By Michael Mussa
The world economy collapsed into steep recession in the final quarter of 2008 with global
real GDP dropping at a 6 percent annual rate. This was undoubtedly the sharpest decline in
world output and especially in world industrial production and world trade of the postwar
era, with virtually all countries participating in the downturn and many registering record
quarterly declines in real GDP.
Incoming data indicate that the global economic contraction continued through the
first quarter of 2009, although perhaps at a somewhat slower pace than the preceding
quarter. Downward momentum will likely continue at least through the spring. A number of
forecasters and pundits foresee a global recession lasting through this year and perhaps well
into 2010. However long the recession may last, the common expectation is that the
recovery will be quite sluggish—the forecast of an L-shaped global recession and recovery.
Despite a huge write-down in my global growth forecast from last September, I am
more optimistic. Aided by substantial policy stimulus, growth in the Chinese economy
should begin to accelerate in the first half of 2009 and the US recession should bottom out
around mid-year with recovery accelerating to about a 4 percent annual rate by the fourth
quarter. Recoveries in other countries will likely lag a little behind those in China and the
United States. But, aided by a bounce-back in global trade from its recent extraordinarily
sharp decline, the world economy generally will be in recovery by year-end. Then we will
observe, as we have many times before, the Zarnowitz rule: Deep recessions are almost
always followed by steep recoveries.
Before this recovery starts the world recession will become the deepest of the
postwar era, with global real GDP falling about three-quarters of one percent on a year-over-
year basis—the first significant decline of world real GDP in six decades. Output declines in
the advanced economies (the traditional industrial countries plus Hong Kong, Israel,
Singapore, South Korea, and Taiwan) will average 3 percent. Many emerging-market and
developing countries, notably those in Central and Eastern Europe, will also see their real
GDPs fall, but significantly positive year-over-year growth in China, India, and some other
countries will keep growth for this broad and diverse group at about 1½ percent plus.
For 2010, global growth is projected to strengthen to 3.7 percent—a sharp rise from
the preceding year but still somewhat below the potential global growth rate of about 4
percent. For the advanced economies, growth is expected to bounce back to 3 percent—
enough to begin to narrow the margins of slack that developed during the recession. For
emerging-market and developing countries, growth in 2010 is expected to rise to 4.7 percent,
on its way back up to a potential growth rate above 6 percent.
At the world level, consumer price inflation peaked in the summer of 2008 with 12-
month rates reaching 6 percent. By the fourth quarter, sharp falls in commodity prices
(notably oil prices) took monthly measures of overall consumer price inflation negative and
brought 12-month rates down to 4 percent. Disinflation continues and it now appears likely
that 12-month rates for consumer price inflation will get down to 1 percent or less during
2009. Core rates of consumer price inflation did not rise as high as overall rates during the
upsurge from 2003 to mid-2008, and their decline in the past nine months has been less
spectacular. At the world level, core consumer price inflation appears likely to decline to
about 1½ percent this year. While the details differ across countries, the general decline in
both overall and core rates of inflation since mid-2008 is a universal phenomenon.
Prices of several commodities have already strengthened from their lows of last
autumn and winter, with world oil prices rising from lows of about $30 per barrel to around
$50 per barrel. If global recovery proceeds as envisioned in this forecast, world commodity
prices should be expected to strengthen further over coming quarters, and this will add a
little upward impetus to overall rates of consumer price inflation. With considerable slack
now existing in the capacity to supply many commodities (including oil), however, a
resurgence of commodity prices and general inflation rates to near their recent peaks is
unlikely anytime soon.
Accordingly, monetary policy in most countries will be able to maintain, through
2009 at least, a stance of aggressive ease in order to combat recession and promote recovery.
