NIESR's world economy forecast, August 2012

NIESR's quarterly forecast for the world economy is published today. Highlights:

• Concurrent slowdown in every major economic region: world growth to slow to 3.3 per cent this year and 3.7 per cent next year.
• All major countries opt for the same policies of near zero interest rates and fiscal tightening.
• European countries face remarkably divergent growth paths next year: Germany above trend growth and Southern Europe in deep recession. Tensions will heighten further.
• World demand below potential output growth means rising unemployment – in some countries even higher than seen in the Great Depression.

For the first time since the integration of the largest emerging market countries, the world economy faces a slowdown in every major economic region. In 2009–10 the emerging markets, China and India in particular, provided some support to world demand. This will no longer be possible as these countries face familiar problems of their own. Around the world, banks are assumed to be insolvent until proven otherwise. Equity market valuations of banks in many major markets are near half book value and funding costs are higher than the corporations they are supposed to serve. World growth is forecast to be below trend this year and next, which means that unemployment will rise further and inflation will remain moderate.

Europe is the epicentre of the debt crisis. Policymakers have a stark choice between forging ever stronger economic and political integration within the Euro Area, or accepting that at least one country leaves EMU and all the contagion risks this brings. Our central forecast is that EMU remains intact, given the political commitment. The prevarication of the past four years can no longer continue. Since Germany is the largest underwriter of the European Financial Stability Fund and the European Central Bank, there is a clear financial link between the economics and politics in Southern Europe and contingent liabilities in Northern Europe. We expect Italy and Spain will need some form of support from the Troika to keep sovereign bond markets open.

Fiscal austerity is the new ‘conventional wisdom’ in many countries, even where unemployment is unthinkably and tragically high. In countries without fixed exchange rates government bond yields are close to zero, suggesting a remarkably low cost funding environment for necessary long-term investment. Faster nominal GDP growth is a much more conducive environment for the necessary debt reduction. The stakes are needlessly being raised by another round of political chicken in the US. Like everyone else we expect an adjustment to the existing legislation to prevent a fiscal tightening of close to 4 per cent of GDP. If we are wrong, the US is likely to face another recession.

We expect the current remarkably low levels of official interest rates to continue well into next year. Central bankers are often fond of saying they have plenty of other weapons in their armoury should it be necessary. If this is the case, the current time would seem to be appropriate to use them.

NIESR's forecasts for the UK and world economy are based on our global macroeconomic model, NiGEM (see here for subscription information).  Forecasts are published on our quarterly journal, the  National Institute Economic Review,  available from Sage Publications Ltd (http://ner.sagepub.com./) at subscription@sagepub.co.uk.