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2010 Economic Outlook - By Andrew Smith, Chief Economist, KPMG LLP

Broadly speaking, there are three ways the economy could go this year.
  • At one extreme is the V-shape recession-and-recovery argument which says the global recession is no different to previous ones - it has just been deeper and scarier. Now it is over, the recovery - like previous ones - will turn into a virtuous circle: as the recovery becomes established, debt burdens become easier to handle and banks will heal more quickly. 
  • At the other is the vicious circle scenario - that this is not a normal recession but the result of a collapsed credit bubble. The world is sinking into a "debt deflation" spiral. Ultimately high levels of debt (both private and increasingly public) will prevent demand from strengthening sufficiently to avert deflation.
  • In the middle is the muddle-through view. Loose fiscal policy and quantitative easing has averted a second "Great Depression" but there will still be long-term consequences. Over-extended borrowers and under-capitalised banks will take time to repair their balance sheets and, while the former are paying down debt and the latter recapitalising, growth will be lacklustre.

None of these scenarios can be dismissed out of hand but, so far, things are going the V-shapers' way.

In the UK - the only major economy not yet officially out of recession - it looks as if growth resumed in the fourth quarter and both the Treasury and the Bank of England have pencilled in a V-shaped recovery starting around now.

But then what? Official policy measures have put a floor under demand but at some point these will have to be reversed. Financial markets may be prepared to wait and see what happens after the general election (due by mid-year), but if investors get impatient about the speed of the policy correction, they could take matters into their own hands and drive the currency down and interest rates up, aborting recovery.

And if the downside risks are overplayed and recovery turns out to be strong and sustained, shouldn't we be worried about inflation given the huge amounts of liquidity that have been pumped into the system?

What central banks and governments do now and in the coming months is crucial. Small wonder then most forecasters are hedging their bets.

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