As we wait, on tenterhooks, for the US House of Representatives to vote on the Paulson bailout plan, more and more people are starting to use the word depression to describe what’s coming — sometimes with a capital D.
ANZ chief Mike Smith used it last week in Business Spectator’s KGB Interrogation when warning of the consequences of a “Nay” vote in House against the Paulson plan — which is what actually happened, leading to a 9 per cent one-day fall on the S&P 500. Some are even talking Depression whatever happens in Washington tonight, our time.
But what is a depression, apart from a word with which to frighten recalcitrant politicians?
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Recession we know about: it’s two quarters of negative growth. But depression, or even Depression? Well actually it’s just the old word for recession.
Before the mid-30s, all cyclical economic downturns were called depressions, which is why the big one in 1930-33 was called the Great Depression: all the others were just common or garden variety depressions.
In 1937-38 economists and political leaders realised that the experience of earlier that decade was so bad that the word depression must never be used again, for fear of causing widespread panic and worsening whatever cyclical downturn was going on, so they invented the word “recession”.
Later on it was agreed that the word “recession” was rather nasty and dangerous as well, so it was quite narrowly defined: two consecutive quarters of falling GDP.
International Monetary Fund economists define a global recession as average growth below 3 per cent, but for individual countries growth has to go backwards for six months. Well, most of the time at least. The US recession in 2001 involved just one quarter of contraction (by 1.5 per cent) but is defined as a recession anyway.
In recent years there has been an attempt to more clearly distinguish recessions from depressions by saying that a depression involves a contraction of 10 per cent or more, which narrows it down to just two: the Great Depression of the 1930s and the one in 1893-96. But that doesn’t seem to be an official definition.
In each of those periods, unemployment reached 25 per cent in both the United States and Australia, so perhaps that’s another way of defining it.
Both Depressions resulted from excessive debt and over-investment, just as we have seen up to 2007. In the 1800s it was largely the colonial government borrowing to invest in railways and other infrastructure, and farmers borrowing to expand into marginal land; in the 1930s there were multiple causes, but primarily it was a debt-driven boom in the 1920s, leading to a stockmarket bubble and bust, and then exacerbated by an unnecessary monetary contraction in 1930, and the 1930 Smoot-Hawley Tariff which put a clamp on trade.
In 1896 there was no central bank and in 1930 there was an incompetent one. This time around, at least, we have the Bernanke Federal Reserve, although it is generally agreed that loose US monetary policy from 2001 to 2004 under Alan Greenspan was behind the credit bubble that is now being painfully unwound.
The US is not yet in recession and GDP is not yet contracting, although most economists now either believe it’s just a matter of time or that it is in recession already and has been for a while. The only countries officially in recession are Ireland and New Zealand.
In fact, up to now all the main indicators for the US economy have been relatively better than the average of previous recessions. Research by ANZ’s Saul Eslake shows that personal income, industrial production, employment and business sales have all held up better than before previous recessions – so far at least.
But data over the past few days suggests that manufacturing in the US is in deep trouble and that car sales have fallen so much the indebted car-makers will be fortunate to survive. The collapse of one or both of General Motors and Ford would be catastrophic for confidence and the economy.
Business Spectator’s interview with Institutional Risk Analytics’ Christopher Whalen this week also raised questions about the survival Morgan Stanley and Goldman Sachs. That would also severely worsen confidence.
But would these things, or another failure by the House of Reps to pass the Paulson bailout cause the D-word to replace the R-word?
I’m not sure the bailout will make much difference in the medium to long term, although it will certainly make a difference to market volatility and confidence over the next few weeks.
We are now in a major process of deleveraging which will cause an economic contraction, along with declines in asset values. There is a worldwide capital deficit in the banking system which, one way or another, will have to be made up by taxpayers.
The previous carry trade of borrowing short, cheaply, and investing in high yielding property-backed securities and company shares has been reversed, so that financiers are being forced to recapitalise at high interest rates and invest in low yielding government bonds.
Governments are now getting the profitable carry — buying low-priced mortgage securities, funded by cheap sovereign debt.
Risk assets — specifically equities and property — have further to fall, in my view, because this deleveraging has a long way to go.
In fact the top of the Australian residential property market seems to have cracked. A friend rang yesterday to report two sales he had heard of in the past week, in Vaucluse and Potts Point, in which the houses sold for 25 per cent less than they had changed hands for a year ago. A 25 per cent fall in high-end property in Australia is entirely consistent with the clamp on bank lending and the drop in investment banking and other bonuses.
The sharemarket has fallen 33 per cent since November 1 last year — largely because of the worldwide sell-off in banks and financials.
But now the resources sector is joining in because of the clear prospect of a global recession leading to falls in commodity prices (which is already starting to happen). That will be ameliorated to some extent by the devaluation of the currency (20 per cent in three months), but that can’t be relied upon since the US dollar seems to be floating on thin air.
Recessions and depressions can only be seen after the event. But the sharemarket is a forecasting machine and so far, it seems to me, it spies with its little eye something starting with R.
Another significant leg down in share prices, any further big corporate failures in the US, and/or a big fall in property values from here, and the R will turn into a D.