The financial turmoil raises concern about the strength of the slowdown in Germany and the Eurozone. Even if the stock market seems to be on a recovery paths, the interesting questions for firms, households and policy is indeed how strong the recession might be. Two recently published forecasts and policy analysis papers try to shed light on the issue.
First, on October 1st, the IMF published the background chapters for the World Economic Outlook. The chapter 4 contains a quite interesting analysis on historical episodes of financial stress and related downturns. Interestingly, the IMF did not only analyse strong recessions – as in the aftermath of the Asian crisis – but “nearly crisis” as well. In general, the findings support most of the conventional wisdom: “Countries with more arm’slength financial systems seem particularly vulnerable to sharp contractions in economic activity, because of the greater procyclicality of leverage in their banking systems.” Regarding to the IMF analysis, the recession in the US is not avoidable, the data however point to a “slowdown” in the Euro area only. Having a look at the very recent data, this is indeed the “optimistic scenario”. Maybe, international agencies do not want to be blamed to be the “doomers”.
A more interesting forecast was published today by the “group of leading research (not only German) research institutes” or “joint diagnosis group” in Germany, presenting a much more interesting analysis on behalf of the German government. Since the text is in German only so far, it is worthwhile to present some key figures here. The report is labeled “Germany at the brink of a recession”, and, yes, indeed this is where we are. As an economist with a strong interest in forecasting and historical forecaster behavior, I once analysed the reaction of forecasters to the first oil price shock. Indeed, at this time forecasters avoided to give “exact” number and some of them offered large forecasting intervals. This is not very popular but necessary at certain stages. Here, the same applies. I will only focus on two questions.
How strong is the recession probability for the Eurozone?
The institutes present two model-based results, first the probability for a recession using a Markov-Switching model (figure 1) and recession probabilities using a probit model (figure 2). Given that the financial turmoil is something which is not part of the historical “knowledge” of such models, the result is clear: Even without the turmoil, the Eurozone would face a very significant risk of downturn – which is even more pronounced now.
Figure 3 contains the forecast for the Eurozone (bars = annualized growth rates, lines = annual averages). The forecasting institutions assume very weak “technical recession” and due to the end-of-the-year-effect (negative growth rates give raise to a weak staring point for 2009) we get a close-to-zero average growth for 2009.
Two scenarios for Germany: Both of them obviously have a strong probability
Regarding Germany, the country where most of the institutes are based, the outlook is presented in two scenarios. Such a presentation is very seldom in the history of this meeting and points to very high uncertainty (typically, differing positions above a certain threshold are presented as “minority votes”, here all institutes together present two scenarios). Officially, all institutes subscribe to what they call “Basisszenario” (baseline), however, they clearly state that the risks shifted to the “Risikoszenario” over the last week (the time the report was finished).
Let’s have a look at the implications of both scenarios (figure 4)
There are three sources of differences. Whereas in the baseline scenario private consumption remains stable over 2009 (+0.8), investment declines marginally (-1.4) and the growth contribution from the net exports is just zero – for the risk scenario things change. Private consumption stagnates, investment declines by -4.0 % and net exports have a slightly negative growth contribution (-0.2).
Last but not least, the most interesting picture (figure 5):
It shows the probabilities of the forecast for 2008. Whereas for 2008 the result is stable, the 2009 forecast range is enormous (not astonishing if you know historical forecast errors), but such a picture has never been published by the institutes so far. Coming back to the original question: where do we stand and how large will the recession be? The answer clearly is – we are at the abyss but we don’t know if we rush. Not yet, not for sure. But the risk is very high.
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