07 01 2009

Saving capitalism from itself (1): The impending recession and why it will be difficult to avoid

The global imbalances and the bubbles in the credit and housing markets that have been building up during the last decade have been noticed by many, and many had predicted that this would not be viable in the medium to long term. But as it often happens, the way this lack of viability expressed itself came as a surprise for almost everybody.

To sum up shortly the well-known facts:

The imbalances: The US and to a lesser degree also some other countries (as the UK) have during the last decade been living far beyond its means, reflected in an abysmal deficit on the current account and a building up of debt in the public sector. This has been financed principally by Asian countries, in particular China, running big current account surpluses and buying US treasury bills. In face of this, the economic policy in the US has been incredibly nonchalant. Despite the soaring deficits the Bush administration reduced taxes and engaged in costly wars and in an endless expansion of defence spending. Consumption was fuelled by easy access to credits, backed by unrealistically increasing housing prices. What is perhaps more surprising is that who you otherwise would consider serious people tried to explain that this was perfectly normal and not dangerous at all. A common argument was that the US economy was so innovative, productive and profitable that it worked as a magnet attracting foreign capital, and by simple definition this inflow had to express itself in current account deficits. Concerning the budget deficit many argued that it would regulate itself through a prolonged period of high growth resulting in rising tax revenues.

There have been several bubbles in the last decade, fuelled by unrealistic expectations and easy access to cheap credit. The most important have been the stock market and the housing market, but also consumer credit has exploded beyond reasonable levels. Bubbles imply that the prices cease to bear a relation to the underlying assets, but are fuelled by the expectation that you can always sell again at a higher price. In the stock market this is measured by the ratio between price and earnings (or price and the market value of the assets), and in the housing market between the earnings of the buyers and the cost of servicing the debt. It is now several years ago that there ceased to be a reasonable relation between these parameters in many countries, among these the US, but in a much more exaggerated manner in other countries as the UK, Spain and Denmark. Just take a look at house prices around London or Copenhagen and you will see that they were far out of reach of common wage earners, unless you could come in with a solid capital gain from selling your former house.

It is always difficult to say, whenbubbles will burst. As long as there is confidence that prices will be increasing eternally, the bubbles can continue. Some external event will normally expose the unrealistic assumptions on which the bubbles thrive, and then they burst. This external event turned (unexpectedly) out to be the sub-prime crisis in mid 2007 (more on this in a later article). And then the bubbles burst. What should be clear, however, is that this is an ongoing event, and particularly the housing prices have a long way to go yet, at least in some countries (e.g. UK, Spain and Denmark), while other countries never had a housing bubble (as Germany).

When bubbles burst, there is a dramatic destruction of apparent wealth. People who thought they were rich are suddenly much less so (their houses or stocks are worth less). The normal effect is for people to reduce spending, so when consumption falls, production falls, investments fall, incomes fall, consumption falls further and so on in a downward spiral. The normal problem is therefore a decrease in demand and an overproduction (or under-consumption) crisis. That is the situation in which most countries are about to enter just now.

But the present crisis is compounded by two other phenomena: an astonishing crisis in the financial sector leading to unprecedented (and extremely expensive) government interventions to avoid a total collapse and the persistence of the global imbalances.

The response from the governments have been first to tackle the break-down in the financial system (by giving banks access to almost unlimited cash from the Central Banks and by partly or wholly nationalising the institutions) and next to try to expand demand to avoid a break-down in the real (production) sector. However, there is still no answer to the question of the global imbalances and only very timid first discussions on how to reform the financial sector to avoid a repetition of the present crisis in the future.

What are the chances that the present policies will be successful to avoid a deep recession? Not very big, to my opinion. And the main acute reason is the global imbalances, but this is aggravated by systemic failures that I think are not yet well understood (some modest thoughts on this in a later article).

The centre of the crisis is the US, where the imbalances are most pronounced (except for some third world countries). The most visible is the deficit on the current account, i.e. US exports of goods and services are much smaller than the imports, so the deficit is running at around 7% of the GDP. This is a type of deficit that is normally associated with developing countries, not at developed economy. It is by now common to hear economist argue that looking at currents accounts is old-fashioned in the era of globalisation. American firms and citizens have taken the (supposedly rational) decision to maintain this level of investment and consumption, and the financial markets are able to channel the necessary funding. Well, that has changed now. The international financing for US banks and private companies has dried up almost completely, even if international investors still have an apparently endless appetite for US treasury bond as they do not seem to doubt the capacity of the US government to pay the money back (despite the risk that the future payments may be in devalued dollars).

This will be the beginning of a process of adjustment of the US economy where it starts to consume and import less and export more to the outside world. So the US citizens will have to tighten their belts, and as private and public consumption and hence production falls, US companies should use the idle capacity to produce for foreign markets instead of the home market. To ease the process, the currency should be devalued so it becomes easier for the companies to compete on international (and domestic) markets, which has already happened. As painful as that may be, it should not be too difficult, should it? That is what economists have been telling other countries to do in similar situations, particularly in the developing world.

To get an idea of the task ahead: The US had a trade deficit of 700 billion dollars in 2007. Exports of goods and services were 1,645 billion. So to reach a balance, exports would have to increase with 43% (or imports should be reduced with a similar amount). However, much of what the American consumers are not willing to consume any more is not easily sellable in international markets (what about redirecting GM's and Ford's production to Europe?). The implication is that the US will have to produce what the international markets demand, and that requires restructuring, expanding sectors where the US is internationally competitive and contracting sector where it is not.

This does not mean to say that it is not possible to redress the imbalances in the US economy, but experience tells us that there is no quick and painless fix. Most countries that have been through the same, have had to pass a prolonged period of recession and restructuring to be able to make the necessary adjustment.

That is why it is difficult to see how the US can avoid a recession. Big packages to stimulate demand by lowering taxes or increasing incomes will either be ineffective (demand does not rise as people save the money, and the public debt goes up) or just perpetuate the imbalances, adding an unsustainable growth in public debt. What can be done, and which is also in the plans of the incoming government, is to increase public investments in infrastructure and social services to mitigate the growing unemployment and the impact of the crisis on the poorest. But that will not avoid the recession.

Even if most of Europe is in a different situation, a recession is likely there also. As a whole, Europe has a near balanced current account, the public sector deficit is limited and (with the exception of the UK, perhaps Switzerland and of course Iceland) the crisis in the banking sector is manageable. That masks big differences among countries, however, with heavy imbalances in Portugal, Italy and Greece, and a collapse of a real estate and construction bubble in Spain. Many countries have room for expansionary policy to increase demand and hence mitigate the crisis, but with an overvalued Euro it is difficult to avoid that the US recession makes an impact. The UK is a different story, in many ways similar to the US. Decades of heavy reliance on the financial sector as the driving sector of the economy and neglect of other productive sectors, compounded by the end of the oil adventure in the North Sea, imply that the international recession is going to hurt.

The main hope is (unprecedentedly) that the big developing economies, particularly China, will continue their growth – even if at a lower level - and thus contribute to keeping up global demand. In both Asia and Latin America there are embryonic initiatives to stimulate regional trade and create new, regional monetary mechanisms to lessen the impact of the paralysation of the financial markets in the developed world, but that will have to (and should) be accompanied by heavy financial stimulus packages to work, particularly in big surplus countries as China and Japan. If they are successful, a quite different world will be an outcome of the present crisis.

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Thorbjorn Waagstein

Thorbjørn Waagstein, Economist, PhD, since 1999 working as international Development Consultant in Latin America, Africa and Asia.

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