The financial crisis that swamped the US and flowed over to the rest of the world was expected by all to adversely affect the real economy. But the speed and extent of the transmission of those effects was a matter of disagreement. It now appears that most observers had underestimated the impact that crisis would have.

The recession in the US, reports indicate, has not just arrived but has been with us for quite some time. Short term indicators are disconcerting. Preliminary estimates of GDP growth during the third quarter of 2008 point to decline of half a percentage point. But GDP growth during the previous two quarters was positive at 2.8 and 0.9 per cent respectively. The only other quarter since early 2002 when growth was negative was the fourth quarter of 2007. Thus, going by the popular definition of a recession—two consecutive quarters of decline in real gross domestic product-the US is still to slip into recessionary contraction.

But the independent agency which is the more widely accepted arbiter of the cyclical position of the US economy is the Business Cycle Dating Committee of the National Bureau of Economic Research. This committee, which adopts a more comprehensive set of measures to decide whether or not the economy has entered a recessionary phase, has recently announced that the recession in the US economy had begun as early as December 2007. That already makes the recession 11 months long, which has been the average length of recessions during the post-war period.

Yet, unemployment figures suggest that at the moment the recession is only intensifying. On December 5, 2008, the Bureau of Labour Statistics in the US reported that employers had reduced the number of jobs in their facilities by 533,000, taking the unemployment rate in the US to 6.7 per cent. This reduction-which is the highest monthly fall in 34 years-comes after job losses of 320,000 in October and 403,000 in September. What needs to be noted is that the official unemployment rate underestimates the extent of the problem because in a situation where there are more job seekers and less jobs to find, many of those who had been working earlier or had been seeking for work choose to opt out of the search for employment. This reduces the reported size of the labour force and therefore the rate of unemployment. The number of those who “left the labour force” despite being part of it amounted to as many as 420,000 in November. Adjusting for such factors is estimated to take the unemployment rate to above 12 per cent.

Total job losses through this year, which corresponds more or less with the recessionary period as identified by the National Bureau of Economic Research, are 1.9 million. This means that the 2.5 million jobs that Obama is promising to deliver through his promised fiscal stimulus package would just about recover the jobs lost during the recessionary period preceding his swearing in, and leave untouched the backlog of unemployed and those entering the labour force during this period.

The intensity of the recession is reflected in the precarious state of the US auto industry, which has always been a lead indicator of the point on the business cycle the economy is on. Chief executives of the big three auto makers, General Motors, Ford and Chrysler have been repeatedly rushing to Washington to lobby for as much as $34 billion in support to save their firms from bankruptcy. While Congress is unhappy with companies they think had not done enough to modernize and cut costs during the boom, Democrats at least do not want to add to the unemployment numbers before Barack Obama takes office. In the event expectations are that the industry would receive billions of dollars in short term loans, to help these firms stay afloat. As Representative Barney Frank put it, aid for automakers would possibly come in the form of a bill that nobody likes.

But these are all temporary measures aimed at moderating the down turn that persists. Effective action to try and reverse it would have to wait till the new President takes over. But to buoy expectations and prop up confidence, Obama has begun to declare intent. Immediately after the November job loss figures were announced, he promised to “create millions of jobs by making the single largest new investment in our national infrastructure since the creation of the federal highway system in the 1950s.” But even if that package is implemented fast and works, this would be a recession that lasts longer than many of its predecessors, and can reach levels where it would have to be termed a Depression.

All that said, we must realise that this is not just an American problem. The recently released preliminary edition of the OECD’s Economic Outlook for end-2008 shows that GDP in the Euro area declined in both the second and third quarters and is likely to fall also in the fourth, and that economic activity in Japan which fell in the second quarter of 2008, is set to fall in the last quarter as well. In the event, GDP growth in the OECD area which fell from 3.1 per cent in 2006 to 2.6 per cent in 2007 and 1.4 per cent in 2008 is projected to fall to -0.4 per cent in 2009, and the unemployment rate which rose from 5.6 per cent to 5.9 per cent between 2007 and 2008 is expected to climb to 6.9 per cent in 2009 and 7.2 per cent in 2010.

Other projections share this pessimism. Chapter 1 of the UN’s World Economic Situation and Prospects 2009, released in advance at the Doha Financing for Development conference, estimates that the rate of growth of world output which fell from 4.0 per cent in 2006 to 3.8 per cent in 2007 and 2.5 per cent in 2008 is projected to fall to -0.5 per cent in 2009 as per its baseline scenario and as much as -1.5 per cent in its pessimistic scenario.

There is much pessimism on how long this recession would last as well. According to the OECD, for most countries "a recovery to at least the trend growth rate is not expected before the second half of 2010 implying that the downturn is likely to be the most severe since the early 1980s, leading to a sharp rise in unemployment.” Moreover, even this assessment is based on the assumptions that the crisis in financial markets would be resolved soon and that there would be no negative feedback loops both between the real sector and the financial sector (which would exacerbate the financial crisis) and within the real sector (which would intensify the crisis in the real economy), before the positive effects of intervention by governments materialise in full. Such assumptions are indeed tenuous, increasing the lack of certainty about a recovery. Thus, job losses in the US are increasing the number of housing foreclosures. Around 7 per cent of mortgage loans were reported to be in arrears in the third quarter, and another 3 per cent at some stage of the foreclosure process. According to the Mortgage Bankers’ Association, about 2.2 million homes will have entered foreclosure proceedings by the end of this year. This would intensify the financial crisis as well as dampen consumer spending, and could worsen the downward spiral.

Such pessimism is also warranted by the evidence that arguments predicated on a decoupling of growth in emerging markets, especially China and India, from growth in the developed industrial countries were unfounded. Direct dependence on developed country markets and indirect dependence on the developed countries via the liquidity injected by capital inflows that sustained a consumption and housing investment boom were important for growth in these and other emerging markets. A recession in the OECD area implies that external markets would shrink sharply and the financial crisis in the developed countries has resulted in an exodus of capital from many emerging market with attendant liquidity and demand problems. Not surprisingly growth in the emerging markets is slipping at a rapid pace, and thus far only China has managed to announce a large package amounting to close to $500 billion to combat these effects. If growth in the other emerging markets falls even further, as it is expected to, and the Chinese stimulus package does not deliver adequate results, the negative feedback on a global scale would be greater and the global recession would be steeper.

In sum, we are yet not in a position to ignore the similarities with the 1930s that have haunted the world ever since the financial crisis triggered by the sub-prime crisis began to unfold. Not surprisingly, demands for a coordinated fiscal stimulus have intensified. But as yet we have only scattered responses from individual countries that are very varied in terms of their scale and scope.

December 27, 2008.