What really happened &  how to survive it.

 Michael Davenport , London Grip’s economics editor,  reflects


 

The outlook for the world economy is as bad as it has been since the onset of the Great Depression. I shall not concentrate on laying the blame for the current situation on bankers, borrowers, regulators or governments; there has been plenty of fault-finding in the press. Rather, in this piece I shall examine the prospects for recovery and argue that an early upturn is extremely unlikely.

Unemployment figures in North America and Europe, as well as surveys of business expectations, consumer confidence and new mortgage lending all signal that the situation is still deteriorating. Rather than another short recession such as those experienced over the last sixty years – typically of one year or less – I will argue that we now have to wait three or more for a lasting upturn. The IMF has predicted that world growth will slow from 5 percent in 2007 to 3¾ percent in 2008 to just over 2 percent in 2009; this represents the first annual contraction since the war. The downturn will be led by advanced economies which will, themselves, contract by ¼ percent in 2009, down ¾ percentage points from the October 2008 IMF projections. The UK is forecast to contract by 1.3 per cent, the worst performance of any developed economy. The Bank of England does not contest the IMF’s forecasts but expects an upturn in late 2009.

The worst is far from over

Why then is this recession likely to be so deep and prolonged? There are four main reasons. Firstly it was spawned by a financial crisis which will take a long time to resolve. Secondly, the housing market, particularly in the United States and Britain, is likely to undergo a “correction” significantly greater than those of the past. Thirdly the emergence of deflation – or falling consumer prices – could result in a major slump in consumer expenditure. And, fourthly, the capacity of governments to take adequate corrective action is limited.

The banking problems began as early as August of last year but only turned into a crisis with the collapse of Lehman Brothers last September. Even without that crisis, there would have been an economic slowdown in Europe and North America, triggered by the sub-prime mortgage problem which led to cuts in the availability of mortgages and weakness in the housing market. Arguably if the initial problems had been tackled early on by major interest cuts and government assistance in recapitalizing the worst affected banks – the Northern Rock problem was a signal that more widespread action was required – they could have been contained and the fallout would have been at worst minor recessions in the US and the UK. Instead what has happened is that the interbank market has effectively frozen up. Individuals, both in their access to credit card debt and mortgage lending, as well as companies, are dependent on short-term borrowing between banks and other financial institutions to offset the randomness of deposits and withdrawals.

This market was initially damaged by uncertainty about the value of the banks’ holdings of sub-prime mortgage debt, a concern which continues since the original “toxic” assets haven’t been fully valued yet. But the market will now remain effectively closed for many months if not years, to some extent because these toxic assets are being increased as originally prime mortgage loans become sub-prime with increasing negative equity in the housing markets, but mainly because of their huge write-offs which mean the banks need to rebuild their balance sheets by reducing their total loan portfolios.

The US and UK governments have stepped in to help recapitalize the banks through buying new preference shares, and in the UK, equity. Some of the banks have had to accept this reluctantly, as they would rather build up their own balance sheets – through, for example, sovereign funds of oil-producing countries – and avoid having to pay interest to and heed the wishes of their new public shareholders.  In the US the TARP plan for the Treasury to buy up the toxic assets of the banks has apparently been shelved but this will mean further write-offs and recapitalization by the government. To the extent that the banks sold those assets at knock-down prices, they will have to write down their capital and thus slim their loan books even further.

Most recessions in the past have been generated by slowdowns in household spending, often provoked by increases in interest rates designed to cut back on inflation, while business investment follows and typically does not decline as much. In the current situation cutbacks in consumption are being matched from the outset by cutbacks in business investment because of the credit markets. The effect will be to both deepen and prolong the recession. In many surveys, business confidence is the lowest ever recorded and it will take a long time before confidence is rebuilt and investment revives, the credit and equity markets permitting.

The deflation threat

Over the past year commodity prices have risen 30 to 40 per cent – depending on which index you use – and then fallen about 60 per cent. They are now about 30 per cent lower than November 2007. With consumer, business and export demand rapidly falling, consumer prices could fall in a number of countries, both in the developed and developing worlds.

Such deflation would exacerbate the existing recession problems as household and businesses will be even more reluctant to spend – ‘better to wait till prices are lower’. And with interest rates close to zero, financial institutions would be even more reluctant to lend.  As happened in Japan between 1990 and 2001, deflation could seriously worsen the recession and make recovery – notably through tax cuts – more difficult.

