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Here's The Scary Side Of The Imf's New Forecasts

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Those reassured by the IMF’s upward revision to its growth forecast for the world economy this year should take a closer look at the predictions just issued. Towards the back of this generally sanguine assessment of the state of the world economy there’s a section headed “downside risks to global growth are much greater”.

This explores a number of possible adverse scenarios, including the risk of an escalation of financial stress and contagion, prompted by rising concern over sovereign risk. “Given trade and financial linkages”, the IMF observes, “the ultimate effect could be substantially lower global demand”.

The IMF then goes on to model a scenario where the magnitude of the shocks to financial conditions and domestic demand in the euro area is as large as that experienced in 2008. The model assumes considerable contagion to other regions including the US, where reduced equity prices would dampen consumer demand. In such a scenario, growth worldwide would be suppressed by a full 1.5 per centage points in 2011 to 2.8 per cent, an even lower rate of growth than seen in 2008. Not pretty.

I’ve written about all this in a longer column for the print edition of the Daily Telegraph, but given my sunny disposition, I’ve taken a rather more optimistic view than these “worse case scenarios” suggest.

What’s absolutely crucial is that Europe doesn’t mess up the stress testing it is currently conducting on nearly 100 banks. To be credible, it is essential that quite a lot of these banks are seen to fail the test and are immediately recapitalised to compensate. If that happens, then we can expect some easing in the renewed banking crisis that has engulfed Europe over the past three months.

But if they all pass with flying colours, the whole thing will be seen as a charade and typical of the denial which has coloured much European policymaking. It will make a bad situation worse, and who knows, the IMF’s worse case scenario may be eclipsed by something worse still.

So if a number of banks do fail the test, where is the money going to come from to recapitalise them? Won't this be sucking money out of the real economy?

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