The financial and economic news over the past four months has been almost unequivocally bad. Hence, it should come as no surprise to readers of this report to learn that economic prospects are bleak. But just how bad will it get? How long will the downturn last? And what are the implications for the major ICT-producing economies? This article addresses these questions. It is based on the analysis that underpins the OECD's latest Economic Outlook 2.
A gloomy economic outlook
The OECD projects that twenty-one of the thirty OECD economies will go through an extended recession of a magnitude not seen for many countries since the early 1980s. In some countries, it is the worst slowdown since the end of the Second World War. For the OECD area at large, negative output growth for four quarters between mid-2008 and mid-2009 is in prospect. The recovery is likely to be slow and will not start before late 2009.
This gloomy economic outlook is the result of the combined effect of tighter financial conditions, subdued income growth and negative wealth effects from lower equity and house prices. These influences will lead to sharp declines in investment and a massive slowdown in world trade growth. At the same time, consumption in most economies will be lacklustre.
As a consequence of the deep economic downturn, the number of unemployed people in OECD countries could rise by 8 million, to reach some 42 million over the next two years. Another consequence is sharp falls in inflation in all OECD countries. Some countries even face a risk of deflation. However, similar to cholesterol, there is 'good' deflation and 'bad' deflation. So far, we have seen the 'good' type of deflation, with a fall in prices due to the sharp drops in commodity prices. This increases households' real incomes and hence purchasing power. However, the effect is transitory, since commodity prices cannot keep falling forever.
In contrast, the "bad" type of deflation is when price falls are sustained. Sustained falls in prices are bad because they increase the real outstanding value of debt, which puts further stress on households' and business's capacity to repay their outstanding debts. That in turn means less ability to spend and invest, prolonging the economic downturn.
Looking forward, the OECD expects to experience a period of reductions in the pace of inflation, as global economic activity weakens, creating spare capacity and putting downward pressure on prices, we do not envisage entering a phase of sustained deflation. Deflation remains a risk, however, and given the experience from the Great Depression and Japan's "lost decade", this risk should be taken seriously.
IUntil recently, most commentators argued that the strength of demand from the major emerging-market economies would drive global economic growth. Indeed, for much of 2007 and 2008 this had been the case, with the bulk of world trade growth accounted for by the non-OECD area (Figure 5).
Figure 5: World trade growth will remain weak next year
Contribution of OECD and non-OECD to world trade growth
Note: Change relative to previous quarter at an annualised rate.Today, however, the major non-OECD countries of Brazil, China, India and Russia (known as the BRIC countries) are slowing too, due to more difficult international credit conditions, earlier policy tightening, income losses due to lower commodity prices, and weaker demand from OECD countries. The only silver lining is that the slowdown in growth in the BRIC economies is from high levels.
Source: OECD Economic Outlook 84 database.
The financial crisis spread to the real economy, as consumer and business confidence collapsed in the wake of Lehman Brothers' bankruptcy in mid-September 2008. Recessionary fears caused stock markets to crash, whilst oil prices plunged to under $50 a barrel in response to slowing demand. Both the US and EU are now officially in recession, meaning that they have experienced at least two successive quarters of negative growth. This comes partly as a result of expensive or inaccessible credit and negative wealth effects from falling equity and property values. Some countries, notably Iceland, Latvia and Hungary, have experienced even greater economic turmoil and have applied for multi-billion dollar loans from the IMF.
This severe global economic downturn stems, of course, from the financial crisis, which erupted in the United States around mid-2007. The turning point, however, was the collapse of Lehman Brothers in mid-September 2008. What followed was a generalised loss of confidence between financial institutions, triggering reactions akin to a 'blackout' in global financial markets. The US financial crisis went global, bringing systematically important bank and non-bank financial institutions to the brink of collapse. In this way, the worst financial crisis since the 1930s was born.
