2009 seen to be year of global recession with worst still ahead

The global financial system literally went into a cardiac arrest after the Lehman Brothers Holdings Inc. collapse and a meltdown was barely avoided through very aggressive policy responses. So what lies ahead in 2009? Is the worst behind us or ahead of us?

Unfortunately, the worst is ahead of us. The entire global economy will contract in a severe and protracted U-shaped global recession that started a year ago. The U.S. will certainly experience its worst recession in decades, a deep and protracted contraction lasting at least through the end of 2009. Even in 2010 the economic recovery may be so weak — 1 percent growth or so — that it will feel terrible even if the recession is technically over.

There also will be recessions in the euro zone, the UK, continental Europe, Canada, Japan and the other advanced economies.

A hard landing for emerging-market economies may also be at hand. Among the so-called BRICs, Russia will be in an outright recession in 2009. Growth in China will slow to 5 percent or less, representing a hard landing for a country that needs expansion of close to 10 percent to move 10 million to 15 million poor rural farmers into the urban industrial sector every year. Brazil will barely grow in 2009. Even India will experience a sharp slowdown.

Most other emerging market economies will suffer a similar hard landing. This severe global recession will morph into a stag-deflation, a deadly combination of economic stagnation/recession and deflation. In the advanced economies, with aggregate demand falling below growing aggregate supply, slack in goods markets will lead to deflationary pressures as companies' pricing power is restrained.

Likewise, rising unemployment will constrain labor costs and wage growth. These factors, combined with sharply falling commodity prices, will cause inflation in advanced economies to ease toward negative territory, raising concerns about deflation.

Deflation is dangerous as it leads to a liquidity trap: nominal policy rates can't fall below zero, so monetary policy becomes ineffective and even quantitative easing may not work.

Falling prices mean that the real cost of capital is high and the real value of nominal debts rise. This leads to further declines in consumption and investment, thus setting in motion a vicious circle in which incomes and jobs are squeezed, aggravating the fall in demand and prices.

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