A “recession” is usually defined as at least two quarters in a row of shrinking economic activity, as measured by gross domestic product (GDP). A recession is eventually followed by a recovery. Normally, stock prices decline before a recession begins, and start to recover before the GDP as a whole recovers. Real estate prices can stay depressed for longer periods. Employment and income generally go up and down with overall GDP. Most economists believe that an occasional recession is inevitable, and in fact may be a healthy way for the system to get rid of inefficiencies or imbalances. Since 1973, almost all recessions were preceded by spikes in oil prices, and the recent recession was no exception. Having to pay more for gasoline and heating leaves consumers with less money to spend on other things.
Most recessions since World War II in the U.S. have been relatively short. The average duration of the 11 recessions between 1945 and 2001 is 10 months. Here is a chart of U.S. GDP growth from 1923 thru 2009.
The blue bars show expansions in economic activity, and the red bars below the line are contractions. Although there was a downshift right after World War II and a long rocky patch in 1973-74, the current recession is the most dramatic since the Great Depression of the 1930s. It is being called the Great Recession. It officially ran 18 months, from Dec 2007 to June 2009.
Since then, economic growth has been positive but muted. Unemployment stays stuck at just under 10%, which is very high compared to past decades. The federal government has been pouring money into troubled banks and offering stimulus packages, but has been unable to get economic growth high enough to bring down unemployment.
Although the Great Recession technically ended in June of 2009, for most households it does not feel that way. Their jobs are still precarious, and stock and housing prices remain depressed. So far, this has been an “L-shaped” recovery, not a short “V-shaped” recovery. By many important measures the Great Recession is still dragging on. Since the fourth quarter of 2008, business profits have steadily grown back. However, businesses have accomplished this largely by cutting costs, i.e. reducing employment. That is fine for stock prices, but bad for workers.
The chart below shows how deep and persistent are the job losses in this recession compared to others. Although we read glowing government reports of job gains in recent months, there is reason to believe those reports (which are only estimates) are quite over-optimistic. The reality is that total number of employed people has nearly flat-lined, and apparent reductions in percent unemployed are due to the numbers of discouraged people no longer seeking work (see article by C. H. Smith ).
HOW DID THIS HAPPEN ?
Why is this recession so different? The underlying drag is a huge accumulation of debt, by both private households and financial institutions. People wanted more stuff (bigger houses, more gadgets) than they could actually afford, and they wanted it now. Instead of saving up to buy stuff later, they borrowed money to buy the stuff now.
Normally, banks would not agree to lend to people whose incomes were not sufficient to pay the money back. However, new financial instruments were implemented around 2005 that enabled the bank or mortgage company that originally made the loans to sell those loans out into the larger financial world. Examples of these financial innovations were “mortgage-backed securities” (MBS) and “collateralized debt obligations” (CDO). These financial instruments were crafted to allow investors worldwide to participate in the U. S. mortgage market. There is an estimated 70 trillion dollars of money in the hands of institutions, rich individuals and various funds which slosh around the globe looking for places to be invested at interest rates higher than the benchmark U.S. Treasury bills. In the years 2004-2007, trillions of dollars worth of subprime (i.e. shaky) housing loans were made, which involved relatively high interest rates, making them attractive to such investors. These loans were sliced and diced and packaged into these MBS’s and CDO’s which were then heavily bought by U.S. investment banks and other institutions.
The bond ratings agencies like Standard and Poors erroneously assigned relatively low risks to this stinking, sinking pool of loans, so investors all over the world bought into them. This allowed the original lender to get the benefit of making the loans, while bearing none of the risk if the borrower defaulted. Thus, these original lenders started making all kinds of “predatory” loans to anybody that breathed, whether or not the borrower understood what they were signing or could realistically ever pay it back. An easy-money policy by the Fed (in the wake of the 2000-2001 dot.com bust) added fuel to the fire.
With all this extra money flooding into the housing markets, house prices went through the roof. It became a classic financial bubble: homebuyers didn’t mind paying high prices for a house, because prices were rising so much that they figured they could turn around and sell it next year for an even higher price. Also, with the commonly used adjustable rate mortgages, the mortgage payments started off relatively low, for the first few years.
A key assumption was that housing values would just keep going up and up, forever and ever. Besides taking on huge mortgages to buy houses, people took out home equity loans (effectively like boosting the size of their mortgages) and then took that cash and spent it on college tuition, cruises, and big-screen TVs. From Wikipedia:
• Free cash used by consumers from home equity extraction doubled from $627 billion in 2001 to $1,428 billion in 2005 as the housing bubble built, a total of nearly $5 trillion dollars over the period, contributing to economic growth worldwide. U.S. home mortgage debt relative to GDP increased from an average of 46% during the 1990s to 73% during 2008, reaching $10.5 trillion.
