Swedbank's Global Economic Outlook, 2010 August

Global Economic Outlook by Cecilia Hermansson 17 August 2010

Economic Research Department, Swedbank AB (publ), SE-105 34 Stockholm, tel +46-8-5859 7740 E-post: [email protected] Internet: www.swedbank.com Responsible publishers: Cecilia Hermansson, +46-8-5859 7720.

Magnus Alvesson, +46-8-5859 3341, Jörgen Kennemar, +46-8-5859 7730, ISSN 1103-4897

The global economy muddles along We have revised upward our current year GDP forecast for the global

economy mainly due to a stronger-than-expected rebound in the euro zone and emerging economies. GDP is growing 4.3% (+0.3 percentage points compared to our spring forecast). Next year we expect global GDP growth to slow to 3.6% and in 2012 we see the pace rising slightly to 3.8%. This is 0.1 percentage point lower per year than in our spring forecast and is mainly due to more modest growth in Europe and Asia. Our forecast of sluggish US growth remains unchanged.

Beyond the rebound, growth in the Western World (West) continues to trend weakly. Fiscal austerity, debt reconstruction and weak labour, housing and credit markets are softening growth prospects. The optimism in Europe that followed in the wake of positive growth data, the bank stress tests and strong corporate earnings will soon be replaced by pessimism, similar to the situation the US now faces. Emerging economies are expected to see a soft landing. Economic policy is being tightened to avoid an overheating in consumption and asset markets. Emerging economies will continue to drive the global economy, and the convergence between them and the West is accelerating.

Despite the slowdown in the US, we consider the risk of a new recession (double dip) to be relatively small (10%). Our main scenario, with weak growth, low inflation and low interest rates in the West, has a probability of 50%. On the other hand, the risk of deflation and weaker growth has increased, i.e., a Japan scenario does not appear to be as far-fetched as before. A zero interest rate policy could also contribute to a deflation scenario. We give this a 25% probability. Faster normalisation driven by high investment growth has a 15% probability.

Although our forecast points to a continued recovery in the Nordic and Baltic countries, the region is vulnerable to a deterioration in Europe and emerging economies. Countries that combine cutbacks/stimulus with structural reforms have a better opportunity to handle new downturns and strengthen their position in the slightly longer term at a time when globalisation is leading to greater competition.

Cecilia Hermansson

Contents: 1. After the rebound, many challenges remain 2 2. The biggest threats to the global economy – 5

and to our forecast 3. A Japan scenario no longer far-fetched 9 4. Economic policy 11 5. Our outlook for the financial and commodity markets 15 6. Regions/countries: Western World, please hold! 20 7. Conclusions for our home markets 40

2 Swedbank’s Global Economic Outlook • 17 August 2010

1. After the rebound, many challenges remain

Emerging countries, the US, Japan and most recently Europe, in that order, have seen their economies rebound following the severe recession of 2008-2009. Economic stimulus programs, rescue packages for the financial sector and stronger future confidence have helped exports to accelerate once again, and inventories have been built up, giving a big, though temporary, lift to growth.

GDP growth on an annual basis (%) in a number of major countries/regions

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It is positive that the recovery has continued, but worrisome that the US is again weakening following the rebound. Pessimism has returned. Gigantic problems in the labour, housing, and credit markets still remain. It takes time to correct balance sheets. The political situation is also becoming more challenging. Our outlook has not changed significantly since the spring: After 2.8 per cent growth this year, GDP will increase by 2.2% in 2011 and 2.5% in 2012.

Global GDP forecast August forecast April forecast

GDP-growth (%) 2009 2010 2011 2012 2010 2011 2011US -2.6 2.8 2.2 2.5 2.8 2.2 2.5

EMU-countries -4.1 1.2 1.1 1.6 0.9 1.3 1.9of which: Germany -4.9 2.2 1.3 1.7 1.3 1.5 2.0

France -2.6 1.5 1.5 1.7 1.5 1.8 2.2Italy -5.0 0.8 0.9 1.3 0.6 1.0 1.5Spain -3.6 -0.7 0.5 1.6 -0.5 0.7 1.7

United Kingdom -4.9 1.0 1.6 1.9 1.1 1.6 2.2

Japan -5.2 2.8 1.4 1.5 2.0 1.4 1.5China 9.1 9.8 8.5 8.1 9.5 8.8 8.0India 5.6 8.0 7.5 7.8 7.5 7.8 8.0

Brazil -0.2 6.5 5.0 5.0 4.7 4.5 5.7Russia -7.9 4.3 4.3 4.5 4.3 4.5 5.0

Global GDP in PPP -0.7 4.3 3.6 3.8 4.0 3.7 3.9Global GDP in US dollars -1.9 3.4 2.8 3.0 3.1 2.9 3.2

Source: National statistics and Swedbank’s forecasts with World Bank 2009 weights. Note: These countries represent 75% of the global economy.

The recovery continues …

… but a weaker US is a concern

Swedbank’s Global Economic Outlook • 17 August 2010 3

Japan’s rebound is closely tied to the high growth rate in China. Exports have risen at the same time that domestic demand is low and deflation remains a problem. In the second quarter, growth faded. Even so, GDP growth has been revised significantly upward to 2.8 % this year, while thereafter the cool off in China and strong yen point to more modest 1.4-1.5%.

The spring crisis in the Eurozone has passed its most acute stage. After the banks underwent stress tests and transparency improved, concerns eased somewhat. Strong GDP figures for the second quarter – particularly in Germany, which has benefitted from demand from emerging countries – have also increased optimism. We expect that like in the US this will turn to pessimism later this fall and that our revised GDP growth estimate for this year (to 1.2%) will be lower for 2011 and 2012. Due to fiscal austerity and continued weak credit and labour markets, activity is not growing as quickly in many export-intensive European countries as the rest of the world develops more slowly.

The West's more U-shaped recovery is clearly more problematic than the emerging economies’ V-shaped rebound. China and India, for example, do not face the same balance sheet problems, public debt crises and subsequent need for austerity. Instead, they have the leeway for a further stimulus. Overheating problems have grown, however, and China, India, Southeast Asia and Brazil, among others, must now tighten their financial and monetary policy in order to fight off the signs of inflation. We feel that a soft landing is possible given the strong fundamentals in emerging countries and the continuing recovery in the West.

The G20 economies’ austerity measures correspond to about 1.25% of GDP in 2011. Central banks are expected to wait before raising interest rates until the end of 2011 (US, UK) and until 2012 (ECB). Additional quantitative easing cannot be ruled out. Short- and long-term market interest rates will remain low in the West during the entire forecast period. Commodity prices are rising weakly. We see the dollar strengthening against the euro at a time of fluctuating economic data and big problems for the Eurozone. After appreciating against the dollar, the Japanese yen is expected to depreciate slightly during the period. The Chinese yuan is rising against the dollar, but very cautiously.

The biggest threat to the global economy is that the wrong economic policies are adopted and concerns about the financial market again send the global economy into a tailspin. We have counted up to thirteen threats, each of which individually or together could change our relatively positive, growth-oriented outlook: a new recession in the West, deflation, instability in the financial markets, government finances, savings imbalances, labour markets, middle class stagnation, protectionism and a lack of global leadership, a political stalemate, ineffective economic policy, inflation, jittery commodity markets, and natural disasters and other major shocks.

In Japan, the lift from China is fading

Big risk that the optimism in Europe won't last

Emerging economies have managed better, but now need to temper demand

We assume that interest rates will remain low with slightly rising commodity prices and a stronger dollar during the period

The forecast risks are both short- and long-term – and complex


Since developments remain complex following the financial crisis, we offer four scenarios. We give our main scenario – “muddling through” – a 50% chance. The risk of a new recession, a scenario with a double dip, has dropped to 10%. We see that the risk of a Japan scenario, i.e., with slow growth and deflation, as higher and give it a probability of 25%. A scenario with faster normalisation driven by a stronger investment climate has been assigned a 15% probability.

Based on a muddling-through scenario, economic policies are pretty much on the mark. Countries facing major fiscal problems have no choice but immediate austerity, as is the case in Southern Europe, the UK and Ireland. Larger economies, on the other hand, can wait until 2012 to ensure that the recovery has legs and better coordinate economic policy within the G20. This means that Germany and Japan are in too much of a rush. The argument that their growth will be stronger if they tighten their belts does not make sense when all countries are doing the same thing and long-term interest rates are already low.

It would be reasonable to delay interest rate hikes, but there are risks. In the report, we show, based on a study by the Federal Reserve Bank of St. Louis, that a zero interest rate policy could steer a country into a Japan-like scenario where deflation becomes entrenched and monetary policy has no effect. Despite quantitative easing and fiscal stimulus, Japan is stuck in just such a stage. That interest rates are not as close to zero in Europe is positive, whereas the risk is greater in the US, where core inflation has now dropped to historically low levels.

The debate among economists, especially in the US and the UK, over austerity versus stimulus (see, e.g., the Financial Times) misses the point that in the longer term it is even more important to consider demographic factors and runaway welfare spending, which are tightening fiscal constraints. As a result, implementing structural reforms that raise growth potential could improve government finances in the medium term and are more important than the next year's policy mix. The quality of financial policy must be a higher priority, in addition to which both stimulus and austerity must be linked to structural reforms. In the report we discuss the reforms that are needed.

The crisis has peaked. Soon the rebound will also be over. There is a risk of a new recession, and even more so that growth will be weaker with an element of deflation. The export-dependent Nordic and Baltic region can learn from crises that it is important to have public and private buffers to reduce the region's vulnerability to global slowdowns. Furthermore, labour and product markets have to function better, and compete-tiveness must be strengthened. The key is also to avoid internal imbalances that can create big problems. The huge debt build-up we are now seeing in the Norwegian and Swedish household sector is a concern from this perspective. On the other hand, the majority of the countries in the region have decided to maintain strict discipline in their public finances, which in any case will soften the blow of any new shocks that occur.

