The great recession, part two

Why it’s coming, and why Canada won’t escape so easily this time

AP Photo / Richard Drew

On May 6, shortly after 2:30 p.m., stock markets in the West went bonkers. In the span of 17 minutes, major indices shed nine per cent of their value, erasing $1 trillion in wealth. Then, just like that, prices rebounded and it was over. Dubbed the “flash crash,” regulators are still probing what went wrong. Analysts have voiced their suspicions. A computerized trading glitch was to blame, or someone had a “fat finger” and punched in an errant sell order. It had to be some fluke, though, because nothing warranted a drop in prices like that.

Except two weeks later, markets were back to the gutter level of the flash crash. There may be flaws in the way computers now handle most trades, but it’s also true a great many investors that day believed stocks were dramatically overvalued.

The sense of fear and anxiety now infecting the markets is showing up everywhere. In just the last month, Canada’s S&P-TSX Composite Index has shed seven per cent of its value. Exchanges in America and Europe fell even harder, dropping 11 per cent. Those people who blissfully watched their portfolios rebuild from the crash in 2008 have now seen their wealth drop sharply. Meanwhile, commodities like oil and copper are way down on worries the weak economic rebound will shift back into reverse. Not even the massive bailouts in Europe—first a $140-billion rescue deal for Greece, followed by a surprise $1-trillion “shock and awe” aid plan for other troubled nations like Spain and Portugal—were enough to convince investors the growing debt crisis can be contained.

Cue the doctors of doom. Forecasters like Nouriel Roubini at New York University are back in the headlines echoing the same warnings they had for the world three years ago about debt and overspending. “The recent global financial crisis is not over; it has, instead, reached a new and more dangerous stage,” Roubini wrote in an ominous piece entitled Return to the Abyss. “The recent events in Greece, Portugal, Ireland, Italy, and Spain are but the second stage of the global financial crisis.” And now the United Kingdom, Japan and the United States—Canada’s largest trading partner—are at risk.

How did we find ourselves back on the ledge so soon? Most economists believed the recession was, by and large, behind us. The crisis that exploded in 2008 has been downgraded from the Second Great Depression to the Great Recession to just another downturn, in the same way meteorologists scale back their assessments of subsiding storms. That sunny outlook was reflected in the markets. Prior to this correction, stocks had soared 80 per cent in just over a year.

But the recovery may not have been nearly as robust, or genuine, as first thought. In the U.S., jobless claims unexpectedly rose last week. The U.S. Conference Board’s index of leading indicators, which forecasts future economic trends, declined in April for the first time in 13 months. Meanwhile, America appears to be in the grips of deflation, the vicious downward cycle of prices, demand and wages that led to Japan’s “lost decade.” “What you’re seeing around the world is investors and markets having an ‘aha’ moment,” says Daniel Arbess, who manages the Xerion Hedge Fund at Perella Weinberg Partners in New York. “They’re recognizing that the rally in credit and equity markets that’s taken place may turn out to have been somewhat artificial because it was facilitated by cheap money.” Or as Tom Samuels, manager of the Palantir Fund in Houston put it to the Associated Press: “The economic recovery story has started to look like a mirage.”

If that’s the case, the dreaded double-dip could become a reality. Since the first mention of green shoots last year, economists have warned that if governments cut back on the trillions of dollars they’ve spent to stimulate their economies, it might plunge the world back into crisis. Instead, by bailing out car companies, the housing sector and consumers—practically dropping money from helicopters—countries have taken on debt loads that now form the heart of this new crisis. Some economists warn there could be a wave of defaults across the world. At the very least, as countries slash spending and raise taxes to reduce their deficits, the result could be years of stagnant growth.
Canada, which came through the recession remarkably unscathed, is arguably better positioned than most countries to weather a second crisis. But that doesn’t mean we’re immune. If the European sovereign debt crisis mutates into something larger, Canada could slip back into recession. And there are reasons to fear it could be worse this time.

The Plague of Athens was a deadly outbreak in 430 BCE that killed a quarter of the city’s population and hastened the end of the Athenian empire. Now it could just as easily refer to the epidemic of toxic debt spreading out from modern Greece.

