If the current recession is to drag on until the middle of next year it will be the longest recession in the post World War II period surpassing all previous records of recessions in the 1970s and early 1980s that all lasted 16 months each.

Shrinking demand, falling consumption, bursting businesses, collapsing financial institutions, failing exports, massive unemployment are some of the shocks experienced by different economies in varying degrees.

Collapsing value of assets held by banks and other financial institutions have pushed many of them into insolvency. The injured banks and financial institutions are now so overcautious that they are not lending liberally. This has further complicated matters making the credit crunch bankrupting business establishments.

The origin of the present economic crisis goes back to Year 2007 when homeowners in the US started defaulting on their mortgages. Too many people with limited or poor creditworthiness borrowed large sums from banks. The banks splurged and lent liberally without exercising caution, taking advantage of the huge liquidity and low level of interest rates in the system. This sub-prime (not a genuine and credit worthy client) spread like a contagion to important financial institutions and created a mayhem that bankrupted top finance companies, banks, investment banks and insurance companies, who included big players like Bear Sterns, Lehman Brothers and AIG.

Risky Chain

The sub-prime credit spurted because the finance market allowed an array of agents to earn lucrative returns through disbursal of risks. Mortgage brokers chased borrowers for a fee, only to create volumes without caring for risks. Mortgage lenders too went on a financing spree to amass mortgages with an eye to garner the interest and amortisation flows from such lending and tried to sell these mortgages to Wall Street banks.

The Wall Street banks bought mortgages gleefully to bundle assets with varying returns to create securities with varying probability of default so that they can sell them to a range of investors such as banks, mutual funds, pension funds and insurance companies.

In this chain, all institutions at every level got bitten with risks with a larger chunk of it going to the final investors in the chain. Thus all players were exposed to each other and their toxic assets too. As sub-prime defaults soared, the whole structure came crumbling down leading to a financial crisis of unmanageable proportions.

Recession Spreads

Credit crunch and crumbling demand coupled with a sharp fall in exports transmitted the virus of recession into most developing countries. There it got translated into a collapse of demand and a crisis in the real economy with indicators of falling output and rising unemployment. Compounding the financial crisis further, there is flight of capital from the emerging markets: net private flows of capital to developing countries are projected to decline to from US$1 trillion in 2007 to US$530 billion in 2009.

Outlook for 2009

The world economy can be bad in 2009, with the United States, Western Europe and Japan going into recession. Developing economies in Asia, Africa and the Middle East can face curtailed growth due to plunging commodity prices and a dip in world trade.

The IMF’s semi-annual World Economic Outlook released in October expects the world economy to grow at a 2.2 percent pace in 2009, down from its earlier projection of 3 percent. Developing economies will see GDP growth rate at 5 percent, despite diving commodity prices that is hitting the oil exporters especially hard.

World Bank View

The World Bank’s Global Economic Prospects Report predicts slip in global GDP growth from 2.5 percent in 2008 to 0.9 percent in 2009. Growth of developing countries may decline from 7.9 percent in 2008 to 4.5 percent in 2009. The Word Bank sees the global economy shifting from “a long period of strong growth” led by developing countries to a time of “great uncertainty.”

The slowdown in developing countries is very significant because the credit squeeze is hitting their investments (FDI), which were a key pillar supporting the strong performance of the developing world. Again, world trade, another engine of growth for many developing economies, will start shrinking by 2.1 percent in 2009, marking the first drastic contraction since 1982.

According to the World Bank report, commodities boom of the past five years, which drove up prices 130 percent, will come to an end. Oil prices are likely to average about US$75 a barrel in 2009. The price of crude has fallen about 70 percent due to the sharp economic downturn since it peaked at $147.27 a barrel in July 2008.

OECD View

In its economic outlook, the Organization for Economic Cooperation and Development (OECD) said economic output would shrink by 0.3 percent in 2009 for the 30 market democracies that make up its membership, against the 1.4 percent growth prediction for 2008. The Paris-based organization said the United States was expected to contract by 0.9 percent in 2009 following a 1.4 percent expansion in 2008.

According to Klaus Schmidt-Hebbel, Chief Economist, OECD, “Many OECD economies are on the verge of a protracted recession of a magnitude not experienced since the early 1980s. As a result, the number of unemployed in the OECD area could rise by 8 million over the next two years.”

Japanese output is projected to contract by 0.1 percent in 2009, following 0.5 percent growth in 2008, while the 15-nation euro-zone will likely shrink by 0.6 percent in 2009, after 1.0 percent growth in 2008. However, the OECD hopes that “Much will depend on how quickly the financial crisis — the main driver of the downturn — is overcome.”

Rewards

One positive spin off from the crisis will be the Central Banks shoring up their finances and governments injecting fiscal stimulus into the economy, to trigger higher spending and low taxes.

Perennial optimists like Olivier Blanchard, Chief Economist for the International Monetary Fund says, “looking at where we are today, the good news is that we have probably stepped back from the brink of financial catastrophe”. Yes that is a good thought if it can alleviate your economic pain!