We have therefore devised four scenarios

While some countries are in need of austerity, this does not apply to Japan and Germany, which can wait until 2012

While it seems sensible to keep interest rates low, there is a risk that the zero interest rate policy in the US is contributing to deflation

Structural reforms have to become a higher priority and be linked to both a new stimulus and austerity measures

The Nordic and Baltic region can learn from the crisis – reducing their vulnerability is a key, but it is also important now to see competitiveness from a broader, longer-term perspective


2. Threats to the global economy – and to our forecast

The threats to the global economy outlined below (in no particular order) should be viewed from a more long-term perspective than a forecast period of two to three years. They should also be looked at as individual threats or linked to and mutually dependent on each other.

New recession in the US, Europe and Japan Although the risk of a new recession has diminished as the financial sector has improved, it still remains and can pop up later during or after the forecast period. A couple of quarters of negative growth does not necessarily have to be a major problem. Only if a new downturn creates instability in the financial market, deflation and bigger political concerns would the effects be serious as policy tools are less effective.

Triggers: A hard landing in emerging economies, sovereign debt defaults, another shock to the financial market, economic austerity and growing pessimism that chokes off consumption, investment and trade.

Deflation Deflation driven by weaker demand and balance sheet corrections upsets the recovery and debt reconstruction, as consumers stop spending in expectation of lower prices, companies find it hard to raise prices, and real debts rise in value. It is usually hard to extricate from a deflationary spiral.

Triggers: A weak labour market and extended period of debt reconstruction in the private and public sectors that causes deflation similar to Japan in the 1990’s and 2000’s. Compare Irving Fisher’s (1933) theories on debt and deflation. A zero interest rate policy can also raise the risk of deflation if negative shocks occur (see more below under monetary policy).

Inflation A huge stimulus in the form of a zero interest rate policy, expanded balance sheets and fiscal programs create the risk of high inflation when growth proves sustainable. At this point the monetary base has increased substantially, but not the money supply.

Triggers: If lending were to increase significantly and central banks don't have the chance to react. The need to fund public budget deficits and higher bank reserves could cause long-term interest rates to rise, which would contribute to higher inflation.

New instability in the financial sector and financial markets There seems to be a general consensus that systemically important financial institutions will be rescued if problems arise, but if this isn't the case there is a risk that new concerns will arise which could spread through counterparty risks and psychological effects. If the concerns are great, global trade, the balance sheets of many players and growth could be at risk.


Triggers: Governments decide not to rescue institutions in crisis or lack the means to do so, new “skeletons in the closet” are found despite the stress tests, important connections are neglected in the stress tests, which means that conditions were not as bright as reported, the public debt crisis in Southern Europe flares up again and spreads to more countries at the same time that rescue packages prove insufficient. In addition, tougher financial regulations could push some banks into bankruptcy. For the financial markets, this could mean new shocks occur at the same time and that assurances normalcy will be restored do not come in time.

Financial crisis for Western governments To date the sovereign debt crisis has been limited to the PIIGS (Portugal, Ireland, Italy, Greece and Spain). The financial market’s confidence in the fiscal policies of the US, the UK, Japan and Northern Europe appears to be intact. This could change, with the risk of major tension in global fixed income, currency and stock markets.

Triggers: The public finances in a number of major economies are considered unsustainable at the same time that signs of budget consolidation are not seen as ambitious enough by the financial market. Foreign players (mainly China and Japan) are no longer willing to finance the US budget deficit. Difficulties in financing Japan's deficit will arise if the Japanese instead invest more abroad or if interest rates rise.

Savings imbalances grow again The US current account deficit again increases at the same time that China’s surplus becomes bigger and its currency reserves swell. Previously this contributed to bubbles in the financial market, which could be the case again in a few years.

Triggers: China is overly cautious in adopting a more flexible currency policy, i.e., the yuan appreciates slowly against the dollar and is offset by its depreciation against other currencies. The dollar becomes stronger, which weakens the trade balance.

US current account balance (US$ billion) and China's currency reserves (US$ trillion)

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U S A C u r re n t A c c o u n t

C h in a 's c u r re n c y re s e rv e s


Labour markets in the West experience jobless growth After a recession it can take time to reduce unemployment. Instead productivity usually improves and new hiring is put on hold. Structural unemployment tends to increase when the ranks of the long-term unemployed grow and competence is lost. Concerns about unemployment reduce turnover and market dynamism. A focus on job security keeps wages in check. Growth and public finances suffer.

Triggers: If orders remain weak, companies will face greater pressure to cut costs, partly by further raising productivity and partly by outsourcing more to countries with lower wages. Pessimism and weak confidence make companies reluctant to hire new workers.

Difficulties for middle class in raising their standard of living Until the financial crisis many US – and European – middle-class families were able to raise their standard of living by borrowing against their homes. Annual incomes for the 90% of the US population with the lowest incomes have remained unchanged since 1973. The 1% of the highest wage earners have seen their incomes triple during the same period. Fewer poor people are managing to climb the income ladder than before. In Europe, social welfare systems are under threat. The great stagnation increases the risk of political instability, populism and protectionism.

Triggers: The middle class has been shrinking for some time. The situation could get worse now that many people are being forced from their homes and the job market is weak.

Protectionism and lack of global leadership After the financial crisis broke out a number of protectionist measures were adopted around the world. “Buy American” in the US, French cars shouldn't be manufactured in Eastern Europe, etc. While some of this was rhetoric, it has had an impact: bilateral trade negotiations instead of multilateral and reduced trade and investments. The US, for example, has restricted Chinese direct investment at the same time that China hasn't done anything to help foreign companies. Integration is being slowed both regionally (EU) and globally. Immigration is also being held back.

Triggers: Weak labour market, political demands to focus more nationally and help the domestic population. Weak growth prospects for households can lead to increased protectionism. National needs take precedence over the need to coordinate global policy.

Political deadlock – political instability The midterm elections in the US could result in the Democrats losing their majority, which would put the administration’s ability to govern to the test. In Japan, the majority in the upper house is lost. In Germany, Chancellor Angela Merkel has lost her majority in the Bundesrat upper house. Political deadlock can arise more easily, which would delay important reforms.

Triggers: Displeasure with the parties that are trying to lift


countries out of the crisis has grown, and politicians are regarded as ineffective. In the US, there is a fear that the country is being Europeanised and socialised.

Ineffective economic policy Economic policy can be ineffective for several reasons. One is that resources/reforms are targeted incorrectly and at the wrong time. To reach compromises, for example, ineffective measures may end up being adopted that benefit a limited few. Another is resources are not available to drive economic policy in the Eurozone, for example, where austerity is being introduced despite that the recovery hasn't proved sustainable. A third is that it has no effect, e.g., a monetary policy where interest rates are around zero but where the willingness to lend or finance is too low for interest rates to have an effect. The fourth reason is policy mistakes, such as the delay in agreeing on a rescue package for Greece.

Triggers: We already see examples of ineffective economic policy. The second case – insufficient resources – will increase due to austerity needs and higher funding costs for some high-debt countries. Complexity alone could raise the risk of policy mistakes.

Rapidly rising commodity prices Commodity prices have rebounded in the same way as the economy in general. However, substantially higher commodity prices could affect growth prospects for commodity-exporting and -importing countries with positive and negative effects, respectively. Major fluctuations can also create tension in the financial markets, e.g., lower stock prices due to poorer earnings prospects for manufacturers. Central banks may have to raise their benchmark rates if the price increases aren't seen as temporary. A stagflation scenario with low growth and high inflation can (with a small probability) be painted.

Triggers: Supply problems in particular can disrupt price trends, but stronger demand from emerging economies could also put upward pressure on certain commodity prices.

Natural disasters and other major shocks Floods, fires and terrorist attacks are examples of shocks that can affect financial markets and commodity prices. Apart from human suffering (see Pakistan, China, Russia and Bangladesh), they can also cause economic disruptions.

The biggest negative forecast risks in 2010-2012 are the effects on the economy of financial markets and financial institutions, psychology and public sentiment, economic policy and debt reconstruction in the private and public sectors. Political developments could also have an impact.

The biggest positive forecast risks are that the labour market improves faster than expected, which increases confidence in the future as well as domestic demand. Stronger investment in light of high corporate earnings and solid demand for computers and other equipment could also raise growth.


3. Japan scenario no longer far-fetched The uncertainty in analysing the current global economy is unusually great. For one thing it is hard to decipher economic trends after a major recession, then a rebound. Secondly, it is unclear what economic policy will be – whether countries will choose austerity or stimulus and which structural reforms they implement. Importantly, this recession has been different, with a structural crisis that resulted in major changes in relative prices, balance sheets and business models, as a result of which the old equations no longer work. Our econometric models are becoming obsolete and have to be replaced.

Reinhart & Rogoff (2009) have studied the financial crises of the last century. With regard to banking crises, they have found that on average they result in the following:

A 35.5 per cent rise in housing prices lasting six years;

A 55.9 per cent upswing in stock prices lasting 3.4 years;

A 7 per cent increase in unemployment lasting for 20 years;

A 9.3 per cent decline in GDP lasting 1.9 years (normal recessions last about a year);

An 86 per cent rise in government debt three years after the banking crisis began.

Thus far this recession has generally followed the earlier pattern, including Japan’s. Compared to a normal cyclical recession, this recovery is taking longer in the West. Even though a Japan scenario no longer seems as far-fetched as before, we see it as a less likely scenario. In our main scenario, deflation is avoided because the financial crisis is addressed faster than in Japan, asset prices have not fallen as much and there is less need for debt reconstruction in non-financial companies in the US and Europe than there was in Japan.