• USA household debt as a percentage of annual disposable personal income was 127% at the end of 2007, versus 77% in 1990. In 1981, U.S. private debt was 123% of GDP; by the third quarter of 2008, it was 290%.
A quick take on the ballooning debts of some financial institutions:
• From 2004-07, the top five U.S. investment banks each significantly increased their financial leverage, reporting over $4.1 trillion in debt for fiscal year 2007, about 30% of USA nominal GDP for 2007.
• Fannie Mae and Freddie Mac, two U.S. Government sponsored enterprises, owned or guaranteed nearly $5 trillion in mortgage obligations at the time they were placed into conservatorship by the U.S. government in September 2008.
That is 9 trillion dollars in debt run up by these institutions, much of it subprime mortgages that will likely never be paid back in full. For comparison, the entire U.S. GDP is about 14 trillion dollars. The federal government and the Federal Reserve Bank have supplied hundreds of billions of dollars to support these banks and agencies.
This diagram shows the domino effects of the bursting of the housing bubble on banks and on the whole economy.
The economics establishment was almost completely blind-sided by this catastrophe, even though all the signs of a classic bubble were apparent in the housing market by 2005-2006. The few economists that did raise warnings were hooted down by the majority whose elegant, rational models had no room for the madness of crowds. As Paul Krugman put it, “economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth.” The two cartoons below (click to expand) tell the tale.
Many books have been written about the recent boom and bust. I happened to read a review of one such book, with the colorful title, The Monster: How a Gang of Predatory Lenders and Wall Street Bankers Fleeced America — and Spawned a Global Crisis. Obviously, we can point lots of fingers at greedy Wall Streeters and incompetent government regulators. The reviewer here, however, notes that Wall Street greed and government incompetence have always been there and will always be there, so it is up to the individual to actually read lending contracts before signing them and do simple arithmetic to see whether something is affordable. That would have prevented this past crisis, and that is the only thing that will prevent the next crisis. According to this reviewer (Jason Williams), more regulations can help a little, but getting Americans financially functionally literate is the only measure that will really make a difference.
CLIMBING OUT OF THE HOLE
OK, that was the bad news. Lots of debt was rung up. Now, how are we doing with climbing out of this debt hole? The plots below (courtesy ContraryInvestor, November post) show that household liabilities are creeping back down toward historical levels, but we have a long way to go. It may take several more years to get the excess debt paid down (“deleveraging”) before people can start spending much on other stuff. Much of the decrease in liabilities shown here is due to people simply defaulting on their mortgages, rather than paying them down, so the pace of debt reduction may slow from here.
The Federal Reserve has lowered short term interest rates to nearly zero, in an effort to encourage people and especially businesses to borrow and expand. The Fed’s recent “quantitative easing” (QE2) is intended to lower interest rates on longer term bonds, again to promote borrowing. However, U.S. businesses in general do not see sufficient opportunities to invest, so they aren’t borrowing much for expansion. The banks are taking the Fed’s money and instead of loaning to Americans, they are investing much of it overseas where they can make a higher return. QE2 is mainly just driving up asset prices, but perhaps rising stock prices will make shareholders feel secure enough to get out there and spend.
Nomura Chief Economist Richard Koo recently gave a talk in which he characterized this as a “balance sheet recession,” since the overhang of debt is sapping other activity. The Fed’s efforts to stimulate the economy through lower interest rates are like pushing on the end of a string. The money is available to borrow, but people are more focused on paying down old debt than taking on new debt. In Koo’s view, it is up to the federal government to take up the slack by spending more than they collect in taxes; the borrowing by the government to finance this deficit spending will offset the lack of borrowing by the private sector. Koo cites examples (e.g. Germany and America in the 1930s, Japan in the 1990s) where massive deficit spending seemed to pull a nation out of depression. However, there is currently a political backlash in the U.S. against deficit spending, which is seen as irresponsible.
Thus, a crucial question for the coming decade is: what are the long-term effects of large amounts of deficit spending? If it does so much good, and no real harm, it would be irresponsible NOT to do it. The belief that piling up national debt hurts future generations has enormous real-world consequences, since this belief will drive policy decisions. There does not seem to be a clear, consensus answer to this question. The common-sense view is that the federal government must balance its books long-term, just like any other entity. Classic Keynesian economists might advocate spending deficits during a recession, with the expectation that they would be offset by budget surpluses in the ensuing recovery. Modern Monetary Theory or Chartelism , on the other hand, says that common-sense budgetary notions do not apply to the government of a nation like the U.S. which issues its own currency. They claim that ever-growing government debt is actually a necessity for a growing economy. Does this mean that the federal debt can grow forever with no real consequences (provided hyperinflation doesn’t kick in), since the U.S. can essentially create its own currency out of thin air? That no matter how big is the interest on that debt, the government can just borrow more from its central bank to finance both current spending and the interest? We shall see….
