08/12/2011 07:05 EDT | Updated 10/12/2011 05:12 EDT

Canada Economic Forecast: Rumours, Uncertainty, Fear Feeds Vicious Cycle

TORONTO - Bad news. Anxiety. Selloff. Repeat.

That's the cycle that is doomed to repeat itself unless political leaders take bold measures to deal with the global debt crisis and end economic uncertainty, investor psychology experts said Friday.

Their comments came after a week of turmoil and frantic selling and buying on global stock markets over fears of a possible double-dip recession in the United States and mounting debt problems in Europe.

Canada's main market, the Toronto Stock Exchange is down 13 per cent from its 2011 high reached in March, with billions of dollars of stock value wiped off the books.

In New York, Wall Street had its wildest week in history, ending Friday's session with a second day of gains. For the week, the blue-chip Dow Jones industrial index had four 400-point swings in a row for the first time in the market's 115-year history.

Such sporadic swings in investor confidence will likely be the new normal for at least the next two years, said Adrian Mastracci, a portfolio manager at KCM Wealth Management.

That's because ongoing sovereign debt problems aren't going to be solved by the current mix of bailouts and austerity measures reaching far into the future, he said.

"I've never understood the school of economics that says 'if I can't support the loans I've got today, then the solution is more loans'," he said. "Dealing with the problem is one of the things that would really give the investors some confidence."

Wild market swings repeat themselves every few years during market slumps and can weaken consumer and business confidence, making it harder to sustain the global recovery.

"We're prone to repeat these mistakes over and over again," said decision-making expert Joseph Arvai, a business professor at the University of Calgary.

Confidence tumbles each time there's a sharp downturn and consumers and companies that feel less confident are less likely to spend or borrow and hire new workers, creating a vicious cycle that can slow growth.

Data out of the U.S. on Friday showed that the consumer sentiment index from the University of Michigan and Thompson Reuters tumbled to 54.9 in August, much lower than the 63.2 reading that had been expected.

Meanwhile, the Bank of Montreal downwardly revised its economic growth forecast for the United States to 1.7 per cent from 2.5 per cent for 2011, saying the forecast reflects recent volatile stock markets, declining consumer demand and growing fears of a recession.

Weak growth in the U.S. means less demand for Canadian exports and spells fewer jobs and weaker confidence north of the border.

Reluctance to take risks means businesses sideline their cash and wait for things to improve, which can cause a self-fulfilling prophecy that can freeze growth, said William Morrison, a business professor at Wilfrid Laurier University who specializes in behavioural economics.

"If all firms think that way, that in itself has a contractionary impact on the economy," he said.

"Then markets don't expand and then individual firms looking at that go 'Well, see I was right to think what I thought. My expectations are fulfilled, I'm on the right path'."

With the 2008-2009 recession still fresh on people's minds, consumers and investors are on edge, making them prone to panic over negative news.

"You've got this long line of very salient bad news that's really easy to recall and not a lot of good news to counterweight that," Arvai said.

Arvai said that has magnified the negative emotional response has made it "really hard to look at something that Flaherty says or Barack Obama says and see credibility in that."

U.S. and European governments should take a cue from Canada's moves to rebalance its budget in the 1990s through a combination of tax cuts and shifting the debt burden to provinces, Arvai said.

Tony Clement, president of Canada's Treasury Board, reminded Canadians on Friday that Canada's economy has weathered economic turmoil better than most and without raising taxes, criticizing opposition parties for suggesting that the majority Conservative government in Ottawa should change course.

"Recent events have demonstrated that governments must have a prudent fiscal plan to make job-creating investments, keep taxes low and reduce deficits," he said in a statement.

"This is the plan that we set out in the next phase of Canada's economic action plan and one that we intend to follow through on."

Governments and central banks often do what they can to reduce fear in the marketplace, such as the announcement by the U.S. Federal Reserve earlier this week assuring Americans that interest rates won't rise for a two-year period.

That was seen as an attempt to prompt consumer spending, which makes up about 70 per cent of the U.S. economy, by easing fears of an interest rate spike that might impede borrowing.

But the experts said it's going to take some bolder, and likely unpopular steps, to convince consumers that the U.S. government is taking measures to ensure fiscal prudence going forward, such as moves to raise more revenue through taxes.

"When they start to do that and they see their economy shift into the positive, I think it's those kinds of measures that will begin to create positive kinds of responses in the economy," Arvai said.

In Europe, the French government was put under further pressure to cut deeper into spending after figures Friday showed economic growth ground to a halt in the spring, raising recessionary fears in Europe's second-biggest economy.

Meanwhile, the Italian government approved nearly US$65 billion in tax hikes and emergency austerity measures over two years to balance the budget by 2013 in response to demands by the European Central Bank.