Despite a downswing in the U.S., there won't be a global recession - By Norbert Walter

Deutsche Bank's chief economist sees U.S. economic growth cooling significantly into 2009. But with most of the economy holding up and other regions sailing smoothly, comparisons with the 1970s oil crisis are misplaced.

International capital and equity markets have recently had to navigate difficult waters. After its outbreak last summer, the real estate and subprime crisis in the U.S. has triggered a second and even stronger shock wave in the markets at the start of 2008.

Over the past few weeks and especially since the beginning of January, fears of a recession have led to a hasty flight out of equities. The results were a shifting of funds from riskier to safer asset classes, soaring volatility in equity markets and an unwinding of carry trades.

All this was accompanied by record oil prices touching $100 (?67.6) per barrel, the price of gold jumping to over $900 per ounce and a concomitant weakness of the U.S. currency versus most other currencies, most notably the euro. Europe's currency is now flirting with the $1.50 mark. In line with these developments, there has been growing pessimism with regard to the American economy and future earnings at U.S. corporations as well as concern that the American contagion might infect the global economy, too.

Especially the worrying signs from financial markets have caused the Federal Reserve to make emergency rate cuts and have paved the way for a speedy fiscal stimulation package in the U.S. This effort, alongside the help from improved competitiveness due to the dollar weakness and a lower oil price, will avert a recession in the U.S. But since the structural deficiencies will largely remain, the U.S. economy is in for a very protracted downturn.

Falling house prices and negative wealth effects on the one hand as well as high consumer debt on the other will induce consumers to exercise considerable restraint. Add to this much tighter lending terms in the banking sector as additional fallout of the financial crisis and, above all, the crisis of confidence. There are concerns the crisis may spill over more strongly to the entire corporate sector and trigger a decline in both investment and employment. The latter appears as an exaggeration, considering good profits in many sectors outside banking and construction.

Not only has the R-word resurfaced in the economic debate but the term stagflation as well. Concerns that inflation may raise its ugly head again are to be taken seriously. First, there has been significant excess liquidity worldwide. Second, some (skilled) labor markets - especially in emerging markets - are running red-hot. Third, quite a few countries are not allowing their currencies to appreciate. This harbors risks of rising inflation, especially when energy and food prices increase due to disproportionate demand expansion from emerging markets and some supply difficulties, such as droughts capping grain harvests. While such concerns are relevant for emerging markets, inflation will recede in the U.S. and Europe soon.

Comparisons of the current situation with the oil crisis of the mid-1970s are misguided. The recession and inflation back then were triggered by supply shocks resulting from drastically higher oil prices following OPEC production limits. The resulting deterioration of the terms of trade for the industrial countries was not compensated by wage restraint but - on the contrary - exacerbated by a wage spike. All this culminated in a wage-price spiral, high inflation and - eventually - a markedly more restrictive monetary policy, which then led to recession because of the dampening effect on growth. At present, the rise in the oil price is demand-driven, unit wage costs are increasing moderately, and there is no need for the central banks to be restrictive.

Apart from the banking industry and construction, America's corporate sector is in good shape. Sound balance sheet structures, low levels of debt, high cash flow and an increasingly international strategy have led to a satisfactory development of earnings and profit margins as well as stable investment activity.

Nonetheless, a protracted downswing looks likely in the U.S. This economic weakening will persist for some time - and probably make itself felt until 2009.

While the U.S. with its 25 percent share of the global economy will pull others along, it will not cause a dramatic decline in world economic growth, particularly because big emerging markets will hold up well. Certainly, some countries - including parts of Asia - will be affected strongly, especially the U.S. "workbenches" abroad like Taiwan or Malaysia, but China, India and much of South America will have reasonably fair sailing.

Europe will continue to lag behind the international cycle. Especially capital goods exporting countries like Germany will benefit for a while from the investment boom still on in many regions, for example Middle East, Asia and Russia. But over time, the combination of weaker U.S. growth and a strong euro will eat into export performance. In the course of 2008 and 2009, the weakness in exports will slow down the European economy. This is particularly true since neither monetary nor fiscal policy will be compensating the diminishing net exports by stimulating domestic demand.

- Prof. Norbert Walter is the chief economist of Deutsche Bank, Frankfurt.