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Recession roundup: how bad will it be?

How big is the risk of global deflation?

Wolfgang Münchau asks the question in Monday’s FT, with a mind, perhaps, to settling a broader debate only recently engaged. Now that the dust has all but settled on a recessionary reality for 2008, the question is, how deep will it be?

Perma-bears, notably Nouriel Roubini, are questing back to the 1930s. And some bank analysts too have raised the possibility of a second “Great Depression”.

For Münchau though, a depression and the severe deflationary environment it would involve is unlikely.

If a debt crisis coincides with severe deflation, the value of outstanding debt rises even as debt gets repaid. While all this is happening, central banks are constrained in their ability to stimulate the economy by the zero nominal interest rate bind.

But it is important to remember that these destructive mechanisms do not kick in the minute the officially recorded rate of inflation falls a fraction below zero. The deflation we fear is a large slump in the price level and a permanent shift in price expectations. During the Great Depression, the US wholesale price index fell by 33 per cent. Such a price fall is not likely in our globalised economy.

It’s also, of course, a scenario central banks will act most strongly to avoid. Thus perhaps, the alacrity with which interest rates have been cut.

And with those cuts, of course, market hopes that the recession won’t be too bad.

But a bearish consensus is emerging slightly beyond what the market is hoping for. Notwithstanding a bear-market rally, even Teun Draaisma at Morgan Stanley sees a recession running through to 2009.

The likelihood of a such middling recession is also born out in a recent Harvard paper, by Carmen Reinhart and Kenneth Rogoff - available here. In their analysis, the US recession will certainly be worse than 1990 or 2001, but not quite, perhaps as catastrophic as 1930. As Paul Krugman of the NYT comments:

On one side, the bursting of the housing bubble is playing the role that the bursting of the dot-com bubble played in 2001. On the other, the subprime crisis is creating a credit crunch reminiscent of the crunch after the savings-and-loan crisis of the late 1980s, which led to recession in 1990.

All of this, of course, is for now, academic.

Tony Jackson writes in Monday’s FT, the current behaviour in the markets is still dominated by a “new phase of global apprehension”. Apprehension perhaps fuelled by the fact that so many variables differ from previous historical examples.

Peter Bernstein, another heavyweight market watcher, goes as far as to suggest we are in an utterly unique situation - a somewhat ahistorical macro-economic environment arisen since we broke the back of inflation in the last decade.

When you look back over history I dont think there’s anything like this…  the bad news grew out of too much good news. From 1982 - going that far back - once we broke the back of inflation, the economy got stronger and stronger, inflation anxieties diminished and the world knitted itself together: central banks seemed to have everything under control. Within the system itself, over an extended period of time, we had a gradual –valid — reduction in sense of risk, and therefore you could take bigger risks.

Finally, even if the recession does prove to be shallow and short - and here’s hoping - then as Münchau points out, we may not be totally out of the woods. With 10-year T-bills currently yielding just 3.7 per cent, a much longer recession has been priced. If it’s over too quickly, those yields may spike - to 6 or 7 per cent.

The price of avoiding deflation, may be a bond market meltdown.

This entry was posted by Sam Jones on Monday, February 11th, 2008 at 9:52 and is filed under Capital markets. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.

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Comments

  1. Feb 12   10:33 Posted by jan andreassen [report]

    Depression? Isn’t this pretty much how one should expect a period of consolidation in debt laden economies to play out. Debt burdens will gradually decline and savings rates increase until a new more robust equlibrium in the capital markets is found. Housing affordability should normalise over the next few eyars.

  2. Feb 11   14:00 Posted by Anonymous [report]

    Labeling Nouriel Roubini a “perma-bear” is really beneath the FT and taking a page from the blithering idiots on the cable business networks here in the U.S.

    He has called the shots better than just about anyone else over the last couple years. People like you lift the references to the Great Depression and leave off the detailed analysis.

    Your blog entries are peppered with long quotes and glib asides, his are often ten pages long. He deserves a little more respect than that.

  3. Feb 11   11:11 Posted by pegnu [report]

    The fact that serious commentators are now talking about the possibility of a Great Depression should worry people.

    His main argument seems to be that the US will be rescued by high productivity growth which seems slightly dubious.

    Also he argues that lower interest rates are ineffective in preventing “a large-scale financial meltdown” which he says could result in a Depression.

    quote: “But surely, lower central bank interest rates today could neither prevent such a scenario from happening, nor provide any comfort to an economy when it has no physical access to credit.”

    then says:

    quote:”Last week, 10-year US Treasuries bonds yielded a mere 3.7 per cent, […].
    In the event that the US recession turns out to be unexpectedly shallow and short (not very probable in my view, but vastly more probable than a deflationary depression), yields may well shoot up to 6 or 7 per cent. So the “price” for avoiding deflation may be a bond market meltdown, your quintessential financial crisis.”

    But does not seem to give any mechanism by which we can restart inflation other than the fact the situation is “different” in some regards from 1990s Japan and 1930s US.

    One wonders if the author is writing this piece to introduce the possibility of a Depression to readers in a more palatable form with his sole argument against it being “productivity growth” which I can’t really understand as an argument because surely there was great productivity growth in the 1910s, and 1920s with the innovation of production lines, etc.

  4. Feb 11   11:03 Posted by Graham Cox [report]

    Bernstein is correct. This experience is unique, and constant comparison in the broadsheets and broker research to past cycles is clouding analytical judgment which needs to be focussed on the drivers and dynamics of this event.

    Just as past cycle navel-gazing in dangerous, so too is any decision based on economic models. They rely on parameters generated from examining past events and if there are new factors , the model won’t have them in other than in the form of guesswork. Specifically in this case, the missing factor is the existence and rapid build-up on a massive scale of new types of mortgage loans that are unprecedented both in that they are
    1) entirely dependant on house price inflation for borrowers to have the ability or willingness to service them over time directly or through re-financing and
    2) many if the mortgage debt holders are too remote to be capable of adjusting terms

    Although the general credit binge and lousy regulation set the stage for current events and subsequent economic interactions are spreading weakness, the catalyst was and lead driver remains US sub- prime foreclosures. Like a black hole, they will continue to suck energy out of the US economy through a vicious downward interaction with real estate prices.

    This may only stop at the point at which the fall in prices in the cheaper housing sectors drive rental yields up to the point at which solvent investors find them irresistible. Analysts trying to forecast future growth of GDP and profits should focus on that consideration to determine the timing of the end game.

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