Housing markets

The third obstacle to a recovery over the next few years is the housing market itself. The banking crisis has fed through into the housing market. In both the UK and the US house prices, between March 2007 and April 2009 fell further and faster than any time since records have been kept. In the UK the average house price tripled between mid-1996 and April 2009. Since then prices have fallen 15 per cent. In the US the average price of a new house doubled between January 1996 and March 2007; since then it has fallen 17 per cent. As a result in both countries repossessions have been increasing and there is no suggestion that the fall in house prices has reached a plateau. The impact of this erosion of house prices on consumer expenditure will rapidly increase as home-owners become unemployed or are unable to meet higher mortgage charges when their introductory deals lapse. The problem is exacerbated by the rapid growth in credit card debt over the last decade.

The house market will continue to weaken as repossessions increase and the banks – on both sides of the Atlantic – resist government efforts to have them lower mortgage rates.  The main banks in the UK have agreed to cut their standard variable rate but that only affects a minority of borrowers. In the US the vast majority of borrowers are on fixed rates and cuts in the Fed Funds rate makes little difference to total mortgage repayments. Further deterioration in the market accompanied by rising unemployment will increase pressure on consumers, as will reductions in the availability and increases in the costs of credit card debt. The UK’s overall household debt sits at 110 per cent of GDP – the highest of the big five Western European countries and the highest in the G7.

Under these circumstances consumer expenditure in the UK and the US is likely to fall sharply in the coming months. In other EU countries it will also fall, but with less household indebtedness – except perhaps in Spain and Ireland – the negative impact on GDP will likely be less.

Counter-cyclical policy

What can the authorities do about this long and deep recession facing the developed countries? Official interest rates have been cut substantially – the Fed Funds rate to 1 per cent in the US and bank rate to 3 per cent in the UK, the lowest bank rate since Winston Churchill was prime minister. Further reductions are on the cards; at a recent press conference, Mervyn King, Governor of the Bank of England, said he is prepared to cut bank rates again “if that proves necessary”. As we have seen, by the time it proves necessary it is too late.

Furthermore as explained above these cuts have not led to similar reductions in the dollar or sterling inter-bank rates (libor) or the Euro zone rate (euribor): nor have they made credit more readily available. Indeed these rates are currently some 125 basis points (1¼ percentage points – as opposed to historical margins of 15 to 20 basis points) above the corresponding official rates. As official rates have been cut, interest rates have come down, but with long delays. (This to some extent explains the recent path of exchange rates, in particular the weakness of sterling, which may be a blessing in that it will help prevent deflation in the UK while boosting exports. The strength of the dollar is explained, on the other hand, mainly by American investors, particularly hedge funds, liquidating holdings in the emerging markets, particularly Russia, China and India, and selling the local currency for dollars.)

A further problem with monetary easing is that it cuts the interest payable on bank savings; this is significant in the UK where savings are a major source of income particularly for pensioners (though much less so in the US where bank interest rates are derisory.) This also means reductions in the coupons on new government bonds which are needed to balance the liabilities of pension funds, resulting in falls in annuity rates for new pensioners.

Fiscal policy has thus become the lifeline. All the larger developed countries and several large, emerging countries are talking about a Keynesian response in the form of increased public expenditure or (somewhat less Keynesian) reduced taxes. The latter is more likely than the former because of lags in the implementation of new public expenditure programmes – much greater than in Keynes’ day.

For both the UK and US either response is dogged by the present horrific budget deficits.  Nonetheless, both Gordon Brown and Barack Obama seem keen to implement significant tax cuts or rebates though the details have still to be spelt out. There is talk of a £15 billion tax cut (or rebate) in the UK. This may sound like a lot but the deficit in the next fiscal year would already have been some £80 billion; it is unlikely that the extra £15 billion will make much difference. In some of the Euro zone countries significant tax rate cuts are feasible, though in Germany, which has already entered recession, the proposed stimulus is paltry.

Another problem with the fiscal approach is that much of the additional household income will be saved at a time when there is, for many, a real threat of unemployment, when pension funds are being rapidly eroded by the collapse of stock markets, when banks and other credit card suppliers are cutting credit lines and, most importantly, when fear of the unknown is pervasive.

Can the emerging markets help?

In Russia and China there is still greater scope and China has just announced a public expenditure boost equivalent to some 7 per cent of GDP over the next two years. China’s announcement that it will invest $568bn over the next two years in infrastructure, reconstruction and housing looks significant given the country’s role in underpinning global economic growth in recent years. This sounds a substantial programme, but it is estimated that about half consists in expenditure previously planned – like Gordon Brown the Chinese seem to be big double-counters – and half of the remainder is supposed to come from state and local governments, many of which are currently cash-strapped and unlikely to contribute. There are also likely to be delays in implementation. The programme will undoubtedly help the Chinese economy but it is no panacea for China or the world. China’s exports are at risk of drying up and it is estimated that the Chinese growth rate may dip to 6 or 7 per cent in 2009 as against 12 per cent in 2007.  The net change in Chinese demand for goods from the west will be substantially negative.

