What if everything goes wrong — fiscal cliff, hard landing in China, and multiple eurozone exits?

Image Credit: IHS Global Insight

Image Credit: IHS Global Insight

IHS Global Insight does a little doomsday prepping:

If the United States federal government fails to resolve the fiscal cliff and the other plausible events unfold — including a surge in oil prices caused by escalating Mideast conflict, the rapid departure of six countries from the Eurozone and a significant slow-down of China’s economy — such a worst-case scenario could see U.S. economic output drop during the first two quarters of the year and real GDP would subsequently contract by 1.7 percent in 2013 — a sharp contrast from the baseline forecast. Other countries would fare much worse under this scenario, with some countries, including Italy and Spain, seeing more than a 4 percent decline in 2013.

In a plausible worst case scenario, the fall off the fiscal cliff and the onset of recession will demolish equity values and boost bond prices. The Federal Reserve will likely respond by adding more stimulus, however, this will be ineffective against the magnitude of the fiscal contraction.

Given the magnitude of this potential disaster, it’s hard to imagine the U.S. government will allow it to continue for very long. At some point—likely three to six months into the year—the economic pain and political damage will become too acute. One or both parties will blink, and a settlement will result. In this scenario, IHS assumes that the Bush tax cuts will be partially restored.

Meanwhile, sequestered funds for defense spending may be reinstated by July 2013 as international tensions increase—perhaps related to new hostilities in the Middle East. A solution by mid-2013 will be too late, serving only to mitigate damage, with the worldwide economy already heading into a severe recession. The unraveling of these volatile, inter-dependent events make up the underlying assumptions central to a possible worse-case scenario that would be catastrophic to world markets.

I think this forecast is actually overly optimistic given the precarious state of growth and business confidence. The GDP decline would be 1.7% for the year, meaning peak to trough would be more like 3% or similar to the 1981-82 recession, but briefer.

You should also keep in mind that the U.S. is already way below trend in growth and employment. Returning to 2-3% growth after short but nasty downturn, for instance,would  still leave a huge growth gap even larger.


5 thoughts on “What if everything goes wrong — fiscal cliff, hard landing in China, and multiple eurozone exits?

  1. LOL… That is the worst case scenario?

    The way I see it the US looks a lot like Greece. It spends far too much and uses borrowed money to keep things going. The worst case scenario is a dumping of treasuries by China, Japan, and/or some other country and a decline in the USD at a time when the Middle East is in flames and oil goes up to $300 a barrel.

    Once the panic in the EU runs its course or reverses it is more than likely that investors will start to look at America’s financing a bit closer. If the dollar index could not rise above its trading range for a year even as Greece, Spain, and Italy threaten to bring down the Euro just how weak will it be when that crisis is over? Do these guys need $5,000 gold to see that something very serious is going on and that the worst case scenario could be a lot worse?

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