The calm before the storm: 2011 review and the 2012 outlook

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Large euro signWhat a year it's been: the Eurozone is in crisis and the US lost its prized AAA credit rating from S&P. But economists warn that next year could be worse. There might be a repeat of 2008 – in terms of a credit crunch and another recession. Worse, the head of the IMF Christine Lagarde warns of a 'lost decade.'
The year started with a brace of extraordinary events: the Arab Spring and Japanese tsunami, causing economic shocks and deep dislocations around the world. Fears of a global recession then loomed large. The extraordinary fall in global markets in August and September was testament to these concerns.

The euro crisis was undoubtedly the dominant reason. The Eurozone lurched from one crisis to another. The faintest outline of a deal to address Greek's unmanageable debt load proved too late to prevent contagion from spreading to Italy and Spain and even touching countries like France and Austria.

This pressure culminated in EU leaders (except David Cameron) declaring a euro-plus pact, which outlined more concrete steps towards a fiscal union to complement the shared currency and developing a liquidity provider to serve as a backstop for banks. This could solve the immediate crisis, but the structure still needs work to generate growth.

Euro countries need budget discipline – something that bond markets aren't used to imposing. However, that's changing as part of the summit proposals which include automatic penalties for violations of fiscal rules. And, bond markets certainly differentiate now among borrowers. This could be vital since countries will arguably respond to bond market pressure more than sanctions.

And, it's become clear the Eurozone needs a liquidity backstop like the IMF provides for the global economy. The attempt to create a temporary rescue fund (or EFSF) isn't working because it's limited by the fiscal capacity of the six AAA-rated countries in the Eurozone. A currency needs a central bank that is the lender of last resort to provide liquidity. The ECB doesn't have that role. The crucial question is whether the EU summit deal provides the 'fiscal compact' that might allow it to step up.

In the longer term, there's also the question of exit. There are two criteria for being in an optimal currency area: trade integration and convergence of incomes.

All 17 countries trade largely with each other, so the first is met. The second is tougher. For a country to grow sustainably in a monetary union requires it to be competitive. It can't come from devaluing the exchange rate, so it has to be based on low cost and higher productivity. If a country doesn't share growth prospects, then it's not viable to share a currency.

Exit from the euro has been raised by German Chancellor Angela Merkel and French President Nicholas Sarkozy, so it's become a question of coping with the consequences. This leads back to needing the institutions to cope with any shock. It comes down to those key sources of support: liquidity backstop (EFSF or the IMF) and preferably a central bank that can step in – if it all goes wrong.

The ongoing debt crisis also means that the European banking system is under increasing stress. The European Banking Authority wants banks to recapitalise to the tune of 114.5 billion euros. Bloomberg reports that banks want to trim their balance sheets by 750 billion euros in the next two years to raise that capital. That could lead to another credit crunch.

Spencer Dale, the Bank of England's chief economist, told me Britain could suffer a repeat of 2008 and that unless U.K. banks relatively quickly issue unsecured term debt "there's a real risk that credit conditions in our economy could tighten further".

Looking ahead, 2012 looks in danger of repeating the global recession of 2008. I recently hosted a panel of leading economists and they all warn that the world economy looks fragile next year. But, there are some bright spots. Standard Chartered's Chief Economist Gerard Lyons – the most accurate economic forecaster in the world according to Bloomberg's assessment – sees the global economy growing at only 2.2% but it's a tale of two worlds: the fragile West, resilient East.

In the first half of 2012, Standard Chartered forecasts a deep recession in Europe and the US will grow at just 2%. Even though emerging economies won't be entirely de-coupled from Western woes, he expects that they will manage to grow as they're better diversified than three years ago.

Closer to home, the UK is already in recession according to John Llewellyn, an advisor to the Treasury. That echoes the forecast by the OECD that Britain is in a "mild recession" and is consistent with the flat growth expected by the Bank of England until the middle of 2013.


Dr Linda YuehDr Linda Yueh is an economics correspondent for Bloomberg Television. Her work examines major economies such as Britain, China, United States, Europe as well as developing countries, and her research focuses on economic growth and the rise of emerging economies.

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