No Easy Fixes for a Debt-soaked Global Economy
If President Barack Obama was trying to put an end to the carnage in global STOCK MARKETS with his speech to the nation on Monday afternoon, he failed. Far from instilling calm after Standard & Poor's downgraded his country's credit rating, as he spoke the pace of the market rout picked up speed, contributing to investor losses totalling more than US$1 trillion during that one day alone. Even so, Obama's speech served as a useful yardstick for how deep in hock the U.S. has sunk. In the brief eight minutes and 19 seconds Obama took to tell the world that "no matter what some agency will say, we've always been and always will be a Triple-A country," another US$12.5 million rolled over on the relentlessly escalating U.S. debt clock.
The unprecedented downgrade of America's credit rating from AAA to AA+, on par with Belgium--a country that's been without a government for 420 days--was just one of several extreme shocks the global economy has suffered in recent weeks. It's not that investors believe America might not eventually repay the staggering US$14.6 trillion it owes lenders. After all, as markets burned, it was to U.S. Treasuries that investors fled for safety. Rather, it's that the downgrade comes even as the world's biggest and most important economy has shown worrying signs it is headed for a double-dip recession.
Now here's the scary part. If the U.S., European and even Chinese economies slide backwards, experts say there is almost nothing policy makers can easily do to revive growth this time around. After the crisis in 2008, governments and central bankers turned on the taps, pumping an estimated US$4.9 trillion in fiscal and monetary stimulus into the global ECONOMY. However, the governments that sailed to the rescue of automakers, banks and investors last time are crumbling under the debt they took on. Meanwhile, the U.S. Federal Reserve has already cut interest rates to virtually zero, and its mammoth quantitative easing program failed to get companies hiring again.
Canada won't be immune, either. Though we dodged the worst of the 2008 financial crisis and ensuing RECESSION, there are no guarantees of a repeat performance. The country's economic fortunes remain tied to those of the U.S., our biggest trading partner. There is also mounting evidence that China's cooling economy, coupled with the European debt crisis, will bring an end to the commodity boom that helped rescue Canada last time. Nor can the housing market, which appears ripe for a correction, guarantee us another get-out-of-jail free card, especially since Canadian households drove their own debt to record levels these last few years and consumers' balance sheets are in perilous shape.
Last week's market rout suggests investors have finally woken up to the fact that the root causes of the 2008 crisis never really went away. In short, the world has too much debt. But instead of dealing with that, the goal of policy makers over the past 2½ years has been a return to the carefree growth enjoyed since the 1980s--growth that was driven by ever-increasing home-ownership rates, a booming finance and investment sector and the pervasive belief that it's okay to use your home like an ATM machine if it means getting that 52-inch wide-screen TV immediately.
Now those bills are coming due, says Gary Shilling, author of The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation, and the world finds itself mired in a long and painful process to unwind all that debt. "With the rally in stocks and commodities, most people thought we were going back to the good old days we knew and loved, and that 2008 was just a bad dream," he says. "But that was just a bear market rally, and now we're going back to reality. There is just no such thing as an easy fix in an age of deleveraging."
Economic indicators are not limited to hard numbers or statistics, and the revival in popularity of Brokers With Hands On Their Faces Blog--a website which, as the name suggests, posts images of horrified traders rubbing their eyes or covering their mouths in astonishment; it captures perfectly the waves of fear infecting markets.
There has been no shortage of recent fodder for the blog. On Monday, Aug. 8, the Dow Jones Industrial Average plunged 633.78 points, the largest single-day loss since 2008 and the sixth-biggest decline in Dow history. As it is, stocks have lost more than 15 per cent of their value since the third week of July, the equivalent of about US$4.3 trillion in destroyed wealth. North American stocks finally lifted off the floor on Tuesday, but even so the VIX fear index, which measures market volatility, remained worryingly high. It has soared 200 per cent over the past month.
It's no surprise, then, that investor psyches are fragile. The scars from the last crisis had yet to heal, with markets still well below their pre-recession peaks even before the crash. That means the wealth effect is more important than ever. When people feel richer, such as when the value of their stocks and homes go up, they spend more. When those assets fall in value, consumers freeze. "If the market does not come back in the next few weeks and these losses continue, the economy will suffer," says Bernard Baumohl, chief global economist at the Economic Outlook Group in Princeton, N.J. "Households have been devastated by the loss of wealth and since consumers make up 70 per cent of economic activity, the U.S. economy, which is already quite fragile, would be teetering on the edge of recession."
