Despite the sense that financial market conditions are easing from the fraught levels of the past six months, Gordon Brown's assertion that the UK bank sector was just three hours from collapse at the time of the £37bn bail-out last autumn, coupled with the daily litany of awful news on the employment front, indicates that in the real world conditions remain dire.
But how dire?
Recent data has confirmed that the UK economy is in recession. It joins the United States, the eurozone and a swath of other countries around the world. Even the formerly fast-growing Asian and emerging market economies are under pressure, and governments are in full-on crisis mode as they attempt to deal with the wreckage that lies before them. There is little doubt that emergency measures are required both to solve this catastrophe and, just as importantly, to ensure that the next catastrophe does not simply run into the back of this one. That is why the pressure is on world leaders (ex-Ben Bernanke) at Davos and at a series of high level meetings in the run-up to London on 2 April not simply to talk the talk but also to walk the walk. Profound action is required, but first it is necessary to establish just how bad things are.
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It is generally accepted that we live in recessionary conditions (we even used the term above), however, we wonder whether the term goes far enough to describe the world in which we live today.
A recession is commonly defined as two consecutive quarters of negative real gross domestic product growth. However, as the US National Bureau for Economic Research (NBER) recently confirmed that the US economy had been in recession since December 2007, the commonly used definition may be flawed. Simply using the headline GDP numbers may give a misleading impression. On that basis the US economy, for example, has only been in recession for around half the time indicated by the NBER.
We have previously noted that delving beneath the headline number always provides a much more accurate picture of an economy's health. By focusing not on the headline numbers but on the components of GDP such as final sales to domestic purchasers, employment, industrial production and detailed data on trends in personal income a much less benign picture materialises. Much as we would like to comfort ourselves by talking about a mere recession (!) we must, using parlance from the rugby field, 'front up' to the possibility that we might actually be in a depression. Thanks to the welfare state, incapacity benefit, unemployment benefit and healthcare for most etc it doesn't feel like the 1930s right now, but were those safety nets to be stripped away how much further away from those dark days might we be?
Whilst we can tinker with the proper definition of recession, sadly no such luxury exists when attempting to get a handle on depression. Certainly, depressionary conditions include an element of time. A typical recession over the past 150 years lasted around 18 months and tended to be fairly cyclical in nature; i.e. bust followed boom, prosperity morphed into inflation and monetary policy, having been accommodative, was tightened, often aggressively.
Clearly, the conditions in which we currently operate have not followed the typical pattern of recent decades.
The financial market crisis and equity market collapse of 2008 was not due to earlier over-valuation, nor was it due to investor exuberance, as it was in 2000. Neither, too, was it down to an earlier period of excessive global economic output growth and its inflationary consequences. This crisis is different, its roots firmly embedded in the expansion of bank balance sheets and the excessive build-up of leverage in deficit countries around the world. The two fed off each other to create an aggressive negative force culminating in a downward spiral into calamity. Suffice to say that this crisis did have its roots in the prolonged period of prosperity lasting the best part of two decades, but that the inexorable and inevitable reversion to mean has significant structural as well as cyclical elements to it. This implies that we are in more than just a common or garden recession.
Typically, recessions are characterised by manufacturing de-stocking. The equally typical policy response favours the absorption of any excesses in the system by stimulating demand. Depressions go further. Depressions involve not only manufacturing de-stocking but also massive balance sheet compression, aggressive deleverage, debt repayment (involving asset liquidation) and a substantial rise in the personal savings ratio. The financial markets, through their response to the crisis, recognise this fact. Yields on US Treasury bills fell, at one stage, close to zero. Essentially this means that the bond market knows that there are more than purely cyclical factors at work. Even after all the unprecedented stimulus measures of the past 18 months, little traction is as yet being achieved. Real economic activity remains depressed, unemployment levels are rising and credit conditions, although easing somewhat, remain stretched.
Curing depression
The past six months have seen a marked step up in governmental intervention. Clearly, the expansion of government balance sheets is necessary to offset the contraction in the balance sheet of the private sector. The aggressive expansion in the money supply addresses the rate of money turnover in the economic system, but does run the risk of storing up problems for later (as we mentioned in last week's article).
Whilst we do not deny that global authorities' top priority is to ensure that the global economy does not nose dive into an all-out debt deflationary spiral, there is little doubt that substantial monetary easing, coupled with the hugely aggressive fiscal policy stimulus, does pose problems for the future. Note too, that huge infrastructure spending only acts with a long lead time and in the near-term has no strong multiplier effect. With inflation off the agenda for now and concern focusing instead on the deflationary consequences of a gigantic global economic output gap in the making, it seems that the money supply can be expanded with impunity. However, without serious surgery the global financial system is looking decidedly rickety. It remains to be seen how long the dollar can benefit as the repository for global investors seeking a safe haven in a storm.
We are unconvinced regarding the new US administration's understanding of the issues at stake. At first glance it appears as if all is well in the White House and on Capitol Hill. The policy response to the crisis has indeed been aggressive and has stepped up a gear or two over the past month or so. The next step might be further intervention (a la Sweden in the early 1990s) or the creation of a so-called "bad bank" into which hard-to-value and highly toxic bank "assets" might be poured.
We don't know the answer but what we suspect is that the ultimate healer of this particular crisis, not necessarily the next one, may simply be time. Just as a patient requires time to recover from a serious heart operation, so the global economy and financial system must be allowed to go through its period of adjustment or, put differently, mean reversion.
What the global authorities do need to do, however, is to recognise the fact that mean reversion always involves the pendulum swinging some way in the opposite direction. The aggressive policy action, where traction still looks hard to gauge, has raised the pendulum to the very top of its arc and hugely upped the ante. This suggests to us that the risk for policy-makers is that frenetic activity now may actually be storing up opposite and potentially even worse problems for later. Economies are super tankers. Pressing buttons and hauling levers to steer away from Charybdis runs every risk of driving us into Scylla's unwelcoming jaws.
Conclusion
Strong secular headwinds suggest to us that this crisis is rapidly morphing into more than just a common or garden recession. Depressions go, as we have attempted to show, far further than recessions. They last longer and they go deeper, gnawing at psychology.
The independent forecasting community is alert to the possibility that aggressive governmental stimulus measures might, in due course, start gaining some traction and indeed the near-term outlook for risk assets, such as equities, is extremely compelling in that context. The blizzard of daily economic data releases have, over the past week or so, begun to show that conditions, although dire, are at least not deteriorating further. Conditions in the credit markets have improved from the Armageddon levels that existed prior to Lehman's collapse; they may recovery further. Equity market investors are eagerly awaiting the confirmation that stimulus measures are working to pile back into risk assets at which point, they hope, crisis will have been averted.
Not a bit of it!
History repeats itself in rhyme. After every period of feast comes an inevitable period of famine. The period in which market conditions appear to be back to normal may, in fact, only be the period during which the pendulum, driven into aggressive motion by the actions of governments and central bankers, swings back through the middle of its arc. In our view, policy-makers must ensure that the architecture of the future addresses not just the resolution of the current crisis, but also the crisis of the future. A depression is a long and deeper recession. It can last, if history is anything to go by (four in the nineteenth century, one in the twentieth), between three and seven years. Depressions may, however, have periodic hiatuses, as evidenced by the mid-1930s. Policy-makers should not be lulled into thinking that simply by shovelling the train wreckage off the rails this time around, that without repair to those rails, another train will not simply plough into the back.
This article first appeared in Week in Preview, published by Charles Stanley stockbrokers.
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