The Global Recession is Here

24^th October 2008
The Malta Independent - Friday Wisdom

There can be little doubt about it now. The credit and financial markets dislocations experienced since the collapse of Lehman Brothers will exacerbate the unfolding recession. Credit markets became so dysfunctional that central banks’ role suddenly changed this autumn from lenders of the last resort to lenders of the sole resort.

This will be the first time since the early 1980s where both sides of the Atlantic will go into recession at the same time.

It will be the first time that the eurozone faces a serious recession since the creation of the single currency and as such this will be an hour of truth for the euro. The depth and length of the impending recession will largely depend on the extent to which the emerging economies of Asia can keep their economies going on through their own internal dynamics, at slower but still strongly positive rate, even though they will be hit by a fall in demand for their consumer exports from the western markets.

I am hopeful that the recession will be much less painful than it was in the early 1980s. It is not just that I tend to be an optimist. There are sound reasons why this should be more manageable. Chief among these is that we are entering this recession with inflation peaking at historically low levels of around four-five per cent and there is clear evidence that inflation will trend substantially lower in the next few months as prices of energy and commodities are falling off a cliff, aggressively reflecting the prospect of falling demand from western economies.

The fall in inflation will permit substantial loosening of monetary policy with interest rates for the euro and GBP probably set to fall to the low levels where interest rates for the USD already are. This shock absorber will also be fortified by reduced cost energy inputs and a gain in competitiveness as the value of the euro and the GBP will fall substantially against the USD and the Japanese yen, and by consequence against the currencies of many emerging markets that are pegged to the USD.

Consequently, I feel that the euro area will fare better than the US in the upcoming recession as it should be increasing market share to compensate, albeit partly, for reduced global demand.

But there is a strong message for euro governments in all this. The euro rules and other sensible good financial housekeeping practices are meant to function properly in normal economic cycles that are not threatened by the sharp financial instability that shocks consumer confidence. It would be wise if these rules are not rigidly enforced in current circumstances. In Malta’s case, given that government has not had the necessity to fund recapitalisation of the banking sector, there should be no great need to depart excessively from pre-set targets. But given that government revenues will be hit from recessionary trends and that government will have to phase out subsidies more gently to avoid further shocks to the economy, we might have to accept that targets for a balanced budget will have to be shifted back.

Even before the current financial dislocation, government budget was wildly off track as a result of pre-election largesse. In normal circumstances, this would have been compensated by post-election withdrawal to regain sobriety; but in current circumstances, this would be a shock too far. So government can borrow an excuse from the international financial turmoil to justify its departure from the 2008 budgetary targets, even though such departure is entirely sourced from domestic causes.

One thing seems pretty obvious irrespective of the recession on the broader economy. The international financial markets will not go back to what they used to be any time soon. Once governments have been constrained to intervene and save banks by recapitalising them using taxpayers funds, regulation will have to be broadened and deepened.

There is no doubt that one of the main reasons why we are where we are today is the laxity of regulation, particularly in the United States, where most of the excesses occurred. I had already commented on this aspect well before the crisis unleashed its full force this last month.

My article in this series of 9 November 2007 was titled ‘Boring bankers’ and I had mused:

“There is another enigma with the business of central banking. When things are going well, central banks target their monetary policy to keep retail prices under control but take very little interest in asset price inflation. For example, the Central Bank never hitched their policy to control the real estate price explosion of recent years. When things turn bad, as is happening presently in the US housing markets, which inevitably spills into the financial markets and possibly on the general economy, central banks start cutting interest rates aggressively in order to stabilise the economy and create a cushion for soft landing.

But something is wrong somewhere. What applies to the downside should apply to the upside which can only be done if central banks include asset price inflation in their monetary policy stance and if they have direct regulatory control over the markets , not only in the banking sector but also on its periphery, that contribute to asset price inflation or outright asset price bubbles. The whole regulatory regime needs to be re-engineered in the light of the 2007 experience’

I never imagined however that I would be proved so harshly right so soon by the events experienced in 2008.