Spreads in credit and bond markets surged to very high levels, paralysing credit and money markets and world stock market prices plummeted. 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 economic activity going forward.
The financial crisis is not the only development shaping economic prospects. 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 fiscal and monetary stimulus and the boost to real household incomes due to sharply lower commodity prices.
In the current economic climate, the uncertainties attached to any forecasts are inevitably large. It is necessary, for instance, to make assumptions about when conditions in financial markets will normalise. In this regard, the OECD Economic Outlook posits that the extreme financial stress since mid-September is short-lived and followed by an extended period of financial headwinds through to late 2009, with a gradual normalisation thereafter. This is an assumption, because it is still too early to judge if the worst days of financial stress, stock market meltdown and the credit crunch are behind us.
Indeed, the risks are many, and for 2009 they are strongly on the downside. 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 a retrenchment of foreign direct investment. 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 so far introduced , including some since the publication of the OECD Economic Outlook.
2 For more information on the OECD Economic Outlook, visit: www.oecd.org/oecdEconomicOutlook
Will major ICT-producing economies be spared from the global economic downturn?
Even though the financial crisis is global in scope, it will affect countries differently. How individual economies are affected depends on their sectoral specialization and their capacity to withstand shocks, such as cooling house markets and plummeting commodity prices. The question then arises as to whether the major ICT producing economies will fare better in these dramatic and uncertain times?
After all, when the ICT boom deflated in at the turn of the century it was widely anticipated that countries with large ICT producing sectors - the United States, the United Kingdom, Finland, Korea, Ireland and Japan - would suffer more intensely. Yet, it turned out that the slowdown was relatively short-lived and the major OECD ICT-producing countries' growth performance was broadly the same as in OECD countries less directly exposed to the burst in the ICT investment bubble.
The short answer, however, is that virtually no economy is spared from the economic downturn, ICT producing economies included. Indeed, it seems that the ICT-producing economies are more vulnerable to the economic cycle. As you can see in the Figure below, the peaks and troughs in GDP growth among the major OECD ICT-producing countries are more pronounced than for other OECD countries. Part of the explanation for this is the fact that business investment decisions are sensitive to current and prospective economic conditions.
Over the next two years we do not expect the profile for GDP growth in each group of countries to differ greatly. There are three reasons for this. First of all, even though the ICT producing sector is large, accounting for some 6% of GDP in the OECD, it is not large enough on its own to make a distinct impact on overall GDP. Second, the ICT sector is not itself directly contributing to the economic downturn. Rather, it is one of many sectors that are bearing the negative consequences of tightening credit conditions. Finally, several of the large OECD ICT-producing economies are exposed to the housing market downturns.
Among the major OECD ICT-producing economies, housing market corrections are especially large in the United States, the United Kingdom and Ireland. In other words, the coincident economic downturn in ICT producing countries is not because of, or despite being large ICT producers, but because they happen to be particularly exposed to the correction in housing markets, which has been underway since early 2007.
There are also several specific factors that will help to support growth in the major OECD ICT-producing countries. For starters, inflation and the rate of growth in employee compensation has been lower and is expected to remain so, compared with other OECD countries. This helps the competitive position of these economies. Indeed, ICT producers are expected to experience stronger export market growth than non-ICT producers over the next two years. Another positive factor is the decision by several governments to design their fiscal stimulus packages in ways that may boost growth in the ICT sector. For instance, the European Commission suggested countries could increase funding for investment in research and technology.
In summary, the major OECD ICT producers are just as likely to be affected by the global economic downturn as other economies. At the same time, the prospect for a more rapid recovery appears favourable, reflecting the responsiveness of these economies to economic shocks.
Recent and prospective performance of major OECD ICT producing economies and other OECD economies
(quarter-on-quarter growth rates)
Note: ICT producers are the United States, the United Kingdom, Finland, Korea, Ireland and Japan. Non-ICT producers are the other OECD countries. The composition of the non-ICT group can vary depending on data availability.