The Great Recession
This term, used by a number of US economists to explain the current economic/financial crises, summarises well how serious it is and the fact that it is likely to last for some time. That is a good definition of a depression, a term most are afraid to use. Whatever you call it the world is now going through a unique event in the post-World War II era and this adjustment will clearly last a considerable period of time.
The International Institute for Strategic Studies is clear on how serious these crises are: “the health of the Western financial system remains precarious, the patient kept alive by massive state support. Following a collapse in demand for goods and services, the world economy is forecast to contract in 2009, for the first time since the Second World War. Recovery seems likely to be slow and fraught with risks.” [Economic Stress Continues, Strategic Comments, May 2009, IISS.]
The IMF has pointed out that history shows that recessions are deeper and more prolonged if they follow a financial crisis, and if they are synchronised across a number of countries. According to the OECD (The Organisation for Economic Co-Operation and Development) GDP is expected to reduce by 4% in the US, 4.1% in the 15 -country Eurozone, and 6.6% in Japan, in 2009. The World Bank forecasts that the world economy as a whole will contract by 1.7% this year, the first such decline since the Second World War.
This Great Recession,will last for at least five years while worldwide businesses, and particularly individuals,deleverage their debt, and rebuild their pension investments. Consumer spending will therefor be all the lower during this period. According to the US Federal Reserve, household wealth in the US peaked at $64.4 trillion in the middle of 2007, and plunged to $51.5 trillion at the end of 2008. Therefore in the order of US $13 trillion of perceived wealth vanished in a short period. “A standard, empirically tested rule of thumb is that an additional dollar of wealth induces the average consumer to increase annual spending by an amount between four and six cents. So we are looking at a potential drop in consumer spending of something like US $650 billion a year (5% of $13 trillion).
To see how big this is, remember that President Obama’s stimulus package amounted to less than US $800 billion, spread over two or more years.” [Robert M. Solow, Institute Professor Emeritus of Economics at MIT ,How to Understand the Disaster, the New York Review, May 14, 2009].
“The goal of many retail [banking] customers, meanwhile, will be to deleverage. The fact that households, not businesses, have so much debt to unwind is something that marks this episode out from many previous banking crises. According to McKinsey, American consumers have accounted for more than three quarters of the country’s GDP growth since 2000 and more than one third of worldwide growth in private consumption since 1990. Although deleveraging can also occur through income growth, the immediate response of consumers has been to save more, depressing demand for credit. This is likely to continue for the foreseeable future.” [Rebuilding the Banks, The Economist, 16 May 2009].
Another reason for a likely lengthy recession or depression is the fact, highlighted by the Economist and some bloggers and others in the US, that the full extent of the problems with commercial real estate (“CRE”), has not yet been fully understood or factored into bank loan write-offs and related recapitalisation. Most CRE purchased over the last few years of the bubble period was acquired at valuation levels that will not be seen again for many many years . There is little doubt that valuation write-downs of between 35% and 50% will be required on much of this property, based on the history of previous property bubbles . Much of the lending on that CRE is due for renewal, roll over, or repayment over the next few years. There is no obvious solution to this situation with most investments significantly underwater, and therefore logically in need of significant equity. However such investment is high risk, and very difficult if not impossible to obtain at present. In the absence of such equity, the alternatives for the banking industry in dealing with such massive problem loans is to extend the term of the debt repayment (this just defers the bad news ), have the loan refinanced fully (highly unlikely), or repossess the asset and take the immediate massive loss. All are grim alternatives. This is why some bloggers in the US worry that the only answer for the government is to create another asset bubble to generate increased values to solve the underwater investment problem in CRE, and I might add elsewhere. In the US the total value of this “iceberg” as it has been called, is approximately US $3.4 trillion.
In the UK, noting that commercial- property values have dropped by 43% since their peak in June 2007, a record decline, the Economist says “the mood is even darker in a majority of the 40 other countries surveyed and compared in a report released on May 19… Loans on commercial property were some $349 billion at the end of 2008. A third is due to be repaid this year and next, according to a forthcoming report from researchers at De Montfort University. This overhang of debt – and the need to refinance so much of it swiftly – is another reason why the outlook for commercial property remains blighted, says Bill Maxted, one of the authors.” [Dire days in commercial property, The Economist, May 23, 2009.]
Paul Krugman, the winner of the 2008 Nobel Prize in Economics, summarises the position overall very well: “this crisis has been so large and the political process has been so sluggish that the difficulties have been greater than expected. And yes, there are some green shoots. Things are getting worse more slowly, but we have not managed to head off a crisis that could turn out to be self- reinforcing, and leave us in this trap for many, many years.”
In its Strategic Comments the IISS gives a broad international perspective on the sources of The Great Recession. “Many economies were ripe for a correction after a long period of economic growth. This was underlined by the real -estate boom in some countries, fuelled by unsound lending. Many economists believe the world had reached an unsustainable situation in which several exporting countries had built up huge foreign-currency savings that they ploughed back into investments in importing countries, further fuelling the import boom. A correction of the huge imbalances between surplus and deficit countries was inevitable. The financial crisis has triggered the start of such a reversal, since exports from China, Germany and Japan have collapsed, and the fall in energy prices has reduced the income of oil exporters.”
