The first step to recovery

The free fall is over, but the comeback will be like nothing we’ve seen before

The first step to recoveryAs Christina Romer settled in to provide the latest economic update for U.S. lawmakers last week, they no doubt braced for another round of brutally frank and frankly chilling discussion on the state of the world’s most powerful engine of wealth. Despite Romer’s clout within President Barack Obama’s inner circle—shortly after the election he asked the Berkeley economics professor and expert on the Great Depression to chart America’s path to recovery—few outside of Beltway policy wonks and Wall Street economists knew much about her. On the surface, her comments seemed to reinforce the grim outlook that’s become so pervasive since the economy went into free fall last autumn. “I’m sorry to say, but in the short run, we are still in for more bad news,” she told the committee members. “We expect to see continued declines in employment and rises in unemployment.” Then came a rare yet welcome but. “We are beginning to see glimmers of hope that the economy is stabilizing.”

Romer’s tone was hardly exuberant, but her comments stood in stark contrast to the utter despair that was de rigueur just weeks ago. What’s more, she’s been joined by a host of sage old voices of the American economy, who together are offering a more reassuring, if cautious, message to the world: we’re not out of the crisis yet, but the worst seems to be behind us. Paul Volcker, the 81-year-old former chairman of the Federal Reserve and the head of Obama’s economic recovery advisory board, last week said the downturn is “levelling off” even if the U.S. economy remains in “intensive care.” Then, over the weekend at the annual Berkshire Hathaway annual meeting in Omaha, Neb., the company’s legendary founder and CEO Warren Buffett tried out another metaphor to convey his sense of cautious optimism. “Our economy, back in September, was like finding a friend of yours in quicksand up to his chest and he’s going down,” Buffett said. The rescue attempt has been painful but necessary. “The important thing was to get out of the quicksand, and we got out.”

That anyone is talking this way about America’s fortunes is remarkable. It was only two months ago that the word “depression” seemed to be on everyone’s lips. Some pundits even predicted that bloody wars would soon break out between collapsing nations, or that rioters would run wild in the streets of America. An overwhelming sense of declinism took hold as investors, companies and workers grappled with staggering losses. As Nouriel “Dr. Doom” Roubini, a professor of economics at New York University, and one of the first observers to accurately predict the financial crisis, famously wrote last November: “The decline of the American Empire has started.”

Or so it seemed. Lately, such anxieties have been drowned out by the roar of the markets. Over the past two months, major stock indices, such as the Dow Jones Industrial Average and Canada’s S&P/TSX composite, have steadily clawed their way back, rising as much as 35 per cent from their lowest points in March. Six months ago investors seized on any news, even when it was relatively positive, as a reason to flee the markets. Now, they’re running back with the same determination. At a time of deepening fears of a flu pandemic, worries over the financial viability of America’s biggest banks and even Chrysler’s bankruptcy, markets surged. The rally has already defied analyst expectations, and in the eyes of even some optimists, the laws of gravity. Many expect that some sort of pullback is inevitable. But even if stocks lose their upward momentum, it won’t necessarily change the view of those who believe the wider economy has turned a corner. No one is saying we’re in recovery mode yet, or even that the North American economy has stopped shrinking. But what many experts are sensing is that after the destruction of some US$50 trillion to US$70 trillion of global wealth, and the loss of millions of jobs, we’ve already endured the brunt of the bad news. “We’ve definitely seen signs that the worst is now behind us,” says Ian Nakamoto, the director of research at fund manager MacDougall, MacDougall & MacTier. “Now it’s time to begin the slow healing process. It’s like an athlete who gets injured. The injury can happen in a split second, but it can take years to heal.”

Which leads to two questions that, until recently, seemed foolish to even consider: what will a recovery look like? And what kind of economy will we have after the Great Recession has run its course?

