Australia | Aug 11 2010
By Greg Peel
Recessions inspired by crises directly within the financial system are different from those which follow that natural ebb and flow of an economic cycle through boom into bust, or so many an economist has pointed out since 2008. Typical recessions occur when markets become over exuberant and consumers overconfident, leading to inevitable blow-offs and a swing back the other way, and thus ultimately “recessions we have to have”.
Most Australian bank analysts made the glaring error in 2008 of assuming any recession resulting from the US subprime crisis would be a typical one in which banks became a defensive, safe haven investment. What it took them too long to realise was that it was actually banks that were the problem.
And the problems in the financial sector highlighted the fact just about everybody else – from corporates to households to governments – was simply carrying too much debt. In typical recessions, corporates have to ride out the drop in demand by slashing spending and cutting staff. In financial recessions, corporates have to do the same but they also have to reduce their debt levels – to “deleverage” – and households are forced to do the same. The requirement to deleverage only exacerbates the downturn and that is why, as CBA points out, financial recessions tend to be deeper and longer lasting than typical recessions.
So here we are about to mark the second anniversary of the fall of Lehman Bros and the world is suddenly screaming “Oh my God, we're heading back into recession again”. But are we really heading back into recession across the globe, or did markets just get a little too far ahead of themselves, expecting a “typical” bounce out of recession and then a fresh bull market shortly afterwards?
Clearly the global economic recovery has been weak, and nothing of the V-bounce some bulls were touting as recently as early this year. But CBA argues that the global economy is simply following a predetermined script. Recovery from something as significant as the GFC was always going to be slow and sluggish – the Fed knew it, and even the RBA knew it, albeit the RBA did not see the cavalry coming so swiftly and decisively in the form of China.
“The factors that make recessions associated with financial crises longer and deeper than typical downturns, “says CBA, “also tend to mute recoveries when they finally arrive. So we shouldn't be surprised when the [global] economic data are weak and uneven”. Statistically, such recoveries in the first year after are only half those of typical recoveries and it takes twice as long to return to previous peak growth. Balance sheet repair acts as a “deadweight”.
Those corporates which survive a GFC have little choice but to get on with it – shareholders expect nothing less. But at the household level, consumers are so terrified into submission that it can take a long time before the scars heal, the pain and fear subside and first timid steps are taken again beyond financial sanctuary. CBA notes that while business confidence measures have returned to average levels, consumer confidence remains well below average. Corporates can increase productivity by slashing workers, but enduring high unemployment levels hit right at the heart of the consumer.
The other problem is that most developed economies went into the GFC with high levels of public debt, and have been forced to increase those debt levels in order to stimulate economies and prevent complete Depression. This means corporates and households are deleveraging as governments are increasing leverage, which means come the recovery governments then have to also deleverage and that only serves to slow down recovery.
In order to deal with government debt levels, a structural step-down in economic growth rates must likely follow, says CBA, particularly in those countries most affected. Which brings us to an age-old economic argument.
If a government wants to reduce a deficit, then it would make sense to raise taxes and cut spending, wouldn't it? More income goes in and less expense goes out. But history shows that in fact the opposite tends to be true. If taxes are cut and spending increased, the resultant pick-up in economic growth provides more in the coffers to use for debt repayment. Raising taxes and cutting spending reduces economic growth, and thus net government takings.
This is what Europe has been forced to do, fearing straightforward debt default. Having initially agreed to join the world chorus of stimulate or die, Europe has simply acknowledged it must now live with lower growth rates for quite some time. Meanwhile over in the US, the Fed last night ceased the withdrawal of its monetary stimulus and there is a growing belief the Obama Administration will extend the expiration date of the Bush tax cuts. America can, after all, just print money.
Economists are usually quick to regret suggestions at any point that “this time it's different” but CBA is prepared to point out a couple of reasons why the recovery from this GFC is different to others past.
The US corporate sector was quick to recognise that the best path to recovery was increased productivity, which meant both very tight inventory management and significant cost cutting. The latter meant “savage” job cuts, suggests CBA. Productivity increases means sales increases flow quickly to the bottom line, and so it has been that over the past few quarters – and the current US reporting season has seen more of the same – corporates have reported modest revenue gains but significant gains in earnings. What this means, says CBA, is that the US corporate sector is recovering faster than would normally be expected.
But clearly the US economy is struggling. Why? Because the corporate sector pales by comparison to the US consumer sector, which represents 70% of the US economy. So while American consumers are still hiding in their caves, business capital spending is actually on the rise. The corporate sector isn't big enough by itself to produce a V-bounce, but it's big enough to prevent a double dip, says CBA.
And a quiet turnaround back to capital spending bodes well, on a lag effect, for the consumer. After capital spending comes employment growth.
The Fed was slow to move at first but decisive thereafter as the GFC hit in earnest. It is now expected the Fed will maintain near zero interest rates all the way through 2011, which keeps a lid on the US dollar. The weaker dollar has been an essential element of what US recovery we've seen so far, because it has lowered the cost of US exports into developing countries.
And in 2010, Europe has felt the same benefit. With all the problems surrounding the eurozone and its common euro currency, Germany is actually benefiting from the crisis given a weaker euro reflecting problems elsewhere in the zone. Had there been no euro, the Deutschmark would no doubt have risen strongly as a safe haven currency and thus impacted the export receipts of the world's biggest export economy, notes CBA.
But even Germany entered the GFC with a budget deficit (albeit a large trade surplus), so now Germans, too, are facing austerity measures designed to rein in European government debt. Europe has a long road ahead to swing deficits into surplus, although early progress is encouraging. However, higher taxes and lower spending simply mean structurally lower economic growth for quite some time.
So we have US and European markets facing subdued economic growth, and consumers who are unwilling to buy too many imports. This is typical of past financial recessions, but there is a new factor this time.
This time we have Asia, and Asian economies are outperforming. While much can be put down to government stimulus measures, the reality is longer term structural changes are seeing the Asian consumer emerge as a major driver of domestic growth, notes CBA. Imports into Asia are growing “very quickly”.
So demand from Asian consumers is growing, while demand from developed countries is subdued but still growing modestly. Asia has thus seen its export economies weaken, but its domestic economies appear to be sufficient drivers even if exports to developed countries remain weak, says CBA.
In other words, we're suffering from a sluggish and uneven rebound out of a major financial crisis and that is only to be expected. Under the current circumstances, what doesn't need to be expected is another slide back into global recession, in CBA's view.
