Where the economy goes from here

Have we hit bottom? Are we starting up? Yes, and no. Yes, we’ve probably hit bottom. No, we’re not starting up – at least the United States isn’t, and most of the developed world will see feeble growth at best. Yet, the global economy is growing, and we are seeing the biggest disparity ever between the developed and developing countries in terms of growth. Recent reports indicate that the rich countries (the “developed” ones) will show a decline in real GDP of about -3.5% for 2009, while the developing countries, led by China and India, will see growth of about +5% – a difference of 8.5%. How can this be? And what happens next?

Well, first of all, the developing countries had a really rough first half – but mostly that was due to what has classically been described as inventory overhang, about which more in a moment. They had been doing so much business with the developed countries, especially America, that they had a whole raft of product in the pipeline when the U.S. economy hit the skids. Now they’ve liquidated that inventory by cutting production, which slashed growth rates in the first half, and are now back to filling current demand. As a result, they’ve taken a hit, but are bouncing back.

Next, the developing countries, especially in Asia, have stimulated their economies, and are seeing the response. Their investment in infrastructure, both at the governmental level, and plant and equipment for corporations, is strong, and consumers have responded to stimulus with demand, just as it says in the textbooks. But in addition to that, the developing countries are trading more and more with each other, and, consequently, are not as reliant on demand from America, Europe, and the other OECD nations as they were before. Hence, as the fast growing countries start picking up steam, they help each other grow even faster, even without their biggest customers. For example, Brazil now buys more from China than it does from America, it’s traditional major supplier, with the result that as Brazil rebounds, it helps China, and vice-versa.

Meanwhile, things don’t look as bad as they did back home. The governor of Canada’s central bank, The Bank of Canada, has declared the recession in Canada is over. The U.S. Federal Reserve has said that the bad news isn’t as bad any more and we are probably at or near the bottom of the recession. France and Germany are starting to look better as time goes on, and will see positive growth this quarter. But it’s not going to be a quick rebound, because this is not a typical recession.

Not your traditional recession

A traditional, inventory-liquidation recession happens when the economy has been booming along, and everyone’s making easy money. As a result, organizations try to sell as much as they can, filling their pipeline with products to be sold, and operating at or near capacity. In the process, they take on short-term debt, typically bank debt, to finance their operations and inventory. As a result, when something happens to slightly jiggle the apple cart, or when the interest paid to the bank to finance inventory start to hurt more than the potential profit warrants, corporations decide to try to lighten up a bit by cutting back on new purchases and production. When everyone tries to do this at the same time, demand nosedives, and the economy goes into the tank. When the inventory has been cleared, the bank debt has been paid off, and the smoke clears, a few companies go broke, but the economy as a whole resets, and starts growing again in a new cycle, typically with strong growth for the first couple of years following the recession. This kind of traditional recession & clearing process took anywhere from 6 months to 2 years.

This is not that recession, not in America. This recession was triggered principally by consumers having too much debt through 25 years of using their home mortgages as an ATM. That kind of long-term debt takes time to pay off, and consumers have to consume less than they make in order to do it. This puts a long-term damper on the economy that takes a long time to wear off.

If we are lucky, America’s economy will be almost flat for the balance of this year, but start growing – slowly – next year. By 2011, it will start to pick up, but growth will still be anemic, and people will be complaining that the recession hasn’t ended. In fact, we are likely to see an unusual combination of rising economic output AND rising unemployment for an uncomfortably long time, perhaps even into 2012.

Possible shocks to be wary of

If we’re not lucky, then the American consumer, having been shocked into a penitent, saving mode, will stay in his or her shell and refuse to buy anything, or will only buy what they have to, for a long time. Add to this the potential for further financial market shocks, which I’ll describe in a moment, and you have a very gloomy scenario indeed. Moreover, if growth stays weak, and unemployment stays high, President Obama may wind up losing the White House in 2012, despite the structural weaknesses of the Republican party, because the economy is the single most consistent indicator of electoral success.

Now, what might be the possible further shocks? Well, if economic growth stays weak, the U.S. government will want to continue to stimulate demand, which means running deeper budget deficits for longer than currently planned. And as I’ve said before (“Wild Card Warning”) the U.S. government is already at risk of running out of money because of the enormous amount of debt it must raise on the open market. If lenders grow weary or leary of U.S. debt, then the U.S. government faces a credit crunch of its own that could precipitate a new financial crisis, and tip the global economy into a renewed depression. Or, if that can be avoided, the banking system is not yet out of the woods, because loans they made for commercial properties are turning bad, and may put further holes in bank balance sheets, again precipitating a new crisis. Neither of these are inevitable, but are real dangers that should be watched carefully, and for which contingency plans should be formulated now.

Canada’s dilemma

In contrast, Canada will experience an interesting dilemma: the demand for oil and food is already growing again, in large part because of the developing countries, and Canada is a major producer of both. (Most people are not aware that Canada has the second largest petroleum reserves in the world, after Saudi Arabia, and is America’s biggest supplier of oil. It’s very expensive tar sands oil, but it is flowing, and makes Canada a petro-power.) As a result, on average the Canadian economy will do pretty well among OECD nations – but this average is deceptive. Demand for Canadian commodities will and is already pushing up the Canadian dollar. This will further damage the country’s industrial heartland in Ontario and Quebec, which are already being hollowed out by the woes of the auto industry, and the transfer of manufacturing to lower cost producers like China. Meanwhile, the parts of Canada that produce commodities, notably Alberta and Saskatchewan, will be feeling no pain. This will exacerbate the real political stresses within the country, where almost two-thirds of the voters come from Ontario and Quebec, but virtually all of the strength in tax revenues, and the large majority of the economic growth, is coming from the western part of the country. It creates an almost impossible situation for the national government, quite aside from the current government’s short-comings and evident weaknesses.

Looking farther out into the future, unless the nasty contingencies described earlier occur, growth and prosperity will return to the “rich” countries, although slowly, and this time people will be more cautious. Some of the thrifty virtues our parents preached will once again be rediscovered, and time will heal the wounds, investment will once again accelerate growth, and (more measured) good times will roll again. This pain, too, shall pass.

Destruction carries the seeds of recovery

In its wake, it will leave the developing countries stronger, the developed countries growing again, but more cautious, and a more interconnected and interdependent world. If we have learned nothing else, we have learned that in today’s world, no one crashes on their own. This cautionary tale may well pave the way to a more stable world economy, and one where fair trade for all is seen as the only alternative to disaster.

Every boom carries the seeds of its own demise. Likewise, every crash sows the seeds of new growth, and new innovation, just as many forests require forest fires to renew themselves. This time will be no different. Carrying the metaphor forward, we’re not out of the woods yet, but that glow on the horizon is more likely to be the dawn than a renewed conflagration. Hold on to that.