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The OECD has warned that the economic outlook in developed economies has become significantly worse. The organization now expects a measly 0.3% growth in Q4, as close to recession as could be possible. The OECD has urged central banks to keep policy rates low and to stand ready for further easing.

In the euro zone, the situation is much worse as the sovereign debt crisis bears down with full force. The euro acts as a gold standard for individual euro zone members. As with the gold standard, euro zone members abdicated currency sovereignty in order to benefit from the price stability of the currency tie. Individual euro zone sovereign states are now currency users with limited policy space, meaning that a recession must be met with the deflationary response of pro-cyclical fiscal policy (budget cuts and tax increases).

Over the medium-term, this decreases demand and reduces economic growth. In a credit crisis, when private sector debt levels are high, debt deflationary forces of reduced output can lead to falling asset prices, debt distress, deflation and depression.

I see the procyclicality as one of the structural flaws of the euro zone; there is no federal agent to do counter procyclical budgeting during a recession. Thus, the euro zone business cycle will invariably be volatile, making current account imbalances a lightening rod for intra-European recrimination.

As I wrote when the sovereign debt crisis was beginning, Spain’s debt woes and Germany’s intransigence lead to double dip (Spain representing the euro zone periphery writ large):

If Spain is forced to run austerity measures as seems likely, in stage two, this shifts their government deficit markedly down. Given Spain’s poor labor competitiveness, sticky wage prices and inability to depreciate the currency, all of the adjustment falls onto the private sector in the form of reduced net savings (which could include larger debt burdens). But, the thing to realize is that total GDP in Spain is lower in this scenario, which means total imports are lower, which means Germany’s total export volume is lower. This is a deflationary scenario.

And indeed, the OECD expects Germany to suffer most:

The German economy could contract by 1.4% in October to December, the Organisation for Economic Co-operation and Development (OECD) has warned.

The OECD said Germany could be most affected by a downturn in global trade, but said high uncertainty surrounded all its latest estimates for the G7 group of the world’s largest economies.

This does not augur well for the euro zone. In the past few months, I have become negative on the euro zone’s chances of survival. I no longer believe the political imperatives for the euro zone will be enough to overcome the politics of this next downturn. I will have more to say on this subject in a separate post.

Source: The Eurozone Double Dip Is Almost Here