Ignore the happy brigade. The forces of recession are already in motion.
Listener: 1 December, 2007.
Keywords: Macroeconomics & Money;
Larry Summers, the best economist ever to have been Secretary of the US Treasury, points out that major international financial crises occur about every three or four years. The last – the Enron bust – was five years ago, so we seem due for another. Does the delay mean it will be a big one?
Certainly, the consensus of informed opinion is that the world financial system is suffering severe imbalances. We seem to have come through August’s liquidity squeeze, and are now in the stage in which the financial institutions’ balance sheets are being substantially written down as their lower-quality loans are valued more realistically.
Correspondingly, investors (and even depositors) are losing wealth. Of course, there is always the happy brigade promising that it’s all over – they’ll be selling used cars in their next life – but I do not know of a single international commentator I respect who takes this view.
They are less clear about what happens next. The financial institutions, including the world’s biggest banks, will be writing down their assets for at least another three months. But sharemarkets seem to be wobbly rather than panicking – so far.
Its unwise to focus on the sharemarket. The US sharemarket may have crashed in October 1929, but the US economy didn’t hit bottom till five years later. Real time, when things happen, is much longer than we remember, or the time it takes to read a history.
We are observing the steady unfolding of a period of slower world economic growth – probably a recession – even if the optimistic business commentators continue to focus on daily change.
I am not hinting that we are headed for another Great Depression. We could be, of course, but the economic orthodoxy is that mistakes by the US reserve bank (the American Federal Reserve, or “the Fed”) were responsible for the severity of that one. One academic expert on the 1930s is Ben Bernanke, current chairman of the Fed. If it makes mistakes this time, they will be different mistakes from those of the Great Depression.
Mind you, the most expensive four words in banking are said to be “This time it’s different.” The happy brigade wants to believe them, but the fundamentals of balance sheets always apply, and serious imbalances must unwind, albeit the detail of the paths will differ.
The problem for economists is how these balance-sheet adjustments impact on the real economy (production, consumption and investment). Obviously, some of the spending and investment generated by poor-quality lending is going to stop. Those whose incomes profited from that lending will be spending less, as will those whose investments have been decimated. The reduction in spending will cost jobs: first, in house construction and real estate; later, as all productive investment slows down because it is harder to get investment funds.
That is economists’ broad understanding of some of the mechanisms that lead to an economic downturn. But in real time, not tomorrow.
Underneath is the state of the US Government’s borrowing, which allows it little room for fiscal manoeuvring if the economy implodes. A seeming loss of confidence in the safety of the US dollar adds to the instability. (More of that in a later column.)
Then there are the transaction costs of winding up the thousands of poor-quality US mortgages, and the social heartbreak associated with honest, decent people’s loss of homes, life savings and pensions.
I am listing this train of misery because it is important to understand that these forces are already in motion. But as they are not the stuff of business journalism headlines, the happy brigade is able to promote uninformed optimism.
The message must be: be cautious. Consumers should roll back their borrowing. Investors would be wise to focus on security, even if that means lower rates of return; those making job decisions could consider doing the same.
Alternatively, I suppose, you could get into the second-hand car market