It's by no means certain America will slip into another recession, says Baumohl. A recession is defined as two consecutive quarters of negative growth, and in the first half of 2011, the U.S. economy eked out growth of 0.4 per cent and 1.3 per cent. Baumohl also points to other positive data, such as an increase in small vehicle sales, consumer spending and the fact that corporate sales are robust.
Even so, in the eyes of many, the odds of the U.S. suffering a double-dip recession are rising. Goldman Sachs, the giant investment bank, says the chance of recession is 33 per cent. Martin Feldstein, the Harvard economist and member of the National Bureau of Economic Research committee tasked with officially dating the start and finish of recessions, says it's more like 50/50. As for Shilling, he pegs the odds of another recession at 60 per cent and believes it will be triggered by a further 25 per cent drop in house prices.
The U.S. economy is in a far more precarious position than it was before the credit crunch of 2008. UNEMPLOYMENT remains alarmingly high, at 9.1 per cent. The average time it takes for Americans to find new jobs has spiked to 40.4 weeks, the longest duration since records were first kept in the 1940s. It turns out the recession was also deeper than first thought. At the end of July, the U.S. Commerce Department revised down growth data, showing the U.S. not only shrank more than earlier believed, but economic output has yet to reach pre-recession levels.
Many state and local governments in America are also showing serious signs of stress. Just days before S&P downgraded Uncle Sam's debt in Washington, seven hours up the coast in Rhode Island, the tiny city of Central Falls (population 19,000) defaulted on its debt after municipal budget-cutting negotiations failed. On Wednesday, Jefferson County in Alabama was also expected to file for bankruptcy, which would make it the largest municipal bankruptcy in U.S. history.
For all that, the greatest risk to America's economy today remains the stagnation in Washington. Relations between the Tea Party and Obama are toxic, and if the U.S. does experience a double-dip, it is widely agreed that it will have been mostly self-inflicted. Not only did Congress fail to reach a debt limit deal that would have maintained spending in the short term and laid out a clear, long-term path to fix America's balance sheet, but the acrimonious debate and the lackluster deal politicians finally agreed to suggest Washington will be paralyzed in the face of a recessionary threat. "There are tools to fight it, but it's a question of whether there's an appetite to do it," says Sherry Cooper, chief economist for BMO Capital Markets.
At issue is the question of whether America should immediately tackle its trillion-dollar annual deficits, and begin to chip away at its debt load, or delay austerity until the economy improves. For a country to unwind its debt, or to deleverage, it must cut spending or raise taxes, or both--all of which drag on the economy. Yet unchecked, the debt can become so large that lenders and investors eventually lose faith in the country's ability to repay it, potentially leading to a sovereign debt crisis. To avoid that, an economy must either grow fast enough so that its debt shrinks on a relative basis, or take the painful steps to reduce it and risk slowing the economy. These are the hard choices America now faces.
Lurking in the background are warnings that America's move toward austerity bears a striking resemblance to the country's experience in the 1930s. Most people assume that decade was one long depression, but it occurred in two stages. The GREAT DEPRESSION lasted from 1929 to 1933, followed by a period of economic growth and a robust stock market rally over two years. In 1937, President Franklin D. Roosevelt, under pressure to cut spending, enacted austerity measures that some argue tipped the U.S. into a second year-long recession.
With politicians in Washington deadlocked today, the task of resurrecting an ailing U.S. economy would normally fall to the Federal Reserve, which sets monetary policy. But unlike 2007, when the Federal Funds Rate was a relatively lofty 5.25 per cent, short-term rates in the U.S., at 0.25 per cent, are already as low as they get (the Fed promised this week to keep the federal funds rate "exceptionally low" until at least mid-2013). And two rounds of massive quantitative easing, where the central bank bought government bonds to drive down borrowing costs for individuals and businesses, have done little to spur economic activity, beyond driving up stock prices.
As if the U.S. didn't have enough problems already, policy makers must also track events in Europe. In late July, just days after European leaders congratulated themselves on a new US$155-billion rescue package for Greece, panic abruptly shifted to Italy and Spain--nations considered both too big to fail, yet too big to bail--driving up their borrowing costs to 14-year highs. The development sent shockwaves through the markets and caught European leaders off guard. Uri Dadush, with the Carnegie Endowment for International Peace, has suggested the combined bailout costs for the two deeply-indebted nations would total US$2.1 trillion, dwarfing the problems posed by tiny Greece. Were Italy to collapse under the weight of borrowing costs, Dadush told the New York Times it would be a "Lehman-type situation," referring to the investment bank which failed in 2008 and led to the collapse of global credit markets. The European Central Bank has since launched a campaign to buy up the countries' bonds, but resentment over the bailouts is growing in Germany, while austerity measures threaten to crush the economies of southern Europe.