With a fiscal deficit of 7 per cent of GDP India is not in a position to copy the Chinese. Russia however could and an announcement may be close. It is currently busy with a programme to lend to the oligarchs who have lost substantial funds in forward positions in the stock market. In any event Keynesian programmes by the emerging nations can only help. However these countries themselves are experiencing major reductions in aggregate demand and any programmes are unlikely to restore the status quo ante where developed country exports to the emerging markets were a major input into economic growth.

Implications for Obama and Brown

If this analysis is correct, the UK economy will still be in dire straits at the time of the next British general election. Though it is certainly true that the UK’s insistence on bank recapitalisation led the way and was subsequently taken up by most developed countries, it is doubtful whether Gordon Brown can continue to project himself as the Messiah for the world’s financial problems when Britain’s unemployment is approaching 3 million – 9 per cent of the labour force. Britain’s firms are going bust in large numbers and Britain’s consumer confidence is at its lowest on record. On the other hand it is equally doubtful that the electorate will appreciate the fiscal conservatism of David Cameron in such troubled times.

Perhaps the most serious fall-out from world recession will be Obama’s loss in the 2012 presidential election. It is clear that he is set to initiate a serious programme of government spending and tax cuts, though as with Gordon Brown, he will be limited by the current fiscal deficit. On the other hand Obama will be able to argue that the problems that triggered the recession – sub-prime mortgages, a lack of adequate banking supervision and delays in the response of the monetary authorities,  and those that make a proportionate response so difficult – the extent of the deficit, the poor state of bank balance sheets – arose under his predecessor’s watch: Gordon Brown has no such alibi. Obama also has most of the $700 billion raised for the now-discarded TARP available, Congress willing, for the first tranche of public expenditure. And at least the job will be one of cutting taxes and raising public expenditure, not the reverse as would happen if the problem were one of inflation rather than deflation.

And, finally, what about us?

A long and deep recession clearly has implications as to what we should do to preserve our millions – or at least the pennies which may remain after the stock market slide. Firstly, what about the stock market itself? There is a constant supply of newspaper articles, not always totally disinterested, arguing that now is the time to return to the stock market.

It is true that the stock market, by its nature a forward-looking construct, has in the past started to recover before the economy. Indeed, in the US, the market has begun to recover on average some six months after the economy has started to decline. But the typical recession – measured as the time taken for the economy to recover the loss to output – has lasted less than twelve months. It might be better to interpret the evidence as indicating that the stock market starts to recover six months before the economy.

The argument of this piece is that the current recession will last for three or more years. Certainly it is possible that the massive falls already registered on the stock market may represent most if not all of the eventual decline. But there is no good reason to believe that the stock market has twigged onto the depth and length of the current recession. Of course some stocks will do well – perhaps, the so-called “defensive” stocks such as pawnbrokers or other money lenders or maybe the cheapest supermarkets – but there is no good reason to believe that the market as a whole is set to begin its recovery.

What about government bonds? The problem here is that both the UK and the US governments are likely to go massively into debt to finance tax cuts and increases in public expenditure. This means they will issue many new bonds, thus reducing the price of existing bonds by pushing up the yields. Another problem – already being felt in Britain – is that expected currency depreciation will lead to foreigners, including foreign central banks, offloading some of their holdings of gilts (UK government bonds) and US bonds.  (The recent strengthening of the US dollar is due to the sale of equity and the repatriation of dollars, a process unlikely to last much longer.)  On the other hand with deflation – or at least very low inflation – on the cards, the value of existing government bonds will benefit. It is quite possible that the latter effect will outweigh the former, but investments in government bonds should reflect the uncertainties. As for corporate bonds, yes but only where the risk of default is low and yields exceed those of the financial institutions underwritten by government.

As for property, the fall in the housing market appears to have some way to go. This leaves the money markets. Banks and building societies in the UK – now almost certain of full government bailouts should there be any question of default – are even now offering up to 7 per cent on short term bonds and not much less on savings accounts. However such rates are certain to fall rapidly in the very near future. In the US equivalent opportunities are not available; short term bond rates are very low and commercial banks offer little other than very low yielding savings accounts.  Other than risking gold – or other precious metals, you could simply stash your hard-earned cash under the bed. If we are entering a period of deflation and with the banks not yet out of trouble, that might be the best solution of all.

_______________________

Michael Davenport has taught economics at the University of York, worked in the Treasury (U.K.) and with the European Commission, and as a consultant to developing countries in the arts of trade policy and negotiation. He now looks forward to a lazy, but elegant, retirement – but wonders whence the wherewithal?

The UK is now facing the worst recession since the 1930s, with the US and Europe not far behind. When will recovery take hold, and meanwhile what to do with our hard-earned savings?

15 nov 08