Tough Times, but Not the Great Depression
In 2004, Paul Kasriel fired a shot across the bow of American optimism. The soaring HOUSING market had crossed into the danger zone, he warned. Prices were rising far faster than people's ability to pay, and a collapse was all but inevitable. Others had raised fears about the emerging housing bubble too, but Kasriel, an economist with the Northern Trust Company in Chicago, was one of the few to fully grasp the threat posed to the ECONOMY. Banks were heavily exposed to residential mortgages. A plunge in the price of homes would infect the financial system, he predicted, and from there it would spread to the wider economy, sending it spiralling into a deep and punishing RECESSION. As we all know by now, few wanted to hear what he was saying. Officials in Washington clung to the myth, widely held at the time, that U.S. house prices never fall. Pundits scoffed at Kasriel's dire predictions. "I was the skunk at the garden party," he says.
Fast forward to today. Everything Paul Kasriel envisioned has come true, and then some. House prices are in free fall the world over. Investor portfolios have been decimated, leaving people suddenly feeling poorer. America's biggest banks have failed or are wards of the state. GM teeters on the edge of bankruptcy, as do whole countries. Here in Canada we think of ourselves as better off, but our STOCK MARKET has plunged, commodity prices have dropped and the housing market is suffering. And every month brings another round of brutal job losses on both sides of the border. So what does Kasriel make of this grim situation? "I'm actually feeling cautiously optimistic."
That someone with such a knack for spotting serious trouble instead sees signs of hope is remarkable. Every day the airwaves, blogs and newspapers are filled with alarming forecasts from economists and financial experts. Time and again, we are told the world is headed for another GREAT DEPRESSION. Some argue we're already there. And still others have taken doom-casting to the next level, predicting global strife as the logical conclusion to the downturn. Historian Niall Ferguson recently proclaimed, "There will be blood ... It will cause civil wars to break out, that have been dormant. It will topple governments that were moderate and bring in governments that are extreme." One newspaper columnist went so far as to ask, "Will this recession lead to World War III?"
In the opinion of Kasriel and other more level-headed observers, what's really needed now, frankly, is for everyone to take a deep breath. This isn't another Great Depression. There won't be hobos riding the rails or huge lineups at soup kitchens. In fact, for all the problems facing the economy, some experts are making a cautious case for optimism. There's a growing feeling that the economy could find its footing far sooner than many are expecting, a result of how dramatic the declines have been as well as the response by central bankers and governments around the world. This isn't to say the economy is going to immediately pull out of its downward descent, or that the Dow will magically return to the levels it was at before the crisis. But it's enough for Kasriel to begin to revise his outlook. "I'm not a raving optimist, but there are things I see that give me some encouragement," he says.
For Canadians worried about where our economy is headed, it all comes down to how quickly the U.S. can recover. With our extensive trade ties, Canada is deeply invested in America's economy; any signs it's improving will give a strong hint as to when Canada will pull out of its recession. (SeeCANADIAN-AMERICAN RELATIONS, ECONOMIC.
Paul Kasriel's change of heart is one positive sign. So might be the fact that few prognosticators share his confidence at the moment. Maybe it's encouraging that, just like in 2004, everyone is dismissing his more upbeat view. In the same way most forecasters were blindly optimistic three to four years ago, many of that same group now refuse to see anything but terrible times ahead. "When the preponderance of data is one way or the other, it is psychologically difficult to have a counter-trend view," Kasriel says. "This is why most economists are useless. The same ones that missed the downturn are probably going to miss the upturn."
It can be hard to be optimistic when you consider who's in the doom and gloom camp. Stephen Jarislowsky, 83, is one of Canada's most respected investors. As the founder and chairman of Montreal-based fund company Jarislowsky Fraser Ltd., he amassed a fortune estimated at $1.4 billion by making shrewd bets on companies when they were out of favour. But when he looks at the situation today, he fears the worst. "The Great Depression is the best comparison to what we're going through now," he says. "Anyone who thinks less is fooling themselves."
