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Global Economy's High-Risk Moment

Author: Christopher Alessi
September 22, 2011

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The U.S. Federal Reserve warned Wednesday of "downside risks" in the U.S. economic outlook and "strains" (WSJ) to global financial markets, prompting a global stock market selloff. The Fed also announced a monetary-easing policy--known as "Operation Twist" (NYT)--that will increase its portfolio of long-term government bonds by $400 billion. The measure is designed to facilitate lending by putting downward pressure on long-term interest rates, with the short-term goal of generating growth and employment.

The move came a day after the International Monetary Fund released its World Economic Outlook, which cut growth forecasts for the global economy to 4 percent for 2011 and 2012. The report warned that policymakers on each side of the Atlantic must address, respectively, the burgeoning European sovereign debt crisis and the stalled U.S. economy in order to stem "severe repercussions" to the global economy.

The IMF assessment comes as eurozone leaders (FT) are working with the Greek government to free up the next tranche of last year's €110 billion EU-IMF bailout package. Negotiations to push through a second loan and expand the temporary European rescue fund are taking place simultaneously. The eurozone crisis continues to threaten Italy--which had its sovereign debt downgraded Tuesday by rating agency Standard and Poor's--putting further pressure on the continent's heavily exposed banking sector. Mounting sovereign debt has put both the periphery and core countries of the eurozone at risk, calling into question the viability and staying power of the single currency.

As noted in the IMF's most recent Global Financial Stability Report, the European banking sector has also come under pressure (BBC). French banks, heavily exposed to Italian and Greek debt, are facing a potential liquidity crisis. Moreover, experts warn that a European banking crisis would have significant effects on the U.S. financial system. The United States remains squeezed by lingering unemployment, a massive budget deficit, and stagnant growth. These problems have been exacerbated by dysfunction in Washington, and put further pressure on global markets.

In Europe, the debate has centered on whether to let Greece default and, potentially, exit the eurozone, or to spur greater fiscal integration as a means of sustaining debt-laden countries. Economist Nouriel Roubini argued in a Financial Times op-ed that Athens' only option is to default and leave the euro. "A return to a national currency and a sharp depreciation would quickly restore competitiveness and growth, as it did in Argentina and many other emerging markets that abandoned their currency peg," Roubini wrote, referring to Argentina's 2001 default.

Conversely, investment banker Roger Altman wrote, also in the Financial Times, that the answer to the sovereign debt crisis is a true fiscal union, coupled with greater monetary policy intervention. The European Financial Stability Facility must be enlarged exponentially," he wrote, "in addition, the mandate of the European Central Bank must be expanded." The ECB has exercised what power it does have, continuing to buy up high-yielding Italian government bonds--known in the United States as "Quantitative Easing"--to take pressure off European markets.

Responses to the economic situation on the other side of the ocean, as indicated by the Fed's decision this week, have also relied heavily on monetary policy. President Barack Obama proposed a fiscal stimulus plan to boost job growth--in conjunction with a long-term deficit-reduction plan that raises taxes on wealthy Americans--but he faces significant resistance from the Republican opposition. GOP leaders favor a combination of spending and tax cuts (NYT) to spur growth and tackle the deficit. The political impasse in Washington helped drive the IMF's weak assessment of U.S. economic growth. "Deep political divisions leave the course of U.S. policy highly uncertain. There is a serious risk that hasty fiscal cutbacks will further weaken the outlook without providing the long-term reforms required to reduce debt to more sustainable levels," the World Economic Outlook concluded.

The IMF and the World Bank are scheduled to address the worsening global economic outlook at their annual joint meeting starting September 23.

Background Materials:

"Fighting for Its Life," Economist

"Why Breaking Up Is Hard to Do," Financial Times

"Fed Eases Policy," Bloomberg

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