Strategy

Outlook 2010: Is the recovery for real?

The economy is growing again, but there's reason to worry the better times won't last.

While the crash only took place six months ago, I am convinced that we have now passed the worst and with continuity of effort we shall rapidly recover.” That sounds like something a Canadian policy-maker might have proclaimed in early 2009. In fact, the speaker was Herbert Hoover, the Depression-era U.S. president. Like desert mirages, misleading signs often punctuate prolonged economic catastrophes — a few quarters of GDP growth, a fool’s stock market rally, or merely a politician’s desperate attempts to reassure the public. Hoover told that to the U.S. Chamber of Commerce on May 1, 1930, at the outset of a miserable decade.

What about now? Canada’s recession officially ended in the third quarter of 2009, when GDP grew, albeit lethargically. Consumers are spending again. Employers are handing out fewer pink slips. The battered manufacturing sector shows signs of life. The updraft of economic stimulus is anticipated soon. A chorus of private-sector economists tells us Canada’s GDP will grow modestly next year. The Bank of Canada calls this recovery “solidly entrenched.” And a recent Ipsos-Reid survey found more than two-thirds of Canadians believe their personal finances will improve in the year ahead.

The worst, it seems, has passed. But has it truly? In the following pages, you’ll learn the latest thinking on how we got into this mess, and how much damage we sustained. We’ll consider how soon Ottawa can return to balanced budgets, what happens after the flood of government stimulus ebbs, and other questions provoking heated debate in the House of Commons, your local Tim Hortons — and everywhere in between.

What just happened?
A year ago, those trying to explain the crisis in one word often cited “greed.” Now, “debt” seems more apt. A cavalier attitude toward it, and an accompanying willingness to accept massive amounts of it throughout the global economy, lie at the root of our current woes. “Between 2001 and 2007, Americans borrowed trillions of dollars from abroad,” wrote U.S. academics Menzie Chinn and Jeffry Frieden earlier this year. “The federal government borrowed to finance its budget deficit; private individuals and companies borrowed so they could consume and invest beyond their means.”

For decades, analysts at BCA Research, the renowned Montreal-based investment advisory firm, have made sense of increasing American and global indebtedness using something they call the “debt supercycle” theory. In short, it holds that since British economist John Maynard Keynes taught governments how to blunt the impacts of downturns, periodic recessions no longer wipe out debts the way they used to. The result has been increasing debt, punctuated by catastrophes. Governments, though, do whatever it takes to avoid a final reckoning. At some point, they’ll simply be unable to prevent a debt bonfire, but BCA has long argued that terrible day lies in the distant future.

This time around, America’s housing market caught fire. Fuelled by low interest rates, lax lending standards and deficient regulatory oversight, home prices surged between 2000 and 2006. Homeowners became hopelessly overstretched. The bubble popped, ushering in a wave of mortgage delinquencies and foreclosures as home prices returned to more sensible levels. Losses were staggering.

In ages past, this would have been sorted out largely between banks and their clients. And with the advent of deposit insurance and other Depression-era innovations, bank runs were supposed to be impossible. But a parallel world — the so-called shadow banking system — had developed, and it was poorly regulated yet globally pervasive. Decades of growth in securitization — the process of parcelling together mortgages, car loans and other types of debt into investment vehicles and selling them off — rendered the banker-client relationship largely irrelevant. Nobel Prize–winning economist Paul Krugman put it this way: “We turned out to be vulnerable to, and had, the functional equivalent to the great bank runs of the 1930s ? creating a massive financial crisis along the way.”

A synchronized global downturn ensued; industrial production and trade fell among virtually all countries. “The outright decline in economic growth this year is unlike anything experienced in the 1980s and 1990s recessions,” Kip Beckman, an economist with the Conference Board of Canada, observed. “During those recessions, some developed countries continued to have economic growth. In the current downturn, almost all developed countries had at least two quarters of declining economic output, primarily because the credit crunch spread like wildfire through global financial markets.” During late 2008 and early 2009, as economic activity around the globe collapsed at a pace last witnessed during the Depression, some began to despair. The dreaded debt bonfire seemed at hand.

