SF Fed: Risk of Recession 50%

The Federal Reserve Bank of San Francisco says, in their Future Recession Risks report,  that because of the European debt crisis the danger of recession the possibility of recession in early 2012 is 50%:

In the next few months, the odds of recession due to domestic factors appear reasonably contained. Those odds increase gradually and reach about 30% in the second half of 2012, after which they decline. However, the curve reflecting the international odds suggests more imminent danger to the economy, although this threat is harder to calibrate using historical data and only indirectly reflects the health of the European financial system. Recession odds based on international factors peak at about 45% toward the end of 2011, but decline rapidly thereafter.

Figure 2
Recession probability forecasts

The combination of these two recession coins, shown in the combined risks line of Figure 2, is quite disconcerting. It indicates that the odds are greater than 50% that we will experience a recession sometime early in 2012. Because the international odds of recession are more imprecisely estimated, one must be careful with a strict interpretation of this result. But the message is clear. Prudence suggests that the fragile state of the U.S. economy would not easily withstand turbulence coming across the Atlantic. A European sovereign debt default may well sink the United States back into recession. However, if we navigate the storm through the second half of 2012, it appears that danger will recede rapidly in 2013.

Most of the risk is coming from Europe, who despite repeated attempts have failed to pacify the markets. The nature of the European Union makes it difficult to make a comprehensive solution, the way the United States did with TARP. When compared to the USA, the EU is a very weak political union. Germans don't want to bail out other nations the way Americans bailed out their failed financial instetutions. Please see

ECB: can a lender of last resort defuse Europe's liquidity timebomb?

Amid the head-scratching over how best to solve the eurozone's crippling sovereign debt crisis, one solution is being increasingly championed by an influential cast of economists: to allow the European Central Bank (ECB) to become a "lender of last resort".

This, say the Nobel prizewinner Paul Krugman and other big guns, will defuse a liquidity timebomb by guaranteeing that cash will always be available to pay out bondholders of government debt. They argue that absence of such a safety net is why the financial crisis has proved so virulent in the euro area.

But despite the consensus forming among the economic elite in thinktanks and newspaper op-ed pages around the world, there is fierce opposition in Germany to any plan which would appear to give the ECB a licence to print as much money as it pleases.

 Additionally, there is the question of moral hazard. Americans were much more willing to ignore issues of moral hazard because they saw saving their economy as being more important. In Europe, on the other hand, Germany is not willing to let debtor nations off the hook so easily. Germany wants them to fully understand the consequence of their actions, with painful austerity to bring their budgets under control.

The irony, however, is that cure of austerity is likely worse than the sickness for nations that have long past the point of no return. The more austerity these country's implement, the worse their economies become and the less likely the are to pay off their debts. See Krugman's The Path Not Taken:

Now, however, the results are in, and the picture isn’t pretty. Greece has been pushed by its austerity measures into an ever-deepening slump — and that slump, not lack of effort on the part of the Greek government, was the reason a classified report to European leaders concluded last week that the existing program there was unworkable. Britain’s economy has stalled under the impact of austerity, and confidence from both businesses and consumers has slumped, not soared.

Maybe the most telling thing is what now passes for a success story. A few months ago various pundits began hailing the achievements of Latvia, which in the aftermath of a terrible recession, nonetheless, managed to reduce its budget deficit and convince markets that it was fiscally sound. That was, indeed, impressive, but it came at the cost of 16 percent unemployment and an economy that, while finally growing, is still 18 percent smaller than it was before the crisis.