Since the global economy has become more complex, economic policy more active and financial crises no longer just national or regional but global in scope, we have to include other scenarios. Below we review the assumptions behind our four scenarios for the global economy as a whole and the probability we assign each of them:

Scenario 1: “Muddling through” – our main scenario The recovery continues, but erratically and with slow growth and low inflation

Assumptions: After the downturn and rebound the global economy continues to strengthen, but with major swings in activity owing to shifting sentiment between optimism and pessimism. Some stimulus measures are reversed and austerity is adopted in countries with no other alternative, although a further stimulus is possible as well. Domestic demand in the West is held back, which limits inflation. Deflation

It is hard to decipher trends beyond rebounds

A Japan scenario no longer seems far-fetched, but deflation can still be avoided

Probability: 50%


is avoided (see above). Interest rates remain low when risk-averse investors choose safer investments in government securities rather than real investments and due to lower growth and inflation expectations.

Scenario 2: Japan scenario The recovery continues with slower growth than our main scenario and with deflation

Assumptions: Japan is already struggling with deflation. The US and Europe see weaker price growth (core inflation) due to sluggish demand and labour market. A zero interest rate policy helps to keep inflation expectations low. Negative shocks reduce them further. Pessimism increases. Debt reconstruction becomes difficult and growth is held in check. To avoid a recession, the US in particular tries to stimulate its economy with the help of fiscal policy and quantitative easing as it can no longer resort to interest rate cuts, but in the Japan scenario this does not help to raise inflation expectations and normalise monetary policy.

Scenario 3: Double Dip A new recession arises

Assumptions: New concerns arise in the financial markets which cannot be managed with the help of economic policy. Weak economic indicators cause concern. Confidence falls in pace with asset prices and currency concerns grow. A recovery takes longer after opportunities for a new stimulus have been exhausted. The recession could give rise to deflation, especially if it is long lasting.

Scenario 4: Faster normalisation The recovery gets stronger with higher growth and a risk of inflation

Assumptions: Strong earnings from large corporations and banks as well as low capital costs pave the way for real investments and innovation. This generates stronger household confidence as the labour and housing markets also improve in the light of more expansive investment conditions. The credit multiplier rises, which means that banks have more money to lend in relation to their reserves and the money supply increases, which leads, in combination with stronger demand and greater opportunities to raise prices, to higher inflation expectations. Another contributing factor is that fiscal conditions and banking regulations push long-term interest rates higher as demand for safe investments declines at the same time that the supply of bonds increases substantially.

Probability: 25%

Probability: 10%

Probability: 15%


4. Economic policy To avoid a depression and deflation, countries around the world have resorted to every possible economic tool at their disposal. Aside from those we see in the simplified figure below, guarantees have been given to financial institutions, for example, to stabilise financial markets.

The strategies appear to be working. A depression has been avoided and a recovery is on the way. Under these circumstances this would seem to be the right time to begin normalising economic policy. There are several reasons why:

Public debt/GDP is projected at 115% in 2015, nearly 40 percentage points higher than before the financial crisis (IMF)

The Greek crisis has shown that the financial market is not willing to finance certain countries’ large budget deficits without very high risk premiums.

Even if the US, the UK, Japan and Germany have the confidence of the financial market at this point, this could quickly change and drive up long-term bond rates.

The zero interest rate policy could lead to an incorrect allocation of capital and create new asset bubbles. In the event of another downturn, there will be no room to manoeuvre. See, e.g., Hoenig (2010).

The balance sheet policies of central banks – quantitative easing – could lead to a dependency on government support (e.g., in the US housing sector) if they are kept in place too long.

Based on our main scenario where the recovery continues but remains slow, we recommend the following:

1) Countries that have no alternative or whose national debt is rising too quickly should tighten their fiscal policies immediately and set medium-term budget targets that generate confidence (PIIGS, UK). Within the G20 austerity measures are estimated at 1.25% of GDP next year.

2) Countries that can afford to wait should set medium-term budget targets and make sure that their fiscal policies are not restrictive in 2011, when other countries are tightening

Economic policy has prevented a depression

If the recovery continues, economic policy should normalise


theirs, possibly providing targeted fiscal support to the labour market, for example (Germany, US, Japan).

3) Monetary policy provides support for the budget consolidation by delaying interest rate hikes at the same time that central bank balance sheets stabilise and shrink automatically.

4) G20 countries coordinate their economic policy in terms of size, timing, mix and reforms.

This probably agrees largely with the strategies that are now in the cards, except that Germany and Japan have decided to turn to austerity earlier. Waiting another year or so would have been preferable. A new quantitative easing is also possible. Moreover, the G20 should not try to overly coordinate policy.

If it turns out in the months ahead that the recovery gets sidetracked and consumer prices and inflation expectations drop, it might be worth considering other measures.

In a 2010 study, James B. Bullard, president of the Federal Reserve Bank of St. Louis, states that a zero interest rate policy in actuality increases the risk of deflation. He claims that the US could find itself closer to a Japanese-style outcome in the years ahead.

His thesis is that with the Taylor Rule that central banks currently use when nominal interest rates rise more than one-for-one when inflation deviates from a given target, there are two stages of steady state1: 1) a conventional steady state where monetary policy is effective/active and where the nominal interest rate is adjusted so that inflation reaches the target, and 2) an unintended steady stage where monetary policy has no effect/is passive since interest rates cannot be reduced when inflation is falling.

In the diagram below we see that the US to date has operated in steady state 1 and Japan in steady state 2. The zero interest rate policy, in combination with fresh inflation data, indicates that the US is shifting westward in the diagram. In the event of a negative shock inflation will not return to the target. Instead both actual and anticipated inflation would be negative, a stage that is difficult to extricate from. This situation is similar to the liquidity trap Japan has been in for years.

Japan has received a lot of advice on how to fight deflation, but has not managed to climb out of this stage despite quantitative easing and fiscal stimulus. Richard Koo (2008) has stated that

1 The Taylor Rule is not linear. If it were the benchmark interest rate would be negative when inflation was extremely low, which is not possible. The other curve in the diagram is a Fisher Relation, i.e., it says that the nominal interest rate has a real interest rate component and an anticipated inflation component. Where the Fisher Relation and the Taylor Rule cross is where the optimal interest rate and inflation point can be found. They cross in two places and therefore there are two stages.

Austerity is unavoidable in certain countries, but Japan and Germany could have waited

A zero interest rate policy can contribute to deflation

Despite quantitative easing and fiscal stimulus, Japan has been unable to avoid deflation


in balance sheet recessions the focus is on deleveraging, so there is little desire to borrow. Monetary policy becomes less active, while the importance of fiscal policy increases. Koo also claims that the advice to “drop money from helicopters” wouldn't work either, since there would be complete loss of confidence in money.

Nominal short-term interest rates and core inflation in Japan (circles) and the US (squares) 2002-2010 – Fisher Relationship (broken line), Taylor Rule (solid line)

Source: J.B.Bullard (2010)

Benhabib, et al (2002), who in 2001 were the first to show that it was possible to go from steady state 1 to 2, view that printing money is an alternative, but not if there are guarantees that government finances will be managed sustainably and people expect tax cuts later on. This would only worsen the deflationary spiral. The suggestion that governments will be perceived as irresponsible and face insolvency problems does not seem relevant in the reality we live in today. Still, Japan has not been able to avoid the deflation stage either, with a debt ratio of 200% of GDP.

The Bank of England (BOE), on the other hand, seems to be better at manoeuvring the situation. Its benchmark rate has not been cut below 2% in 314 years, and the BOE chose to set a floor of 0.5% (ECB at 1%). Quantitative easing entails purchases of government bonds, which more than purchases of mortgage bonds drives up inflation expectations. On the other hand, the monetary base can be adjusted quickly both upward and downward, which actually should not affect inflation expectations. Quantitative easing has not helped to prevent deflation in Japan either.

The advice being given is unreasonable given today's reality

It is important not to cut to zero – maybe the US should raise rates earlier?


Efforts to correct balance sheets in the private and public sector will take time. There is no room for a massive fiscal stimulus given the state of the financial markets and that demographic trends are already contributing to rising debt ratios. The measures that are being taken must be correctly targeted in areas where they are needed, such as the labour market. Furthermore, expansive monetary policy must be combined with structural reforms that raise growth expectations over time. In the West, especially the US, the time horizon appears to be short and the direction based too much on boosting household consumption as a growth engine despite all signs otherwise. New growth models must focus on investments in the future in order to compete with China, which is busy developing its infrastructure and human capital – though still from low levels.

Structural reforms should therefore focus on:

Measures that speed up the replacement of growth models if needed and reduce global savings imbalances;

Strengthen financial regulations through global coordination and with a reasonable time horizon given the current economy (an analysis of the financial regulations and a postponed Basel III is forthcoming);

Measures that increase regional and global integration –totally new frameworks for collaboration are needed within the Eurozone (will be dealt with in a fortcoming analysis);

Pension reforms where the retirement age is raised, since we live longer;

The functioning of the labour market – to increase employment;

Efficiency improvements in the public sector – to handle social and welfare needs;

New budget targets and spending and tax reforms;

More flexible currency regimes – needed mainly in China;

Liberalisation of trade and investments;

Deregulation of product and service markets – the service sector needs to be more dynamic and integrated, especially in the EU;

Educational reforms – to handle globalisation and growing competition;

Infrastructure investments – that help to expand local labour markets and strengthen productivity and growth.

Too much focus on fiscal and monetary policy and too little on structural policy


5. Our outlook for the financial and commodity markets

The forecast in our main scenario is based on assumptions regarding interest rates, currencies, stocks, housing prices and commodity prices. There are considerable forecast risks involved, since it is notoriously difficult to predict individual exchange rates and asset prices.

Interest rates Fiscal austerity and weak domestic demand will soften price pressure in the West during the forecast period. Compared to last year consumer prices are rising, but in many cases inflation is below its target. Emerging economies are cooling down to reduce overheating problems, which is keeping inflation in check.