It was not to be. Just as BCA predicted, governments resolved to prevent a depression at all costs. Exhibiting unprecedented co-ordination through international bodies like the G20, central banks slashed interest rates, facilitating continued borrowing and spending. Governments released large amounts of fiscal stimulus. And teetering industries — notably banks and automakers — were propped up by complicated bailouts devised on the fly. “We learned our lessons from previous financial and economic crises — management of banking crises in many places, the ruptured Japanese asset bubble in the 1990s, and even the Great Depression itself,” wrote Conference Board of Canada chief economist Glen Hodgson. “Governments stepped up in a massive way.” In large part, this massive intervention assuaged the fears of businesses, consumers and investors, and ended the recession.

We’re often told the economy is cyclical — surges, recessions and recoveries are bumps on the road to inexorable long-term progress. Viewed in that context, the past two years are not particularly alarming. But astute observers perceive a difference between this and other recent recessions. “What complicates this situation, as compared to the ordinary garden variety recession, is that we have this financial collapse on top of an economic disequilibrium,” Paul Volcker told the German newsmagazine Der Spiegel, the latter factor including American overconsumption and massive trade deficits. “History tells us that recessions induced by financial sector problems tend to last longer, create deeper loss in output, and lead to more tepid growth than ordinary recessions,” University of Chicago professor Raghuram Rajan explained last year. A decade-long bacchanal of debt makes for one hell of a hangover.

Damage report
Recent post-mortems of the Great Recession have been stark, with the OECD and IMF dubbing it the worst since the Second World War. Such assessments seem incongruous in much of Canada, where the damage often appears transitory. Indeed, Canada fared better than most. GDP contracted for three consecutive quarters, for a cumulative decline of 3.3%, compared with an average 4.7% drop across G7 countries. Exports fell sharply, and Canada had its first trade deficits in decades, but those were fleeting, thanks to a recovery of American spending this fall. Federal Finance Minister Jim Flaherty recently said that Canada’s recession “has been less severe than in virtually all other major industrialized economies.”

Job losses came fast in the five months beginning in October 2008, with about 400,000 Canadians punted. Though labour markets settled after that, by December 2009 unemployment stood at 8.5%. We’ve not seen such levels in more than a decade. Even so, Canada entered the crisis with the best employment climate in more than a generation. And today’s elevated rate is historically unremarkable. “If you held up a chart of Canada’s unemployment rate for the last 25 years at arm’s-length, you’d see an 11% back in the early 1990s,” says Dale Orr, an independent economist. Orr believes much of today’s elevated unemployment is temporary, and will subside by mid-decade.

But the recession pummelled already-sickly industries. Ontario’s auto sector is a shambles. Detroit’s manufacturers have been in decline for decades, but the crisis caused North American auto demand to contract sharply, harming all manufacturers and bankrupting the weakest (including General Motors and Chrysler). The number of Canadians employed in auto assembly fell to the lowest level in four decades — and owing to plant closures by GM, Ford and Chrysler, many of the job losses are permanent. Other companies in the supply chain are also contracting or failing, and the Big Three have closed many dealerships. “Don’t buy into the rhetoric that’s come out of Detroit lately,” says George Magliano, director of North American automotive research with IHS Global Insight, pointing to news of Ford’s profitability and GM’s plans to repay government debt by the summer. “Everybody in this business is going to struggle and struggle.”

Forestry is similarly stricken. Canada exported huge volumes of softwood lumber to the U.S. to feed America’s housing boom. Farewell to that. The Conference Board of Canada says demand for paper products fell so quickly during the recession that producers couldn’t cut output quickly enough, resulting in swelling inventories and falling prices. It estimates that Canada’s paper products industry lost $1.2 billion in 2009 — the worst year on record, and that’s after losses in each of the preceding six years. “What’s more, the industry will be permanently smaller because of lower demand for paper products going forward,” says the Conference Board’s Michael Burt.

Governments bought us out of this recession. The result is mounting public debt. Thanks to more than a decade of relative austerity, Canada’s books are the best in the G8. We are now undoing all that progress, at least in nominal terms. Our cumulative debt recently rocketed past $500 billion, and its burden relative to GDP will deteriorate further. “If you’re really an optimist, you look at our debt burden relative to the U.S., Britain and Germany and say, we’re looking like the best horse in the glue factory,” says Orr. “Our debt burden is going to be way worse than what we thought it would be — bitter disappointment there.” Some provinces, notably Ontario, are now fiscal basket cases. And since there are few credible plans to repair the damage to public balance sheets, it’s quite likely future generations will pay for it.