With margins of slack likely to remain substantial, relatively easy stances of monetary policies
are likely to be appropriate for some time. Monetary policy, however, needs to be forward
looking about threats of rising inflation. Hence, once recovery is solidly under way during
2010, monetary authorities will need to consider dialing back on extreme measures of
monetary easing in order to prepare the way for eventual moves to more neutral monetary
The present forecast envisions a world recession that is somewhat shallower and
shorter than many other forecasts. More controversially, it envisions a V-shaped recovery
that is considerably more vigorous than commonly thought to be likely. This is especially the
case for the present forecast for the US economy, where the forecast for the real GDP this
year (a decline of 2 percent) is toward the top of most forecasts and where the forecast for
2010 is a little above the top of the range of the 50-some forecasts reported by Blue Chip. In
this paper I explain the reasons for this relative optimism concerning the US economy.
Before that, I turn to some brief observations on the causes of the present global recession
and on economic performance and prospects for the rest of the world.
Causes of the Present World Recession
The standard story of the present global recession and financial crisis emphasizes the
centrality of developments in the United States—especially the expansion and subsequent
collapse of the real estate and real estate financing bubble and its impact on an overleveraged
US and global financial system. Others point more broadly to persistently easy monetary
policies, very low interest rates and interest rate spreads, and general disregard of growing
risks in the financial system as key causes. Some, especially among present and former US
officials, point to the "global savings glut," particularly the part emanating from China's
massive current account surpluses and reserve accumulation, as a key underlying cause of
All of these explanations harbor a degree of truth, especially the first two. However,
to understand both the sudden sharp deepening of the global recession and financial crisis
last autumn and the reasons to anticipate recovery, it is important to look to a broader set of
causes of present difficulties.
While it seems like a distant memory, it is important to recall that from mid-2003
through early 2008, the world economy enjoyed a boom of broad scope and exceptional
vigor, with average annual growth of global GDP approaching 5 percent and with virtually
all countries participating in the boom. As reflected in a deteriorating balance of real net
exports, through the end of 2005, growth of domestic demand in the US economy in excess
of US real GDP growth contributed to the boom in output in the rest of the world. The
upsurge in residential investment in the United States and the impact of increasing
household net worth from rising home and equity prices on US consumption contributed to
this phenomenon. In 2006 residential investment turned downward, and growth of US
domestic demand slowed. With the aid of a weakened dollar, US real net exports began to
improve. Indeed, from the end of 2005 through mid-2008, the improvement in US real net
exports slightly more than offset a very large decline in real residential investment. This kept
US real GDP growing, albeit at a reduced pace, despite a considerable slowdown in real
domestic demand growth. Thus, the rest of the world helped to cushion the slowdown in the
This was fortunate from the perspective of the rest of the world as well. Rising
inflation, not weak output growth, was the key macroeconomic problem for the rest of the
world. This is evident both in the actual rise of inflation and in the fact that many countries
were tightening their policies in order to combat rising inflation. Indeed policy tightening
was undertaken in virtually all industrial countries, except the United States, until the
summer of 2008, and many emerging-market countries (notably China, India, and Brazil)
were also tightening their policies. From their perspective, the slowdown of demand growth
in the United States and the improving US real trade balance were helping in the battle
The stress and turbulence that began to develop in world financial markets in early
2007—linked to worries about US subprime mortgages and complex financial instruments
based on such mortgages—was not such a mutually beneficial development. The deepening
of these troubles in August 2007 was similarly unwelcome. The United States was clearly a
key source of these difficulties, but it was not the exclusive source. The United Kingdom
had its own problems related to mortgages as reflected in the need to nationalize Northern
Rock. Difficulties with mortgage finance in Ireland and Spain also had domestic origins.
And, for those financial institutions whose problems stemmed largely from assets based on
US mortgages, it is noteworthy that they purchased these assets of their own free will.
During 2008, stress in world financial markets deepened and broadened, led by
developments in the United States. The near failure and emergency rescue of Bear Stearns in
mid-March increased concerns about wider classes of assets and financial institutions.
Deteriorating conditions in markets for mortgages and related financial instruments induced
the US government to take over Fannie Mae and Freddie Mac. In mid-September, the
outright failure of Lehman Brothers and emergency rescue of AIG (or, more accurately, of
AIG's counterparties) began an unprecedented disruption of world credit markets.
This extreme disruption of key credit markets in the United States and worldwide
continued through October and into November and only partially abated by year-end. The
negative impact on economic activity and on trade was severe and virtually immediate. This
explains at least an important part of the sudden economic collapse in the final quarter of
2008 and the first quarter of 2009.