Inflation outlook based on the consumer price index (%)

2009 2010 2011 2012US -0.3 1.5 1.3 1.5

EMU-countries 0.3 1.3 1.0 1.2UK 2.2 3.0 1.9 1.8

Japan -0.7 -1.0 -0.3 0.5China -0.7 3.2 3.0 3.0India 2.2 8.5 6.5 5.5

Brazil 4.3 5.2 4.8 4.3Russia 11.7 6.6 8.9 10.0

Global CPI 0.9 2.6 2.4 2.5

These conditions, along with the fact that the growth rate is slowing and the recovery is taking more time, mean that central banks are not expected to raise their benchmark rates as early as we predicted in our spring forecast, where we assumed that rate hikes would begin in Europe and the US during the second half year. Now we do not see the first hikes for another year. The zero interest rate policy will continue.

Note: These assumptions are based on our main scenario that deflation can be avoided. If, however, a Japan scenario occurs, interest rate hikes will come later, probably not at all during the forecast period. Then quantitative easing will also intensify, which means that the balance sheets of central banks will expand.

Consumer prices are rising, but core inflation remains low

Interest rate hikes have been delayed for a year


Short-term interest rate assumptions 2010-2012 Poliy interest rates 2010 2010 2011 2011 2012

16 aug 31 dec 30 jun 31 dec Average

Federal Reserve, US 0.25 0.25 0.25 1.00 2.00ECB, Euro zone 1.00 1.00 1.00 1.00 1.50BOE, Great Britain 0.50 0.50 0.50 1.25 1.75BOJ, Japan 0.10 0.10 0.10 0.10 0.10

Thanks to the continued recovery and weak inflation, long-term bond rates are staying relatively unchanged or trending slightly higher. In a Japan scenario, they would fall further, and in a scenario where normalisation happens faster, with the risk of inflation in the slightly longer term, they could rise much faster.

It should be noted that in the diagram below it took a fairly long time before Japanese bond rates had dropped before levelling off at below 2%, despite that deflation was already a fact.

At the same time it should be kept in mind that when confidence in a country's finances is undermined in the financial markets, bond rates will quickly rise, as we have now seen in Southern Europe, for example.

Long-term market interest rates , 10 yr government bonds (%), US, UK, Japan and Germany


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Currencies Since the beginning of the year the euro has fallen by just over 11% against the US dollar and by 3.5% against the British pound, while the Japanese yen has appreciated by 8.4% and the Chinese yuan by less than 1%. Through June the US dollar had risen by slightly over 4% based on a broad, trade-weighted index after last year's depreciation.

The more positive trend in Europe this summer since the worst of the debt and banking crisis had passed has strengthened the euro and pound against the dollar. The yen has also continued to rise, but at the same time that China appreciated the yuan slightly against the dollar, it has weakened against the euro.

Low bond rates can quickly turn higher – if confidence sinks


Exchange rates of various currencies against the dollar and the dollar's trade-weighted trend (Index August 2007 = 100) – a rising curve indicates weakening

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S te rling aga inst the U S do lla r

We expect the dollar to rise against the euro during the forecast period driven by slightly faster growth and a continued appetite for US treasuries, which are still regarded as safe bets. The Eurozone’s continued problems are also a contributing factor.

The Chinese yuan will continue to appreciate assuming that the global recovery lasts, but the pace will remain slow at about 4-5% per year. If a new global recession occurs, we think it is likely that China will again stop the yuan’s appreciation.

While the yen isn’t likely to lose ground in the year ahead, it probably won't go much higher from today's levels either. A relatively strong yen is partly due to the need among central banks to diversify their currency portfolios away from the dollar. As the dollar appreciates, this need subsides. Slower growth in 2011 and 2012 will also weaken the yen slightly.

Exchange rate assumptions 2010-2012 2010 2010 2011 2011 2012

16 aug 31 dec 30 jun 31 dec Average

EUR/USD 1.32 1.30 1.25 1.22 1.20RMB/USD 6.77 6.60 6.50 6.30 6.15USD/JPY 86 87 90 95 98

Commodity markets In line with a stronger global economy this year, we are raising our oil price forecast upward to 78.5 dollars a barrel (75 dollars in our spring forecast). The growth rate will then slow and be weaker in 2011 and 2012 compared to our previous forecast. Oil is now expected to rise to 82 dollars in 2011 and 90 dollars in 2012.

The price of oil will remain considerably above the average for 1970-2010 of 27 dollars, and even above the average for 2005-2010 of 72 dollars.

The dollar is expected to rise during the forecast period

China remains cautious

Diversification away from the dollar is helping the yen

After rebounding oil prices will rise more slowly


Nominal price of oil, US dollars/barrel 1970-2010

Source: Reuters EcoWin

70 73 76 79 82 85 88 91 94 97 00 03 06 09

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dol

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arre

l

0

25

50

75

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125

150

First Oil Crisis

Second Oil CrisisKuwait

Asian Crisis

9 eleven

Irak

High demand, also some supply problems

Financial bubble

IT bubble

201220112010

We expect metal and food prices to continue to trend upward, although the growth rate will slow in 2011 and 2012 compared to the rebound after the crisis. The risk of higher grain prices has increased due to the fires in Russia and the export stoppage there and in Ukraine, although the inventory situation still seems better than during the supply shock in 2008.

Commodity price trend in dollars (Index 2000 = 100)

S ource: R euters E coW in

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Food price index

C om m odity p rice index - to ta l

C om m odity p rice index - exclud ing energy

Asset markets Housing prices have not yet hit bottom in Spain and Ireland, for example, and even though the slowdown has eased in the US and Denmark there are as yet no signs of a clear recovery. In the US, the phase-out of tax subsidies has created uncertainty,

The fires in Russia have increased the risk of higher grain prices


in combination with the Federal Reserve’s decision to stop buying mortgage bonds from Fannie Mae and Freddie Mac. A new stimulus for debt-burdened homeowners and mortgage institutions cannot be ruled out and could give housing prices a boost, but a self-generating, robust recovery is still in the future. There is still considerable overcapacity. A recovery has been noted in the UK, where supply is limited and demand has risen in pace with low interest rates, but prices have now been falling for two months. In Norway and Sweden, the rise in housing prices has gotten ammunition from a rapid credit expansion. Provided that low interest rates stick around for a while longer, housing prices will remain stable or rise in a number of countries, except where there is overcapacity and too many homes were built before the crisis.

Housing price trend in selected countries (Index 2000 = 100)

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Market jitters returned in 2010 due to the Greek crisis and the Eurozone’s inability to handle it. To date stock markets have benefitted from corporations’ lower costs. Order bookings, especially from the West, are lower than normal, however. Going forward they will have to increase in pace with the recovery – a reasonable scenario – but since the impact of cost savings is ebbing, stock prices are rising slower than in 2009.

Stock price trends in the US, Japan, India, China, Russia and Europe (Index January 2009 = 100)


0 6 0 7 0 8 0 9 1 0

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Strong equity prices will require an increase in order bookings


6. Regions: Western World, please hold! Although the global recovery is continuing, there are signs of slower growth in the second half year as the effects of stimulus measures fade and the rebound after the great recession comes to an end. In particular, growth is no longer getting the same lift from inventory investment.

In the years ahead the recovery will also slow due to tighter economic policy, mainly fiscal policy, though also gradually less expansive monetary policy as well as stricter rules on the financial sector.

Emerging economies, especially in Asia, have had a strong impact on the recovery. Growth has been high not only in China and India. The economies of Singapore, Taiwan, Thailand, Malaysia, the Philippines and Indonesia are also growing strongly, at between 6% and 20% on an annual basis. The West is getting a boost, especially export-oriented countries such as Germany, Japan and Sweden.

Annual GDP growth in a number of Asian countries (%)

S o u rc e : R e u te r s E c o W in

Q 1 Q 3 Q 1 Q 3 Q 1 Q 3 Q 1 Q 3 Q 10 6 0 7 0 8 0 9 1 0

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cent

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2 0S in g a p o re

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M a la y s ia

P h il ip p in e s

Activity in many emerging countries has risen a little too quickly, however, and there is a risk of overheating. One sign is high inflation. Others are rising asset prices and a rapid increase in consumer spending.

Attempts are being made to reduce imbalances and cool off these economies. The key is to avoid too fast of a slowdown, especially if stricter economic policies are coupled with lower capital inflows and a downturn in more developed countries. Our main scenario includes a soft landing in emerging countries such as China, India and Brazil. The risk of a recession there is limited, and if one does occur, it could be countered by new stimulus measures more easily than in the West. (Russia will be dealt with in a forthcoming analysis).

In more developed countries, i.e., the West, there is greater concern for a new recession after several quarters of growth. The risk has eased, however, thanks to greater transparency in

Thanks to a V-shaped recovery in emerging economies, the global economy is getting a lift

The key is to avoid a hard landing in emerging economies


the European banking system following the stress tests and after Greece implemented the reforms and cutbacks that had been expected, which calmed the financial market. The West still faces a massive debt restructuring in the private and public sectors, at the same time that the financial sector has to shrink in the wake of the financial crisis and new regulations.

Note: The focus should not only be on the size of austerity packages but also on the difference between previous stimulus measures and austerity – a major “swing” that at the same time is slowing activity in several sectors in several countries.

The US has led the recovery. The rebound has also been stronger than expected in Japan. The fourth quarter of 2009 and first quarter this year were the strongest measured in terms of annual and quarterly growth. Now we expect a slower second half at the same time that Europe, which usually trails by about a half year, sees its growth peak in the second and third quarters. The positive trend in the US about six months ago has crossed over to Europe, and with it optimism has followed.

It is important, however, to look beyond rebounds and instead focus on the underlying trend. Western countries are struggling with relatively similar problems: weak labour, housing and financial markets and growing political instability. The US is expected to stabilise with GDP growth of 2.5% in 2012, while the Eurozone and Japan are more likely to reach 1.5%.

