EIU: World Economy Headed for the Rocks?

Economist magazine’s ‘Economic Intelligence Unit’ has published its current take on global financial market turmoil. The full report in pdf is available here, and a brief web summary here.

The tremors in financial markets have gone far beyond their beginnings in the US subprime mortgage sector, and indeed far beyond the borders of the US. The full impact on the markets, and the repercussions on the global economy, remains unclear, but we can sketch out three broad scenarios:

• Scenario 1. The Economist Intelligence Unit.s central forecast, to which we attach a probability of 60%, sees the impact being contained by timely monetary policy action, with only a modest effect on the global economy.

• Scenario 2. Our main risk scenario, with a 30% probability, envisages the US falling into recession, with substantial fallout in the rest of the world.

• Scenario 3. Should the US enter recession, another, darker scenario arises: that corrective action fails, and severe economic repercussions cascade from the US into the world economy with devastating effect. We attach only a 10% probability to this outcome, but the potential impact is so severe that it warrants careful consideration.

We have some quibbles with the analysis, but it’s an informative one nonetheless, with plenty of good data points. However, regarding EIU’s primary concern that "the main risk to the world economy is a deflationary spiral in asset prices", we would simply point out that it’s important to distinguish between a credit crisis and a monetary one. Both cause market volatility. But a credit crisis is a normal feature of the business cycle, and provides an important signal that profitable opportunities in a particular area have been exhausted for the time being (a compounding factor this time around is financial innovation, which is causing a great deal of uncertainty; but the tradeoff was greater availability of credit during the boom and, assuming business practives and accounting standards can adapt in short order, this benefit should continue). Only a broad monetary crisis can cause a significant contraction in overall economic activity and anything resembling economist Irving Fisher’s general ‘debt deflation’. And the indicators we rely upon for assessing the state of monetary policy are still rather tame at the moment. The Bernanke Fed’s use of the discount window implies that they see this as a credit crunch, and it marks an encouraging change from the operating tendencies of his predecessor (that the ECB stood pat today may signal that major central banks are largely in agreement with this view).

Based on the foregoing assessment and our model of how the world economy works, we disagree with the EIU conclusion that timely monetary policy is the best answer to the current crisis, and instead would reiterate that the most beneficial measures that could be taken in this country are non-monetary in nature, and would aim at raising long term expected rates of return in the U.S. That requires lower taxes and more efficient regulation overall, i.e., lowering the cost and thus raising the return of doing business. Utterances from Congress about bringing fairness into the U.S. tax code are fine and good, but will only help the economy if they lower the effective burden on productive activity, and improve our competitive standing in the world.