The source of the extreme stress in financial markets was not exclusively in the
United States. Severe problems in the banks of Britain (especially the Royal Bank of Scotland
and Lloyds), Ireland, Belgium, the Netherlands, and tiny Iceland were primarily of their own
making. Despite their generally sound management, Spanish banks faced difficulties linked
to the inevitable collapse of the domestic housing boom. Other Western European banks
were vulnerable because of overleveraging and due to their excessive exposure to affiliates in
Central and Eastern Europe.
Beyond the stress in financial markets, the world economy also suffered important
negative shocks late last year from several other sources. The upsurge in world commodity
prices, especially in world oil prices to $147 per barrel in July 2008, was a significant negative
shock to users of these commodities. This shock was clearly not the consequence of
financial stress, in the United States or elsewhere; but allowing for a slight lag, its economic
impact hit at the same time as extreme credit market turbulence. More recently, the collapse
of many commodity prices has clearly begun to undermine growth in exporting countries.
Policies to combat rising inflation undertaken through mid-2008 probably also operated with
somewhat of a lag, reinforcing the downturn in the world economy in late 2008 and early
2009. The slowdown in China's growth late last year probably owes more to the earlier
tightening of Chinese policies and the wind-down from the Beijing Olympics than to global
financial turmoil, and the Chinese economic slowdown has affected its trading partners
especially in Asia. Other emerging-market countries that earlier had tightened their policies,
including India and Brazil, found the effects inconvenient by year-end. The slowdown in the
euro area during the second and third quarters of last year was at least partly the
consequence of policy tightening to combat inflation. By the fourth quarter, this effect was
adding unexpectedly and undesirably to a precipitous decline in output. In the United States,
the 2008 tax cuts provided a modest boost to demand in the second and third quarters, but
the wearing off of this effect added to the pace of decline in the fourth quarter. In sum, the
extremely sharp declines in global economic activity and world trade in late 2008 and early
this year reflect several important negative shocks, with the stress and turbulence in world
financial markets playing the leading role.
Other Advanced Economies
The other advanced economies are all in recession, with year-over-year declines in real GDP
for 2009 forecast to range from about 1 percent for Norway to 5 percent for Japan and 6
percent or more for Hong Kong, Singapore, South Korea, and Taiwan. The particularly
steep output losses for these Asian countries all reflect severe collapses of exports that are
already in the data for the fourth quarter of 2008 and initial data for 2009. Domestic
demand, especially investment, may be expected to weaken further in the light of very weak
exports, but I do not expect the decline in exports to become much worse. Rather, I believe
that we have seen a very severe one-time disruption of world trade that has overshot to the
downside and will be partly reversed during 2009 as growth picks up in China and the
United States. Reflecting my relative optimism, these forecasts for the advanced economies
of Asia (including Australia and New Zealand) are above most other forecasts. For 2010,
substantial positive growth in the advanced Asian economies is likely on the back of more
vibrant expansion of world trade.
Growth of 2 percent for Japan, 4½ percent for the newly industrialized Asian economies,
and 2½ percent for Australia/New Zealand are a reasonable prospect.
In Western Europe, the recession is likely to last a little longer than in the United
States, and real GDP is forecast to decline by 2½ percent for 2009. Reflecting the relatively
high importance of both manufacturing and exports for Germany, real GDP is forecast to
decline by 3 percent this year, while the output decline for France is likely to be closer to 2
percent. Italy is suffering from very weak domestic demand, as well as severe problems with
exports, and has little room for discretionary fiscal expansion. An output drop of about 3
percent this year is likely. In Britain, output is also likely to fall about 3 percent. This reflects
the negative impacts of problems in housing and in the very important financial services
industry. British manufacturing should get somewhat of a boost from the depreciation of
sterling, especially against the euro, but this impact is likely to be felt more in 2010 than this
year. For Spain, the long-anticipated retrenchment of residential investment, along with
more general weakness in domestic demand, implies about a 3 percent output decline this
year. Most of the smaller Western Eur opean countries are likely to see declines in real GDP
in the neighborhood of 2 percent.
