Should we be optimistic?

I have had a lot of other things on my plate and haven’t been able to write as regularly as I would like. But I am going to try to increase the volume of posts by putting out more quick hits like this one that capture my macro view without a specific topic behind it because I was thinking about this question this morning and felt that I had something of value to write.

The question is about where we are headed next. Right now, you continue to hear headlines about Spain and their needing a bailout, about Greece and their needing one, about a double dip in the UK and the fiscal cliff in the US and so on. On the other hand, in the US, the housing market has perked up and in Ireland, the country has returned to growth and the capital markets. At the same time, we have over 25% unemployment in Spain, with Greece just behind. Unemployment is still dangerously high in Portugal and Ireland too. And in the US, the same is also true, the reason the Fed has decided to maintain its ultra easy monetary policy.

So, the data aren’t really clear. If you just step back and look at the data as a whole, you have to think that they are incredibly weak given the fact that this is a crisis which legitimately began 5 years ago in August of 2007. That tells you this is a macro environment of a different caliber than the ones we have had in the past. But knowing this still doesn’t answer the forward-looking question of whether we should be optimistic.

So, let me answer the question with another question then. Why is this downturn so different? What sets it apart from the others? I think this is the question people are really grappling with. In a garden-variety downturn, you turn on the stimulus taps and the problems correct themselves. Usually, it’s a case of inventory builds getting out of hand and business correcting this with the attendant spillover into unemployment, business bankruptcies and so on. That’s classic business cycle stuff irrespective of whether the central bank plays a role in creating the boom or the bust. But this recession is not like that.

As I was searching in my archives for what I said in the past on this topic, I came across this post: “Inexact but telling comparisons to the Great Depression” and I thought it represented what I wanted to say here well so I’ll quote a few lines from it:

For me, it is the Great Depression where I see the greatest lessons for us today, particularly given the parallels in complacency today and that witnessed in 1930 and 1931. So let me say a few words about where I think we are in this crisis and what this should mean to policy makers and citizens alike.

When I first wrote about what was then an impending credit crisis in March 2008, I spoke of its roots being in the accumulation of high private sector debt burdens due to easy money. What has become clear since that time is the level of fraud that also occurred due to the lax regulatory environment. So, in many ways, the pre-conditions of this crisis were very similar to those that created the great depression (low interest rates, high private sector debt, globalization, large current account imbalances, speculative mania, a financialized economy, lax regulation, cronyism and fraud).

What we are now being told is that the response in this particular downturn has been very aggressive and all-encompassing across the globe. The result, we are told is that we are out of the woods economically.

But, is that really true? I would agree that we have averted the worst. However, I would argue that the global economy is still so fragile that complacency still risks a catastrophic outcome. 

I could have written those words today! Here’s what I found telling though:

These are the first paragraphs of Michael Hudson’s latest missive “The Coming European Debt Wars.” Quite frankly, I do not think his language is hyperbolic. The Europeans need to confront these issues. We are facing a sovereign debt crisis. There are many ticking debt bombs beyond Greece. And we are way too complacent about it.

The European sovereign debt crisis has proved much worse than many believed as I anticipated. And I think the reason I got it and others were complacent is that I was making comparisons to the Great Depression and they were not. The real comparison is the private debt in my view. This is what got me to thinking about this topic. I remember coming to New York City in 1990 and seeing a city crushed by a real estate and financial bust. The way I remember it now – back then I was having to good a time to think of it this way – is as a period of serious economic upheaval in that city with banks and property developers nearly going bust everywhere. Citibank teetered on the brink of collapse. And Alan Greenspan turned on the Fed’s turbo boosters by cutting rates and leaving them low for a really long time. I always ask myself what’s different about today than 1990 and why should I make a comparison to 1929 rather than 1990?

So here are my quick thoughts on that:

1. The downturn was global in nature instead of more localized in the early 1990s. You had downturns across Europe, in Japan, ANZ, and in North America. It was a global bust.
2. There was a housing crisis then too. As I mentioned, the US had a bust in places like NYC, San Diego, and Boston. It wasn’t a national bust but it was a pretty serious bust nonetheless.
3. The early 1990s saw a severe banking crisis as well. In the US, Citibank almost went bust. The S&L crisis was a complete fiasco and terrifying to many at the time as we saw bank runs for the first time since the Great Depression. And all of Scandinavia had a banking crisis due to their property bubble.

So the quick and dirty analysis here says this crisis isn’t all that different than 1990. The difference is the severity and the policy tools available.

1. Household debt levels are much higher everywhere.
2. Policy rates are much lower everywhere
3. Government debt levels are much higher everywhere, in part due to the severity of the crisis and the bailouts

So, to me this says that 1990 was a mini-1929, whereas what we are living through now is a much more similar episode. And the reasons for that are entirely in terms of the severity of the private sector debt levels and the limited policy tools available. What this analysis also says is that this debt crisis has been building across business cycles for a long while. It was 22 years ago that we saw this 1990 bust. And we saw a similar episode 29 years ago in 1973 that I don’t remember from actually living through it since  was too young at the time.

My conclusion: systemic crises and depressions  are not borne out of out of the blue whocouldanode type of events that should catch people by surprise. They are borne out of a cycle of rising debt and reduced policy space that is part and parcel of fighting cyclical recessions with stimulus. It is because we fought the previous recessions so vigorously and allowed debt to rise and policy space to contract that we are in the bind we are in now.

So, the crisis today is big for two reasons. First, not every downturn is global and encompasses large scale property and loan losses. This one is, as was the one in 1973 and in 1990. Second, debt levels are exceedingly high and policy space is reduced, meaning that the normal cyclical tools used to fight the crisis are less effective. In a nutshell, we have hit peak debt in the private sector.

Should we be optimistic? I’d like to be. Wouldn’t you? I think what I have just written says that this recession is a more severe case of two similar crises from which we have recovered in the past 40 years. So, that’s the reason to be optimistic. The reason to have caution however is that this is clearly a more severe crisis. than those other two and I believe that means we are in a situation more akin to the Great Depression in economic terms. It is the psychology of Depression and economic nationalism that then become the prevailing problems because they lead to an ‘us versus them’ mentality as the pie shrinks.

I hope this essay answers the question. I like to be optimistic and I think there is reason to be. But I think this crisis is too severe to just be optimistic. I wouldn’t even say I am cautiously optimistic. I think we have a long slog ahead of us because the traditional policy options are so limited. And from what I have seen, most policy makers are still unaware of the nature of this crisis and its causes. That is going to make resolution much harder.