The outlook for the world economy has deteriorated rapidly. Increased uncertainty in the financial markets has led to declines in key stock market indices and risk premia have risen in both government and corporate bond markets, increasing financing costs. At the same time, demand has shifted towards ‘safe haven’ investments, such as German and US government debt securities and gold, which has lifted their prices to record high levels. ‘Uncertainty always erodes growth prospects,’ noted Governor Erkki Liikanen at the press conference for the Bank of Finland journal Euro & talous.

The continuation and spillover of the euro area sovereign debt crisis have impaired the functioning of euro area financial markets. In interbank markets, financial intermediation has been disturbed, as the spread between secured and unsecured interest rates has widened and the price of credit-risk protection has risen. The uncertainty has already been reflected in the real economy. Indicators for household and business confidence and expectations have fallen in many countries. Receding confidence portends very weak near-term economic performance. 

The sovereign debt crisis increases the risks of financial institutions via two channels. On the one hand, uncertainty about recovering investments in crisis countries appears to have increased. On the other hand, the overall weakening of growth prospects increases the risk of higher loan losses. ‘The most effective tool for restoring confidence in the financial system is recapitalisation of banks. This is primarily the task of the shareholders,’ said Governor Liikanen. 

The Bank of Finland has lowered its growth forecast for the world economy in respect of the current and next year. Prospects have worsened especially for advanced economies and for world trade. ‘In order for the economic slowdown to remain temporary as forecast, confidence must be boosted quickly. If not, there is a danger that the economy will slip into another recession,’ stated Governor Liikanen. 
Restoring confidence in politicians’ ability to make decisions is key to stabilising the situation. The sovereign debt crisis is no longer only the problem of some small countries but a euro area-wide crisis that has taken on systemic dimensions. Measures taken by a troubled country no longer suffice to remedy the situation; a broad-based common commitment is required. ‘The basics have not changed. Achieving structural primary surpluses is a prerequisite for the sustainability of debt levels. If Europe fails to constrain the debt crisis, the loss of confidence will also undermine world economic growth,’ stressed Governor Liikanen. 
An important step in reinforcing confidence is a prompt implementation of the crisis-management decisions made by European heads of state or government on 21 July. ‘It is of the essence that modifications concerning the European Financial Stability Facility (EFSF) are implemented in full and the EFSF becomes operational,’ emphasised Governor Liikanen.
At its September meeting, the Governing Council of the ECB decided to leave the stance of monetary policy unchanged. However, the Governing Council changed its view of the risks to economic activity in the euro area. ‘The risks to economic growth are substantially on the downside. The risks regarding inflation have also changed. In an environment of a particularly high degree of uncertainty, we must continue to monitor all developments very closely,’ said Governor Liikanen.

Euro & talous 4/2011 Rahapolitiikka ja kansainvälinen talous

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