Economic policy in Western Europe is working to limit the recession and promote
recovery, but the combined effect of monetary and fiscal policy is likely to be significantly
less than in the United States. This lack of fully equivalent policy response r eflects both a
somewhat less dire economic situation and a tendency toward less active use of discretionary
policy in the euro area than in the United States. On the first score, it is noteworthy that in
the euro area, the increase in the unemployment rate through February 2009 from the low
reached in the recent expansion (which was itself about ½ percentage point below the low in
the previous expansion) is only 1 percent, versus a 3.7 percentage point increase in the US
unemployment rate through February from its low of 4.4 percent in the recent expansion.
There is presently a good deal more slack in the United States than in the euro area, and this
is still likely to be the case a year from now despite the forecast of slightly more output
decline in the euro area than in the United States for 2009.
On the second score, monetary policy makers in Western Europe generally place
somewhat greater weight on keeping overall consumer price inflation low than does the
Federal Reserve. Moreover, the admitted weaknesses on the balance sheets of Western
European banks is probably more limited than the weaknesses so far admitted on the
balance sheets of their US counterparts, especially if account is taken of the exposures of
Western European banks to financial problems in Central and Eastern Europe. On fiscal
policy, the automatic stabilizers operate significantly more forcefully in Western Europe than
in the United States. This should help to cushion the recession but will symmetrically tend to
weaken the recovery. In view of both the constraints of the Stability and Growth Pact and
the generally higher level of government deficits and debt levels relative to GDP, European
governments are rightly reluctant to use discretionary fiscal policy with quite the wild
abandon now in evidence for the United States. Combined with other factors, the result is
likely to be that recovery in Western Europe will lag a little behind that in the United States;
and, especially with potential growth rates somewhat lower than in the United States, the
pace of subsequent recovery is likely to be more subdued.
Nevertheless, the Zarnowitz rule assures us that once recovery starts in Europe, the
pace of that recovery will surprise on the upside. Year-over-year growth rates for 2010 will
likely exceed 2 percent in most countries and will probably reach at least 3 percent in some,
probably including Germany. So long as oil and other commodity prices remained exceptionally strong,
the Canadian economy enjoyed an important degree of insulation from the slowdown in the
United States and in the world economy more generally. With the drop in world oil and
other commodity prices, the Canadian economy is now falling into recession, and a real
GDP decline of about 1½ percent is forecast for this year. With strong ties to the US
economy (including through the highly integrated automobile industry) and continuing links
to world oil and other commodity prices, the forecast of a stronger than expected recovery
in the United States and in world commodity prices beginning around mid-2009 implies a
relatively optimistic forecast for Canadian economic growth for 2010—likely on the order of
Emerging-Market and Developing Economies
By itself, the Chinese economy accounts for more than one-fifth of the economic weight of
all emerging-market and developing economies (using PPP-based exchange rates to
aggregate national GDPs). The imputed decline in China's annualized real GDP growth for
fourth quarter of 2008 to barely more than 1½ percent, from a 13½ percent annualized rate
two quarters earlier is, therefore, an important part of the explanation for the precipitous
decline in real GDP growth late last year for all emerging-market and developing countries.
This arithmetic effect was undoubtedly enhanced by the sizeable impact of slowing Chinese
economic growth on exports from many of China's trading partners, especially in Asia.
Looking ahead, the response of Chinese policymakers to a greater than desired
slowdown in economic activity has brought forth both serious measures of fiscal expansion
and very substantial easing of credit conditions (more than reversing their earlier tightening).
It is reasonable to expect that the Chinese economy will respond to these new policy
measures with a resurgence of growth, yielding 7½ percent growth year-over-year for 2009
and better than 8 percent growth for 2010. The pick up in Chinese growth after slowdown in
the second half of 2008 will help to boost growth in China's trading partners, especially in
India carries a little less than half of the weight of China in world GDP (using PPP-
based exchange rates). After five years with average annual growth above 8 percent, India is
forecast to deliver somewhat slower but still significantly positive output growth this year
with an annual rise in real GDP of about 5 percent. The Indian economy is feeling the
impact of the global recession and financial crisis but is less strongly linked to the rest of the
world economy through both trade and finance than most of Asia. Reasonably solid growth
of domestic demand and the effects of a favorable monsoon on India's important
agricultural sector will keep growth positive. Monetary policy, which in the first half of 2008
was oriented toward combating rising inflation, has shifted toward an easier stance. The
upcoming elections have not been a force for fiscal restraint.
