Saturday, 20 February 2016

Those Recession Blues

Don’t panic! A conspicuous feature of mainstream accounts of recent stock market torments is that beneath the systematic shredding of share values everything is fine. Both UK and global equities have lost approximately 9% of their value since the start of 2016 and around 20% since April last year. Nonetheless, financial experts have been on hand to point out that the real economy has not suffered from this ‘equity bloodbath’, and is not likely to.

The sage and sceptical voice of the Telegraph’s Ambrose Evans-Pritchard, despite other downbeat pronouncements, advises a cool view be taken of ‘these deranged markets’. ‘This a stock market rout we should celebrate’, he says. The New Statesman’s Go To finance analyst, Felix Martin, maintains that the ‘global economy is in reasonable shape’. Only its software, the financial system, is faulty and ‘can be debugged’.

I think we should not be taken in by these soothing utterances. There are reasons to be worried. Which become more apparent, when you consider, in depth, the reasons frequently given for why we shouldn’t be:

Stock crashes don’t always affect the real economy

This is true, historically speaking, but the reasons why it was so in the past don’t apply now. The most notable example of a stock market crash not translating into a recession or depression was 1987. Then, the US stock market lost nearly 29% of its value in three days. But a downturn did not materialise (although there was, many argue, a delayed recession from 1990-92). The reason for this was the instantaneous reaction of the US Federal Reserve under new Chairman Alan Greenspan. Interest rates were cut and $12 billion injected into the banks.

Another stock market crash in 2001, the bursting of the dot com bubble, prompted a similar response. After successive rises at the height of the boom, Interest rates were again cut - to 1% in the US and to 4% in the UK. An immediate slump was sidestepped but the seeds of the Great Recession were planted in these actions. Banks, corporations and consumers took advantage of the low rates to borrow like crazy and when interest rates were subsequently raised, the housing market folded.

The official response to the Great Recession, in addition to massive bail-outs and subsequent doses of Quantitative Easing, was to again drop interest rates – to historic lows. Last December, the US Federal Reserve edged them higher and then came to regret the decision as stock markets haemorrhaged value. In fact, they have headed in a resolutely southwards direction, even since the Federal Reserve ended its 6 year $4.5 trillion invented money, Quantitative Easing programme, in late 2014.

Thus, central banks are in an impossible situation. The traditional response to a stock market crash – slashing interest rates – is not an option if they are near zero to begin with. And increasing them to secure the breathing space to drop them again only seems to instigate the very crash you want to avoid.

This is why William White, chairman of the OECD’s review committee, said recently, “Things are so bad that there is no right answer. If they raise rates, it’ll be nasty. If they don’t raise rates, it just makes matters worse.”

This quandary is what people mean when they say central banks have no ‘ammo’ left to fight a crash. And if, in contrast to the recent past, they are bereft of weapons, then a stock market crash will inevitably infect the rest of the economy.

The global economy is not ripe for a fall

Alright, say the recession sceptics, the world economy may not be hitting the high spots of the turn of the century, but it is chugging along nicely. The ‘macro picture’ belies nothing to be concerned about. Evans-Pritchard says world economic growth has been ‘drearily stable’ for years – 3.4% in 2012, 3.3% in 2013, 3.4% in 2014, 3.1% in 2015 and forecast to be 3.4% again this year.

Moreover, the drop in oil and commodity prices, while hitting commodity producing countries and companies, (Japan, Canada, Australia, Russia, Ukraine, Brazil and Greece all experienced recessions in 2015) has been a massive shot in the arm to consumers, akin to a large tax cut. Coupled with near zero inflation, consumers are recovering from the gaping wound to their living standards inflicted after 2008. Consumer spending amounts to up to 70% of GDP in the UK and US, so, the logic goes, when consumers prosper, so do economies.

The flaw here is that there is no real evidence that falling consumer spending or faltering economic growth precipitates stock market crashes or recessions. Or that rising consuming spending is an inoculation against them. Economic growth was respectable (and much better than now), in the run-up to the 2008 crash. But the crash still happened. Research has shown a negative correlation between economic growth and consumer spending in the US. When economic growth was higher in the 1950s and ‘60s, consumer spending occupied a lower share of GDP. Conversely, 2001-10 was a decade of relatively high consumer spending, but low economic growth. The key to economic growth seems to be the level of business investment**.

