A global depression? Not yet

Nouriel Roubini is not one to mince his words. The well-known economist and professor at New York University's Stern School of Business said in one of his articles, "the rich world's financial system is headed towards meltdown".

That is not all. "When policy actions don't provide real relief to market participants, you know that you are one step away from a systemic collapse of the financial and corporate sectors. A vicious circle of deleveraging, plummeting asset prices and margin calls is underway. So we cannot rule out a systemic failure and global depression", Roubini continued.

No, he did not make these comments before the relatively innocuous sub-prime crisis mutated into the disastrous global financial crisis. Roubini's comments came last week just as the coordinated rescue plans from governments of developed nations were slowly calming the markets. It is also not that Roubini was a bit late into the game and got to understand the problem only now. In fact, he was one of the first to predict disaster, as far back as 2006. For that warning, he even earned the sobriquet of 'Dr. Doom' from The New York Times.

But, is a systemic market failure or global depression still possible as Roubini believes? Even after the interest rate cuts, pumping of cash to ease credit markets, aggressive financial bailouts, economic stimulus and other forms of government interventions?

No doubt, we are in a recession
Just like trucking demand is one of the best barometers of local economic activity, shipping rates are a very reliable signpost for global economic trends. The Baltic Dry Index, which is the most widely followed index of shipping rates for goods in bulk, has crashed more than 85 per cent over the last five months. Not even the worst performing stock market index has fared so badly!

The steep fall in shipping rates is a clear indication that the slowdown is spreading across the globe, and spreading quite fast at that. Over the last few years, freight rates had shot up as trade volumes exploded. In many busy routes, there was a severe shortage of capacity. Shipping lines placed huge orders for new vessels and shipbuilders were booked for many years. But suddenly, the boom has disappeared. Last heard, some the shipbuilding yards in South East Asia, which had ramped up capacity in a big way are facing bankruptcy as orders for new vessels are being cancelled.

There are other signs as well, especially in commodity prices. Earlier this year, steel makers in China and Japan readily agreed to a doubling of iron prices from last year by big miners in Brazil and Australia. Demand for steel was still on the rise and not many expected a correction. But, international steel prices have slipped more than 20 per cent in recent months. Big steel makers like Arcelor Mittal and Corus have announced production cuts. Prices of steel billets, or crude steel used to make finished products, have tumbled over 70 per cent on the London Metal Exchange as demand from smaller steel manufacturers have dropped sharply. Big mining companies have already lowered their earning forecasts for the current year and next.

The sharp fall in oil prices will remove one of the auxiliary engines of global growth - the huge spending in infrastructure and other construction by major oil exporting countries. If oil prices had remained close to the record levels seen earlier this year, major oil exporters would have earned an additional $1 trillion or more from oil exports over last year. A good part of this windfall would have been spent to sustain the building boom that was underway in the Middle East. The balance would have flowed into sovereign wealth funds, to be invested in foreign assets. This capital would have provided succour to big western companies, especially the banks, which are in dire need for funds. But, lower oil prices have upset all these calculations. It is a while since the sovereign wealth funds announced a big ticket investment in a large foreign company.

The slowdown is becoming quite evident even in China and India, which were considered relatively immune to the global crisis until now. Third quarter GDP growth in China has slowed to 9 per cent, well below the 12 per cent achieved for the same quarter last year. India will be lucky if it can achieve growth of 7.5 per cent this year and close to 7 per cent the next.

Forecasters have steadily lowered their outlook for global GDP growth. The IMF now expects the world economy to expand 3.9 per cent this year and 3 per cent in 2009. Now, 3 per cent may appear healthy for large, individual economies. But, for the global economy, most economists would consider it close to a recession. The US economy will barely expand in 2009 while most European economies will contract. Japan is already in a recession, after reporting a 3 per cent decline in output for the third quarter. Other Asian economies will do better, but there too growth will slip substantially from recent trends.

Estimates from other forecasters are even more downcast. Economists at Citigroup expect global growth to decline to 2.4 per cent in 2009 while UBS says they expect it to be 2.2 per cent. Credit rating agency Fitch has forecast a 2.7 per cent growth rate for the global economy next year. JP Morgan is the most cautious and has forecast 2009 growth of just 1.2 per cent. All these forecasts place the global economy in recession territory for the next year.

But, a depression is another matter
The definitions of a recession and a depression are still very arbitrary. But, as generally understood, a recession is a relatively short affair that may last a few quarters or slightly more than a year. In the context of the global economy, a recession may be called so even if there is no fall in output, but only a decline in the rate of increase in output. A depression, on the other hand, is a protracted downturn when economic output actually contracts. If recession is mild fever, then depression is typhoid - much more painful and difficult to recover from.

On the evidence we have so far, the global economy may not be headed for a depression. Here is why.

Unlike earlier recessions, the global economy is in much better shape. Rapid growth over the last three decades, with mild recessionary bouts in between, has built up enough buffers for the global economy to survive this crisis. The world economy is also much more integrated, both in terms of capital flows and trade. While on the downside increased integration has facilitated faster spread of the slowdown across the world, large pockets of relatively high growth like China and India will actually soften the blow to the global economy.

Also, most governments have been very proactive, or even hyper-active, in their efforts to fight the slowdown and prevent the risks of a depression. Interest rates have been cut substantially and money is being poured to increased liquidity. Governments are taking direct ownership stakes to prevent more erosion in market confidence. Expect more comprehensive economic stimulus plans in the developed countries in the near future. Nobody expects these unprecedented government initiatives to have no negative fallouts in the future, like creating other price bubbles. But, for now, these are necessary steps to prevent the global economy from weakening further.

The emerging countries are better prepared than ever before to face a recession. While their fiscal situation can cause concerns, most of these countries have huge reserves of foreign exchange. With the global slowdown just beginning to reach their shores, governments of these countries can be expected to come out with aggressive stimulus plans of their own to support growth. The only factor that may restrain them is the relatively high inflation levels which may prevent them from cutting interest rates as fast as they would like to.

So, be prepared for a recession that may last a while. It may even turn out to be the worst downturn for the global economy in decades. But, despite all the scary newspaper headlines, odds of a global depression still remain very remote.