Like all dreamers, US policy makers have very often confused disenchantment with truth. The inconvenient truth in financial markets today is that the US is already in recession.
The turmoil in the credit and housing markets is prominent. This has crept into the real economy, visible through the weakening labour market and the increasingly vulnerable consumer. Compounding this is the fact that borrowers are the furthest behind on their debt payments in 15 years.
Even the Fed chairman, mentioned the “R” word as a possibility, only to have the IMF vindicate this “as the result of mutually reinforcing cycles in the housing and financial markets”. So it’s now crystal clear, that the US, the epicentre of economic woes, and the global economy, is in a recession.
In its economic evolutionary process, the boom bust cycles in the US have been unprecedented in terms of volatility in the prices of commodities, currencies, real estate and stocks, and the frequency and severity of financial crises.
Although all crises have been different, many have shared common features. They begin with capital inflows from foreigners seduced by tales of an economic El Dorado. This generates low real interest rates and a widening current account deficit, domestic borrowing and spending surge, particularly investment in property.
Asset prices soar, borrowing increases and the capital inflow grows. Finally, the bubble bursts, capital floods out and the banking system, burdened with mountains of bad debt, implodes.
With variations, this story has been repeated time and again. It has been particularly common in emerging economies. But it is also familiar to those who have followed the US economy in the last 8 years.
When bubbles burst, asset prices decline, net worth of non-financial borrowers shrinks and both illiquidity and insolvency emerge in the financial system. Credit growth slows, or even goes negative, and spending, particularly on investment, weakens. Most crisis-hit emerging economies experienced huge recessions and a tidal wave of insolvencies. Will the US economy sustain itself?
The labour market doesn’t think so. March non-farm payrolls declined by 80,000 – bringing the total number of jobs losses in the first three months of this year to 232,000, while unemployment rose to 5.1%.
Job cuts were concentrated in manufacturing, employment services and the construction industry but the damage is becoming more widespread. The spread of labour market weakness bolsters the case for a recession this year.
Financial companies also cut jobs as the effects of record losses in the banking industry began to be felt. US commercial banks alone are forecast to cut about 200,000 jobs over the next 12-18 months.
Meanwhile, growth in the US services sector, which represents about 80% of the total economy, almost stalled, with only 13,000 positions created last month. On these base numbers, the US unemployment rate could potentially balloon to 8% in 2009.
Exacerbating this is the expectation that in 2008, asset-backed security woes will migrate to commercial property and other loans, perpetuating even larger credit write-downs.
Globally, central banks have also started to fear credit deflation whilst ignoring price inflation, which could see the brewing of a “perfect storm” for recessionary conditions on a global scale.
Total credit losses of US$1,400bil will cause a contraction in world GDP of 2.5%, or half the present rate of global growth. So, the global economy now looks a dull shade of grey, in a dreary world of semi-recession and sticky inflation that will last a long time.
Monetary policy has also not cured the dilemma that has plagued US markets since the credit squeeze took hold last summer. Interest rate cuts are far less effective in forestalling economic slowdown this time round than in 2001/02, given rising uncertainty and counterparty risk, uncertainty over accuracy of asset prices and financial institutions’ own exposure and liabilities, and household wealth elasticity of spending overwhelms interest elasticity of demand.
Policy measures have thus far been ad hoc and reactive. A more concerted effort on disseminating fiscal spending, its target sectors, and timelines will serve to boost confidence especially through fiscal measures that offer the prospect of boosting growth against a prolonged downturn.
Absent government intervention in utilising fiscal discretion will continue to see the bleak economic mood prevail. For now, the US economy needs a stabilising force, a force which monetary policy alone cannot deliver.
Today’s credit crisis is far more than a symptom of a defective US financial system. It is a symptom of an unbalanced global economy. The knock-on effects from a global confidence crisis and risk aversion remain a clear and present threat to global markets.
The author is group chief economist at Kuwait Finance House. KFH is one of the world’s largest Islamic banks and the first with an economic and investment research arm, KFH Research Ltd.
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