World Economy in a Downward Spiral

In 2008, the cyclical upturn in the world economy came to an end. In the course of the year, output growth decelerated progressively. The indicator of world economic activity calculated by the Kiel Institute dropped dramatically in the second half of the year after having been on a downward trend already since mid-2007 (see figure). The shock of September, when the global financial system barely escaped collapse, has sent the world economy into a downward spiral as stock markets and economic sentiment plummeted simultaneously around the globe producing an adverse feedback loop for economic activity. Economic weakness increasingly spread also to emerging market economies where growth generally had been surprisingly resilient until mid-2008.

World Economic Activity 1997–2008^a,b

^aBased on economic sentiment indicators from 41 Countries; — ^bEstimate based on large industrial countries (USA, Japan, Euro Area, United Kingdom, Canada) and large emerging economies (China, India, Russia, Brazil, Mexico, Korea).Change over previous year, 2008 Q3: partly estimated.

Inflation came down quickly in recent months as a result of a rapid decline in commodity prices. Although core inflation in most countries has not reacted strongly to the downturn so far, the combination of falling commodity prices, substantial reductions in asset prices and the prospect of rapidly declining capacity utilization have raised the spectre of deflation in a number of countries, including the US. Against this background, and in view of only marginal progress in the restoration of confidence in the financial sector, central banks in many countries aggressively cut interest rates. The Fed ultimately embarked on a zero interest rate policy supplemented by aggressive quantitative easing. Monetary policy will nevertheless only slowly gain traction as progress with recapitalization of banks will be slow given current policies and the prospect of a substantial increase in the share of nonperforming loans due to the recession. Fiscal policy also switched on an expansionary course, although to varying degrees in different countries, and further significant stimulus can be expected going forward. We do not, however, think that fiscal policy can prevent the industrial countries from falling into the worst recession in the post war period. And with fiscal deficits spiralling to levels as high as 8 percent of GDP in the US and the UK, fiscal policy is going to hit a wall at some point in the future.

In the near term output is set to decline steeply in the industrial countries given the extraordinarily rapid decline of indicators for economic activity seen over the recent months to levels only comparable to those in the deepest recessions on record in post war history. And there is still no light at the end of the tunnel as in a number of countries the downturn is fuelled by a correction of macroeconomic imbalances that usually takes time and will slow any recovery. We expect real GDP in the industrial countries to contract by as much as 1.8 percent in 2009 followed by growth of only 0.6 percent in 2010. All major economies will experience major declines in activity with growth falling to –1.5 percent in the US and Japan and even around –2.5 percent in the euro area and the UK (see table). Economic growth in the world economy as a whole will virtually come to a standstill as the Chinese economy will slow to only 6 percent, the worst performance in 18 years, and other emerging market economies will decelerate even stronger. 2010 should see some improvement although global growth is expected to remain low by historical standards.

Real GDP, Consumer Price Inflation, and Unemployment Rate in the Industrial Countries in 2008–20010 (percent)

Business Cycle Forecast