The US and Eurozone are both growing about one percentage point lower than before the financial crisis. The US is back at its GDP level before the crisis late last year, while Japan and the Eurozone will have to wait until 2012. The difference between the US and Europe isn't that great, however, about 5 percentage points, compared to China and India, which instead are expected to grow 35-40% during the period (2008-2012).

Actual and estimated real GDP growth 2007-2012 (Index second quarter 2008 = 100)

7580859095

100105110115120125130135140145150

Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

2007 2008 2009 2010 2011 2012

USJapanEurozoneChinaIndia

While the West is obviously starting from a higher income level, the financial crisis and recession are accelerating a

Optimism has turned to pessimism in the US – Europe is likely to follow

It is important to look at the trend beyond a single economic rebound


convergence. Given growth of 8% and 2.5%, respectively, China will pass the US as the world's largest economy in 9-10 years with GDP in PPP terms. If GDP is calculated in dollar terms, it will instead take slightly over 20 years.2

2009 2019 2030PPP US-dollar PPP US-dollar PPP US-dollar

US 1 14.256 1 14.256 China 1 19.189 2 10.598 China 1 44.740 1 24.711China 2 8.888 3 4.909 US 2 18.249 1 18.249 US 2 23.944 2 23.944Japan 3 4.138 2 5.068 India 3 8.100 9 2.159 India 3 18.887 4 6.524India 4 3.752 11 1.296 Japan 4 4.802 3 5.880 Russia 4 7.488 8 3.430Germany 5 2.984 4 3.347 Russia 5 4.377 10 2.005 Japan 5 5.657 3 6.927Russia 6 2.687 12 1.231 Germany 6 3.463 4 3.884 Brazil 6 5.628 6 4.380UK 7 2.256 6 2.175 Brazil 7 3.290 7 2.561 Mexico 7 4.290 10 2.437France 8 2.172 5 2.649 UK 8 2.888 6 2.784 Germany 8 4.079 5 4.576Brazil 9 2.020 8 1.572 France 9 2.520 5 3.074 UK 9 3.791 7 3.653Italy 10 1.922 7 2.113 Mexico 10 2.508 13 1.425 Korea 10 3.689 11 2.289

Our conclusion is that the West is continuing to grow below its potential, at the same time that emerging economies are cooling off but still expanding greatly in comparison. Even without the financial crisis and recession, the convergence would have continued, but now it is accelerating due to slower anticipated growth in the West.

In other words, the countries around the world are operating at different speeds. China and India are driving in the fast lane, Brazil and Russia are in the centre lane, and the US, Europe and Japan are in the slow lane. On the shoulder are the economies that continue to shrink such as Iceland and Greece.

Note: For the West to grow faster will require structural reforms that lead to higher productivity and compensate for the negative effects of austerity measures.

US – Weak growth and price pressure

• Weak labour, housing and credit markets are holding back the recovery

• Continued low interest rates, more quantitative easing and fiscal stimulus

• Many challenges: public finances, the middle class, demographics, politics

Despite that the US central bank, the Federal Reserve, cut its benchmark interest rate to zero two years ago and expanded its balance sheet by US$1.2 trillion – and the administration pushed through a fiscal stimulus package worth nearly US$800 billion in February of 2009 – the American economy has not shown signs of a lasting recovery.

2 Other assumptions include an annual growth rate of 5% in other emerging economies, 2.5% in the UK, Canada and Australia, and 1.5% in the Eurozone och Japan. The PPP assumptions here are constant, but in reality will change over time.

The financial crisis has accelerated the convergence between East and West

An unconvincing recovery despite the stimulus


During the fourth quarter of 2009 and first quarter this year the economy grew strongly by 4.9% and 3.7% on an annualised basis. Domestic demand remained weak during the second quarter, however, while net exports contributed negatively to GDP growth, which measured a more modest 2.4% - a preliminary result which most likely will be revised downward.

Note: If we exclude the inventory build-up and public spending, growth was a meagre 0.5% on an annualised basis.

The Bureau of Economic Analysis, which releases GDP data, has also revised its previous data. In fact the recession was worse than previously reported and the huge job losses are more in line with the new GDP statistics.

The fact remains that the US has not experienced such a severe recession since World War II, and with such a big impact on employment. Since January 2008, 7.5 million jobs have been lost, including a temporary blip due to the national census. In the last quarter only 51 000 new jobs were added in the private sector.

During previous recoveries the US labour market benefitted from its mobility, but because this recession was nationwide in scope and people aren’t moving to the same extent, along with the fact that the housing market continues to stagnate, there is a lack of vitality in the economy. Long-term unemployment has risen. Unemployment compensation has been extended to avoid a further slowdown in spending. The risk of higher structural unemployment is high.

There is a lack of consensus among US economists on the recipe for a robust recovery. So it is not strange that American politicians can't figure out what to do, either. Democrats, who feel that the stimulus package was too small, have had an interest in seeing the economy weaken so that an additional stimulus can be approved. Republicans also have an interest in a weaker economy, in their case to bolster their position going into congressional elections this fall. In general there are concerns about the impact the stimulus is actually having and that the US is becoming more like Europe, where the state’s role is bigger (i.e., a fear of socialism).

Confidence in politicians is low. This includes President Obama, who is fighting for support leading up to the elections in the Senate and House of Representatives on 2 November. If the Republicans can gain 10 seats, they would secure a majority in the Senate (51-49 vs. 41-59 now). That would lead to a political impasse with difficulty passing any reforms, which could impede the recovery and affect the growth prospects in the longer term.

In our previous economic forecast we predicted that the economy would weaken during the second half year when stimulus measures were phased out and the impact of the inventory build-up had passed. The signals we are now seeing – continued weakness in employment, housing sales, lending,

The national recession and weak housing market are reducing mobility in the labour market

A political impasse is expected following the election, which would make it difficult to pass any real reforms


and especially among small and medium-sized businesses –seem to indicate that this recovery will take longer. We are retaining our forecast from last spring with estimated GDP growth of 2.8% this year, 2.2% in 2011 and eventually up to a modest 2.5% for the US in 2012.

The following factors support our forecast:

Private consumption (about 70% of GDP) remains weaker than normal due to high unemployment and small income gains, a weak credit market, high credit card debt and diminished wealth, which increases the need for debt reconstruction and saving, as well as a slow recovery in the single family home market as tax rebates are phased out. With households’ real and financial net wealth as a percentage of disposable income having returned to the 1990 level, the saving ratio will continue to rise for a few more years.

Saving and outstanding debt in relation to disposable income


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The manufacturing sector has held its own so far, especially in IT equipment, but weaker global growth and slowing investment demand for replacement products will impede the recovery. Small and medium-sized businesses are in a historically weak situation due to the slow demand. Companies are still facing overcapacity and have little need for new investment or hiring. The problems with commercial real estate continue to affect investment conditions and could lead to financial instability among regional banks.

The stronger dollar and slightly slower global growth are expected to impede exports. Instead there will be a shift to imports of foreign products in manufacturing, which makes it harder for domestic players and does nothing to alleviate surplus capacity.

Stricter regulations on the US financial sector are expected to contribute to slightly slower growth, partly because of lower lending volumes and partly because of less innovation in the sector.

The effects of the fiscal and monetary stimulus are fading at the same time that the administration has been unable to garner support for a new stimulus. If the so-called Bush tax cuts from 2001 and 2003 are not extended when they expire in 2011, it could


pose a risk to growth. The medium term fiscal issues are now being shifted to 2012 or 2013.

Optimism among small businesses (index 1986 = 100) and the percentage that intend to hire new workers


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< - - - S h a re o f c o m p a n ie s p la n n in g to re c ru it

Weak demand and excess supply are keeping pressure on consumer prices and limiting opportunities for companies to raise their prices.

Political uncertainty is also creating less confidence among households and businesses. The difficulty in reaching a consensus on immigration policy and uncertainty about health care reform despite its having passed are two examples. High unemployment could lead to more protectionism, especially vis-à-vis China. The negative sentiment that has arisen since growth numbers brought on a disappointed reaction in the media and the financial markets raises the risk of a vicious cycle of pessimism, political bickering and a sluggish recovery in the private sector.

One positive forecast risk is that business investment (which accounts for about 6.5% of GDP) rises more than expected thanks to low capital costs and higher profits. At a growth rate of 15%, this would contribute 1% to growth.

At this point the risk of a double-dip or a new recession has diminished since late last spring as Europe's situation has improved. The most likely scenario is weak GDP growth in line with our forecast, with little in the way of consumer price increases. The risk of deflation in the US has risen, however.

Core inflation (consumer price index less energy and food) was less than 1% in April, May and June, the first time this has happened since the 1960s. US 10-year treasury notes have fallen from 4% in April to 2.8% at the time of writing. The US imports deflation due to a weaker euro/stronger dollar. In Japan, deflation is already a fact, and parts of Europe also risk deflation.

As more and more jittery households and businesses decide to “sit on their money” and invest in treasuries, the demand for money increases. Lending isn't working as it normally should, and even banks are investing in government securities.

IT investments are surprising on the upside and can raise growth

Deflation problems are getting closer


The Federal Reserve has cut its benchmark rate to zero, where it is expected to remain for some time to come. With such a monetary policy the US could find itself in a Japan-like scenario with low nominal interest rates and deflation for an extended period, since new negative chocks are reducing inflation expectations and monetary policy has become passive. New quantitative easing is likely to alleviate at least some of the deflation threat, but the positive effects will probably be modest at best. Also, the credit multiplier (the money supply in relation to the monetary base) is lower since banks are lending less and increasing their reserves.

And so the signs of a Japanese scenario don't seem all that farfetched for the US: A period of weak to modest growth, deflation or low inflation, a liquidity trap, debt restructuring and growing hopes that fiscal policy is the recipe.

