DUBAI (Reuters) - The “D” word has crept into the debate ahead of the Washington G20 crisis summit. Not Deflation, but Depression.
The result — according to the thinking of some officials, advisors and strategists gathered at a meeting of the World Economic Forum in Dubai — is that governments and central banks should throw caution to the wind and combat the crisis with every means available.
“There is a real possibility of a real, deep, international depression,” said one senior monetary official, who spoke on the condition of anonymity, calling the crisis “the worst in 100 years”.
As the financial crisis chokes the economy and lending to most corners of business remains all but stopped, economists have cut forecasts, with recession now a certainty in leading western economies and the likelihood increasing of deflation and even a global depression.
To put that in context, a depression is defined by some as a severe and long recession characterised by high unemployment, and by others as a 10 percent fall in output — something that has not occurred globally since the 1930s.
“This financial crisis has now started to undermine the real economy in a very severe way,” said a senior executive at a major international bank who plans to attend the Washington summit.
This week, the International Monetary Fund has warned the world’s richest economies face their first year of contraction since World War II and leading central banks have resorted to drastic action.
The Bank of England shocked markets with a 1.5 percentage point rate cut and the European Central Bank cut by half a point, leading top central banks on a path toward the 1 percent rate now set by the U.S. Federal Reserve.
China meanwhile approved a 4 trillion yuan (371 billion pound) government spending package to boost domestic demand and lift the world’s fourth-largest economy.
But many policymakers fear existing tools won’t work. Emergency liquidity injections have been unable to unfreeze lending so far, with western banks recoiling from any risk due to fear that borrowers, even trusted ones, won’t be able to pay up.
The lending freeze has stopped construction, forced businesses to close, driven up unemployment and forced billions of dollars in bank losses. It has also exposed weaknesses in how the system has been managed up to now — such as in banking regulation or crisis coordination.
Traditional monetary tools such as lower interest rates have had little effect, as they are not being passed on to the real economies in the form of easier lending by banks.
Fiscal expansion — or ramped up government spending and tax cuts — is likely to have the biggest effect, but carries the risk that governments themselves become indebted to the point that markets lose faith in sovereign issuers.
“The instruments we have won’t have the traction they once had in the past,” said one senior policy advisor to a European government. “This crisis is going to be extremely difficult to get out of.”
There is no light at the end of the tunnel and policymakers should begin bracing for another round of recapitalisation by banks, who have written off billions of dollars of losses and will likely write down billions more as the real economy hits the skids, several senior advisers said.
This will force policymakers to improve coordination, discard concerns about inflation or moral hazard, and develop new tools for controlling how banks measure and plan for risk.
“You can keep up the rhetoric about inflation but in a recession, it just doesn’t matter,” said the banker.
G20 leaders gathered in Sao Paolo, Brazil, this week have called for quick and decisive action to address the crisis.
But hopes are low that international policymakers gathered in Washington will fly back to their capitals on November 15 with significant reforms, given competing agendas of those attending.
Editing by David Holmes