To say it’s been hard to get a clear picture of where the economy is headed is a huge understatement. Since the downturn kicked into high gear last fall, with the collapse of some of the world’s largest financial institutions and the ensuing credit crunch, economists have been wading through a slew of numbers for any hint of when we might hit bottom. For months, those searches turned up signals that were nothing short of grim. Since the official start of the U.S. recession in December 2007, a staggering 5.7 million people have been thrown out of work. In Canada, where unemployment has hit eight per cent, some 357,000 jobs have been lost since October. At the same time, the economy has shrunk at an alarming rate. In the U.S., in the first quarter, GDP plunged by 6.1 per cent on an annualized basis. It was the first time since 1975 the country’s economy has shrunk three quarters in a row, all but assuring that this will be the worst economic decline since the 1930s. The Bank of Canada recently estimated that Canada’s economy contracted at a jaw-dropping annualized rate of 7.3 per cent in the first three months of the year.

With figures like these dominating the headlines, it has often felt like there was no bottom to find. Yet, in the arcane corners of the economy, hidden from most consumers, signs of hope have begun to emerge. Many are the types of stats that only economists can get excited about. For instance, Robert Gordon, a professor of economics at Northwestern University, recently declared the economy will reach its lowest level this month or next. He based his analysis on a historical link he’d uncovered between unemployment insurance claims and past economic cycles. Some have taken solace in China’s purchasing managers index, which showed marked improvements in April. The Federal Reserve Bank of Chicago’s own National Activity Index, a basket of 85 economic indicators in the U.S., hit bottom in January, notes Paul Kasriel, an economist at Northern Trust, who was among the first to predict the global recession. Others still read the U.S. Commerce Department’s latest release—the one with the stunning 6.1 per cent decline in GDP—and found good news in the fact inventories at companies have plunged, suggesting they may soon need to ramp up production to eventually restock warehouses. These are the “green shoots” so many analysts have talked about lately, the first signs of life after an economic winter.

But if you really want to understand why economists are suddenly smiling again, it comes down to two very important shifts in the U.S. economy. One has to do with the housing sector. It was America’s torrid love affair with real estate that got the country into this mess, so analysts have been closely watching for signs of life amid the ruins. Until recently, all they found was misery. In February, the S&P Case Shiller index, which tracks house prices in America’s largest urban centres, was down 18.6 per cent from the year before, and more than 30 per cent from its peak in May 2006. It’s gotten so bad that in some parts of the U.S. banks are opting to tear down newly built homes rather than pay property taxes and liability insurance on homes that can’t be sold. In Victorville, Calif., where city officials have begun levelling hefty fines against unfinished real estate projects, a Texas bank that owns 16 homes there has hired a demolition crew to knock them down. The good news is that with prices now returning to some semblance of normalcy, and with mortgage rates at record lows, buyers are tip-toeing back into the market. In several hard-hit markets in California, Nevada and Florida, house sales are up between 35 and 45 per cent, albeit from extremely low levels. This week the National Association of Realtors said pending sales of existing homes across the U.S. inched up from February to March—the second-straight monthly rise. “We need to see the housing market really bottom before we can see positive growth in the U.S., and that’s beginning,” says Sherry Cooper, chief economist at BMO Capital Markets.

In the same way house prices collapsed, the psyche of the all-important American consumer also cratered this past winter. Rising gas prices last year already had commuters feeling anxious about their prospects when the collapse of Lehman Brothers sent America into a deep funk. Mounting layoffs only made things worse, eroding confidence to levels not seen in three decades. This is crucial, because consumers account for 70 per cent of the U.S. economy, and it didn’t take long for their waning confidence to be reflected in empty shopping malls and car lots. Several big name retailers such as Circuit City and Linens N’ Things, their aisles empty of customers, have gone bust. And as Americans reined in their spending, it sent waves of economic damage around the world—from Canada’s auto plants and oil wells to China’s bustling factories, no one is exempt from the reckoning.

