Exploring the worst-case scenario

WASHINGTON Sun Oct 12, 2008 3:10pm EDT

A man stands outside the NASDAQ Market Site as the televised speech by U.S. President George W. Bush is broadcasted in New York October 10, 2008. REUTERS/Shannon Stapleton

A man stands outside the NASDAQ Market Site as the televised speech by U.S. President George W. Bush is broadcasted in New York October 10, 2008.

Credit: Reuters/Shannon Stapleton

WASHINGTON (Reuters) - The global economy is drawing closer to a dangerous downward spiral and time may be running out for world leaders to find a way to stop it before it inflicts lasting damage.

Economists are beginning to warn of a depression-like cycle where an inability to obtain credit stalls growth, triggering more defaults and still tighter lending terms. Governments have unveiled one unprecedented move after another in the past three weeks to boost confidence and get banks back in business, yet so far nothing has been able to arrest the fall.

"There's no hyperbole that can describe it," said Kenneth Rogoff, a Harvard University professor and former chief economist of the International Monetary Fund. "It's very, very unlikely (that the world economy will fall into a depression) but we've taken five of the 10 steps we need to get there. Hopefully we won't take the other five."

The world's richest nations agreed on Friday to do whatever it takes to restore normal order to credit markets that have essentially shut down, choking off the flow of money to borrowers who normally would have no trouble obtaining loans.

In a sign of how worried companies have become about getting credit, General Electric Co (GE.N) considered seeking a bank charter that would give it access to government lending channels, sources familiar with the company's thinking told Reuters last week.

Citigroup economist Steven Wieting said it was particularly worrisome that banks were still hoarding cash even after the U.S. Federal Reserve flooded markets with emergency money and lowered its benchmark interest rate by 3.75 percentage points in the span of 13 months.

Central banks elsewhere around the world have also opened up government coffers, and they banded together on Wednesday in the broadest coordinated interest rate cut on record, yet that proved insufficient to restore market confidence.

"With no desire to exaggerate, this might be considered the financial pre-conditions of a depression," Citigroup economist Steven Wieting wrote in a note to clients.

"Evidence suggests credit rationing is inhibiting day-to-day activities for many firms, with a harsh and worsening backdrop for consumers," he said. "Sadly, some risk exists that financial events could still unfold like a proverbial 'dam break.' This might leave policy-makers treating very serious and lasting damage to the financial system, rather than preventing further erosion."

Already, the crisis has taken a heavy toll on economic prospects. Wieting now expects nominal U.S. economic growth next year will be the weakest since 1954, with unemployment climbing to 8.5 percent from the current 6.1 percent.

CONSUMER SPENDING CAVES

Since the bankruptcy of investment bank Lehman Brothers and government rescue of insurer AIG (AIG.N) in mid-September, U.S. consumer confidence has tumbled almost as sharply as stocks, and spending has slowed dramatically.

A government report on Wednesday is expected to show that U.S. retail sales fell 0.6 percent in September from a month earlier, according to a Reuters poll of economists. Major retail chains reported weak monthly results last week as even wealthy shoppers closed their wallets.

Consumer spending accounts for two-thirds of U.S. economic activity, so if it remains weak, the economy would surely sink into recession, dragging much of the world with it. The bigger risk is that it reinforces and deepens the credit crunch.

Banks are already reluctant to extend credit, primarily because they are paying the price for previous lending mistakes. As that slows economic growth, companies are cutting jobs, which in turn means more people may miss payments on mortgages, credit cards and auto loans, driving up bank losses and forcing them to clamp down even harder on lending.

Once that cycle gets going, it is difficult to stop.

Michael Feroli, an economist with JPMorgan in New York, said he now expects the Fed to lower its benchmark federal funds rate by another three-quarters of a percentage point to 0.75 percent by December, and it could hit zero.

If that happens, it would leave the U.S. economy vulnerable to another shock that would increase borrowing costs, weaken growth, and potentially create a "Depression-like outcome."

Feroli said he was holding out hope that the "financial cavalry" would arrive in time to avert that doomsday scenario, whether in the form of globally coordinated insurance of bank liabilities, the U.S. government's $700 billion bailout, or another massive expansion of central bank lending.

Britain has proposed guaranteeing banks' loans to each other, but the Group of Seven rich nations stopped short of endorsing that plan at their meeting on Friday. Some economists thought that was a mistake which could prove costly.

Lena Komileva, head of G7 market economics at Tullett Prebon in London, said there was a risk policy-makers would have to "start again from scratch" if they cannot quickly turn investor sentiment around.

"If this scenario were to unfold, governments would have to effectively nationalize the entire flow of funds in G7 economies and start lending directly to businesses and consumers. Surely, they can do better than this," she said.

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