Koo sees close parallels between the current U.S. situation and the experience of Japan in the 1990s. Japan went through an enormous real estate bubble that burst in 1991. What followed was a long period of economic stagnation, termed Japan’s Lost Decade(s). This chart overlays the ups and downs of Japanese real estate prices in the 80’s and 90’s as compared to the last decade in the U.S. If the parallels continue to hold, it will take many years for U.S. real estate prices to recover. Millions of existing adjustable rate mortgages in the U.S. will be adjusting upwards in the next two years, which may lead to additional defaults/foreclosures that will dump additional housing on the market.
A parallel disaster in commercial real estate loans is largely kept from public view. Many enterprises that borrowed money from banks to buy commercial properties at inflated 2004-2008 prices cannot service these loans. Because the property values have dropped so much, the banks do not dare foreclose on these loans; to do so would force them to formally book the losses, which would render the banks insolvent. (See here, here, and here). Instead, the banks, with the connivance of the federal regulators, are granting loan extensions as though the borrowers’ financial conditions were about to dramatically improve (“extend and pretend”).
WHAT LIES AHEAD ?
The discussion above hopefully sheds light on the present and the recent past. Predicting the future is, of course, much harder. At a minimum, we can say that there are structural reasons to believe that for the next several years, growth in GDP will be fitful, and unemployment will remain high. The rapid recoveries in past recessions were largely due to laid-off manufacturing workers returning to their factories , but now there are few manufacturing jobs left in the U.S. To meaningfully cut into unemployment will require years of GNP growth averaging 5% or more, which is well above the experience of recent decades.
Our economy remains highly dependent on petroleum as a cheap energy source and as the underlying resource behind our food production. It is unlikely that we will be able to increase conventional crude production much beyond current rates, as new oil discoveries struggle to keep pace with declines in old fields and as geopolitics enters in. Also, Asian customers will be bidding oil away from the West. The liquid fuels of the future (from deepwater, Arctic, tar sands, biomass, shale) will be increasingly expensive, in part because the very production of these fuels eats up energy. This will be an added drag on growth going forward. Another drag must be mentioned, which is the revenue shortfalls experienced by state and local governments, due to declining tax intakes and the generous employee salaries and benefits that were negotiated in the earlier boom years. Now states and municipalities are being forced to lay off active workers in order to pay for lucrative pensions that kick in as young as age 50.
This discussion so far has assumed no exogenous shocks. On the surface, it seems like the world financial systems have weathered the storm and are back on their feet. However, the situation in Europe remains dicey. Several countries on the periphery, dubbed the PIIGS ( Portugal, Italy, Ireland, Greece, Spain) are muddling through credit crises of varying severities. A key factor is that these have all given up their own currencies in favor of the Euro, so (unlike the U.S.) they cannot create more money out of nothing. If Greece/Ireland/Portugal drag Spain down along with them, there could be a real mess. There do not seem to be enough resources to bail out Spain along with the others. There is also some uncertainty about China’s continued growth. And there are any number of geopolitical events that could throw markets into a tizzy, like war breaking out in Korea, or a coup somewhere. These “Black Swan” events can blow away all our careful extrapolations.
U.S. government spending will likely keep going up and up. This makes a job with the federal government or an entity that does business with the government to be an attractive proposition. The Washington, D.C. area should prosper as all that government money for salaries and contracts trickles down to spending for homes, cars and dining out. The finance industry continues to generate profits and pay out bonuses – – nice work, if you can get it.
It would be well to position yourself where you can prosper in many situations and survive in nearly all. For investing, this translates mainly into a very diversified portfolio, including a reasonable cash/precious metals holding to enable you to buy stocks and commodities low after a dip. Periodically rebalancing a diversified portfolio forces you to sell high and buy low. We’ll conclude with investing advice excerpted from ContraryInvestor:
This is a balance sheet recession that is fundamentally different than inventory led or Fed induced (taking away the punch bowl) recessions of the post war period. Yet we see the Fed/Treasury/Administration traveling down a remedial path assuming a typical post war recessionary experience. It is not.
…What is appropriate thematically is a focus on yield/total rate of return… Without question, the Fed/Treasury/Administration will do everything in their power to reflate the system… Is oil the poster child asset class [to deal with the resulting monetary debasement]? Inclusive in this theme is also precious metals, industrial metals in general and importantly ag exposure.
Finally, we want exposure to longer term fundamental economic growth… [where] the emerging markets are a fit. But again, we expect volatility to be the rule… [so] we want to buy panic and fear. You’ll know it when you see it and at the appropriate time to buy, the key signal will be no one will want to.
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There many resources on the web for understanding things economic. For savvy analysis and investing recommendations, I turn to the Pragmatic Capitalist. The monthly analyses at ContraryInvestor are loaded with tables and charts which often focus on debt issues. For an entertaining introduction to microeconomics, see Economnomnomics
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