By Nariman Behravesh

The full fury of the two shocks that have hit the world economy - the financial crisis and record oil prices - is beginning to dissipate. Unfortunately, the full impact of these shocks on the real economy has yet to be felt.

There is little doubt that the economic outlook will get worse - possibly much worse - before it gets better. Nevertheless, given the recent dramatic reversal in the price of oil and other commodities, the gradual thawing of credit markets, and the large amounts of fiscal and monetary stimulus that have already been set in motion or are likely to be enacted soon, the recovery is likely to be more robust than many pundits are currently predicting.

The data from the last couple of months leave little doubt that the US, European and Japanese economies have fallen off a cliff. Others are likely to follow. The current recession is likely to be the most severe in two decades, and possibly one of the deepest in the post-war period.

The worst recessions of the last four decades were caused by a combination of large oil shocks and tight monetary policies. The expansion-killing blows of 2008 were similar, yet, arguably, not as bad. The demand-driven oil “shock” of the last few years, exacerbated in its final stages by speculative activity, was less damaging than earlier shocks, which were triggered by supply disruptions. The collapse in oil prices in a matter of weeks is a function both of expectations of a world recession and a flight to safety, as investors have fled commodities markets.

While monetary policy in many parts of the world, especially the United States, was (and is) loose, the impact on the real economy has been completely undermined by the freezing up of credit markets. As a result, by many measures credit conditions are as tight as or even tighter than those that precipitated the deepest recessions in the postwar period. Assuming that the large and co-ordinated financial rescue packages succeed in unclogging the banking systems, the impact of loose monetary policies will eventually feed through to the real economies but it may take many months.  In the meantime, de-leveraging in the US, UK and other afflicted economies will depress growth even further.

In my view, then, the recession will be deep - but the recovery is also likely to be strong. Here are four positive factors to keep in mind. First, oil prices are flirting with $50 a barrel, nearly two-thirds lower than their peak earlier this year, and could possibly end up as low as $40 a barrel. This is a huge relief to consumers and businesses. In fact, falling food and fuel prices will give a nice boost to disposable income in most parts of the world over the next year.

Second, the swift and  concerted  action on the financial crisis by the governments in the hardest hit economies will pay off; indeed, it already is. Early indications are that banks are beginning to lend to each other again and the inter-bank rates have fallen to levels last seen before the collapse of Lehman Brothers. Nevertheless, more help may be needed, especially if there is a risk of a meltdown in other parts of the financial system, such as the market for credit default swaps. Recent aggressive action by governments suggests that they will do whatever is necessary to deal with such aftershocks, as they occur. This is in sharp contrast with the very slow action by the Japan’s government in the 1990s, which was a major factor behind that country’s “lost decade”.

Third, there is a huge amount of liquidity that has already been pumped into the global economy, and there is more to come. The Fed is likely to ease again: a federal funds rate of 0.5 per cent, or even lower, is a safe bet in the next few months. The European Central Bank and the Bank of England are expected to slash rates by at least another 125 to 150 basis points by mid-2009 and have more room than the Fed to cut again, if they need to. Almost every other central bank around the world has either started cutting or will do so soon. As the credit crisis eases, this massive monetary stimulus will boost growth.

Finally, further fiscal stimulus is in the pipeline. In the US a fiscal boost of  between $200bn and $300bn is a priority for President-elect Barack Obama and has broad-based support in Washington.  Many governments in Europe, Asia, and other parts of the world have either enacted or are about to enact spending increases and tax cuts. Also noteworthy is the 4,000m yuan ($586 billion) stimulus package recently announced by the Chinese government.  All this, too, is good news for the recovery.

The easing of credit conditions is likely to occur slowly and the impact of monetary stimulus will be felt only with a lag. Meanwhile, the housing recessions in the US, UK, Spain, and elsewhere will get worse before they get better. Similarly, fiscal stimulus will not occur soon enough prevent negative growth for the next few quarters. Bottom line: the US,  European and global economies will contract during the rest of this year and through the first half  of 2009.  Nevertheless , the stage has been set for a modest recovery in 2010 and a more robust recovery in 2011.

Nariman Behravesh is chief economist at IHS Global Insight and the author of the forthcoming book, “Spin-Free Economics: A No-Nonsense, Non-Partisan Guide to Today’s Global Economic Debates” (McGraw-Hill Professional)

Tags: Deficit spending, Interbank lending, Interest rates, UK economy

November 25, 2008 3:30pm in Central banks, Credit squeeze, Keynesianism | Comment