Jarislowsky, unlike so many other market commentators today, actually lived through that financial crisis as a young boy in Holland during the 1930s. "I remember a whole bunch of poor people walking around the streets selling anything they could, like peanuts, hoping that somebody would buy out of semi-charity," he says. Does he think the economy will get that bad again for individuals? "The way things are going now, we're going to get there in a handbasket because the government is totally incapable of handling it."
Dire stuff, indeed. But then again, it's always difficult to know how much to credit a particular prediction. Jarislowsky himself, though he warned two years ago that the U.S. might face a recession, was still advising newspaper readers to invest in American companies like Procter & Gamble and General Electric, calling them "reasonably safe." Those stocks have since tanked, along with the rest of the market. And yet Jarislowsky is hardly alone. Billionaire George Soros, former U.S. Federal Reserve chairman Paul Volcker and even President Barack Obama have all warned that this crisis has the potential to morph into another depression.
But there is a long history of this kind of declinism in North American financial circles. In almost every major downturn since the Second World War, economists, politicians and newspapers have sought to convey popular fears by drawing comparisons to the Great Depression. Ronald Reagan, in his first speech as president, warned the U.S. was in the "worst economic mess since the Great Depression." Yet the current downturn is still not even as severe as some of the deep recessions that hit over the past several decades, and from which the economy fully recovered.
It helps to recall just how brutal life was for people living through the 1930s. More than a quarter of all U.S. workers lost their jobs back then, while the average wage plunged by 40 per cent. So far during this downturn, unemployment in the U.S. has risen to 8.1 per cent, which means there's still some way to go before reaching the 10.8 per cent unemployment level seen during the 1982 recession. American wages even eked out a modest gain in February, despite the loss of 651,000 jobs. In Canada the gap between the present downturn and the recession of the 1980s is even wider, never mind how dismal the job market was during the Great Depression. In January, nearly 130,000 workers lost their jobs, sending the unemployment rate to 7.2 per cent. On March 13, Statistics Canada will update its job numbers for February, and economists expect another round of painful job losses. Yet while Canada is clearly in the throes of a nasty recession, unemployment is still relatively close to the 33-year lows we saw in 2007, when it ran at six per cent. Not even the most dour of economists expect Canada's unemployment rate to reach even the 11.4 per cent mark we hit in 1993, when former prime minister Kim Campbell warned Canadians not to expect a return to single digits any time in the next decade.
Nor are economies experiencing anything like the slowdowns felt in the 1930s. In the first three full years of the Great Depression, America's economy shrank an astonishing 28 per cent. When America's GDP fell by 6.2 per cent in the last quarter of 2008, it sparked fears a depression-era contraction was under way. Yet the thing to remember is changes in GDP are expressed at annual rates. The actual decline in the fourth quarter was a far more mild 1.6 per cent, and though the recession began in 2008, the economy actually eked out a 1.1 per cent gain from the year before. No one doubts this year will be rough. Even Kasriel expects the U.S. economy to shrink by three per cent overall. But that would still make this recession only marginally worse than the one that occurred in 1982, and not even close to the depths of the Dirty Thirties.
In Canada the economy is certain to shrink, but there is light at the end of the tunnel. That's been the message all along from Bank of Canada Governor Mark Carney, who has emerged as the country's leading optimist. He originally said to expect a recovery later this year, but has since been forced to push that date back to early 2010. Even so, a quick glance at Canada's economic performance over the past quarter century provides some hope we'll emerge from this recession with somewhat fewer scars. From 1981 to 1982 Canada's GDP plunged 4.9 per cent, peak-to-trough, with another drop of 3.4 per cent between 1990 and 1992, according to Doug Porter, deputy chief economist at BMO Capital Markets. This time around, he is forecasting a decline of around 3.1 per cent, though he cautions that could still rise. Fortunately, the Canadian economy was in far better shape before the current recession struck. In the last two recessions, for instance, the country faced double-digit interest rates. In the recession of the early 1990s there was the added problem that Canada's finances were in shambles. "The governments couldn't support the economy because they were battening down the hatches and dealing with huge deficits," says Porter.
