The global financial system has suffered a once-in-a-century meltdown. Confidence is shattered and panic has taken hold. Even before the latest explosion in the financial crisis, the leading OECD economies were diving into an unusually synchronized recession, driven by the simultaneous collapse in consumer and business spending and a rising threat of job losses and bankruptcies. If the world's central banks do not restore order soon, this recession will become a major slump.
For the financial economy, it is now a much bigger problem than simply adding up the bad debts, even though this figure has become even bigger and more widespread. On top of this are the nasty effects of marking down all debt - good and bad - based on the slide in asset prices. Such a mark down has the potential to blow massive holes in financial institutions balance sheets and few have the cash and reserves to readily cover the gap. Central banks and governments are helping out but this may be too little too late.
For households and companies alike, the risk is no longer limited to cutting spending plans. The immediate threat is the freezing up of credit and struggle to access working capital that pays wages and input costs. The loss in spending already in the pipeline is enough to cause a nasty recession - GDP will probably fall in the US and Europe in 2009 - but taking account of current turmoil, the drop in GDP could escalate to proportions more typically seen in third world debt crises. Some suggest a drop as big as 10% during the next few months.
To illustrate the impact of the credit crunch, the State of California is having problems with credit lines necessary to pay teachers wages - this is the type of problem that hit Russia in the mid-1990s but was never expected to be seen in the US. In the worst phase of the 1997-98 crisis, Asian companies could not even get finance to ship goods out of the factories and ports - it seems unbelievable that this threat is now being contemplated on a global scale. For the consumer, this is equivalent to finding plastic is no longer accepted and cash machines close. If voters want to know why central banks and governments have to lead a bail out for the global financial system, they should think of the consequences for themselves of such a collapse in trust and the monetary system.
Will this recession engulf the global economy? Up to mid-2008, the emerging market economies remained strong but now the crisis has deepened it will impact everywhere. The outcome for China is particularly important as it has been the mainstay of growth over the last couple of years - it has doubled its share of world GDP over the last decade and now offers the best hope for keeping the world economy ticking over. However, it seems increasingly doubtful that any region will remain immune from the crisis even if some countries, like China, avoid a recession - the highly coincident weakening in the US, Europe and Japan points to a substantial shock to global trade and commodity markets, the boom-bust in property has hit many countries and the panic in stock markets is also global. This crisis is not only taking a toll at a worldwide level but it will also require a massive global effort - and possibly some extraordinary 'out of the box' measures - to turn around.
Synchronized Dive into Recession: Focus on Damage Limitation, Briefing Paper, Vanessa Rossi, October 2008