China, another of the world's key economic engines, is a source of concern, too. When the crisis hit and American consumers stopped buying Chinese exports, Beijing instituted a huge US$620-billion spending program. The measures unleashed an orgy of construction projects across the country, but also sparked what has been described as history's largest housing bubble, while driving up prices for consumers. "They've already had to introduce a big stimulus package a couple of years ago, so it's going to make it harder to go back to the same playbook again," Brian Jackson, economist at Royal Bank of Canada in Hong Kong, told the Wall Street Journal.
Even without a U.S. recession, China's economy could be headed for a hard landing, says Shilling, who believes officials in Beijing will botch efforts to moderate growth. To that end he's betting that a bubble in commodity prices is about to burst. Over the past three months, prices for oil, copper and cotton have slumped, and while commodity bulls insist the drop is temporary, Shilling believes it signals something worse. "It's like those old cartoons where Wile E. Coyote runs off the cliff and for a moment he's standing on air," he says. "Then he realizes there's no ground beneath him and--wham."
If that happens, Canada's resource-dependent economy and stock market better watch out below.
Canadian investors have already had a taste of what the Great Recession, Part Two might feel like. Earlier this week, the closely watched S&P/TSX composite index suffered its biggest drop since March 2009, as investors reacted to falling stock and commodity prices elsewhere in the world and renewed concerns that the recovery in the U.S, which buys three-quarters of Canada's exports, might be on its last legs. The fact that Canada's GDP unexpectedly contracted by 0.3 per cent in May didn't help either. "If the U.S. economy goes into recession, there's a great chance that we will too," says BMO's Cooper. "We're unlikely to be hurt as bad as the economies in Europe or the U.S. But with the declines in oil prices and our stock market, and if we do continue to see our trade with the U.S. and Europe deteriorate, then the Canadian economy is also at risk."
While Finance Minister Jim Flaherty has stressed that the country is "well-positioned to face global headwinds," some observers caution Ottawa against being complacent. "The recovery thus far in Canada was, to a large extent, relatively better than other countries, and that's because of commodity prices and a hot housing market," says David Madani, an economist with Capital Economics. This time around, though, there are concerns that China's cooling economy and a drop in raw material prices would have a big impact on Canada. Already there is talk in Alberta about the possibility of big oil sands investments being shelved if oil prices stay below US$85 a barrel.
At the same time, Canada's unstoppable housing market, which almost single-handedly pulled the country through the 2009 recession, now looks more like a millstone hanging around our neck. During a June speech in Vancouver, BANK OF CANADA governor Mark Carney suggested the rush among Canadians to take advantage of rock-bottom interest rates to buy homes has not only ruined the balance sheets of many households, but has actually impeded growth by diverting resources from other parts of the economy. He also reiterated his warnings about soaring debt-to-income ratios and said the number of Canadian households vulnerable to an economic shock has reached a nine-year high.
Canada's real estate market creates a particular conundrum for Carney. With the U.S. holding rates low for the next few years, Carney will have a tough time raising rates and may even be forced to cut them again if a double-dip recession comes to pass, throwing even more fuel onto the real estate market. Madani, for one, believes that a major correction in the housing market is long overdue. He has predicted a 25 per cent price drop over the next several years in some markets. Others see everything from flat prices to a 10 per cent or 15 per cent drop. "If we're right and we see housing go into a slump, then it could hit the economy fairly hard too," Madani says, adding that an external shock like falling commodity prices could be what ultimately tips things over the edge. Or he says it might just "fall over" by itself if Canadians, spooked by more bad news out of the U.S. and Europe, simply lose confidence.
Whether it's Canada, the U.S., Europe or even China, the underlying debt problem will make it nearly impossible for policy makers to find a quick and easy solution if another recession occurs. "There is no magic bullet," says Shilling. In fact, the Harvard University economist Kenneth Rogoff, co-author of the book This Time Is Different: Eight Centuries of Financial Folly, has argued America hasn't suffered from a traditional business cycle recession at all. Instead the world is caught in the grips of what he calls the second Great Contraction (the Great Depression was the first). The answer, he says, is a sustained period of high inflation, which would erode the value of debt, at the expense of lenders, and bring the global financial system back into balance. Such a policy is anathema to central bankers and politicians wary about rising prices.
In the meantime, the world continues to hold its breath that a double-dip is averted. The green shoots that pushed their way up through the scorched landscape of the last recession failed to ever fully bloom. The question now is whether politicians can even do anything to save them, or whether they will simply wither and die.
Maclean's August 22, 2011