“In the longer run, however, policy changes will be needed to stimulate demand in surplus countries [countries which rely on permanent export surpluses for their national wealth ] on a more lasting basis. While Beijing, Berlin and Tokyo have taken measures to create a temporary stimulus, it is far from clear that they have forsworn their heavy dependence on exports for growth. Therefore, there is a remaining risk of unsustainable surpluses and deficits contributing to instability. Some analysts detect unrealistic hopes that pre- crisis boom times can simply return. “
In these circumstances the countries that were going to be particularly badly hit were those with high public borrowing levels ( the US and the UK), high private borrowing levels (the US, Ireland, and other property boom countries), countries who had opened up their financial markets but were still going through economic reform and transition (many of the countries of Eastern Europe and the Baltics), poorer countries, and those reliant on commodity or other exports dependent on unrealistically high Western demand.
Looking to the future there has been much simplistic comment about the inevitable rise of China and the decline of the US because of these crises. Both assumptions (if you could grace this thinking with such a term) are likely to be shown to be completely incorrect. China faces a very significant demographic challenge of a reducing population, ageing dramatically (without any social safety net — unique historically) and an imbalance of males and females. This on top of a financial structure where many decisions are made solely for political purposes, and with corruption a pervasive and growing problem, makes betting on the future of China a particularly risky gamble. The US, unique amongst the great powers, faces a very positive demographic future, and with the new administration appearing willing and able to reform deeper and quicker than anyone else, will likely recover quicker than most countries. The US is still clearly at the centre of efforts to deal with the current crises.
The international Institute For Strategic Studies, looking at these issues from a broad strategic perspective, has this to say: “The crisis has demonstrated the continuing economic importance and the size and depth of American financial markets – especially the role of the dollar as the key trading and investment currency… The crisis underlines the massive resources that the Federal Reserve and other federal authorities can bring to bear to stabilise markets. As a result, investors around the world still see U.S. Treasury securities as a very safe haven. This puts Obama in a strong position globally, even as economists and pundits argue about the precise measures Washington adopts.”
“America’s continuing underlying strength needs to be borne in mind when considering the global power shifts that could be accelerated by the economic crisis. These seem likely to be relative and partial. China, normally diffident in international gatherings, was notably assertive at the G 20 London summit, advancing an anti-protectionist agenda and arguing with France over the treatment of tax havens… While Chinese leaders may have openly criticised Western consumption, they have an interest in restoring something like the previous status quo. Apart from the vulnerability of export markets and dollar investments, they have reason to be concerned about the domestic impact of, for example, the sudden rise in joblessness. Thus, the vaunted ‘rise of China’ as a world power is likely to be nuanced and drawn out.” [Strategic Comments, May 2009].
China, like Japan and Germany, has to face up to the fact that one of the key imbalances that led to the current situation was their endemic trade surpluses. China has at least acknowledged its need to change in this area. Privately it has to be aware that the consumption party in the US was enabled by its own unsustainable export drive based on an undervalued currency. Putting the dollars it earned back into the US helped keep down interest rates there , thereby raising house prices and encouraging Americans to buy even more to Chinese goods. As Nicholas Lardy, an American economist specialising in China, the two countries were as co-dependent as a dope-dealer and an addict.
The widespread assumption that China would pick up the slack from US consumers is also likely to be very wide of the mark. The Chinese government trumpeted a US $586 billion spending package which was widely commended. However, as the Economist has explained, this package needs careful analysis . “For one thing, some of the money is being spent subsidising Chinese exports. This worsens the overproduction at the heart of the crisis… By contrast, household demand is not getting any real long-term boost, despite a few most notable initiatives… Indeed, demand is depressed precisely because household savings are being funnelled by the state banks, paying measly rates of return on deposits, to big companies. Loans to small businesses have actually fallen.”
“ If domestic demand is to grow, then finance has to be liberalised to allow savers to earn an honest return and deserving companies to get finance. But this would be to challenge the state’s chief powers, which is why it will happen only slowly, if at all… Either way, China‘s leaders will be too busy saving China to bother about running the world.” [May the good China preserve us, the Economist, 23 May 2009.]
Chinese demand will therefore not be available to replace that off the US, leaving a very large hole in worldwide demand that is unlikely to be replaced. The impact this will have on the two other countries heavily reliant on worldwide demand to fuel their export surpluses, Germany and Japan, has I believe not been fully acknowledged nor accepted by either country.
Meanwhile a massive Catch-22 looms over the US and the world financial systems.
Government spending and therefore related government debt is effectively replacing lost personal consumption and corporate investment and spending, and the deleveraging of both , of necessity. However at a certain point ,printing money and increasing government debt leads people to “grow dubious about the financial solvency of governments” (Paul Krugman). They will also grow concerned about the stability of the dollar and the US deficit and government debt and therefore worried about a possible dollar bubble. As George Soros has put it :”the interesting thing is that what needs to be done in the short term is almost exactly the opposite of what needs to be done in the long-term. Obviously the problem was excessive leverage . But when you have a collapse of credit there is only one source of credit that is credible, and that’s the state: the Federal Reserve and the Treasury. Then you have actually to inject a lot more leverage and money into the economy; you have to print money as fast as you can can,expand the balance sheet of the Federal Reserve, increase the national debt. And that is, in fact, what has been done, which is the right thing to do. And then once this policy is successful , you have to rein in the money supply as fast as you can.” (From a symposium on the economic crisis presented by by Pen World Voices and the New York Review of Books , April 30, 2009.)
Just as government policies in many respects created the enabling environment that led to the Great Recession, we are once again reliant on government policies not to repeat the same policy errors.
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