In the end what really sets this downturn a part from the Great Depression, for individuals at least, are the safeguards that have been put in place. Roughly 9,100 banks went bust during the first few years of the Depression, wiping out the life savings of millions of households. Today bank deposits are insured and backed by government against losses of up to $250,000 in the U.S. and $100,000 in Canada. There is also a social safety net made up of welfare, unemployment insurance and health coverage that was completely absent in the 1930s. There won't be a repeat of Grapes of Wrath-scale sorrow, with hundreds of thousands of migrant workers forced to watch their children starve. As John Hussman, a Maryland-based fund manager who saw the current crisis coming, wrote in a recent market commentary, "To say that this is 'the worst economy since the Great Depression' is like blowing up a crate of dynamite on the Nevada Proving Grounds and saying it is the worst explosion since the detonation of the atomic bomb there. Even if the statement is accurate, the comparison is absurd."
So why does all the talk of a depression hold such sway over us? Possibly because we've just come out of one of the longest booms in North American history. The problem is, this has left a large segment of the population unprepared for what seriously hard times are really like. Many workers today were too young to even remember the harsh downturn of the early 1980s. "We've forgotten how to do recessions," says Glen Hodgson, an economist at the CONFERENCE BOARD OF CANADA. "This is what a recession looks like. Profits are down. Jobs are being lost. People have stopped spending. We've almost become too good at macroeconomic management so when recessions do happen people don't have it as part of their personal memory."
Whatever the reason, while most economists and pundits continue to dwell on comparisons with the Great Depression, a small number have turned their gaze to the eventual recovery.
Even before the recession began, many in the West were already primed for Armageddon. The terrorist attacks of 9/11 touched off a publishing bonanza for books about the decline of the American Empire. Climate change fears reached a fever pitch with warnings by the World Bank's former chief economist that global warming would trigger a worldwide depression. Then fear turned to the prospect that the world would soon run out of oil, forcing us all to trade in our SUVs for a horse and buggy. From there, it was just a short hop to financial apocalypse. So it's no surprise that an overwhelming sense of gloom has taken hold. Consumer confidence in the U.S. recently hit a 40-year low. Yet that, paradoxically, is exactly why some keen observers are starting to look for signs that things could soon perk up.
George Vasic, a strategist at UBS Investment Research in Toronto, believes a shift is underway in the minds of consumers that could indicate a recovery in stock markets, a crucial indicator of better times ahead. Stocks typically begin to rebound four to six months before the end of a recession. So far, with major indexes like the Dow Jones Industrial Average down more than 50 per cent from their 2007 peak, investors seem as bearish as ever. But Vasic argues that could be about to change. Every month the U.S. Conference Board asks consumers to assess both the current conditions in the economy and their future expectations. The difference between what consumers expect in the future and their current assessment is something Vasic calls the "expectations gap." And during past recessions, going back to the 1970s, when the future has begun to look dramatically better than the present, a stock market rebound and economic recovery have invariably followed behind. "We're at the point when consumers' expectations about the future, even though they're bleak, are better than the abject despair that is the assessment of the current situation," he says. "The expectations gap has turned up, and the length of time it's turned up is consistent with a bottom occurring in the stock market in the near term."
It's important to note that even if the market were to rally this month, that would still mean a recovery wouldn't occur until the end of the year, or early next. But perhaps it's no coincidence that several prominent bear market investors have recently turned bullish. Last week Steven Leuthold told investors not to put their money in his Grizzly Short Fund, which makes bets that stocks will fall in value. Last year the fund rose 74 per cent, but Leuthold has joined other perennial pessimists in suggesting the stock market is close to bottoming out. Despite all the pain caused by the market crash, there's more than US$4 trillion sitting on the sidelines in money market funds waiting to be invested. You can think of all that cash as money building up behind a dam, ready to flood into the stock market as soon as there are signs of recovery. It's that money that fuels a rebound in the capital markets, and there's now more money built up behind that dam than ever before.
