Opinion

Recession planning

Finance | John Kelly | 1 May 2008

John Kelly says the current economic slowdown is not a typical recession.

The nature of a conventional recession is familiar to all economic observers. In response to excess in the system, typically inflation, interest rates are raised. The increased cost of money squeezes activity, growth slows or reverses, price pressures ease and in time the tightening phase is ended. So familiar is this pattern that it is the interpretation we default to whenever we see signs of declining growth. Sometimes, however, it is an incorrect assessment. It was wrong in the US in 1929, in Japan in 1990 and maybe it is wrong now. This is because the current slowdown is not the result of action from the authorities, but the result of financial de-gearing, which is causing a financial crisis which is in turn causing problems for the economy. The position is critical in the USA but will impact on other economies too, including the UK. Because the debt expansion has been going on for so long it has become easy to see it as the norm, but eventually consumer expenditure, currently bloated with debt, has to come into line with income. That will be driven by dramatic changes in credit markets as the availability of credit reduces and the cost of credit adjusts upwards, despite falls in official interest rates. A broad, and at first indiscriminate, tightening of credit availability forces asset sales – a position made worse in the current cycle because many of the assets, built on innovation in product design in low quality loan portfolios, have no buyers and may have no value.

In order to arrest what can become an accelerating and self-seeding decline, governments need to take firm action in a number of areas. Firstly they must provide the necessary liquidity to keep the financial markets functioning. This can be seen with great clarity in the US where the Federal Reserve has cut interest rates aggressively and has widened the range of assets it will accept as collateral. In the UK the action has been less dramatic, interest rate cuts have come more slowly and only very recently has the Bank of England expanded its provision of emergency liquidity.

The second required action is a devaluation. Realistically, given its dependence on foreign investors, the US will not adopt an official weak dollar policy, but the recent strength of the euro and yen relative to the US currency and the soaring price of gold clearly indicate an adjustment is being man-aged. The dollar has fallen about 15 per cent lower against the average of the euro and yen exchange rates since June of last year. To bring that into a UK context, sterling is down about 9 per cent on a trade weighted basis over the past six months.

The third requirement is for confidence to be rebuilt by government guarantees of key financial institutions – the public (and other banks!) have to believe that there is no risk of failure, because without that the deposit/lending cycle cannot begin again. In the US the staged rescue of Bear Stearns sits under this heading, with official guarantees allow-ing a private sector rescue to take place. In the UK, Northern Rock saw its depositors better off after it’s crisis as they gained a state guarantee. Given the scale of the problem it is unlikely that these will be the only casual ties and we should expect to see more.

It is clear that the US authorities understand the risks of the situation and are taking clear and determined action to correct it. Other central banks are also taking action, albeit without the same level of need. We should not, however, expect the adjustment process to be over in months.

Growth rates in developed economies will slow as consumers adapt to less accommodating conditions. Investment markets will become riskier, not just in terms of day-to-day volatility but also in the harder sense of true risk of loss. Inflation could rise as lower exchange rates and higher commodity and food prices combine. In this environment charities need to be clear of their objectives and strategies. They should be sure that the risks in their portfolios are needed and used efficiently. Like all change, the current situation will bring opportunity for the patient, the prudent and the prepared.

John Kelly is head of client investment at CCLA

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