The smaller Asian emerging-market economies are being more seriously affected by
the global recession and collapse of world trade. Disruptions of trade financing for
emerging-market economies are also having some negative effect, but Asian countries
generally do not need to finance significant current account deficits and most have adequate
reserves. Some countries, such as Malaysia and Thailand, which are heavily dependent on
manufactured exports, are likely to see output declines this year. The group as a whole,
however, will probably post slightly positive growth for 2009 and return to substantially
positive growth for 2010.
Recently released data indicate that Brazil, Latin America's largest economy, will
probably see real GDP decline this year (by about 1 percent) for the first time in a decade.
The generally sound state of the public finances, a favorable trade balance and modest
current account deficit, ample foreign exchange reserves, and limited foreign currency
indebtedness (of the government), however, provide confidence that Brazil will weather the
current global economic storm without serious damage. For 2010 a return to growth of 3
percent or better looks like a reasonable prospect.
Argentina is in more serious economic difficulty, for domestic reasons as well as
because of spillovers from the global crisis. The government hopes to prop things up until
the elections, but a real GDP decline of about 3 percent is likely this year, with considerable
uncertainty about the pace of recovery in 2010.
As the fourth quarter real GDP results again testify, Mexico remains tightly linked
economically to its northern neighbor. Fortunately, substantial but orderly depreciation of
the peso's exchange rate against the dollar over the past year and the availability of ample
external financing and Mexico's generally sound fiscal policy provide important protection
against the type of crises that have hit Mexico in previous steep global recessions. Following
developments in the United States, Mexico's output this year is likely to decline about 2½
percent and then recover smartly by 3 percent or better in 2010.
Elsewhere in Latin America, the picture is mixed with most countries likely to record
at least modest output declines this year followed by recoveries of varying strength in 2010.
Venezuela and Ecuador will be hit fairly hard by the drop in world oil prices, while Chile and
Peru fair somewhat better despite considerable declines in the prices of their primary
exports. Altogether, Latin America's real GDP will probably shrink by about 2 percent this
year and grow about 3 percent in 2010.
In Central and Eastern Europe, several countries (including the Baltic States,
Hungary, Romania, and Bulgaria) are in deep difficulty because of the collapse in external
financing for their large current account deficits, as well as the general economic impact of
the world recession. Turkey is discussing a possible resumption of International Monetary
Fund (IMF) support and will see output decline this year by 2 percent or more. Poland and
Slovakia are in better shape and might scrape by with little or no growth. For the region as a
whole, a decline in real GDP of about 3 percent is likely this year. Assuming that Western
Europe stages a moderate recovery in 2010, the Central and Eastern Europe region should
follow in its wake.
In the Commonwealth of Independent States (CIS), the Russian economy is
suffering from the collapse of oil prices and from some of the poor policies that high oil
prices made possible. Real GDP this year is likely to decline at least 2 percent. The Ukraine
is a mess, economically and politically. Despite financial support from the IMF and Western
Europe, economic activity will shrink this year, perhaps by as much as 10 percent. Belarus is
also in trouble and amazingly even admits it. Even more amazing, Belarus has negotiated a
program with the IMF. It will be interesting to see how that turns out. Elsewhere in most of
the CIS economic conditions are better—if one believes the data. Nevertheless, with the
largest economies clearly in difficulty, the CIS will likely see a decline in real GDP of at least
3 percent this year, and prospects for recovery in this region in 2010 are highly uncertain.