The medium- and long-term fiscal situation in the US is a concern and does not allow for another large stimulus package. As a result quality must become a greater focus in reform efforts: middle-class stagnation, gradually declining education levels, demographic factors in healthcare spending, growing structural problems in the labour market and the financial difficulties facing many states (e.g., about US$ 1 trillion more is needed to pay public pensions). These are only a few of the challenges the US faces in the years ahead.

Japan – Boost from China is fading

• Deflation and weak domestic demand are slowing growth as the export rebound ebbs

• Tighter economic policy through fiscal policy and the appreciation of the yen, passive monetary policy

• Growing concerns how Japan’s government debt will be financed in the future

Like the US, Japan saw its GDP rebound after the deep recession in 2008 and 2009. In the first quarter of this year GDP grew by 4.4% on an annualised basis, mainly due to a recovery in auto exports. A strong boost from China and other parts of Asia has benefitted Japanese exporters and is reflected in the optimism in the Tankan business sentiment index. The second quarter saw a more modest growth of 0.4% in annualised terms.

After the strong first quarter Japan’s GDP in real terms is back to the 2005 level. Nominal GDP, on the other hand, is only back to the same level as 1993. This is an indication of the deflationary problems Japan has faced in the last two decades. Except for 1997/98 and 2008, consumer prices have fallen.

We expect the economic recovery to continue, but not as quickly as earlier in the year. In 2010 GDP growth is expected to reach 2.8%, an unusually high number mainly the result of stimulus measures, the inventory cycle and strong demand from

The risk of a Japan-like scenario in the US is no longer negligible

Japan’s nominal GDP is back to the 1993 level!


China and the rest of Asia. Next year and in 2012 we expect Japan to return to GDP growth of around 1.4-1.5% per year.

Real and nominal GDP growth and CPI 1980-2010


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The slowdown is partly due to slowing GDP growth in Asia and partly to the stumbling recovery in Europe and the US. The stronger Japanese yen will also affect export opportunities. Debt reconstruction in Japan’s public sector and elsewhere around the world as well as in the private sector could hurt growth. To date export gains have not led to more jobs and will weaken consumption once rebound is over.

In our March forecast we assumed that the yen would weaken significantly when it again became popular as a funding currency for the carry trade. Instead foreign investors (central banks and sovereign funds) have purchased Japanese securities, despite the marginal return, to diversify their portfolios away from the dollar and euro. The yen – now about JPY 85 per US dollar – is stronger than businesses would like (the pain threshold is around 90). However, the real effective exchange rate has not appreciated as much due to deflation. Since unit labour costs have fallen greatly in the wake of increased productivity, industry’s profit margins have held up so far. If the yen rises further, which authorities are trying to offset by giving commercial banks greater incentive to lend to certain sectors, and later possibly interventions as well, there is a risk of a new recession.

In addition to hurting exports, a stronger yen could intensify deflationary pressures. Weak domestic demand also makes it difficult to raise prices. We expect consumer prices to fall by about one percent this year and marginally in 2011. This means that the central bank, the Bank of Japan, will not raise its benchmark rate during the forecast period.

With a public debt ratio of around 190% of GDP and an acute crisis of confidence in European government finances, Naoto Kan, the Democratic Party of Japan’s second Prime Minister since Yukio Hatoyama stepped down in June of last year and Japan's fifth PM in four years, launched a fight to improve the

If the yen becomes even stronger, interventions may be needed

A political impasse is close at hand in Japan as well


country's fiscal situation. His goal was to cut the budget deficit in half by 2015 (from the current 7.5% of GDP) and reach a surplus in 2020. With an unpopular proposal to raise the VAT from 5% to 10%, the DPJ lost its majority in the upper house on 11 July (but still has a majority in the lower house). At the same time domestic policy has been paralysed, making it difficult for the current government to pass reforms. There is a strong likelihood Kan will be replaced during the DPJ’s convention this fall.

Japan's biggest challenges are to fight deflation and at the same time avoid driving bond rates so high that it becomes hard to manage the huge government debt (which is 95% financed by the Japanese). An aging population will also make it harder to improve the government's finances. Lighting a fire under domestic demand, the labour market and satisfying younger generations are therefore important priorities.

China – Trying to avoid an overheating

• The economy is cooling off to a more sustainable growth rate – a soft landing is likely

• Slower lending growth, but it is still rising – the yuan is slowly appreciating

• Focus on transition from export- and investment-led to consumption-led growth

The Chinese recovery slowed during the second quarter of the year, which was welcome. Annual GDP growth fell from 11.9% in the first quarter to 10.3%. On an annualised basis the slowdown was even more evident, from about 11% to about 8%, according to unofficial figures. The question now being asked is whether China can manage a soft landing or whether the slowdown will be drastic in the quarters ahead, which would impact the global recovery.

The reason why has China been forced to step on the brakes is that the tremendous credit growth through the banking system, which has been permitted to offset the effects of the recession, has created a risk of inflation and overheating in several sectors: real estate, the stock market, retail, auto sales, etc. This year banks are committed to add only US$ 1.1 trillion in new lending, 22% less than last year. It hasn't hindered growth, however.

Note: Chinese banks’ bad loans are likely to increase dramatically in the years ahead. Although the state finally realises the problem, the banking system is likely to grow more unstable. Furthermore, the government’s finances will be seen in a slightly less positive light.

Although credit growth has now slowed, it is still too expansive


By also raising mortgage rates and requiring larger down payments on housing purchases, activity has abated somewhat. Since the statistics aren’t of high enough quality, there is considerable uncertainty about the real estate sector. We believe that housing prices have now begun to decline in areas where they had previously risen significantly, such as Beijing and Shanghai. Growth in auto sales has declined as well, from over 100% to about 25% on an annual basis. The Shanghai Stock Exchange has fallen by nearly 20% since the beginning of the year. The purchasing managers index (PMI) indicates that production and order bookings in the manufacturing sector have faltered and only now begun to stabilise.

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The economy is still posting strong growth, however. For example, retail sales are climbing 15-20% on an annual basis and exports are rising significantly. But if government measures to slow growth are combined with weaker global growth and lower capital inflows, there is a risk that the economy will face a hard landing. Since we do not foresee a new global recession as the most likely scenario, China has the opportunity to avoid a hard landing. If one occurs nonetheless, China can again quickly increase lending and institute another fiscal stimulus.

China’s currency – the yuan – in relation to the US dollar and euro as well as nominal trade weighted index from BIS (inverted here and forecast for July)


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Several indicators point to the Chinese economy having downshifted to a lower gear


Another question is whether China has begun a transition to stable growth driven more by private consumption and less by exports and investments. China’s increased flexibility in terms of the yuan has created hopes, but to date the currency has depreciated due to the stronger euro. The trade surplus has continued to grow. Exports are breaking new records, rising nearly 50% in June on an annualised basis. Relations with the West, though also with other emerging countries, may sour unless China shows greater resolve in achieving a transition.

At the same time there has to be a realisation that this transition will take time. Strengthening the social insurance system so that greater security encourages more consumption and less saving won’t be a quick fix. It is worth noting that wage growth has risen among foreign companies along the coast after strikes. A new law from January 2008 strengthening workers’ rights has produced results and been applauded by the administration (at least in the case of foreign companies). Better educated workers in a new, younger generation are more assertive about their rights.

Wage growth has been relatively high in recent years, at about 9% per year in dollar terms. Labourers in urban areas demand compensation on par with Thai or Filipino cities. Minimum wages have increased. In addition, the Chinese population is aging and the number of young people who possibly could move is shrinking. Although there are still workers inland (around 70 million) who could potentially move, the hukou system of residency permits may be holding back younger workers who won’t as easily give up their rights. According to hukou, immigrants and their children are treated differently than urban residents when it comes to healthcare and education, for example.

Although wage growth has intensified, productivity has increased even faster, which means that Chinese manufacturing has become more competitive, not less. The key, however, is to be able to repeat this, which is unlikely. All indications are that foreign companies will look for opportunities in inland China or other countries in Asia, such as Vietnam, where wages are lower than along the Chinese coast.

If costs increase, there is a risk of inflation that may affect China and the rest of the world. At the same time this isn't the West’s headache, where concerns about deflation should be a higher priority. China, on the other hand, is sensitive to inflation, and it is likely that it will only narrowly stay below the central bank's comfort range of around 3-4%.

Our expectation is that China will grow by nearly 10% this year (9.9%). During the second half of the year economic growth will cool to an annualised rate of 8.5% by year-end. Since stimulus measures are not having the same impact on growth and the West is growing somewhat slower, we expect China to dip down to 8-8.5% in 2011-2012. In other words, there will be a soft landing in our main scenario.

After the adoption of a more flexible currency policy the yuan has depreciated because of the euro

The saving ratio cannot be reduced with a quick fix

Competitiveness has risen thanks to high productivity growth –higher wages on the coast are pushing production inland


India – Struggling with supply problems

• Rapid growth in service and goods production – urban population benefits

• Further interest rate hikes and possibly a stronger rupee – lower subsidies reduce the budget deficit

• Structural reforms should take greater precedence – a long time until the next election

India’s economy grew relatively strongly at slightly over 8.5% during the third quarter of 2009 and first quarter of this year. Growth was supported by stimulus measures and domestic demand sparked by strong activity in the manufacturing and service sectors. Agriculture, which accounts for 15% of GDP, has started to recover after the unpredictable monsoon rains last year.

Despite that growth only slightly exceeds India's potential (around 7.5%), there have been growing problems with overheating. High commodity prices, rapidly rising wages and the strong domestic demand, which provides companies with opportunities to raise prices, coupled with a shortage of certain foods, have contributed to rising inflation. In addition, the government is reforming its program of fuel subsidies, which is also raising consumer prices and having one-time effects. Inflation, measured in wholesale prices, is rising by around 9-10%, but inflation will slow along with consumer prices for industrial workers and farmers now that the monsoon rains have stabilised.

