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.

Financial crisis: Why and what's the reason for?

There’s an old Bob Dylan song called ‘Who killed Davey Moore?’ It’s the tale of a boxer killed by a fatal punch and the song recounts the protests of those involved – the referee, the crowd, the gambler, his manager and his opponent – that they weren’t the ones really responsible for his death. “It wasn’t me that made him fall,” they all cry. “No, you can’t blame me at all.”

That song springs to mind whenever anyone apportions blame for the 2008 financial crisis. There are no shortage of culprits. And given that the world may experience similar economic tremors in the near future, the question of who is to blame is extremely relevant.

Who really did make the system fall?

Culprit # 1 Senior Bankers

Bankers are, unsurprisingly, the most likely suspects. Adjectives like reckless and greedy have clung to banks like leeches since 2008 (which may be an apt analogy). But according to Dutch author Joris Luyendijk, the fatal flaw was not so much greed as wilful incompetence. The recently released movie The Big Short exemplifies, he says, the atmosphere in run-up to 2008. Days in which extremely clever finance geeks took advantage of the fact that senior managers in most banks had no idea what was really going on in their organisations. The impenetrable financial products they devised combined to make them vast fortunes and lay the seeds for financial meltdown.

Luyendijk quotes former UK Chancellor Alastair Darling who laments the fact that top managers in US and UK banks “failed to understand – or even ask – what was making them so much profit and what were the risks.”

He attributes this failure to lack of personal liability. In the days before the Big Bang, financial firms were organised as partnerships, rather than publicly floated corporations which any person, or hedge fund or other company could buy shares in. Partnerships ensured managers kept an unblinking eye on their organisation’s activities, says Luyendijk, because if things went awry they were personally liable for the cost of mistakes. But when partnerships were taken over by publicly floated banks or the investment divisions of major banks began marketing their own financial products, this discipline was lost.

I believe that while deliberate blindness on the part of senior managers was a factor in the financial crisis, it is far from a complete explanation. Firstly, bank executives were not as unaware as Luyendijk or The Big Short suggest. From pooled mortgages, to Libor and Forex fraud, the idea that senior executives were utterly oblivious to the machinations going on beneath them is not credible. When apologies become necessary, incompetence is always preferred to culpability.

In 2004, it was agreed that banks needed to have capital or deposits worth a mere 8% of the risky loans they had on their books. That agreement, known as Basel II, was “largely written by the banks themselves” says Mark Blyth in his book, Austerity: The History of a Dangerous Idea. Banks became massively indebted in the early 21^st century (they still are) and that was a conscious decision on the part of senior managers; a way of securing more profit by increasing the amount of money they loaned out. European banks, especially, became chronically ‘over-leveraged’ and may yet have to be recapitalised ‘on a scale yet unimagined’. To blame all this on unruly traders is way too convenient.

Second, the financial crisis was not just about the risk-laden products, the famous mortgage backed securities, collaterized debt obligations and credit default swaps, that boomeranged on the institutions that devised them. It spread across the world with such devastating effect because other institutions – other banks, companies, governments and NGOs – bought those toxic assets. And they bought them because they seem to embody the irresistible combination of low risk and high yield.

Lastly, risk-taking by banks was not merely an internal transgression. They were subject to pressure, possibly decisive pressure, from outside …

Culprit # 2 Shareholders

“In the run-up to the financial crisis, shareholders failed to control risk-taking in banks,” concluded the UK Parliamentary Commission on Banking Standards, “and indeed were criticising some [directors] for excessive conservatism. Some bank leaderships resisted this pressure, but others did not.”

So it wasn’t just that senior executives in banks failed to control super-intelligent and ambitious underlings who could reel off all the prime numbers up to 100 in 2.5 seconds. As directors of publicly floated companies, they were also under constant pressure to deliver greater and greater profits for the owners, the shareholders. And aware that if they didn’t succeed, they needed to look elsewhere for regular remuneration. In the words of Citigroup chief exec Charles O Prince in 2007, (in an article written by Luyendijk) “as long as the music is playing, you’ve got to get up and dance.”

To whose tune were the senior bank managers dancing? Other banks, primarily. Financial behemoths like Barclays, JP Morgan and Deutsche Bank top a list of 147 multinationals who literally own each other through interlocking shareholding. Other major shareholders include hedge funds, fantastically wealthy individuals and pension funds.

What these owners have in common is a need to maximise yield. According to Paul Mason, economics editor of Channel 4 News, big institutional investors such as pension funds, in their pressing need for higher returns on their investments, have become “crucial drivers of instability”. The signature products of the 2008 crisis, mortgage backed securities and collaterized debt obligations, seemed, before they exploded, low risk. So major shareholders were happy to buy them and to breezily criticise banks for ‘excessive conservatism’.

What lies at the root of this predilection for risk-taking among shareholders is the same weakness that Luyendijk criticises bank executives for – that if things go drastically wrong, they know they won’t be accountable. Just as bank executives are cushioned by a lack of personal liability, so shareholders enjoy the protection of limited liability.