That country was by no means alone in its profligacy, but after lying for years about the true size of its deficits, it became the first to falter. Across the European Union government balance sheets are crumbling fast. Portugal faces deficits this year equivalent to 8.8 per cent of its GDP, according to the International Monetary Fund. In Spain, the figure is 10.4 per cent, and in Ireland it’s as high as 12.2. Meanwhile, the United Kingdom, which awoke to a shaky new coalition government in early May, is staggering under the weight of deficits equal to 11.4 per cent of its economy. The U.S., at 11 per cent, is just as bad. In all of these countries government debts have swelled to well in excess of 60 per cent of GDP. Based on projections from the Bank for International Settlements, unless drastic changes are made, debt levels will explode to between three and five times the size of their economies over the next 20 to 30 years. “Greece is the canary in the coal mine for other profligate sovereign credit countries,” says David Rosenberg, chief economist and strategist at Gluskin Sheff in Toronto, just as trouble hit Thailand before the Asian crisis in 1997 and the collapse of New Century Financial in 2007 signalled the financial crisis. “The problems of debt and debt service have obviously not been washed away.”

When the recession hit, governments rushed to shovel out stimulus. Never mind that it was an excess of debt, in the form of toxic mortgages and strained lines of credit, that helped cause the crisis of 2008; they took on trillions of dollars of new leverage in the span of a few months. The onslaught of borrowing came despite structural deficits that spendthrift countries were already running. On top of all that, developed nations are on the hook for gargantuan promises to fund health care and pensions for their aging citizens.

As the recovery gained steam, investors turned a blind eye to bloated national balance sheets as if they no longer mattered. Think of it like a cancer patient who goes to the hospital for treatment, only instead of putting the patient through chemo to treat the disease, doctors simply removed the bad cells from one part of the body and injected them in another, hoping the malignancy would go away. During the financial crisis toxic debt was simply shifted from the household and corporate sectors onto governments. “The debt never went away,” says Arbess. “All that’s happened is a process of serial balance-sheet contamination. In the same way subprime securities infected the financial system, now the infection has moved to sovereign balance sheets.”

One worry is that investors are losing faith in the ability of some reckless nations to pay up, which would drive up borrowing costs and make it nearly impossible for them to refinance their debts. That was the case with Greece in late April, when investors demanded a premium of 12 percentage points to hold Greek over German bonds. The Mediterranean nation was on the verge of defaulting on its debt, most of which is held by European banks. Ultimately the EU and the IMF decided a bailout was the only option.

If investors shun sovereign debt, there are fears it could gum up financial markets and lead to another credit crunch where banks are afraid to lend. In that way the crisis could easily spill into the wider economy. At the very least, many expect the sovereign debt crisis will drive up global interest rates, making debt more expensive. It’s a concern shared by Bank of Canada governor Mark Carney. “Canada’s fiscal position is among the best, [so] we will do better than others,” he said last month. “But we will be pulled up by the rise in global interest rates, and that will have a knock-on effect on investment and growth in this country.”

Now a dark cloud hangs over the global economy in the form of austerity. To avoid a worsening debt crisis, and to bring their finances under control, countries are being forced to dramatically slash spending and raise taxes. While government spending cuts are generally seen as a good thing, they can also cool the economy by pushing down demand. The fear is, austerity measures will drive countries back into recession. Greece’s war on its deficits is likely to do just that. In order to meet the terms of its rescue plan, it has raised the minimum retirement age, jacked its value-added tax to 23 per cent, imposed steep tax hikes on cigarettes and alcohol, and declared widespread public sector layoffs and pay cuts. The goal: to reduce Greece’s deficit-to-GDP level from 13.4 per cent to less than three per cent by 2014, but the moves have been met by protests and riots.