The Middle East region is suffering a large decline in export revenues from the fall in
world oil prices, but this does not show up directly in volume measures of real GDP. Cuts in
oil production to meet OPEC's reduced output quotas, however, do negatively impact real
GDP. Also, for a number of countries where oil export revenues are an important driver of
domestic economic activity (such as Dubai), the drop in world oil prices is an important
negative development. All told, I expect that real GDP growth in the Middle East region will
decline from about 6 percent in 2008 to 2½ percent in 2009. Assuming that we see
significant recovery of world oil prices (to about $80 per barrel) as the global economy
recovers, growth in the Middle East region should strengthen to 4 percent in 2010.
The IMF remains relatively optimistic about growth prospects in Africa. Their
forecast released in January envisioned 3.4 percent growth this year, rising to 4.9 percent
in 2010. In the face of the collapse of world trade and in the prices of many primary
products exported by African countries, I find the IMF's optimism a little overdone.
Africa will be fortunate if it can sustain 2 percent growth this year and then stage a
recovery to 4 percent growth for 2010.
Recession and Recovery in the United States
With the sharp drop in real GDP in the fourth quarter, –6.3 percent at an annual rate, the
US economy has clearly fallen into a steep recession. Preliminary data for the first quarter of
2009 indicate that real consumption spending has stabilized, at least tempor arily, after two
quarters of sharp decline. Other data, especially for the labor market, indicate that the
economy is still contracting at a rapid pace. All major categories of real gross private
domestic investment (business fixed investment in nonresidential structures and in
equipment and software, residential investment, and inventory investment) are probably
contracting, and real US exports are probably shrinking faster than US real imports. There is
no clear sign yet that this process of economic contraction is about to come to an end.
The task of an economic forecaster, however, is to forecast even when the hard
data do not provide a clear guide to what is about to happen. I first seriously confronted
this problem 27 years ago when I was asked to join the forecasting panel for the Graduate
School of Business of the University of Chicago, replacing my future boss at the US
Council of Economic Advisers, Beryl Sprinkel. I asked my colleague Victor Zarnowitz, a
distinguished scholar who specialized in business cycle analysis and who sadly died just
last month, for his advice. Victor explained that forecasters had never been very
successful in forecasting business cycle turning points: when an expansion would end and
a recession would begin, how long or how deep a recession might be, or when expansion
would resume. Long expansions did not appear to die of old age and were not necessarily
followed by deep or long recessions. Indeed, Victor noted that there was only one reliable
regularity about business cycles and business cycle forecasts: Deep recessions are almost
always followed by steep recoveries, and forecasts generally fail to take account of this
regularity in consistently underpredicting the initial strength of many economic expansions.
In deep recessions, such as those in the mid-1970s and the early 1980s, there is
usually a growing sense of gloom as the recession deepens, and few can see any reason for
hope that the recession might end. As employment and income fall, demand for
consumption and investment declines, bringing on more declines in employment and
income, in a downward spiral that appears to be without end. However, recessions do end
when the negative shocks that have created them are absorbed and dissipated and the natural
processes of economic recovery, often aided by stimulative economic policies, begin to
I sense that we are nearing that point in the present recession. Last autumn, when
the US economy was already quite weak, it was hit hard by the turmoil in financial markets
and the other factors that have already been explained. The economy is absorbing the
negative impact of those shocks in its present steep downturn. But shocks are dissipating
and we are approaching the plausible limits on how much the economy needs to adjust
before a natural rebound will begin. Meanwhile, extremely aggressive policy actions have
been taken by the monetary and fiscal authorities to blunt the shocks that have already
occurred, to guard against any important new shocks, to help bring an end to the downturn,
and to promote a more vigorous recovery. Experience suggests that all of this should
work, and I believe that it will.
In a nutshell, I expect that real GDP has declined at an annual rate of about 4
percent in the first quarter of 2009, with inventory investment falling more into negative
territory. The pace of decline is expected to moderate in the second quarter as the effect of
past shocks wears off and policy stimulus begins to work. The cyclical turning point will
occur about mid-year, with real GDP posting a modest advance in the summer quarter. By
the autumn, the recovery will be firmly under way, supported by strong policy stimulus.
Growth during 2010 will proceed at better than a 4 percent annual rate (on a fourth-quarter-