By Greg Peel

The world is currently gripped by a fear of a return to global economic weakness. The three major factors influencing such a fear are (1) a post-stimulus return to weakness in US housing and possible associated economic double-dip; (2) a forced slowing of the Chinese economy including measures to crunch property prices; and (3) strict austerity measures being applied in Europe to counter sovereign debt risk.

In the case of the first, “double-dip” implies a return to recession after a brief recovery from the GFC, but most economists agree a more likely scenario is simply a dip to a slower level of growth. This is nothing surprising given economies usually respond in such a manner post recession, as fiscal and monetary measures are wound down and an initial burst of inventory rebuilding wanes. Note that US December quarter GDP growth was 5.6% and March quarter 2.7%, playing to the script.

Note also that the script is exactly the way the Fed has called it all year, expecting slow growth only, albeit a slight downgrade has since been made in the light of factor (3). Factor (3) also means the Fed will retain its near-zero interest rate policy for the foreseeable future. In the meantime, President Obama championed the notion of further government stimulus from the G20 at its meeting in Toronto on the weekend, but was pipped by support for Germany's push to tighten budgets and increase taxes in light of the European sovereign risk issue. This does not mean, however, Obama cannot unilaterally reintroduce stimulatory tax credits for the US housing market. If US housing data continue to weaken, he may well.

In the case of the second factor, Chinese growth of 8% instead of 12% simply means steady and stable rather than bubbling dangerously. And given the number of Chinese with mortgages is small by Western standards, a fall in property prices is not expected to upset China's domestic economic growth push.

Which brings us to factor (3).

It is interesting to note that Greece set the sovereign risk ball rolling at the beginning of 2010 with a budget deficit of 12% despite a 3% limit imposed by the EU. What then came to light was the fact every single EU member is indeed in breach of that limit, by varying degrees. Even Germany has been running a 5% deficit, despite having a massive trade surplus.

With sovereign risk contagion a pressing issue, German chancellor Angela Merkel has chosen the austerity path in defiance of US pressure to print more money. Germans are typically frugal types, unlike Americans who believe they have a God-given right to spend money even if it doesn't exist. Merkel has won support from her EU colleagues, so while Greeks, Portuguese and Spanish protest over budget cuts the Germans, French, and particularly the British are also set to suffer.

Taking the budget cut measures put forward by eurozone members to date, Danske Bank economists calculate a result of one full percentage point being wiped from eurozone GDP growth. This is what has the world worried, given global fortunes are inexorably linked. For example, Australia may not see Europe as a major trading partner but Europe is China's biggest export market. If China sells less goods to Europe, it needs to buy less raw materials from Australia.

But to focus on policy-affected reduced GDP growth alone is to ignore offsetting factors, suggests Danske.

Firstly, while the EU has vowed to defend the euro against sovereign risk fears through massive support packages, the truth is it will also let the euro weaken gradually. Were the IMF called in to save a defaulting Europe, the first thing it would do is insist on budgets cuts and currency devaluation in return for assistance. The EU is doing exactly the same without the IMF.

A weaker euro has two benefits. It lowers the purchasing power of Europeans, thus curbing discretionary spending and forcing austerity, and it lowers the value of European exports on the global market, thus affecting higher export volumes and trade balances.

Secondly, prior to the Greek crisis there had been an expectation building the ECB was ready to increase its cash rate from 1% for the first time since the GFC. Clearly that will not happen now we have a European sovereign debt crisis. Like the Fed, the ECB will maintain stimulatory interest rates for the foreseeable future.

When Danske calculates the positive influences of a weaker euro and lower-for-longer interest rates in the eurozone, it comes up with a boost of 0.8 of a percentage point to GDP. So add back 0.8% from 1.0% (austerity) and we arrive a net negative growth impact of only 0.2%.

That's really not something to panic about.

Danske does, nevertheless, qualify its calculations by suggesting the spectre of sovereign credit risk will still overhang the market, affecting, for example, tighter lending conditions and a general conservatism with respect to investment. But to suggest the world is about to fall into another big economic hole because of Europe's woes is to be overly pessimistic, Danske implies.

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