But just as analysts were ready to write off the American shopper, with some observers declaring an end to everything from consumerism to globalization, the urge to buy has lured them back. Last week, the U.S. Commerce Department said consumer spending rose 2.2 per cent in the first quarter of the year, ending the longest slump in 30 years. The unexpected consumer recovery has yielded more than a few pleasant surprises. For example, when glass maker Corning Inc. reported better-than-expected first quarter results at the end of April, it attributed the success to a rebound in demand for flat-screen TVs. There’s no question consumers’ moods have brightened. The Conference Board’s index of consumer confidence shot up in April to 39.2, from 26.9 in March. That puts confidence levels back where they were before Lehman collapsed last fall. No doubt the dramatic rise in stock prices has fuelled much of rebound. And the consumer psyche is undeniably fragile. But economists believe the shift shows consumers have stepped back from the ledge. “When you’re living through a downturn and everyone is talking about a depression, it always feels like it will end in calamity,” say Ed Yardeni, chief investment strategist at Yardeni Research. “What we’re learning here is that the business cycle is alive and well. Booms are followed by busts, and busts are followed by booms. This recovery will just be slower than in the past.”

Just as the start of the recession played out like a cruel game of dominoes—first the subprime mortgage sector collapsed, toppling the housing market, then the banks, consumer spending and employment—a recovery will require all the pieces to be put back in place more or less simultaneously. But what will that recovery look like? For one thing, economists and forecasters are all over the map as to when a rebound might actually begin. While the consensus among economists is for growth to inch back up as early as the third quarter, Cooper at BMO Capital and Kasriel at Northern Trust both believe it won’t happen until near the end of the year. That’s a forecast also shared by central bankers in both Canada and the U.S., where interest rates have been slashed to near zero. Bank of Canada governor Mark Carney believes the recovery will begin later this year, and reach “full force” in 2010, though economists say any talk of a true recovery in Canada is moot until the U.S. gets back on its feet. On the other end of the spectrum, pessimists like Roubini don’t believe we’ll see any sign of growth until well into 2010. But almost everyone agrees on one thing: this recovery, even after the economy starts to grow again, won’t feel like much to celebrate.

We’ve seen this lag in sentiment before. The most recent recession in Canada lasted from April 1990 to April 1992. Yet as late as 1994 many Canadians were convinced the country was still trapped in a downturn. Long after the recession had officially passed, headlines in the financial press continued to ask: “Is the recession finally ending?” Given the depths of this downturn, it will take even longer to shake off the after-effects. Kasriel expects this recovery will last longer than any since the Second World War.

One big reason is that even after the recession is officially declared over and GDP begins to grow again, unemployment is likely to continue to rise for several quarters. That’s been the pattern in almost every past downturn. And this time, with 18 cities in the U.S. already suffering from unemployment in excess of 15 per cent, it will seem even worse. Several industries, such as the auto sector, media and finance, will have shrunk dramatically. For instance, even if Chrysler and GM manage to get back on their feet, analysts say thousands of automotive jobs will have vanished permanently. Companies aren’t likely to go on a hiring spree until they’re certain the recovery is for real, says Nakamoto. “No company wants to go through the process of layoffs again,” he says. “There’s going to be a great deal of hesitancy to rehire people.” For this reason many forecasters expect unemployment to continue to rise well into next year. Roubini argues the unemployment rate in the U.S. will hit at least 11 per cent before falling, up from 8.5 per cent now. Likewise, TD Economics expects unemployment in Canada to keep climbing to 10 per cent (up from eight per cent in March) even after GDP returns to growth later this year.

Nor does anyone expect a quick and speedy fix to America’s housing problems. There is a huge number of unsold McMansions collecting dust in American suburbs, and many homeowners are underwater on their homes, meaning their mortgages are greater than the value of their property. By one estimate, 7.6 million mortgage holders in the U.S. are more than five per cent underwater thanks to falling house prices. Yardeni says it could take up to five years to work out all of the problems in the housing sector. “It’s going to take a long time to unwind the excesses of the housing bubble,” he says. “Growth will have to come from other sectors.”

Despite the early signs of life economists have detected in the retail sector, few expect shoppers to return to the go-go days of 2006. Without the wealth effect of soaring house prices, Americans will feel a lot poorer, less able to take on debt and less willing to spend to maintain elaborate lifestyles. This isn’t necessarily a bad thing, according to Peter Schiff, an economist at Euro Pacific Capital who has warned for years that the American consumer is drowning in debt. “The economy will not find a solid foundation unless consumers decide to live within their means,” he said recently.

