In 2010, the world economy, led by emerging markets, staged a remarkable rebound from the deepest global recession since the 1930s. Growth moderated in 2011, however, and the global economy is again on unstable ground. With economic activity gradually picking up in the United States, the European crisis—which is pushing Europe into a shallow recession, and possibly much worse—has reclaimed the spotlight. Though we expect the world economy to continue to grow in 2012, its pace will slow further and the downside risks will be very high. With little economic space and even less political will for more expansionary policies, policymakers must focus on preventing a catastrophe in Europe.

Losing Momentum

After building an impressive head of steam in 2010, the global economy lost momentum in 2011. Weighed down by the European crisis and the earthquake in Japan, global industrial production growth slowed from 8.3 percent in 2010 to virtually zero in the first half of 2011. Production growth accelerated to 3.2 percent annualized in the most recent three months (August through October), bringing the annualized growth rate for the first ten months of 2011 to 3.2 percent—roughly in line with the pre-crisis average—and finally returning the industrial production level to its ten-year trend.

As the chart shows, however, emerging economies—and principally Asia—have fared far better than advanced countries, where production stagnated in 2011 and has yet to return to pre-crisis levels.

Global trade is slowing as well. after growing by 10.4 percent in 2010, world trade volumes have been flat from January through October 2011—compared to an average pre-crisis growth rate of about 7 percent.

This slowdown has hit stock markets—which have still, three years since the great Recession’s outbreak, not recovered to their pre-crisis level—implying adverse wealth and confidence effects. since the start of the year, major stock indices are down 5 percent in the United States, 10 percent in the UK, and 20 percent in Europe and Japan. Brazilian and Chinese indices, furthermore, are down 20 percent.

As economic growth slowed, inflationary pressures abated. Commodity prices, which contributed to the uptick in inflation this year, have dropped by 20 percent since May after surging by 45 percent in the ten months prior. Consequently, inflation expectations have fallen: based on the yield differential between garden-variety and inflation-protected bonds, markets are predicting 10-year inflation at 1.9 percent in the United States, 2.5 percent in the UK, and lower still in Germany.

Most important, concerns about overheating in emerging markets have eased somewhat. Partly in response to inflation falling from 6 percent (m/m of the previous year) in June through September to 4.2 percent in October, China eased bank reserve requirements for the first time in three years. in Brazil and India, inflation has declined since September, but, at 6.7 and 9.4 percent (both m/m of the previous year), it remains high in both countries. the decline in Brazil prompted its central bank to cut interest rates three times since September.

Reflecting the search for safe havens from the euro crisis, as well as the decline in global growth and inflationary pressures, bond yields in the largest advanced economies remain at or near record lows. U.S., UK, and German ten-year bond yields are all hovering around 2 percent, while Japanese bond yields are even lower, around 1 percent. By contrast, yields in Italy, the third-largest government bond market are at 6.8 percent.

Reasons for Hope

Despite the slowdown, growth in emerging and developing countries remains strong even by historic standards. according to the most recent estimates by the International Monetary Fund (IMF), emerging and developing countries will grow by 6.4 percent in 2011, higher than their precrisis average of 5.8 percent. Employment levels in the BRICS (China, India, Brazil, Russia, and South Africa) are above their precrisis averages. U.S. dollar per capita GDP, moreover, is estimated to grow by about 60 percent on average from 2007 to 2011, suggesting that these economies, which purchase 18 percent of global imports, can continue to account for a large part of world demand growth.

Economic activity is gradually picking up in the United States as well. Consumer spending on services, which accounts for about 45 percent of the U.S. economy, grew by 2.9 percent (q/q, annualized) in the third quarter, the fastest rate since 2006. overall consumption expenditures growth also accelerated to 2.3 percent, but remains slightly below the long-run average.

Crucially, though unemployment remains high and labor force participation is still low, the U.S. job market is finally showing solid signs of improvement. Unemployment dropped from 9 to 8.6 percent in November (partly because of labor force adjustments) and the private sector is on pace to add 1.87 million jobs in 2011, which would be the fourth-best year, in both absolute and percentage terms, since 1999.

Finally, U.S. nonfinancial corporations are in good health. After-tax U.S. corporate profits reached $1.6 trillion, or 10.3 percent of GDP, in the third quarter of 2011, the highest in history by both measures.

Reasons for Worry

The European picture is darkening ominously. since infecting Italy, the eurozone crisis has spread throughout the continent’s banking system and is causing a severe credit crunch. GDP declined in the third quarter in Italy, Greece, Ireland, the Netherlands, and Portugal and stagnated in Spain. as a best case scenario, the eurozone is expected to slip back into recession this quarter or in early 2012.

The eurozone represents 20 percent of world GDP, and if its crisis continues to intensify as it has done steadily over the last two years, the global economy could face another Lehman moment—or worse. the bond markets of Greece, Ireland, Italy, Portugal, and Spain total $4.6 trillion, three times the size of the entire U.S. subprime mortgage market at its peak. the Organization for Economic Cooperation and Development estimates that disorderly defaults would lower eurozone GDP growth by 5.8 percent over two years and world growth by 3.4 percent, while some private analysts (pdf) estimate that a breakup would be several times more severe.

Though the Italian ten-year bond yield—currently the best single barometer for the crisis—is down from the 7.2 percent peak it hit last month, it remains around 6.8 percent, well above what most analysts believe is sustainable. European Central Bank (ECB) bond purchases have kept the rate from rising higher, but the ECB has repeatedly warned that its purchases will be temporary and limited. At the same time the ECB has greatly stepped up its liquidity support for banks. Politicians continue to inch toward a solution—their most recent effort includes an agreement to tighten fiscal discipline as a prelude toward a “fiscal union”, whose shape remains entirely unspecified, and a commitment to add about $200 billion to the IMF. but Europe is still far from anything resembling a definitive solution.

Europe is not the only trouble spot, however. after the failure of the congressional “supercommittee” to pass a deficit reduction package, the United States has no clear way to reduce its rapidly rising public debt. Though markets have shrugged it off as a long-term problem, the supercommittee’s failure could have effects soon if the “trigger” cuts to discretionary spending go into effect in 2013. With the opportunity for fast-tracked, filibuster-proof reform now gone and a gridlocked Congress struggling to agree on a widely supported extension of the payroll tax cut and unemployment insurance benefits, it is unclear whether the U.S. political system is capable of providing fiscal policy that responds appropriately to the business cycle, much less act to reduce government debt in the longer term.

Finally, despite its high, albeit slowing, growth, China is plagued by uncertainties too. in part, these are associated with risks coming from the advanced countries, but there are also major domestic concerns. Slowing growth and the delayed effects of tighter monetary policy are deflating property markets, which are already down by 3 to 10 percent in major cities over the last four months. Sharper declines in property prices could produce a string of bankruptcies that disrupt the financial system. With China accounting for a third of global growth over the past five years, a significant slowdown there would clearly endanger the global recovery.

Conclusion

With many advanced countries lacking policy space to respond to an economic downturn, the focus must be on crisis prevention and containment. the stakes now for heading off a worsening of the crisis in Europe could not be higher. No longer able to survive on half-baked solutions, Europe must commit to closer fiscal integration and to more expansionary policies in Germany and other countries that can afford them. meanwhile, a larger rescue fund and ECB support for the periphery when needed must be part of the short-term solution. Because European resources alone may not be able to save the euro, the United States, China, and other major economies should make a determined effort to enlarge the IMF. Without these changes, the fragile global recovery may not last through the coming year.

Uri Dadush is the director of Carnegie’s International Economics Program. Bennett Stancil is a researcher in Carnegie’s International Economics Program.

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