How Will the Financial Crisis End?

The financial crisis which erupted in 2007 caused a very deep balance sheet recession. It's effects are still leaving a dark cloud over the global economy. There are real concerns over

• Persistently high levels of unemployment
• Sovereign default in the Eurozone
• A double dip recession

After the initial stimulus attempts of 2008 and 2009, policy makers have fallen back on short term fiscal austerity as they worry primarily over budget deficits. Yet, this is likely to prolong the economic recession.

What is Happening at the Moment

• Fiscal Austerity
• Limited Monetary stimulus (some in UK and US; the EU's contribution is to increase interest rates in 2011)
• Economic slowdown is spreading to emerging markets such as China.
• Deflationary pressures. The boom in commodity prices is coming to an end. When commodity prices stop rising, it will be more obvious that underlying inflationary pressures are very weak. Some countries will see a fall in prices due to the fall in demand throughout the economy. This deflation will exacerbate slowdown. (deflation)
• Debt Deleveraging. Due to weak growth, falling real wages and prospects of deflation, the real value of debt is increasing. This is making the balance sheet recession worse and limiting spending and investment.
• Falling asset prices. House prices have fallen significantly since boom levels of 2006-07. (UK house prices have been protected by a chronic shortage of supply). But, overall global house prices have fallen due to the financial crisis.

How Will it End?

• Very slowly banks will improve their balance sheets and slowly begin to lend more.
• Slowly consumers will be able to reduce their level of debts and in the future will be more willing to spend.
• Even with a few years of economic growth around 2%, it will take several years for the output gap to close.

This policy of deflation will gradually restore competitiveness. Eventually there will be strong economic growth, but it could take several years.

No Quick End

There will be no quick end to high unemployment and sluggish economic growth.

If policy makers were bold and imaginative, they could have been doing much more to stimulate the economy. They should have avoided the rush to short term austerity. But, I can't see European or US governments simultaneously agreeing on a short term fiscal stimulus package, whilst agreeing on real long term fiscal cuts to entitlement spending.

Europe is even more beleaguered as the unfortunate ECB seem unwilling to diagnose the fundamental problem - which is not just sovereign debt but a slide into a double dip recession which will exacerbate everyone's debt.

Could It Get Worse?

If Europe really messes up and countries other than Greece slip into default, there is potential for crisis to worse. If it led to ever greater rounds of fiscal austerity, a small double dip recession could become a full scale depression. It is possible. It is hard to forecast at this stage. There is a lot of hope, that gradually things will improve.

Examples of Balance Sheet Recessions

1. Japan - the lost decade

Japan Financial Crisis 1990-2001

Latvian Economy

source: Krugman (bully for baltics)

A Kind of Recovery, but unemployment remains high, and GDP well below pre-crisis levels.