There are other signs, admittedly still faint, that the economy is on the mend. The U.S. Conference Board's index of leading indicators, a basket of measurements that acts as an early warning system for where the economy is headed, surprised analysts by rising for two consecutive months in December and January. While consumer confidence levels and the unemployment rate attract most of the headlines, they are lagging indicators, meaning that those stats say more about where the economy was a month ago than where it will be six months hence. Unemployment can continue to rise for as long as 18 months after a recession has officially ended.
Some are also taking solace in America's new-found frugality. After years of living beyond their means, the savings rate in the U.S. hit five per cent in January, the highest level since 1995. That's a good sign the excesses that caused the financial crisis in the first place are stabilizing. "This whole thing was driven by consumers vastly overspending for a decade," says Chris Thornberg, an economist with Los Angeles-based Beacon Economics who predicted the housing crisis. "When savings rates hit eight per cent or so, the primary driver of the economic turbulence will be over with. Then we're in clean-up mode." The fact that retail sales and consumer spending have at the same time inched up could help the economy recover while people repair their sorry finances.
While miserabilism has become the pervasive tendency, one long-time gauge of economic suffering has failed to keep pace. In the 1960s economists combined the rates of unemployment and INFLATION to arrive at the "misery index." But while the misery index typically gets lots of attention when times turn bad, it's largely ignored now. That's because, with inflation at less than one per cent, the misery index sits just above eight per cent, a far cry from the 21.9 per cent it peaked at in 1980. Many expect inflation to rise as a result of all the liquidity central banks have pumped into the economy. But for now this traditional yardstick of misery suggests some of the gloom is overblown.
What remains to be seen is how successful all the various government stimulus programs will be. Later this month, for instance, the U.S. Treasury Department and the Federal Reserve will rev up a massive program intended to jump-start financing for automobiles, credit cards and small businesses. The program could inject up to US$1 trillion into the securitization market. "If you look around the world at the U.S., China, Canada, there's a lot of action being taken," says Paul Kasriel.
But for all the talk of leading indicators and stimulus programs, Kasriel's optimism remains deeply rooted in the history of the Great Depression, of all places. Contrary to what most people believe, the 1930s were not one long, unending malaise. Instead there were two separate downturns, divided by four years of tremendous growth during which time the U.S. economy expanded by 9.4 per cent. That growth came despite a series of terrible policy decisions in the early part of the decade. The Smoot-Hawley Tariff Act threw up protectionist trade barriers and caused global trade to collapse. The Federal Reserve raised interest rates by two full percentage points in the course of one month. And Washington hiked the top marginal tax rate to 63 per cent from 25 per cent in a misguided race to avoid deficits. That the U.S. economy could overcome all of those hurdles and still grow suggests we can expect a repeat performance. "It's remarkable the economy was able to recover in the spring of 1933," says Kasriel. "When I look back at what was done to prevent a recovery, and I look at today's environment, at what's being done to promote a recovery, it gives me reason to be hopeful."
Warren Buffett, the world's most famous value investor, offered a similar message in a TV interview last week. While most focused on his observation that the economy had "fallen off a cliff," he also said he believes in the American economy's ability to right itself. "Everything will be all right," he said. "We do have the greatest economic machine that man has ever created."
Don't get Kasriel wrong. He still sees serious problems in the economy. He also admits that he tends to be early in his forecasts. But flick on the TV today and the misery relayed by economists and pundits is out of step with reality. This isn't the Great Depression. It's a recession like so many others we've rebounded from. But chances are you won't hear many experts espousing that point of view. At least, not until the recovery is well underway.
Maclean's March 23, 2009