We have sensed it for a while but signs are multiplying that there is indeed a recession on the way, and it appears that the slowing of the economic growth rate is rapid. When I use such careful terms it is the consequence of the simple fact that reliable economic data releases often arrive only three months after the events, so in fact we still have only very little facts to judge the situation on.
We have received a slew of economic indicators from the US since the banking crisis broke in early September. Which is in fact quite remarkable since we are now only at the end of October. This is because US economic indicators to a higher degree than elsewhere in the world are based on what could best be characterised as opinion polls. Where many other countries have national statistical offices, tasked with collecting and treating economic data right from the sources, this is not the case in the US. Many US economic indicators are indeed based on interviews, aiming to recreate a sentiment. This is not entirely unreliable to the extent that sentiment often precedes decision making.
In the current situation, however, it makes judging the actual situation a good deal more difficult. We have been presented with 24/7 coverage of the banking crisis, in some instances it has even made its way into the sports pages (sic!). Obviously, that has made a great impression on many. When we then have that our own uncertainty a few weeks later is repackaged and presented as an economic fact, we become even more nervous.
So while there is no doubt that the banking crisis was severe, it has largely been averted, but now things are beginning to look bad in other sectors as well.
So how much is there about the economic situation as it unfolds right now – is the downturn created by TV coverage of the banking crisis?
I believe it is important to start with the fact that over the past years – since 2001 to be precise – the world has experienced a growth of credit without historical parallel. The impact has been visible everywhere, as cheap credit has been available globally, and nowhere more so than in the USA. However, the impact on people’s lives has critically depended on the way consumers and industries would have access to the credit. Probably, the consumers in USA and UK are the most “addicted” to credit, whereas a country like Germany has a tradition of financial prudence at an individual level. Not many years ago, buying a car for borrowed money in Germany would have led to a few lifted eyebrows. And in China, consumer credit is still only in its infancy.
One effect of years of easy credit is that people get used to it. It therefore begins to affect real economic allocation of money. Various investment projects get less scrutiny. For a family, often the most important investment in their lives is their home. In the good old days clearing one’s mortgage debt before retirement was considered a prudent way of approaching the investment.
But from the US evidence has appeared that many families began to consider their home as a short term investment rather than a place to live. Many began systematically to practice “equity extraction”, i.e. borrowing against the increasing price of the property, using the proceeds for spending.
With steadily increasing prices, with falling standards of verification from the lenders, with an unregulated process of selling new mortgages loans, it developed into a dangerous leveraging of the personal balance sheets of many American families. Through the increasingly integrated global economy, this spread to other countries as well.
One can shake one’s head and ask how this could continue, even as more and more indicators pointed to the simple fact that the price of residential property had long time exceeded the level where a normal family could afford to buy.
But the logic from the creditors was simple: the buyers (or borrowers) will profit from ever-increasing prices, so if they cannot afford the mortgage, they can always sell – and even make a profit out of it.
In most countries, buying a too expensive home quickly will put a squeeze on other kinds of consumption, not least because the banks and mortgage companies scrutinise the borrowers. There will simply be a stop for further credit. This also goes for the “equity extraction” loans.
In the US – and increasingly in the UK as well – the separation of credit card companies from the banks have led to a huge increase in credit financed consumption. It is not unusual for US families to have 5-6 credit cards and to roll the balance from one credit card over to a new credit card. As long as no delays are tracked in the monthly payments to each company, no red lights are set off. But at some point in time, of course this Ponzi scheme will come crashing down. We could very well be at that point in time, and the effect on US consumption more profound than understood by the market.
Irrespective of the poor quality of economic indicators from the US, there is no doubt that we are now well into a massive cleaning out of consumer’s balance sheets in that country. Finally, American consumers are coming to terms with the drying up of credit. The effect could be deeper than we currently think.
What makes the situation serious for the rest of the world is not only the fact that the US is a very large player in the world economy. It is also the fact that private consumption accounts for almost 70% of the US economy. Contrast this with Europe, where it is not unusual that public spending makes up some 50% of the economy and about 10% comes from corporate investment, leaving about 40% to private consumption. Hence, in a downturn (as well as an upturn), the US economy is very likely to see wider and faster swings than the European economies.
Add to this that the US consumer has had a zero or negative savings rate over the past years, fuelled by the easy credit.
The main problem about all this is that it often takes years to repair consumer balance sheets. My home country, Denmark, had an experience of the same kind in late 1986. It took the biblical 7 years before the economic situation had improved sufficiently for the economy to take off, and that even required some clever fiddling with the tax system to “help” consumers make the right savings decisions.
If this experience is anything to go by, there is no chance that the US recession will be a short-lived experience. Rules have changed for mortgage credits, property prices are dropping, pension plans are reduced in value, credit cards will be harder to come by. Car finance will not be as readily available.
My guess is that sorting out this situation will take all of Obama’s first election period. It may even cost him reelection. As a consequence rest of the world will experience a period of slower growth. I am afraid we are only at the beginning. The economic indicators will come in and show that this is more than just a feeling.
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