In reaction to the risk of overheating, the government has tightened fiscal and monetary policy. The question, though, is whether they shouldn't have done so earlier. At the same time the effects of economic policy shouldn't be exaggerated. For the 70% of the population that lives in rural areas, supply problems are of greater importance, and it is hard to alleviate a shortage of lentils, for example, by raising interest rates.

Real GDP growth and inflation in India June 2005 - June 2010 (%)


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Stronger domestic demand and supply problems have both driven inflation higher


Signs of overheating have been negated, however, by tighter economic policy and weaker domestic demand resulting from global developments and domestic bottlenecks. Capital good production growth is slowing down. Even so, we are forecasting GDP growth of 8% this year, slightly stronger than our spring forecast (7.5%). However, we have revised our forecasts for 2011 and 2012 downward to 7.5% and 7.8%, respectively. It will take longer to return to the growth rate of around 10% India had before the global financial crisis broke out.

The fact remains that the urban population has benefitted from rapid growth in many service-oriented sectors: outsourcing, IT, telecom, real estate and finance. Wage growth is in the double digits. Moreover, taxes have been cut. The urban population has had plenty of opportunity to increase consumption, and car sales in particular have climbed substantially. In spite of a slight slowdown, we expect domestic demand to remain strong, driven by large capital inflows, foreign and domestic investment, and latent demand following the financial crisis, during which many people saw their net wealth shrink.

At the same time these capital inflows, which are driven by a combination of attractive investment opportunities and higher interest rates, represent a problem for financial stability. The central bank may want to try to regulate inflows, which in turn could hurt the investment climate. The benchmark interest rate can only go higher. We expect the Reserve Bank of India (RBI) to continue to gradually raise it from the current level of 5.75% up to 8% in 2012. To reduce inflation it would also help if the rupee further appreciated. Given the volatile capital flows, however, exchange rate trends are uncertain at best.

Since India does not have an upcoming congressional election scheduled, the sitting government has the opportunity to consolidate the budget and introduce unpopular structural reforms. By further reducing subsidies and broadening the tax base, it could boost revenue. Combined with the recovery, this would enable it to slash the budget deficit from nearly 7% last year to just below 5% this year. The national debt, at around 80% of GDP, is still trending higher, and that has to change.

Structural reforms include the need to strengthen the supply side of the economy to avoid bottlenecks. Investments in infrastructure and human capital would help. Making the labour market more flexible so that more people shift from agriculture to services and manufacturing is desirable, but targeting productivity improvements in the agricultural sector is important as well. Social areas such as health, education and sanitation therefore must be strengthened in both qualitative and quantitative terms.

The urban population’s standard of living has improved in recent years

With no elections in the near future, will the government take this opportunity to institute reforms?


Brazil – Prepping for presidential election

• Major upward revision of growth forecast for 2010 – but now growth is slowing

• Certain inflation risks will cause the benchmark rate to further rise to a high 12%

• Regardless of who wins the 3 October election, macroeconomic stability is critical

Brazil has handled the global financial crisis and recession well. Last year GDP fell by a marginal 0.2%. International confidence in the country seems fairly strong, and access to foreign capital has been good. The future challenges facing the country are to ensure a soft landing after signs of overheating and to successfully hold the presidential and congressional elections in October.

With growth of nearly 9% on an annual basis (11.4% measured on a seasonally adjusted basis) for the first quarter, we have had to significantly revise our spring forecast upward from 4.7% to 6.5%. Domestic demand – investment growth – has been especially surprising and has received support from foreign direct investment, strong commodity demand and higher future confidence among businesses and households. Retail sales have been helped by relatively strong income growth for the population as a whole as the labour market improves in pace with the higher growth. Since imports have also risen substantially, net exports are not contributing positively to GDP growth.

GDP and various components of the national accounts, annual percentage change


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After strong growth of around 6.5% this year we anticipate a soft landing when fiscal and monetary policy are tightened, global growth slows slightly and domestic demand falls. In 2011 and 2012 GDP growth will reach a more cautious 5%, but this is still stronger than the 3.5% average for the last 10 years.

We have significantly revised our GDP forecast for 2010 upward – investment is surprising on the positive side


There is a big risk that inflation will exceed the central bank's target of 4.5% and in fact close in on 6% this year. A tighter labour market is increasing wage pressure, which could lead to higher inflation given the current strong demand. More restrictive economic policy will gradually ease price pressures. The central bank is expected to raise the SELIC rate from 10.75% to slightly over 12%. Uncertainties include the country’s exchange rate. The real has appreciated 25% against the dollar and nearly 30% against the euro since January 2009. Commodity prices are also affecting domestic inflation, and based on our assumptions we see a slightly positive trend.

Fiscal policy will be a more important focus after the 3 October election. Regardless of who wins – the Workers’ Party (PT) or Social Democrats (PSDB) – macroeconomic policy isn’t expected to change, i.e., budget discipline will stay in place. The budget deficit as a share of GDP is estimated at 2% this year and the national debt could continue to decline during the forecast period to 60% of GDP (40% of GDP net).

The two most popular presidential candidates are Dilma Rousseff, President Lula da Silva’s chief of staff (Rousseff who has been ill this year and hasn’t been seen much in public until now) and José Serra, the former governor of Sao Pãulo. Rousseff recently passed Serra in opinion polls. Since the Green Party has a candidate (Marina Silva) with some support, a second round of voting is expected when the two of principal candidates can face off.

From a longer-term perspective Brazil’s democratisation has progressed well. Both candidates will continue Lula da Silva’s fairly successful economic policy. At the same time elections are being held for the entire lower house and two thirds of the senate. It is worth noting that 147 of 513 lower house members, as well as 21 of 81 senators, are being investigated on corruption charges. With Brazil's new “Ficha Limpa” (Clean Record) legislation, corrupt politicians who have been convicted are not able to remain in Congress to the same extent as before. If the law is followed, it will be another step toward democracy.

Eurozone – Temporarily positive sentiment

• After some optimism, reality returns in the form of weak growth and the risk of deflation

• Budget consolidation in large parts of the Eurozone – the benchmark rate will be held unchanged in 2010-2011

• Many challenges: A single framework for Euro zone cooperation, the banking system, divergence between countries in the north and south

Developments in the Eurozone have been anything but homogenous in recent years. While Germany and other

Higher inflation and interest rates are a concern, but the real’s appreciation could ease the situation

Economic policy is not expected to change significantly after the election


Northern European countries have improved their competitiveness, the Southern European countries have fared worse and face huge current account deficits. Imbalances have been accumulated over time driven by negative real interest rates, a public and private debt build-up, high wage growth, weak productivity, overinvestment in sectors such as finance, real estate and retail, and a rapid expansion of the public sector, as in Greece.

When the financial market no longer wanted to finance the burgeoning budget deficit, which was due to both the financial crisis/recession and earlier domestic structural problems, there was no alternative to austerity and reforms. Currencies can not be devalued. Rising long-term interest rate differentials mean higher costs to finance the deficits in debt-heavy countries, Greece being the most extreme example.

Differences between various countries 10-year government bond rates, and Germany’s ditto, percentage points


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The €110 billion rescue package for Greece took too long for Germany and the other euro countries to agree upon. As a consequence, a massive €750 billion rescue package had to be passed in early May to avoid having the Greek crisis spread to Spain, Portugal and potentially other euro members with high levels of public debt such as Italy. Despite uncertainty about the specifics of the package, it has had a calming effect on the financial market.

The stress tests of European banks have also created calm, as have their strong results in the last two quarters. A number of outstanding questions remain, such as whether the requirements in the tests were tough enough. In any case, the increased transparency into the European banking system has been positive. While US banks have written off “toxic” assets, shrunk their balance sheets and secured US$700 billion in new capital in the last 18 months, European banks have largely sat on their hands. They are therefore less capitalised and carry about twice as much debt as their American competitors. The stress tests showed that 7 of 91 European banks had to

The imbalances in Southern Europe in particular were unsustainable

Despite uncertainty about the specifics, both the rescue package and …

… stress tests have helped to calm financial markets


strengthen their capital base, and if that isn't possible, to merge with other banks.

Concern about public debt in the Eurozone is simply concern about the region's banking system. Of the US$2533 billion debt Greece, Ireland, Portugal and Spain have issued, and which is being held abroad, Eurozone banks account for 75%. Despite the rescue package, Greece’s national debt will reach 150% of GDP within a couple of years, so the risk of a suspension of payments has merely been put off a little longer.

Still, the countries of Southern Europe now enjoy a respite to resolve their problems with the help of reforms and cutbacks. In the meantime Germany, France and other countries, where banks are sitting on the claims, can find new ways to renegotiate. We can expect this to happen within a two-year period.

The Eurozone faces a murky situation due to declining confidence in politicians to handle crises. Between November of 2009 and June of this year the euro depreciated by slightly over 20% against the dollar, though it has since begun to rise again. Expectations that the euro will collapse are mostly outside Europe. Although this fear subsided during the summer after the results of the stress tests were announced and Greece was praised by the IMF’s oversight board, the region still faces a number of issues going forward.

Political leadership is needed within and outside the Eurozone. The difficulties Germany and France have had reaching an agreement are a problem. Germany is disappointed that countries that haven't acted responsibly have to be given support and that the ECB has been forced to buy government bonds in the secondary market to help banks. There is anecdotal evidence that not only Greek and Spanish banks but also German citizens are moving their money from euro accounts to Switzerland, for example.

Germany’s four-year, €80 billion austerity package should be seen as a way to restore budget discipline throughout the region and the so-called stability and growth pact. But there is still a need for appropriate regulations to penalise countries that fail to abide. The rescue packages that have been introduced could send a signal that gives rise to moral hazard problems.

