"It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way in short, the period was so far like the present period, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only."
- "A Tale of Two Cities," Charles Dickens
It was autumn in the fifth year of the third millennium.
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On that side of the Atlantic "pond," on a little island that calls itself Great Britain, it was the best of times. In contrast to its neighbours on the Continent, Britain had rung up an extraordinary period of growth and prosperity over the last dozen years. Recovering dramatically from the deep recession of the early 90's, the UK had enjoyed its longest expansion since the Second World War. GDP growth in the new millennium had averaged around 2.5% per year, unemployment had halved from 10% in 1993 to 5% in mid-2005, inflation during 2001-2005 was a tame 1.5% per annum, while the Bank of England base interest rate had dropped from 14% in the early 90s to 4.5% in mid-'05. Housing values had appreciated faster and faster in late 2002, annual house price appreciation hit 25%!
Britons were getting dramatically wealthier and it showed. Home equity extraction and other forms of consumer debt fueled consumption with retail spending rocketing ahead at real annual growth rates of 3-4% during '03 and 04. More than 600,000 Britons, over 1% of the population, now owned holiday homes abroad especially in France and Spain. It was a dramatic turnaround for a nation that 25 years ago was dubbed the "sick man of Europe." The performance stood in stark contrast to the major European economies that were stuck with low growth and double-digit unemployment rates.
On this side of the pond, a big island known as the cradle of liberty and democracy, the USA, also basked in the glow of prosperity and global dominance. The world's only remaining superpower, it was also the engine of global economic progress especially as the world's 2nd and 3rd largest economies, Japan and Germany, remained mired in slow/no growth.
Over the last 15 years it too had made gigantic strides growth averaged more than 3% annually, unemployment dropped from 8% in the early 90s to 5% in 2005 and long-term interest rates (the 10-yr Treasury bond) fell from over 8% in 1990 to around 4% in 2005. The only recession in this period was in 2001 and it was the shallowest and shortest recession in the post-war era. Core inflation dropped from over 4% in the early 90's to less than 2% as the new millennium dawned. There was a dramatic renaissance in American labor productivity, zooming from the sclerotic 1.5% - 2.0% in the 70's and 80's to more than 3% by the late 90's.
And there was a meteoric rise in American wealth first with the stock market boom of the late 90's and then with the housing boom of the early 2000's. The dominant nation of the 20th century, the USA, was at the "top of its game."
Indeed, for the entire English-speaking world it was the best of times. In the Far East, incomes and wealth were rising rapidly in Australia and New Zealand. Ireland's spectacular growth had earned it the title of "Celtic Tiger". And here, in North America, things were bubbling along nicely north of the border in Canada.
And yet, the skeptics and the contrarians were not convinced. They pointed to dark clouds on the horizon. They claimed that these "best of times" were not sustainable. They predicted that soon we would arrive at the worst of times. What were they worried about? Were they just perpetual worrywarts, perma-bears who always went around like Chicken Little saying the sky was falling? Were the facts they cited significant? Was their reasoning sound?
On the other side of the pond, as Britons returned from their long summer holidays, to be sure, there were causes for concern. Alarmed by the rapid escalation in housing prices, the Bank of England had started raising interest rates from post-war lows in the fall of 2003. By mid-2004 they had jacked up rates from 3.5% to 4.75%.
As a consequence, the economy had slowed dramatically from a growth rate of 3% in late 2003 - early 2004, to 1.6% in the 2nd quarter of 2005. House inflation stopped dead in its tracks and informal reports indicated that some regions were experiencing declining values. Retail sales slowed dramatically. Reports from banks cited pressures on profits as consumer debt write-offs increased.
Nationwide, there was a lot of debate and hand wringing over consumer indebtedness and responsible lending. Clearly, the consumer was feeling stretched as higher interest rates increased their mortgage payments and the "equity extraction" well dried up. GDP growth rate forecasts were being cut. The Bank of England, reacting to the slowing economy, cut its rate by 25 basis points to 4.5% in August. The yield curve was still inverted in the past a sure harbinger of recession. Would the economy continue slowing? What would happen to employment?
On this side of the pond, the US economy continued to grow strongly at a 3%+ clip. House prices continued to rise as both new and existing home sales maintained record levels. It had been a year since the Greenspan Fed started on their interest rate tightening cycle from the historic low of 1%. By November, the rate stood at 4.0%.
But the long-term rates barely budged and the mortgage and housing mania continued unabated. In spite of numerous dire warnings and predictions, the housing bubble (if it indeed was a bubble!) continued inflating defiantly. The Fed showed no signs of fatigue, and neither did the bubble. So it seemed that the standoff would continue during the rest of 2005 as the long warm days of summer waned into the short cold days of winter. Would the 2005 winter blossom into the spring of hope in 2006? By November, the Fed was less than 50 basis points from an inverted yield curve. Would history repeat itself? And what about oil prices which had more than quadrupled over the last half dozen years? Was the US economy immune to this oil shock?
On both sides of the Atlantic, there were other remarkable similarities too. Manufacturing was shrinking. Services were booming. Global labour competition was severely constraining real income growth. Income-short consumers had adopted the "borrow and spend" mantra with abandon and savings rates had plummeted. Trade and budget deficits had mushroomed. Consumers were staggering under record debt burdens. Most business activity was concentrated in the financial and housing sectors. Job creation centered on financial and housing services, real estate, government, healthcare, and low wage industries like retailing and hospitality. Whether or not they had the incomes, Americans and Britons wanted the good life now even if that meant mortgaging the future!
And so we wait with bated breath to see what lessons that great teacher, History, has in store for us. If the past is any guide, the combination of interest rate hikes and oil price shocks is sure to lead to recessions. And the central banks on both sides of the pond are sure to respond with the only trick in their playbooks interest rate cuts.
The critical question is how deep and prolonged the recessions are going to be. On both sides of the Atlantic, the consumer holds the key. Will he/she maintain spending levels long enough for the central banks to come to the rescue with sharply lower interest rates and reduced debt service burdens? Or will he/she cave in as the recession brings higher unemployment and lower incomes? Most importantly, will credit defaults on mortgages and other consumer debt deal a serious blow to the safety and soundness of the financial systems? If the latter happens concomitantly with a steep stock market decline and housing bust, we face a serious global recession or even a depression.
Yes, it is indeed the best of times on both sides of the Atlantic. That's the good news. The bad news is that it could be the precursor to the worst of times. As Charles Dickens wrote in "A Tale of Two Cities" about France in 1775, both the US and the UK have "rolled with exceeding smoothness down hill, making paper money and spending it."
And yet, the trials to come will provide plenty of opportunity to rebuild the character that made these nations great foregoing immediate gratification, living within one's means, saving rather than borrowing, and investing to increase real productivity and ultimately incomes.
At least we have that consolation.
By Mukund Sheorey, president of Modelytics Incorporated, a Customer Value Management services company. You can email Mukund at mukund.sheorey@modelytics.com
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