Japan and the rising risks to the global recovery

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Last month, I asked in this space if the global recovery was becoming a sure thing. Some economists had started to become buoyant about the world’s economic prospects and boosted their growth projections, but I had a few doubts. There seemed to be too many risks hanging about out there to be fully comfortable that we had finally extricated ourselves from the financial crisis. Now those risks seem to have only increased further.

The big one, of course, is Japan. As a second awful day on Wall Street proves, investors are still wrapping their minds around the potential dangers that the fallout from Japan’s quake poses for the U.S. and the rest of the world. Though in the end, the trauma facing Japan may only have minimal impact on global growth, the picture emerging of the damage done to Japan’s economy is getting gloomier. Industrial production continues to suffer. Automobile manufacturers have extended production stoppages, for example. That only raises the chances of Japan’s anemic recovery turning very ugly in coming weeks and months.

And adding to the uncertainty, of course, is the crisis at the quake-hit Fukushima nuclear plants. At a minimum, the damage to the plants will likely cause power shortages for the Japanese economy for weeks, if not months, continuing to disrupt production and depress economic activity. In a worst-case scenario, a major catastrophe could create massive upheaval in the economy and in its trade with the rest of the world. Over the long-term, it seems highly likely the nuclear fiasco will undercut what had been increased interest in nuclear power around the world, and that will have major implications for global energy markets. Though oil prices have pulled back in recent days, a slowdown in nuclear power development can only mean greater dependence on oil and thus higher oil prices down the road. For example, China’s State Council on Wednesday said it was suspending approvals of nuclear facilities until undefined new safety rules were in place. A less nuclear China would mean the world’s fastest-growing economy would require more imported oil in coming years, likely keeping upward pressure on prices.

Lofty prices for commodities are weighing on the economy right now. Oil prices, even at their recently reduced level, are still three times higher than in late 2008. And with continued unrest in Libya, Bahrain and other parts of the Middle East, there is more than enough reason for prices to head upwards once again. Food prices, meanwhile, hit another record high in February.

Not only are these higher prices for basic commodities eating into the ability of consumers to spend, thus slowing down potential economic growth, they’ve also been fueling inflation, which is becoming a bigger and bigger worry around the world. At China’s recent National People’s Congress, Premier Wen Jiabao named controlling inflation the government No.1 economic priority. In India, inflation in February clocked in at an above-forecast 8.3%. What was worrying about India’s data is that it showed a significant increase in core inflation – a measure that removes the influence of volatile food prices – implying that despite efforts by the central bank to cool down the economy, inflationary pressures are still increasing. What we can expect are more interest rate hikes and other tightening measures in both China and India, which means slower growth in the world’s fastest growing economies, and thus potentially slower growth globally. (UPDATE: India’s central bank raised its key interest  rate again on Thursday.)

The bigger problem with inflation might be percolating in the developed world, however. With inflation on the rise in the euro zone – to 2.4% in February — the European Central Bank strongly hinted earlier this month that it would start raising interest rates. Analysts are expecting a hike in April, which would make the ECB the first major central bank in the industrialized world to take such a step. (In response to the quake, Japan has actually been easing money.) A euro rate hike might work just fine for Germany, which is recovering quite nicely from the recession, but what about the weak economies of the periphery – Greece, Ireland, Portugal and Spain? They are still contracting or barely growing, and suffering under severe austerity programs and higher borrowing costs. Higher interest rates will only further suppress their growth prospects, and make paying their debts more challenging.

And  yes, the European debt crisis is still alive and well. We’ve forgotten a bit about it amid the turmoil in the Middle East and Japan, but the markets have not. Spain, Greece and Portugal all got slapped with credit downgrades in recent days. We have, however, received a bit of good news on the euro front. The leaders of the euro zone last week conceded that its current bailout methods were insufficient and reached a fresh pact of measures to try to half the crisis. They agreed to expand and reform the rescue system for weak zone members. The finances of the $1 trillion rescue fund formed in May were shored up so it could lend out the full amount pledged, and it will eventually be increased in size as well. The fund was also given new powers to purchase bonds from cash-strapped governments to try to keep borrowing costs in control. The zone’s leaders also admitted that the terms of the bailouts were too onerous, and they reduced the interest rate on rescue loans for Greece by a full percentage point.

As usual, however, Europe didn’t go far enough. Germany and France rejected a proposal, advocated by the ECB, that the rescue fund be allowed to purchase bonds of troubled sovereigns already trading in secondary markets, limiting the influence the fund could have on borrowing costs. Furthermore, countries will still have to request help from the EU and submit to severe austerity programs in order for the fund to purchase their bonds. So the new bailout system is really just a slightly tweaked version of the old bailout system that failed to stop the crisis. The negotiations also exposed serious rifts among Europe’s leaders. An effort to reduce the interest rate on Ireland’s rescue loans failed when the new Irish prime minister refused to increase the country’s corporate tax rate in return. Germany and France have been irked by Ireland’s low rate for some time and they are clearly trying to use the country’s weakness to impose policies they favor onto the Irish government. So here we find the real problems behind the failure to resolve the euro crisis. Europe’s leaders continue to link issues irrelevant to the survival of the euro zone with measures that could truly resolve the debt crisis. And more crucially, the euro zone is increasingly being run as a French and German fiefdom, not a true European community.

Europe’s half-measures have produced half-results. The much-touted new euro deal has in reality done very little to support struggling economies, eliminate the immediate causes of the debt crisis, or improve the likelihood that debt-plagued governments will be able to pay their creditors. Portugal’s borrowing costs remain astronomical and the pact didn’t reduce the chances that the country will at some point be forced to seek a bailout. Though Spain’s bonds have stabilized, uncertainty is still high about the nation’s finances, mainly due to the state of its financial system, which has been hit hard by a property bust. Though Spain’s central bank says that its lenders require just over 15 billion euros ($21 billion) in new capital, ratings agency Moody’s estimates that in a high-stress scenario, the banks might require as much as 120 billion euros ($167 billion.)

Add in the ongoing U.S. housing crisis and persistent high unemployment is large parts of the industrialized world and I can’t see the upbeat projections for the world economy holding up. How all of these risk factors play out and impact global growth is hard to figure. But I wouldn’t be surprised to see economists start downgrading their growth forecasts for 2011.