Where’s the next one coming from?
During the middle years of the Depression, U.S. efforts to stimulate the economy seemed to work. (America’s GDP grew more than 10% in 1934, for example.) But public finances deteriorated under the strain. Eventually, Hoover’s successor, Franklin Roosevelt, succumbed to impulses to pull back and let consumers and businesses carry the economy forward. “A premature retraction of economic stimulus, among other things, pushed the U.S. back into recession” in 1937, Mikka Pineda, an economist with Roubini Global Economics, wrote recently.

Our modern dilemma is similar, if not quite so stark. Unfortunately, those who counsel against premature withdrawal and those who worry about mounting deficits are both correct. As the IMF’s managing director, Dominique Strauss-Kahn, explained: “Exit too soon, and you kill the recovery. Exit too late, and you sow the seeds for the next crisis.” At best, the 1937 experience suggests Flaherty and Carney (and their international colleagues) will need the timing and reflexes of champion prizefighters to knock out the recession for good. The greater risk is that no sweet spot exists — and that once governments no longer prop up the economy, its decline will resume. (Jason Kirby considers this quandary in “What happens when stimulus ends?”.)

If debt truly lies at the heart of our problems, Canadians have more of it than ever. “Aggregate debt levels have risen sharply relative to income,” Carney observed in December. “Those debt levels have continued to grow fairly rapidly this year, unusually so for a recession.” He should not be surprised: the Bank of Canada’s consistent easy money policy helped blunt the recession’s impacts but also likely enticed Canadians to keep borrowing. (For a discussion on the implications for Canada’s housing market, see “Is this a real estate boom or a bubble?”.) Benjamin Tal, an economist with CIBC, believes Canadians will be paying down debt in the years ahead. “Deleveraging will be the key for the next five years,” he says. “In the new post-recession economy, you will see less credit in this market and more savings.” This is just one of many reasons Ottawa may need to keep the economy on life support longer than expected.

Meanwhile, Canada’s public finances are deteriorating. Jim Flaherty warns of years of fiscal austerity. Canadians face higher taxes or declines in the quality of public services (think education and health), or both. And we’ll have fewer financial resources to cope with future difficulties, including an aging population. (Jacqueline Nelson considers federal finances in “Are the deficits here to stay?”.)

The OECD warns of slow job recovery in most countries. “Creation of productive jobs tends to lag significantly behind the recovery in output,” OECD secretary general Angel Gurría has noted, “and thus unemployment and under-employment is likely to continue rising in many of our countries in the months to come.” A jobless recovery is definitely possible — and that would not feel like a recovery at all for many families. (In “When will the job market rebound?”, Laura Cameron examines the outlook for Canada’s job market.)

The dollar, ever a source of anxiety, continues to bother. It has flirted with parity with the American greenback for much of this year, raising fears that Canada’s export-driven economy may suffer as the U.S. dollar continues to deteriorate against other currencies. (In “What’s next for the loonie?”, Thomas Watson explains why such fears may be overblown. As for the ever-mercurial stock market, Bryan Borzykowski considers its outlook in “Can this bull market continue?”.)

All things considered, Canada’s situation remains difficult, yet hopeful. But if this recession taught us anything, it is that events in foreign lands, and far beyond our control, can wreak havoc here. So great are the troubles of our largest trading partner, the United States, that it will be preoccupied with them for years, perhaps decades. (For an assessment of America’s prospects, see “Is America really insolvent?”.) According to Parliamentary Budget Officer Kevin Page, “the potential that the emerging U.S. recovery could be weaker than anticipated and the recent strength in the Canadian dollar … both pose a risk to Canadian exporters and could delay the Canadian recovery.” (Thomas Watson disputes the popular notion that China’s ready to replace the U.S. as the driving force of the global economy in “Is China now in the driver’s seat?”.)

Mounting public debt elsewhere leaves nations vulnerable. Debt-rating agencies like Moody’s and Fitch are warning that certain countries are at risk of ratings downgrades. The situation is bad not only in small countries like Greece and Dubai, but also major ones such as Japan and Britain. The OECD warns, “Stopping the rot is clearly necessary and will call for fiscal consolidation that is substantial in most cases and drastic in some.” It’s now an open question whether some countries can afford long-term stimulus, should it be necessary.

The recovery, then, remains vulnerable. Another shock could easily send the global economy (and Canada’s along with it) spiralling into a dreaded “double-dip” recession. “We will wake up in 2010 and discover that the recession has not ended,” predicts David Rosenberg, Gluskin Sheff’s perpetually grim chief economist and strategist. Even if he’s wrong, the wind is still in our faces.