Recession chances to rise to 70% unless euro crisis resolved

Published on Thursday, 03 November 2011 11:30
Posted by Scott Buckler

Today NIESR publishes its regular quarterly forecast for the world and UK economies. Given the uncertainty surrounding developments in the eurozone, forecasting is particularly difficult in the current conjuncture

Our forecast therefore assumes, as a baseline scenario, a "successful" resolution of the eurozone crisis, in which market speculation eases and sovereign spreads gradually recede; there is no default contagion to other Euro Area countries; and adequate support for vulnerable banks is provided.
However, such an outcome is far from certain, and perhaps not even probable.

Dawn Holland and Simon Kirby's paper, also published today, explores three alternative scenarios:

- under scenario 1 "muddling through", risk premia remain elevated for a further year. This has a negative effect on growth, not just in Greece and other peripheral eurozone countries, but elsewhere. Recession becomes a near certainty in Italy and Spain, while the probability of a recession in the UK rises to about 70%.
- under scenario 2 "default contagion", default on Greece raises the probability of default in Portugal and (possibly) Ireland and Italy. Such a cascade of defaults would make a more generalised banking crisis likely ; in order to avert such a damaging outcome, the ECB might need to commit to acting as lender of last resort for vulnerable governments
- under scenario 3, Greece exits the euro. In such circumstances, devaluation is certain, and explicit default is also likely. This would lead to lower interest payments on government debt, and lower asset prices could also result in capital inflows. Under such a benign scenario, output would rise, perhaps quite sharply, much as it did in similar circumstances in Argentina in 2001-02. On the other hand, there are very large downside risks (in particular, the difficulties of full currency redenomination, and the possibility of forced EU exit) that were not present for Argentina.

It should be noted that these scenarios are not forecasts, and do not claim to be exhaustive, but they illustrate some of the potential impacts of future eurozone developments.

 

Source: NIESR

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