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OECD Sees These Threats Beyond Fiscal Cliff 2013

At a press conference announcing the release of its new Economic Outlook report, the Organization for Economic Cooperation and Development (OECD) issued a stern warning to the U.S. to resolve the impasse over fiscal cliff 2013 or risk falling into recession, possibly dragging the rest of the world economy down with it.

"The US "fiscal cliff,' if it materializes, could tip an already weak economy into recession, while failure to solve the euro area crisis could lead to a major financial shock and global downturn," said OECD Secretary-General Angel Gurría. "Governments must act decisively, using all the tools at their disposal to turn confidence around and boost growth and jobs, in the United States, in Europe, and elsewhere."

The OECD expects growth in the U.S. to decline from 2.2% in 2012 to 2.0% in 2013 "provided the "fiscal cliff' is avoided," then increasing to 2.8% in 2014. U.S. unemployment is expected to decline from 8.1% in 2012 to 7.5% in 2014, using a harmonized measure of unemployment that allows comparisons between countries.

Although the consequences of failing to resolve fiscal cliff 2013 loom large, the European debt crisis was cited as the main risk to global economic growth. Gross domestic product (GDP) growth in the Eurozone is expected to improve from -0.4% in 2012 to -0.1% in 2013 and a positive 1.3% in 2014.

Why Eurozone Concerns Trump Fiscal Cliff 2013

The OECD said that there are three negative feedback loops in Europe that are making the situation there worse.

First, fears about the solvency of European banks and governments are reinforcing each other as governments have guaranteed banks and banks own large amounts of government securities.

Second, fears of a breakup of the euro are increasing yields which increases breakup fears.

Third, fears of a government default drive up yields on sovereign debt, raising new fears of default. A comprehensive resolution of the euro crisis is needed, particularly breaking the link between bank solvency and the risk of sovereign default.

The crisis in Europe is also hurting growth in emerging economies due to poor demand for exports. According to the OECD, comparing the first half of 2012 to the first half of 2011, poor demand in Europe reduced GDP growth in Brazil by 0.2 percentage points.

For China and India, GDP growth was 0.5 percentage points slower than it might have been while growth in South Africa as 0.8 percentage points less.

To prevent a further slowdown, the OECD is strongly recommending that Europe, Japan, India and China ease monetary conditions further and that the U.S. continue its current easy monetary stance.

But the economic body warns, "…unconventional monetary stimulus, while necessary in the current situation, involves negative risks. Keeping long-term rates very low for a long period could delay necessary deleveraging and prompt excessive risk-taking and resource misallocation."

While calling for continued or accelerated monetary easing in the short-term, the OECD says that budget cutting should take place at a moderate pace over the medium- to long-term. The danger of the fiscal cliff is that it would impose large budget cuts immediately, which could tip the fragile U.S. recovery back into recession.

A Major Flaw in the Plan

Nowhere in the document does the OECD mention anything about the declining velocity of money in the major world economies.

In Japan, which has had some form of quantitative easing and zero interest rates since 1999, the velocity of money has fallen from 1.5 to 0.55-which means that for every 100 yen of money created by the Bank of Japan, Japanese GDP grows by only 55 yen.

The velocity of money is declining sharply in the U.S., too. This is a consequence of the deleveraging of the economy.

During a financial crisis, when credit allocation through the banking system is disrupted, businesses and consumers take advantage of low interest rates and easy money to pay down debt and restore their balance sheets. If the banking system fails to return to the business of banking-taking in deposits and making loans-then businesses and consumers worry about the availability of credit in the future. If they think credit might not be available, then they have to fund both current and future spending by increasing savings.

When you have ultra-easy money, zero interest rates and a dysfunctional banking system, there is no penalty for not spending or investing money. In a non-inflationary or deflationary economy, cash will maintain or increase its value without taking any risk.

That is why, in the aftermath of the tsunami that devastated Japan in March 2011, it was not unusual to find bags of cash among the rubble of destroyed homes.

Today's OECD report draws attention to the problems of the world economy. But the solutions don't even consider the unintended consequences of further easing.

As bad as the disease may be, the cure could be even worse.

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