Economist predicts 40% chance of world recession

Calculated Risk has the info:

• 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

I've scanned this report and I'm quite disappointed in it for two main reasons.

The first is that there is no mention of a potential oil shock. In July, just before the subprime crisis began to spray all over the financial bowl, The Economist admitted that oil production was not keeping up with demand, thus making the price higher. Sadly, it put this down to choices by oil producer rather than even entertain the possibility that production may have reached a geological peak. In many ways, the price of oil acts in the same way as interest rates - a high oil price encourages inflation and high interest rates, while a low price encourages low inflation and low interest rates. In theory, OPEC could act as the world's central bank by flooding world markets with crude and causing oil prices to plummet, thus acting as a international economic stimulant - which would be great if there were no production limits to pumping out the stuff. By ignoring the problem of oil supplies, the Economist's 60% estimation of "everything will be okay" looks way too generous.

The second is that there is no discussion of the overvalued US Dollar. The US has been sucking in imports from all over the world and has paid for this by borrowing from international investors. This is partly responsible for the "easy money" environment that created the subprime bubble in the first place (the other cause is the Fed's low interest rates since 2002). With recession the US a real possibility, it stands to reason that international investors may decide to pull out of direct investment in US companies. With more profitable investments in places other than the US, this outflow of capital would result in less demand for the US dollar, weakening it somewhat. Additionally, if Ben Bernanke and the Fed decide to aggressively lower interest rates in response to the subprime mess, international investors in US bonds will wish to invest in more profitable debt markets where interest rates are more attractive - the effect of which will be to lower the value of the US dollar. Unfortunately, a drop in the value of the US dollar will encourage domestic inflation in the US which should therefore result in higher interest rates to cope - which would be deadly to an economy that is on the brink of a recession anyway due to the subprime crisis.

My guestimation is: 25% chance of recovery, 50% chance of recession, 25% chance of severe recession.

The full report can be downloaded here (pdf file 507.6kb)

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