The Organization for Economic Co-operation and Development, 30 high-income economies (including the United States), is an authoritative source for analysis and policy recommendations pertaining to the world’s free market democracies. This forecast, delivered in late November, is by the OECD’s Chief Economist. By year’s end, predictions were for a loss of 8-10 million jobs in the OECD area and as many as 25 million worldwide.

Many OECD economies are in or are on the verge of a protracted recession of a magnitude not experienced since the early 1980s. As a result, the number of unemployed in the OECD area could rise by 8 million over the next two years. At the same time, inflation will abate in all OECD countries and some even face a risk, albeit small, of deflation.

The financial turmoil that erupted in the United States around mid-2007 has broadened to include non-bank financial institutions and rapidly spread to the rest of the world. Prompt and massive policy action to restore confidence and provide liquidity appears to have successfully limited the period of panic, but the need for financial institutions to operate with less leverage and to repair their balance sheets remains. This process of adjustment will take time and impair the flow of credit, and is the key factor weighing on activity going forward.

We assume that the extreme financial stress will be short-lived, but will be followed by an extended period of financial headwinds through late 2009, with a gradual normalization thereafter. The main features of the economic outlook are the following:



•    U.S. output declines through the first half of next year, then gradually picks up as the effects of the credit squeeze abate, the housing downturn bottoms out and monetary policy stimulus takes hold. The recovery, however, is likely to be languid, as consumption is held back by the large losses in households’ wealth. Inflation eases significantly, as the recent declines in commodity prices filter through the economy and as economic slack exerts downward pressure on prices.

•    Euro area activity also falls over the next six months, as tighter financial conditions, subdued income growth and negative wealth effects from lower equity and house prices damp consumption and investment. Economic activity then gradually recovers as monetary easing gains traction.

•    Japan, after a brief growth spurt in early 2009 due to fiscal stimulus, will experience stagnant output over the second half of 2009, as the global economic downturn and the recent appreciation of the yen curtails external demand.

•    Other OECD countries where the economic downturn will be severe include Hungary, Iceland, Ireland, Luxembourg, Spain, Turkey and the United Kingdom.

•    The major non-OECD countries are in many cases also slowing due to the combined effect of more difficult international credit conditions, earlier policy tightening, income losses due to lower commodity prices, and weaker demand from OECD countries.

The financial crisis is not the only development shaping the projections. Other important drivers include ongoing adjustments in housing markets, which in many European economies still have a long way to go. Moreover, they come on top of negative wealth effects from the steep fall in equity prices. Partially offsetting these contractionary forces is the sizeable monetary stimulus.

Against the backdrop of a deep economic downturn, additional macroeconomic stimulus is needed. In normal times, monetary rather than fiscal policy would be the instrument of choice for macroeconomic stabilization. But these are not normal times.

Infrastructure investment is often mentioned as a desirable instrument for stimulus. While it will boost both supply and demand, provided the investments are well chosen, infrastructure investment typically takes a long time to be brought on stream and, once begun, is difficult to wind down in line with a recovery in activity. Alternatives, such as tax cuts or transfer payments aimed at credit-constrained, poorer households, might prove more effective in boosting demand.

Once there are clear signs of a recovery taking hold, it will be necessary to begin promptly to unwind the macroeconomic stimulus in place to prevent inflationary pressures from gaining a foothold. At the same time, with high public debt in many OECD economies, it will be equally important that a credible fiscal framework is in place to ensure long-run public finance sustainability, especially in the face of spending pressures associated with population ageing.

Moreover, the now global scale of the financial crisis underscores more than before the necessity for international co-ordination to avoid measures that distort competition or effectively shift the problem to other countries. Individual countries may find it difficult, acting on their own, to unwind the exceptional measures that are currently needed, again pointing to the need for co-operation. Reform of financial market supervision and regulation is clearly necessary to build a more resilient financial system.

I welcome, in particular, the commitment of the G20 to continue furthering multilateral co-ordination to overcome the immediate problems facing the global economy and to strengthen the international financial architecture over the medium term.

The reform agenda is comprehensive and the many complex issues involved will take time to address. It will be important, therefore, to remain focused on the objective of strengthening the global financial architecture. While substantial government intervention to support financial markets has proven necessary because of their systemic importance, back-pedaling on open and competitive markets would prove very costly.

In this respect, a quick, successful completion of the Doha Round would contribute to supporting world growth, boost confidence, and demonstrate a commitment to competitive and open markets. wt



Klaus Schmidt-Hebbel, a national of both Germany and Chile, was appointed Chief Economist of the OECD in April, 2008 after previously serving with the World Bank and the Central Bank of Chile.