Strategy

Recessions: Uh-oh domino

A recession is like a series of falling dominoes — and they're still toppling.

It has been a long time since there has been such universal gloom on the world outlook. The new year opened with eye-wateringly bad data, whether collapsing employment in the U.S. and Canada, strikingly weak industrial production in Europe, or stunning drops in exports in Asia. It looks as though we’re in a global recession, perhaps the most severe since 1974. And most agree that things will get worse before they get better.

But economists are frequently wrong about the outlook — and few saw the recession coming. So has the herd become too pessimistic? Unfortunately, this time the consensus is rightly gloomy. A recession is like a series of falling dominoes, as cutbacks in one sector affect income and spending in another. And the dominoes are still toppling.

Consumers know a recession is in progress, and that makes them more cautious, particularly on big-ticket items. Business has seen a frightening drop in orders since last summer, as credit has become scarcer. Companies are cutting back on inventories, investment spending and jobs.

The attempt to control inventories lies behind some of the most dramatic statistics in recent months. Some retailers, as well as producers in weak sectors such as autos and construction, cancelled orders late last year when sales slumped or credit dried up. Shocked suppliers responded by slashing orders and laying off employees. In most cases, the order freeze will be temporary. U.S. consumer spending fell 2% to 3% in the second half of 2008 (not annualized), so those suppliers looking at order books down by far more can hope for a pickup before long. An exception is any product to do with capital investment — companies are shelving investment plans. Another exception is luxury goods: this downturn has hit the better-off hard, and for ordinary people, too, luxuries are an easy area to cut back.

The U.S. remains the epicentre of the crisis. House prices are still falling, eroding household wealth and bank capital. Payrolls shed 1.93 million jobs in the last third of 2008, and GDP growth in the fourth quarter, due to be released on Jan. 30, looks set to have fallen in the neighbourhood of 2% (8% annualized). Europe is in recession, too. The U.K., Spain and Ireland are suffering from their own housing and financial crises, while Germany has been hit by the slowdown in car purchases and capital-goods orders. France and Italy have turned down, while some countries in eastern Europe are struggling to manage excessive debts and overvalued exchange rates. Asia, like Canada, was slow to this crisis, buoyed by strong domestic spending and commodity prices. But Asian exporters hit a wall in the last quarter as orders collapsed, and business is slowing sharply. China has slowed abruptly, and India is ailing. Commodity producers in Russia, the Mideast and Latin America face lower prices, and their domestic booms have come to a stop.

Is there any good news? Well, it has to be the speed of the policy response. Partly because inflation is not a worry — indeed, deflation is the concern now — governments and central banks have responded with unusual energy. The U.S. Federal Reserve pushed rates to almost zero in December, and few countries now have rates exceeding 2%.

Progress is slow because the underlying problem in the financial sector — huge losses requiring new capital — has still only been partially addressed. Most of the central bankers’ efforts between August 2007 and October 2008 focused on liquidity, but the real problem is solvency. Only when the bad assets are fully written down or sold will the credit crunch be over. But now, the deepening recession is bringing more losses, so new government capital injections are likely to be necessary in many countries.

The U.S. is also leading the way in fiscal expansion. Congress is having the time of its life with new spending plans and generous tax cuts. Other countries are following, though more cautiously. The U.S. looks set to have a budget deficit of over 10% of GDP in the fiscal year ending September. This will help the economy, though infrastructure spending takes time to work through and much of the tax cut will be saved as households struggle to restore their wealth.

Most U.S. forecasters predict the worst is already over. They look for the U.S. economy to decline again in Q1, but only modestly, and then pick up over the summer. My view is more pessimistic. I expect the U.S. economy to continue to decline rapidly in the first half, and then we can expect only a slow, halting recovery after that. In housing, the ongoing fall in prices and the overhang of inventory mean that house-building, normally one of the leaders in recovery, will keep falling this year. Meanwhile, the slowdown in commercial construction is only beginning, as rising vacancy rates and scarce credit take their toll. Exports, the one bright spot in 2007–08, will struggle amid a world recession, even if governments avoid protectionism, as we pray they do. And the Obama fiscal stimulus, while crucial, will need more time to take effect.

Still, fears that this downturn could turn into a depression (sometimes defined as a fall in GDP of 10% or more) appear overblown. The Great Depression of the 1930s was caused by a series of policy mistakes, including protectionism, interest rate hikes and, in the days before deposit insurance, allowing the banking system to almost completely collapse. Even the very bad recessions of 1974–75 and 1980–82 were made worse by hikes in official interest rates to try to control inflation. This time, inflation is low and commodity prices are falling, so interest rates will stay low.

Once the U.S. troughs (with luck, in Q3), much of the rest of the world should be able to improve. It is the U.S. that has the imbalances this time, and a few other countries have similar problems — notably the U.K., Spain, Ireland, Australia and New Zealand. But the rest of western Europe, Asia and Latin America face a cyclical downturn, not a structural crisis. An environment of a slow U.S. recovery with low interest rates should enable many countries to rebound strongly. Canada is probably somewhere in between. Like the U.S., it has a household savings rate that is too low, even though Canada’s house price boom was less extreme. Also, the inevitable dependence on the U.S. economy will hold Canada back. But its problems are not as severe as those to the south, and the weaker loonie will help.

Overall, the widespread gloom at the beginning of 2009 looks justified. Business, in my view, correctly expects the next couple of quarters at least to remain very difficult. Indeed, many economists are probably not gloomy enough yet, and will again need to revise their forecasts down as the recession spreads. But they are right to emphasize this: the downturn will not last forever.

John Calverley is head of North American research at Standard Chartered Bank, based in Toronto. His new book, When Bubbles Burst: Surviving the Financial Fallout, will be published in spring 2009.