Other countries must inevitably follow suit. “Getting their finances under control is going to require draconian spending cuts and tax increases,” says Rosenberg. “We’re talking about a very big chunk of GDP in these countries being taken out of the system for them to meet their EMU [Economic and Monetary Union of Europe] fiscal targets.” How much? In a new report, the IMF examines the steps industrialized nations must take to contract their fiscal policies in order just to bring their debt levels down to 60 per cent of GDP by 2030. For instance, the agency says the U.K. needs to cut spending and raise taxes by an amount equal to nine per cent of GDP over the next 10 years to meet that goal. Spain requires fiscal tightening of 9.4 per cent. The result will be much slower growth in the next few years. But if markets are worried about Spain and Portugal having to tighten their belts, the fallout from America’s fiscal woes are downright frightening.

When California Gov. Arnold Schwarzenegger went before reporters in mid-May, there was none of the movie-star bravado he brought to the office seven years ago. Instead, he warned Californians the state faces a US$19.1-billion funding gap this year. Programs like welfare, child care and mental health services would be chopped. But it was the way he framed the cuts that truly startled onlookers. “You see what is happening in Greece, you see what is happening in Ireland, you see what is happening in Spain now,” Schwarzenegger said. “We are left with nothing but tough choices.”

Did the Terminator just say California could be the next Greece?

It’s not quite that dire, yet. California’s debt amounts to a tiny seven per cent of its GDP, while the economy—the eighth largest in the world—is far more diverse. The greenback, meanwhile, enjoys reserve status among world banks, giving the U.S. tremendous clout to fend off the speculators who triggered Greece’s debt crisis. And as Rosenberg points out, America has the world’s largest military and stores of gold under Fort Knox. “The day this gravitates to U.S. shores is probably further off than people think,” he says.

Perhaps. But the laws of economics still apply, even to Washington. In a blunt speech to the Council on Foreign Relations, the chief economist of Citigroup, Willem Buiter, said the U.S. must embark on a dramatic campaign of fiscal tightening, or within three years the country will lose its coveted triple-A credit rating. Last week, for a short time, the state of California even made it onto a list of the top 10 sovereign borrowers most likely to default on their debt, as compiled by CMA Sovereign Risk Monitor. It’s all left markets shaken, and looking for answers to how the crisis will play out. “What we’re seeing now is not so much fear,” says Arbess. “Fear is something that is specific and known, and includes scenarios for which investors can take a position. This is anxiety, an emotional reaction to something much, much larger, which is the eroding confidence in the whole global monetary system. It’s very hard for investors to digest, because it reaches the very foundation of the investment environment and investors have no experience with the potential outcomes.”

Canadians can be forgiven for feeling somewhat disconnected from the panic. The so-called Great Recession left all our banks standing. While unemployment rose to 8.7 per cent, it never matched the previous two recessions. Yet Canadians still have plenty to be concerned about. If Europe goes into the tank, and the U.S. recovery stalls, we won’t escape. At the same time, officials in China have warned that exports to Europe, its second largest market, are weakening. If Chinese factories close en masse, as they did in 2008, it could crush commodity prices and threaten the resource jobs that kept so many Canadians employed through the downturn.

But above all, our own finances have deteriorated badly over the last two years. In his speech, Citigroup’s Buiter singled out Canada as a country that likes to think it’s in good fiscal shape, when in fact our government debt-to-GDP ratio is a staggering 82.5 per cent. The outlook for deficits in Canada is better, but the country “should not be thumping its chest too vigorously,” Buiter said. “Today’s best of breed would have been possible entries for the ugliest dog in the world contest a couple of years ago.”

Meanwhile, Canadian households took advantage of ultra-low interest rates to pile on more mortgages, lines of credit and credit card debt than ever before. Total household debt hit $1.4 trillion last year, according to a new report from the Certified General Accountants Association of Canada. Put another way, Canadians now owe $1.44 of debt for every one dollar of income they earn, making ours the most overextended households among the top 20 developed nations. Canadian families now owe more than Americans, on that basis; even Greek households are more frugal. We’re in far worse shape should the global economy slip back into recession.

It’s happened before. Despite what many think, the Great Depression was not one long, unending misery. In the midst of the ’30s, the U.S. economy staged a remarkable recovery that lasted four years. Along the way, markets also enjoyed several rallies, one of which saw the Dow soar more than 50 per cent. So the Great Depression was in fact two depressions that history has melded into one, and the recovery in between proved too good to be true. The question now: is history about to repeat itself?