IMF Predicts Recession in Europe This Year Will Slow Global Recovery

Trouble for the world economy. The IMF has lowered its global growth prediction to account for continuing weakness in Europe. They now predict that Europe will return to recession this year and that this contraction will put the brakes on world economic growth:

The IMF chopped its 2012 forecast for global growth to 3.3 percent from 4 percent just three months ago, saying the outlook had deteriorated in most regions. It projected world growth would strengthen to 3.9 percent in 2013.

The Washington-based lender said economic activity was decelerating but not collapsing. However, it warned that global growth would come in about 2 percentage points below its already soft forecast if European leaders allowed the crisis to fester.

For the first time since the debt turmoil erupted two years ago, the IMF said the 17-nation euro zone would likely slip into a mild recession in 2012, with output contracting by about 0.5 percent.

I am now guardedly optimistic about the US recovery - I have no illusions of robust growth but I think we have started the long slow climb out of the humongous hole we have dug - but the persistent headwinds blowing across the Atlantic will slow us down further and headway will be hard to make.

Interestingly, the IMF also cautions countries that are pursuing austerity measures to do so with moderation:

[The IMF] also called on governments to avoid imposing drastic spending cuts on already sickly economies. Fiscal tightening is necessary to correct the hefty debt burden left from the boom years, the IMF said, but it, "should ideally occur at a pace that supports adequate growth in output and employment".

"Countries with enough fiscal space, including some in the euro area, should reconsider the pace of near-term adjustment," it added, in a suggestion that will be widely viewed as aimed at Germany, which is pressing ahead with austerity measures despite its healthy budget position.

Why Would the Death of the Euro be Such a Bad Thing?

This was a question, posed to me by a well-known beer writer when I met up with him recently in the UK (which is feeling pretty darn smug right now for not joining the Euro).  It is a good question (surprisingly, given its provenance), and I have been thinking a lot about the answer to this.

To be clear, we all understand that leaving the Euro by a small and heavily indebted country like Greece would be a disaster for them: they would adopt their own currency again, and heavily devalue.  Capital would flee astonishingly fast as folks got their Euro deposits and investments out as quickly as they could.  This would both incapacitate the government by essentially cutting off all credit and would lead to a complete collapse of the banking sector.  Bad times.

But why doesn't Germany, which is not at all happy about having to rescue the hopelessly mismanaged Greek economy, just cut and run?  They have a robust economy, could re-launch the Deutche Mark credibly and off they would sail into the sunset...

The first and obvious answer is that cutting and running might lead to Greece, Portugal, Spain and even Italy falling into crisis and Germany would not be immune to the sickness that would spread - they would be seriously hurt by this and the resulting recession would likely be pan-European.

But the less obvious answer is that if Germany exited, the Euro would immediately lose a lot of its value and German banks have a lot of Euro denominated assets that would suddenly be worth a whole lot less.  This would necessitate a bailout of German banks and a subsequent very tight credit environment as banks had to shore up their balance sheets.

In fact, UBS released a study which claims that that it would be much cheaper for Germany to bail out Greece than to exit the Euro. From the report:

Were a stronger country such as Germany to leave the Euro, the consequences would include corporate default, recapitalisation of the banking system and collapse of international trade. If Germany were to leave, we believe the cost to be around EUR6,000 to EUR8,000 for every German adult and child in the first year, and a range of EUR3,500 to EUR4,500 per person per year thereafter. That is the equivalent of 20% to 25% of GDP in the first year. In comparison, the cost of bailing out Greece, Ireland and Portugal entirely in the wake of the default of those countries would be a little over EUR1,000 per person, in a single hit.

The moral is that it is pretty easy to create a monetary union, but a whole lot harder to break it up.