risk is that a persistent credit crunch will emerge. Because of this policy-makers have the urgent task of advancing the re-capitalisation of the banks. By hesitating the situation could worsen or at least the crisis could be prolonged. Then a scenario similar to Japan in the 1990s would be likely.

The industrialised countries have taken different approaches to tackling the problems in the banking sector, and there certainly is no blueprint for the best solution. It is unavoidable, however, that the German government must increase pressure on the banks and force them to accept state assistance. Even nationalisation would be a lesser evil than a persistence of the difficulties. The sooner the situation can return to normal, the more other measures of economic policy can improve the outlook for economic activity. In particular this would enhance the effectiveness of the monetary policy.

Faced with the depth of the economic downturn and low inflation in the euro area, the European Central Bank should lower key lending rates to 0.5 percent. Even a zero interest rate would not be a sufficient reaction to the crisis. Instead, the ECB should design its tender business with a greater longer-term perspective than has been the case, as it is apparently planning to do. If a lasting drop in lending volume or the money supply aggregates in the euro area cannot be prevented in any other way, the ECB should adopt a policy of quantitative loosening, i.e., it should buy corporate and government bonds. To be sure, a circumvention of the banking sector is less promising than in the Anglo-American countries, for example. Also the decision as to which government bonds should be acquired is politically explosive for a supranational central bank like the ECB. However, faced with the choice of either purchasing bonds or allowing deflation to take hold, the former would be the lesser of the two evils.

German fiscal policy has responded to the recession with two economic stimulus packages. They contain measures that could support medium-term growth such as investment projects, the lowering of the marginal rates of taxation and the reduction of social insurance taxes. For this reason it is justifiable to temporally finance these measures by taking on new debt. This of course does not apply to measures designed to stimulate consumption in the short term and thus have a distorting effect, such as the "scrapping grant" for older cars.

Particularly against the background of the foreseeable increase in the budget deficit, a further economic stimulus package is not advisable under the present circumstances. A more expansive fiscal policy is only justifiable under specific conditions. If the efforts of the governments in the euro area to restore the banking sector fail, and if for this reason the financial crisis worsens throughout Europe and a credit crunch emerges, the economic outlook would again clearly deteriorate. If even an unconventional monetary policy were not able to stimulate the economy, additional fiscal policy measures should be discussed, which would have to be synchronized on a European level.

The long version of the Joint Economic Forecast as pdf-file (available only in German)