That’s a message that many Americans seem to have finally begun to heed—they’ve put a modest dent in their staggering debt loads over the past few months. In February, total consumer debt stood at US$2.56 trillion, a drop of US$30 billion since the start of the year, according to the U.S. Federal Reserve. Part of that decline was due to mortgage foreclosures, but also the fact that people have been paying down their lines of credit and credit cards. If Americans keep up the pace, they’ll have paid off 9.7 per cent of their revolving credit lines by the end of the year. So while it’s encouraging to see American consumers relearning how to manage their chequebooks, their new-found sense of frugality is an impediment to the recovery. “I do not think there are grounds for great optimism,” Volcker said recently. “It is going to take a while, I think, to have a strong recovery.”

If you think of the global economy as a patient that has suffered a serious accident, it’s safe to say it has stabilized. It’s breathing on its own, communicating, and starting to move its limbs. But as with all complex recoveries, the risk of a serious setback is very real. There’s as much that could go wrong with this recovery as there are hypothetical green shoots poking their way out of the ground. There are serious concerns the rising unemployment levels could lead to a fresh round of foreclosures. Meanwhile, some economists worry about what will happen if the stock markets suddenly catch a chill, again, and plunge to new depths. The consumer psyche has been pummelled, and another serious drop would quickly open up old wounds. In short, the recovery is off to a very shaky start. On top of all this, fears of inflation are once again gaining ground. Governments around the world have pumped trillions of dollars into the global economy to get it off of life support. The fear is such massive stimulus spending could cause inflation to quickly get out of hand. “There are still significant downside risks,” Roubini wrote recently. “While optimists speak about green shoots there are still plenty of yellow weeds.”

But even if none of that happens, the most significant change in all of this may revolve around our understanding of what a healthy economy looks like. Think of it this way. If the pre-credit crunch economy was built on “false financial innovation, excess leverage and rock-bottom risk assumptions,” as Eric Lascelles, chief economics and rates strategist at TD Securities in Toronto, wrote recently, all three legs of that stool have been sawed off. What then will the “new normal,” as Lascelles and others have called it, look like?

Everyone, it seems, has an opinion. U.S. Treasury Secretary Timothy Geithner recently described how he envisions the new normal. “When we get through this, people are going to care a lot less about what they make, more about what they do [and] what they achieve with what they make,” he said. “That will help make this country stronger.” In a similar utopian vein, Jeffrey Sachs, the economist and director of the Earth Institute at Columbia University, believes the post-recovery U.S. will enjoy “a renewed sense of fairness.” Others have gone further in predicting dramatic changes. In a March report, analysts at Citigroup said the U.S. has behaved like a leveraged hedge fund for decades, but that has come to an end. “Not only is the lifestyle and wealth creation likely to be unsustainable going forward but if you believe, as we do, that we have been operating in a ‘leveraged’ economy, then the new normal in terms of economic data, profitability of companies etc. may be a shadow of the past.”

Yardeni has heard all of this before, and more. He’s seen the U.S. economy rebound from enough crises to know it would be foolish to count it out this time. Yet he too sees huge changes afoot. Two things seem certain, he says. With the recovery likely to be led by China and India, the global balance of power is shifting. At the same time, both in America and abroad, government is likely to play a much bigger role in the economy than it has in 30 years.

Who can say, of course. Only a handful of economists accurately predicted this crisis, and it’s likely few will prove accurate in their predictions of what the patient will look like when it’s discharged from hospital. For now, most are happy just to hear a heartbeat.


“Our economy, back in September, was like finding a friend in quicksand up to his chest and he’s going down. The important thing was to get out of the quicksand, and we got out.” —Warren Buffett, founder and CEO, Berkshire Hathaway


Bull run North America’s stock markets hit a bottom in early March, and have staged an astonishing comeback over the past eight weeks. Canadian stocks have rallied by more than 30 per cent, while the Dow Jones Industrial Average has jumped by 25 per cent. The question: is this the start of a sustained bull market, or just a temporary reprieve?

Bull run

The confidence game The sudden upturn in stock markets, combined with the recent stabilization of various economic indicators, has driven a turnaround in consumer confidence over the past two months despite continued job losses. The hope is that retail sales and investment will follow, reversing the vicious cycle of the past year.

The confidence game

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