Declining consumer spending is thus a consequence of recession or stock market crashes, not its cause. One variant of Marxism argues, persuasively in my view, that the crucial element is the overall profit of companies. This profit level should not be confused with profit margins* (the percentage of profit compared to total sales), which can be increased by bearing down on ‘costs’ such as wages, and are currently very healthy. By contrast, overall profit levels are, it is claimed, near post-1945 lows for US corporations, and will, in time, lead to lower business investment. Earlier this month, economists at the mega-bank JP Morgan warned of a 10% fall in corporate profits compared to a year ago. “A double digit decline in profits is a rare event outside of recessions, having been recorded only twice in the last half century,” they say.

In other ways, too, the global economy is labouring under lowering clouds. Debt levels are huge, having grown by £37 trillion since 2007. Debt has doubled in emerging markets while increasing by around a third in developed economies. And this is after the last crash, which was transformed from a bearable ‘v shaped’ recession, into a global credit crunch by huge levels of private debt.

Overall corporate leverage (debt) is at a 12 year high. It stands at $29 trillion in the US and, it is estimated, one third of companies globally are not generating high enough returns to cover their funding. European banks are especially vulnerable, think of Deutsche Bank’s recent losses and credit risks, and may have to be recapitalised ‘on a scale yet unimagined’, says the former chief economist of the Bank for International Settlements. Taking on debt to buy back shares and thus bolster the share price and apparent health of the company, has become a major activity for large US corporations over the past five years. In the words of one financial strategist, “this is not for real economic activity.”

So the major actors in the global economy, the multinational corporations, whose health will determine whether stock markets crash and economies dive into recession, are not in reasonable shape.

You can continually dodge the recession bullet

Underlying all these predictions that the global economy can weather stock market storms is a fantasy – that recession can forever be averted provided the economic fundamentals are sound enough. Before the 2008 crash, similar siren voices were insisting there was nothing to be concerned about.

But history paints a more realistic picture. Two Russian researchers, Korotayev and Tsirel have calculated that there have been six recessions since 1973. This is using the IMF’s definition of a recession – six months where global growth dips below 3%. Using the accepted developed economy recession definition, two successive quarters of contraction, there were recessions in 1974/75, 1980/81, 1990/92 and 2008/9. As opposed to none from the end of the Second World War until the mid-seventies. So, if recent history is any guide, the question is not if, but when.

‘What happens when’ is the crucial question. Because the recession that awaits us is not an ordinary one. By ordinary, I mean a V-shaped downturn during which growths dips below zero and then swiftly recovers. The 2008 slump was not ordinary. It was so prolonged, sweeping and deep because it was accompanied by massive debt contraction on the part of over-leveraged banks and corporations. The signature products of the crash – credit default swaps and collatarized debt obligations - betray exactly what was going on.

Nothing in the official reaction to the 2008 crash, the lowering of interest rates and propping up markets with masses of confected money (QE), has done anything to deal with these underlying causes. It’s why one economist has condemned the worldwide governmental response as “self-contradictory and doomed to failure”.

Thus, the next recession is likely follow a similar course to the last, with the exception that governments have exhausted their ammunition to combat the contagion.

“Debts have continued to build up over the last eight years and they have reached such levels in every part of the world that they have become a potent cause for mischief,” said William White, chairman of the OECD’s review committee last month. “It will become obvious in the next recession that many of these debts will never be serviced or repaid, and this will be uncomfortable for a lot of people who think they own assets that are worth something.”

The critical assumption here is the inevitability of the next recession and what will follow its in wake. Then we will see if governments really are bereft of ammunition or can conjure yet more monetary tricks to kick the can further down the road. If they can’t, the consequences will be profound.

 *As far as I understand, it is quite possible for a business to increase its profit margins (by cracking down on wages, utilising zero hour contracts or slashing the marketing budget) but reduce its overall profit. Conversely a business can increase profit levels by expanding (taking on more staff, moving to bigger premises etc) yet reduce profit margins. But the long-term aim would be to increase profit and, in time, profit margins. Since 2008, many companies have followed, not the traditional maxim of ‘grow or die’, but rather ‘sweat or die’.

** If this is true, it is a damning indictment of a major plank of public policy over the last 40 years – slashing corporate taxation as a way, it is claimed, of giving businesses more money to invest and thus create jobs. An approach known as supply side economics. Actually business investment as a share of GDP has fallen in most developed countries since 1980. A period when recessions have become much more common.

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