As second quarter GDP figures were released in Europe, optimism rose. The weaker euro is giving a boost to exports. Emerging countries are contributing with strong demand for European products. Germany in particular is reporting strong growth after record high export numbers, which have now nearly returned to the pre-crisis levels of 2008. Industrial production is back at the 2006 level. On the other hand Southern Europe still lags behind, and its underlying problems remain.

Concern about public debt = concern about the banking system

Concern about a euro collapse feels overblown – political commitments are being forgotten

Optimism is now returning to Europe, but it is likely to be short lived


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We forecast GDP growth in the Eurozone of 1.2% this year, but with big differences between countries. Germany’s GDP growth will reach more than 2%, while the economies of Spain and Greece are shrinking. Stronger growth in the second and third quarters mirrors the US in the fourth quarter of 2009 and first quarter this year. Growth will then fall and at the start of 2011 will again be weaker. Next year GDP will grow 1.1% before rising a little more in 2012 to 1.6%. The modest numbers are due to debt reconstruction, tighter economic policy and jitters about the future.

The labour market has deteriorated but with regional differences. Unemployment has risen to nearly 20% in Spain, upwards of 10% in France – the Eurozone average – and 8.6% in Italy. In Germany, on the other hand, unemployment has fallen after a brief upturn partly thanks to a shortened work week (kurzarbeit) and partly because the labour market has become more flexible in general. This differs significantly from the US, where productivity has improved considerably without any real job gains.

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Compared to the 2000’s, when inflation varied between Eurozone countries, they are now more harmonised. Inflation is below the ECB’s target of less than 2%, but the trend is upward. In light of weaker growth and economic austerity, we expect inflation to reach 1.5% on an annual basis this year and rise slightly in 2011.

Since the Eurozone does not face a major inflation threat and deflation is probably a greater risk in light of upcoming fiscal constraints, it would be reasonable for the ECB to wait before launching a period of interest rate hikes until 2012 at the earliest. What could change this picture are if the central bank governor is replaced (by the more inflation-focused Axel Weber), commodity prices rise or growth surprises by being consistently stronger than expected.

Like ourselves, we expect many forecasters to revise their GDP growth projections upward for the Eurozone after a strong second quarter. It is important, however, not to draw hasty conclusions since the rebound, like in the US, may not be sustainable. The Eurozone – like the US – is struggling with a number of underlying problems: a weak labour market, a huge need for debt reconstruction, a shrinking and more regulated financial sector, cutbacks in the public sector, pensions and wages. That is why developments weaken in 2011 and 2012 compared to 2010, and why we revise our forecast downward.

As long as the Eurozone does not address its structural problems – partly at a regional level and partly at a national level – the cutbacks will lead to weaker growth. The important thing is to combine austerity policies with reforms that strengthen growth in the medium term. For the Eurozone and its member states, it is important to make the labour market more flexible, reform the pension system, develop the service sector within and across national borders and be able to attract investments and ideas.

UK – Shrinking public sector

• Domestic demand is under pressure from weak balance sheets and labour market

• Fiscal austerity, the public sector must be shrunk, temporarily high inflation, but the benchmark rate will not be raised until the end of 2011

• Uncertainty about the staying power of the coalition government due to the cost cuts it must enact

The British monarchy is struggling with a number of problems. Households are holding tightly onto their wallets now that the job market is weak, it is hard to obtain credit and debts have to be paid off. Furthermore, a stronger pound and higher costs will hurt exports going forward. In the political world, the new coalition government's biggest challenge is to trim the largest

The ECB isn't expected to raise its benchmark rate when fiscal policy is tightened

The key is not to draw hasty conclusions based on the second quarter’s positive data


budget deficit of any G7 member this year and shrink the public sector.

One example of an overblown expansion is that the number of public employees has increased by 877 000 in the last decade, while the private sector hired 870 000. Wages have risen by 3.3% in the public sector, but by 2.7% in the private sector.

The goal of the new government, consisting of the Conservative Party led by Prime Minister David Cameron and the Liberal Democrats headed by Deputy Prime Minister and Minister for Constitutional and Political Reform Nick Clegg, is to reduce the budget deficit from around 10% to 2% in 2014. This will require tax hikes and spending cuts. In addition to trimming the public payroll, the VAT is expected to be raised from 17.5% to 20% in January of next year.

The UK’s growth model, like the model in the US – consumption driven by a large share of investments targeting finance and real estate – has to be replaced. The purchasing managers’ index indicates that export orders are beginning to stabilise rather than continuing to rise. If the global economy slows and the pound remains fairly strong, it will be hard to create higher growth through the export sector. Relatively high inflation of around 3% is also contributing to higher costs compared to competitors.

The British central bank (the Bank of England) seems to have a tougher equation to solve than its counterparts – at least in the short term. The problem is that inflation remains above its comfort zone. Waiting too long to raise the benchmark interest rate from the current 0.5% is risky. There hasn’t been a new quantitative easing since February of last year. British banks have strengthened their results, but if the economic recovery grinds to a standstill due to budget consolidation and weak domestic demand, the banking system again faces a risk. A new quantitative easing cannot be ruled out.

At the same time the medium-term risk of deflation is lower in the UK than in the US and the Eurozone. It is also positive that the central bank hasn’t adopted a zero interest rate policy and instead focused more on quantitative easing in the form of government bond purchases that, if anything, raise inflation expectations.

Our new GDP growth forecast is intact at 1.1% and 1.6% for 2010 and 2011 compared to our spring forecast, but slightly weaker for 2012 due to the growing impact of the budget consolidation and slightly weaker global demand.

The challenges facing the UK are to maintain political stability, i.e., keep the coalition together until the next election, and at the same time drastically slash public spending. Furthermore, political leadership is needed to change the previous growth model, in no small part by creating confidence in the future and implementing reforms that create incentives to change.

The public sector has expanded quicker than the private sector in the last decade

The British have to change their growth model

The BOE may have to raise interest rates earlier – a more difficult equation to solve ...

... although the risk of deflation is lower!


7. Conclusions for our home markets The financial crisis has clearly shown that small, open economies have to reduce their vulnerability in connection with global recessions and financial crises, see, e.g., Gylfason, et al (2010). It is important to have buffers in the public sector, so that automatic stabilisers are truly effective. Private players also have to have strong balance sheets, so that they can survive major downturns.

By strengthening labour market efficiency, countries can protect their manpower resources in the event of a recession which greatly and suddenly reduces activity. Mobility – between sectors and geographically – is important so that it is considered easy to find new work after layoffs.

It is also important to avoid that domestic imbalances are built up which cause the global recession to have an even greater impact at home. Households in Sweden and Norway right now are building up debt related to rising housing prices, but which could prove unsustainable in a few years if a new recession arises or if interest rates were to jump substantially.

Crisis preparedness and financial regulations also help to quickly create confidence in the event of a crisis. The Nordic and Baltic countries now have experience that will be important when the next crisis occurs.

The most important question, however, concerns competitiveness. It should be seen from a wider perspective than unit labour costs over time. The key will be to attract investments and skilled labour in the years ahead, and to stand up to growing competition from emerging countries that are much hungrier than the West. Innovation, ideas and entrepreneurship will move us up the value chain, create a higher standard of living and help to ensure that our social welfare systems remain strong.

Taking a holistic view of globalisation and looking at developments from a much longer term perspective have become increasingly important following the crisis. Planning for measures that create growth far beyond the mandate period is a challenge, but it is essential that we overcome it.

Cecilia Hermansson

Vulnerability is reduced through public and private buffers

An efficient labour market benefits employment during downturns

Domestic imbalances must be avoided – Norwegian and Swedish households have to watch out!

After the crisis the question of globalisation has taken on greater priority – the key is to see competitiveness from a broader and longer term perspective

Swedbank Economic Research Department SE-105 34 Stockholm Telephone +46-8-5859 7740 [email protected] www.swedbank.com Legally responsible publisher Cecilia Hermansson, +46-8-5859 7720. Magnus Alvesson, +46-8-5859 3341 Jörgen Kennemar, +46-8-5859 7730 ISSN 1103-4897

Swedbank, Global Economic Outlook is published as a service to our customers. We believe that we have used reliable sources and methods in the preparation of the analyses reported in this publication. However, we cannot guarantee the accuracy or completeness of the report and cannot be held responsible for any error or omission in the underlying material or its use. Readers are encouraged to base any (investment) decisions on other material as well. Neither Swedbank nor its employees may be held responsible for losses or damages, direct or indirect, owing to any errors or omissions in Swedbank’s Global Economic Outlook.

References:

Bank of International Settlements (BIS),.(2010). Annual Report.

Benhabib, J., S.Schmitt-Grohé, & M.Uribe. (2002). “Avoiding Liquidity Traps.“ Journal of Political Economy 110: 535-563.

Bullard, J.B., (2010). Seven Faces of “The Peril”, Federal Reserve Bank of St. Louis Review, September-October Issue, Preprint.

Fisher, I., (1933). “The Debt-Deflation Theory of Great Depressions”. Econometrica. Vol. 1(4), October, p.337-57.

Gylfason, T., Holmström, B. Korkman, S. Söderström, H.Tson. & V.Vihriälä. (2010). Nordics in Global Crisis – Vulnerability and resilience. The Research Institute of the Finnish Economy (ETLA), Helsinki.

Hoenig, T.(2010). “What about Zero?” Remarks delivered at Santa Fé, New Mexico, April 8th

Koo, R., (2009).The Holy Grail of Macro Economics – Lessons from Japan’s Great Recession, John Wiley & Sons, Singapore.

Reinhart. C.M. & K.S. Rogoff. (2009). This Time is Different. Princeton University Press, Princeton. USA.

Swedbank's Global Economic Outlook, 2010 August

Economy & Finance

Transcript of Swedbank's Global Economic Outlook, 2010 August