The Great Correction!

The world continues to be in a state of shock as the world economy faces a severe downturn as a result of the financial crisis happening in the United States that has now spilled into most of the other advanced and developing economies. The financial crisis in the United States erupted as a result of the collapse of the sub-prime mortgage market in the United States in 2007. While the economic impact is more evident in developed countries of the Western hemisphere, emerging markets are beginning to be affected as their economic growth begins to slow. Inflation continues to be a concern even though the prices of commodities and economic activity deteriorates worldwide.

Figure1 shows that the global economy has been booming for four years from 2004 to the summer of 2007. In this period, Global GDP rose at an average of approximately 5% a year, which is the highest sustained rate of world GDP growth since the early 1970s (IMF, 2008). This period of high global economic growth is coupled with a relatively low and contained rate of inflation. After the implosion of the sub-prime mortgage market in the summer of 2007, most of the advanced economies are already in or heading into recession.

Earlier this year, there were two prevailing opinions by local economists on the world economy. The first was that the economic activity of the BRIC countries (Brazil, Russia, India, and China) would be able to sustain world economic growth and that the emerging and developing economies would be decoupling from the advanced economies. Table 1 shows the forecast earlier this year of Asian economies. Data obtained in June implies that even if the US is in recession, Asian economies would continue to be robust. Most of the Asian economies are seen to be moderately affected in 2008 and continuing an upward growth trend after 2010.

The second widespread believe was that the spike in oil and basic commodity prices due to supply shocks would result in a global stagflation whereby global recession would be accompanied together with a period of high inflation. However, recent data on the world economic condition shows that both opinions are unlikely to be correct as economic growth in emerging and developing countries are affected while commodity prices have on average fallen from their peaks in recent months. This is an assumption base on average aggregate economic data as different regions; the Middle East for example is headed for a period of economic slowdown and high inflation.

Data obtained from the IMF’s World Economic Outlook in October shows that the emerging and developing economies are more severely affected than anticipated. Even countries of emerging Asia which many economists had hope would sustain world economic growth is seen to be very much adversely effected by a slowdown of economic activity in the advanced economies. Figure3 shows the drastic slowdown in G7 countries of which have been heavily affected after a full blown financial crisis in the United States in 2007.

The advanced economies grew at a collective annualized rate of only 1% during the period from the fourth quarter of 2007 through the second quarter of 2008 (IMF, 2008) dropping 2.5% since the third quarter of 2007. The drop in economic growth of advanced economies mainly stem from the correction in housing prices and tightening credit conditions that have resulted in a contraction of economic activity. Both business sentiments and consumer confidence indicators for the United States and the euro area are currently close to the low levels experienced during the 2001-2002 recession.

Credit growth in the non-financial corporate sector and households are now slowing visibly in the United States and Western Europe. This implies that the massive liquidity provisions by central banks of developed nations are used to strengthen capital positions of financial institutions instead of rechanneling these funds into the economy. This is a great source of concern as it implies that the real economy of the US would be slowing down dramatically as financial institutions adopt tighter credit lending policies in an effort to recapitalize.

Further Reading

The Impact of the Sub-prime Mortgage Crisis and a Global Economic Slowdown on Malaysia

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