The Worst May Be Yet To Come

Source : The Business Times, April 25, 2009

All in all, the economy isn't shrinking as rapidly as it was. But so what? It's still shrinking

IS THE worst over? Investors seem to think it is. Confidence that the crisis is winding down has been mounting. But the right answer to the question depends on what 'worst' is meant. Appropriate replies include: probably, yes but so what, not yet, probably not, and let's hope so.

The worst of the credit squeeze is probably over. True, loan losses are still increasing. But the official aid is massive: minimal policy interest rates, ample liquidity supplies, capital injections and implicit loan guarantees.

The aid from above has helped push dollar interbank borrowing rates down in the last six weeks. The cost of insuring against corporate failure in the credit default swap market has also fallen by 0.5-0.7 percentage points to about 1.9 and 1.6 per cent annually for the main US and European investment grade CDS indexes. Improving bank credit has contributed to this trend. Better credit all round means more loans will be refinanced, so fewer companies will go under than would otherwise be the case.

The big official liquidity push also gives investors more cash to put into the markets. The additional buying power may account for some of the sharp increase in oil and equity prices. There have also been tentative signs of revival in the junk bond and IPO markets. To some extent, the mood is following the money.

It may be due to government help or it may just be the passage of time, but another worst that has probably passed is in the pace of economic decline. The huge sudden drop in activity after the collapse of Lehman Brothers last September has already become something of a business legend. If the decline had continued at that pace, economies would be back to the Stone Age in a few decades.

It's not going to be that bad. Globally, exports are down 30 per cent since last July, according to Lombard Street Research. But the pace of decline is moderating. Similarly, US housing starts, which have declined by 75 per cent since the 2006 peak, may have reached their low.

The balance of indicators still suggests GDP is falling in most developed economies, but at a much less dramatic rate than a few months ago. When the economy is only declining at a moderate pace, some measures typically suggest that growth is returning - the much talked-about 'green shoots' - but more show further decline. That seems to the case now.

Inventories complicate the picture. A sharp decline in global demand led to an even sharper reduction of inventories as retailers and manufacturers cut back. As the inventories are rebuilt, production will most likely pick up faster than consumption.

So yes, all in all the economy isn't shrinking as rapidly as it was. But so what? It's still shrinking. On that yardstick, therefore, the worst isn't yet over.

Now look at another measure of 'worst': unemployment. Even when growth does return, recovery is likely to be anaemic. It will take time to absorb the excesses built up during the credit boom, from houses in the US to too many Chinese factories making cheap goods.

What's more, it's not as if all that private-sector debt has gone away. The rise in savings rates in the US and elsewhere isn't going to be a one-quarter wonder. This means that the peak in unemployment could easily be two years away.

And will that then be the end of the pain? Probably not. The crisis will leave government balance sheets shot to pieces. The best case scenario is that the authorities manage to suck all their fiscal and monetary stimulus out of the economy safely once economic growth has bottomed out. Then all that the world will suffer is high taxes and slow growth.
But there is a risk that this outcome proves too unpopular and that the authorities instead take the current fad for 'quantitative easing' to the extreme - and just print money to finance their deficits. The outcome would then be inflation.

An inflationary outburst might even lead to another sort of financial crisis - a loss of confidence in key currencies. That could be worse than anything seen up to now.

Can such a dire outcome be avoided? Let's hope so.