Recession, recession, everywhere we turn, we are reminded of this dreaded scenario. For those who are still shy to utter the word “recession,” let’s not kid ourselves anymore. The earlier we face up to the truth, the faster we are on the road to economic recovery.
The week actually didn’t start off with a pall. On Monday, the bulls came charging back in Asian and European stock markets after China announced a $586 billion plan to stimulate its economy and leaders from the Group of 20 nations urged more cuts in interest rates and increase in spending. Sadly, the excitement lasted all of one day.
US stock market was consistent in its gloom. Stocks fell Wednesday for the third session in a row, with the Dow Jones tumbling over 400 points. In 3 days, we saw a 661 point drop, a strong testament of how recession fears have shaken investors. The CBOE Volatility (VIX) index reflected market jitters when it rose 8.2% to close at 66.5 – its highest level since Oct. 29.
The barrage of bad corporate news is overwhelming – huge losses (Fannie Mae and AIG), 300,000 job loss forecast and a distinct possibility of General Motors following the footsteps of Circuit City in seeking Chapter 11 protection.
US October car sales was down 32% from the previous year and GM attributed their hardships to “tight credit, rising unemployment, declining incomes, falling stock markets and deterioration in the housing market which resulted in an “abrupt halt” in consumer spending.” This situation is typical of most businesses at the moment.
I believe a strong dose of Keynesian medicine is needed to revive the global economy and stem rising unemployment. The economy spirals downwards when businesses and consumers expect prices and wages to fall. People are naturally inclined to hoard money in difficult times but a vicious cycle develops as times become even more difficult when people hoard money.
If the situation goes unchecked, governments will then have to deal with a monster known as deflation which is a general drop in prices. In such a climate, cash is king as falling prices made our money more valuable. There is an incentive to hoard cash as people await prices to fall further and they can buy more for the same dollar. The overall effect on the GDP is dire and those who took on huge debts will suffer the most.
In a high inflationary environment, we are paying for debts with money which is devaluing fast. It makes financial sense to invest in housing or for that matter, anything which appreciates in value, but the reverse is true in deflation. You can read in greater detail the effects of deflation in this book – Cycles of Inflation and Deflation: Money, Debt, and the 1990s.
Deflation was the malaise which plagued Japan after the burst of its housing bubble and banking bad debts and it is a text book lesson for governments who waited too long to take action. When everybody hesitates to make huge purchases or investments, oversupply naturally occurs which force businesses into a price war to attract consumers. Waiting for the market to absorb the extra inventories and self-correct this phenomenon may take years or even a decade, assuming the worst.
Keynes states that if individuals refuse to spend regardless of how much the government expands its money supply, then the government should simply take the lead and spend. Keynes famously described this final government effort to reestablish the circular flow of money as “priming the pump” of the economy.
Keynes’s theories have been accused of being “too simple” but they have withstood the test of time. He encouraged governments to invest in infrastructure or put more money into the hands of consumers by reducing interest rates. A multiplier effect happens when the initial stimulation of capital is injected into the economy. This in turn sparks more production, investment and savings and the total increase in economic activity will be a multiple of the original investment.
According to Keynes, in a recession, there is no evil in budget deficits. Conversely, to suppress inflation in boom times, governments should increase taxes or cut back on outlays. Government outlays need not be wasteful, ie. printing and throwing money around just for the sake of doing it. Focusing on areas like research, public health, education, and infrastructure boost the private sector as well as allow the government to reap the rewards when boom time is back.
I am actually glad that China, as the world’s fourth-largest economy, is taking a pro-active step of stimulating its economy and softening the effects of recession. Much of the stimulus will go into infrastructure spending, tax deductions and farming subsidies. Its central bank has already cut interest rates three times in two months, joining policy makers from US, UK, Japan and India in efforts to lower borrowing costs and inject cash to avoid recession.
Investors are not reacting well to this stimulus but patience is necessary. There will be a time lapse before the economy feels the beneficial effects of increased government spending. On paper, this is definitely a step in the right direction.
Personally, I am concerned that the current economic slowdown hampered the construction and research of clean energy facilities. The financial reality is that it is no longer cost effective to substitute oil with other resources, now that the oil prices has dipped below $60.
However, let’s be mindful that oil may reach $200 in 2030, as postulated by the International Energy Agency. China will be guzzling lots of oil as more of its citizens discard their trusty bicycles for cars every year. Thus, in the long term, the country which is ready with alternative energies and reduce its reliance on oil will enjoy a very strong competitive advantage.
Oil at $200 is uncharted territory and will force drastic changes on the economic landscape. Only the very rich or oil producing nations can enjoy the luxury of oil usage, for the poorer nations.. I dread to think about the outcome of inequitable distribution.
Currently, the good news is that credit squeeze has eased compared to a month ago. However, the financial sector has not stabilized fully with credit card debts being a big worry. The US Treasury is keen to allocate a substantial portion of the $700 billion bailout to credit card and auto loan debts, now that it has forgo the idea of purchasing toxic assets from financial institutions.
How will the Treasury implement the shift in emphasis of their bailout? Seriously, I doubt if Paulson or Bernanke have a clear idea either. Anyway, that is for another discussion. As a parting shot, for those who have the means, remember to do your part for the economy and spend. Till tommorrow.