Limited liability means that shareholders can lose only their investment in a company; they are never on the hook for the entirety of its bad debts. It is a right granted by the state. Limited liability first originated in Britain in the 1850s and was opposed in an earlier time by the father of market economics, Adam Smith, because of the dangers he saw in separating ownership and management.

The situation is complicated by the fact that, while shareholders seem very adept at pressurising the managers of the corporations they own to maximise profit without heed to public welfare, they are positively impotent when it comes to reining in harmful behaviour. Senior managers seem able to set their own pay which has mushroomed to 180 times that of the average worker in Britain. When shareholders do revolt over excessive executive pay – as they did at Shell in 2009 - they find that their opinion is merely advisory. In many ways, the senior management of large, shareholder-owned corporations are a law unto themselves.

So some have concluded that protecting the public from the selfishness of corporations requires removing both the limited liability of shareholders and the personal liability of company directors. “The most effective way of curbing predatory practices is to withdraw limited liability and hold the shareholders and directors of these enterprises personally liable,” argues Essex University’s Professor of Accounting, Prem Sikka.

Sikka wants alternatives to the corporate model – mutuals, cooperatives, not for profit and worker owned enterprises – to thrive and be promoted by government. “All are subjected to community pressures and control by employees, savers and consumers,” he says. “They see something beyond making a fast buck.”

The trouble is, during the crisis of 2008/9, the eyesight of these supposedly alternative enterprises seemed as myopic as anyone else’s.

Culprit # 3 the global market

The list of mutuals in Britain felled by the financial crisis is embarrassingly long. The Dunfermline Building Society, the Scarborough Building Society, the Chesham Building Society, the Derbyshire Building Society and the Cheshire Building Society all either collapsed or had to be bought by other financial institutions. In the case of the Dunfermline, the Bank of England bailed it out and ran it for a time.

Building societies don’t have shareholders. They are owned by, and in theory accountable to, their members – people who have mortgages or savings with them. But, though they didn’t create the banks’ financial ‘weapons of mass destruction’, they were just as reckless with the way they lent money.

In May last year, regulator Andrew Bailey, the chief executive of the Prudential Regulation Authority, warned building societies that they must not return to the ‘fatal’, high risk lending that helped trigger the financial crisis. He cited evidence that building societies were resuming the pre-crisis practice of making loans many times larger than their customers’ income and property.

These failings are not limited to Britain. In 2009 two of Germany’s famous state-owned Landesbanken, were forced to merge after they had borrowed too much capital and invested it in toxic US sub-prime mortgage assets. Four others had to be bailed out by state governments in Germany to the tune of millions of euros.

In Spain, savings banks, known as cajas de ahorros, are owned by non-profit foundations and dedicated to charitable activities as well as savings and mortgages. But they were at the heart of the implosion of Spain’s housing bubble. Of 45 cajas in existence at the start of the crisis in 2007, only two survived. The rest collapsed and had to be taken over by banks or the government. The effects have been catastrophic. Hundreds of Spaniards have been evicted every single day and the unemployment rate has reached a staggering 25%.

The financial crisis may have been hatched in corporate-land but it unfolded like a virus throughout the world because of markets. And allegedly alternative enterprises were as starry-eyed about these markets as anybody else.

Why then did alternative enterprises, which presented themselves as different to soulless, money-grubbing corporations, turn out to be not so different after all? Partly, because of a lack of real accountability. Though they were accountable in theory, they weren’t in practice. German Landesbanken had advisory boards that were meant to keep senior management in check but merely rubber-stamped their activities. In Britain, the Cooperative Bank’s woes can be attributed to the fact that its elected board didn’t have the knowledge or confidence to challenge the ‘incredibly optimistic’ assumptions of the management team. In this sense, the corporate and mutual sectors suffer from a similar affliction – out of control senior executives.

We don’t live in democratic societies. People don’t have the knowledge, time or inclination to hold the powerful to account. Without a conscious change in that level of knowledge and intention, mechanisms of accountability will remain empty shells.

But perhaps the problem is deeper still. The Marxist economist Andrew Kliman argues it is foolhardy, in a capitalist economy, to expect nationalised or worker controlled banks to behave differently to their corporate equivalents. “In order to survive, a state-run (or worker-run) bank must pursue the goal of profit maximisation, just like every other bank,” he says. “As long as there is capital, what are actually in control are the economic laws of capitalism.”

Those economic laws of capitalism mandated that building societies and other mutuals compete with major banks for market share and profitability. And doubtless many members, at the time, agreed with these aims. Governments in Britain have since the 1980s relied on rising house prices to ensure re-election. When that measure goes into reverse, as it did for the Conservatives in the early ‘90s, they watch as erstwhile supporters desert them in droves. Pensions funds are a ‘crucial driver of instability’, yet many millions rely on them to deliver high investment returns to fund their pensions.

This is not to descend into the ethical void and assume that everyone is equally guilty. Some people are infinitely more culpable than others. A tiny elite get to set their own pay. A tiny elite have been bailed-out by government and their wealth rescued by state action. A tiny elite get to make – and rig – the rules of the game. But, as in Dylan’s Davey Moore parable, it is the rules of the game that need altering. The blame game confers only an ephemeral pleasure. A bit like shopping.