HOW A DOWNTURN COULD TURN INTO A DISASTER

The economic weakness we are seeing in the United States and the eurozone is neither extreme, nor entirely unexpected.
Technically, the US may already be in recession, as some US economists say. But even if that were true, there is as yet no evidence that this cyclical slowdown is particularly severe, either by historic standards or compared with other industrial countries. An unemployment rate of 6.1 per cent is not exactly a calamity. In France and Germany this would be called full employment, even considering the structural differences of their labour markets.
I also believe that most commentators are exaggerating the extent of the eurozone slowdown. Spain and Italy look weak, but this is unsurprising. Germany is still holding up, but getting weaker. We are looking at a few quarters of stagnation, no doubt, but not a recession.
Considering that we are currently going through one of the toughest periods of financial turbulence in history, with money and credit markets now dysfunctional for over a year, we should be surprised how little damage has so far been done to the real economy. None of the industrialised economies is yet suffering a sustained decline in economic output, which is what a recession means.
In the US the combination of ultra-loose monetary and fiscal policies has kept the economy afloat. Spain and Germany can and will use fiscal stabilisers to the full extent and Spain is already doing more. France and Italy are more constrained. But in the absence of nasty financial or economic shocks, my main scenario would be at most a mild recession in the US, and a fairly average economic downturn for the eurozone.
There are two kinds of shocks that could tear up this scenario and both present a tail risk against which central banks and investors might wish to insure.
The first is a global financial meltdown. This scenario, while not probable, cannot be ruled out. The opaque $6,200bn (€4,346bn, £3,506bn) market for credit default swaps remains as risky today as it was a year ago. The primary danger would be a chain reaction of non-payments that could lead to huge uncovered exposures by some investors. If you think that hedge funds have escaped the crisis, just think about what would happen if the credit default swap market imploded. It is a huge but distant risk.
The other threat to the baseline scenario is at least as destructive, and somewhat more probable. It is a dollar crisis.
Given the recent movements of exchange rates, it might be easy to dismiss this possibility. The fall in the oil price has reduced pressure on the world's most important bilateral exchange rate – the dollar/euro rate. But this is mostly a belated recognition in financial markets that the eurozone economy is also going through a weak patch.
The fundamental reasons for a strong euro all remain in place: a large and persistent differential in short-term interest rates; higher US inflation and expectations of long periods of slow US growth.
I would expect the current interest rate differential to remain in place, or even to increase, unless the economic situation in the eurozone deteriorated sharply. Last week's tough statement by Jean-Claude Trichet, president of the European Central Bank, should serve as a warning not to take an early interest rate cut for granted. The ECB may even raise rates if the much-predicted slump does not come and inflation remains sticky.
By contrast, the Federal Reserve will either maintain the present level of interest rates for a long time, or even cut it as the jobless rate edges up a few further decimal points. It is not completely unrealistic to expect a fiscal expansion in the US after the presidential election, no matter who wins. With monetary policy as it is now, and in the absence of a crash in global growth, global and US inflation rates could easily rise.
What then? This is the scenario that could give rise to our second tail risk. If US inflationary expectations were to go up to 4 or 5 per cent, we might see an exodus of global investors from the US, forcing an abrupt and destructive adjustment of the US current account deficit.
We have heard time and again that global investors collude as they have an interest to prevent such an outcome, but this is a silly conspiracy theory. Some recent research* by the economists Harald Hau and Hélène Rey suggests that global investors might be inclined to switch out of dollars much faster than some people believe.
The result would be a toxic feedback loop of a falling US dollar, rising US inflation and real financial disturbance of a kind we have not yet seen. It would lead to a huge increase in dollar market interest rates, bank failures and a recession – of the type where nobody would argue whether it fulfils the technical criteria or not. This scenario would constitute a huge crisis for Europeans as well, who would be cracking up under the weight of an overshooting exchange rate.
I am not predicting this scenario either. But given the present set of policies in the eurozone and the US, there is a non-trivial and not too distant tail risk of such a calamitous event. It may also be one worth insuring against.