Imbalances and the Economic Crisis

James Bevan, Chief Investment Officer CCLA Investment Management Limited gave a talk to the Keynes Society on Thursday - it was full of insight into the causes of the financial crisis and the chances of a sustained recovery in the next year or two.

Much of the current crisis is the result of widening global economic imbalances - for many years there have been substantial imbalances – which persisted at least in part because it suited the key participants

China and India:
(i) over producing
(ii) under consuming
(iii) accumulating excess savings
(iv) exporting goods, services and capital

USA:
(i) under producing
(ii) over consuming
(iii) no savings
(iv) importing goods, services and capital

Formal definitions of recession matter much less than behaviours when consumers and businesses are exposed to the impact of a downturn.

Recessions are quite well understood –
(a) they typically involve reductions in the level of economic activity brought about by a tightening of monetary policy in response to over-heating, and
(b) they typically respond well to monetary easing.

Depressions in contrast are rare and less well understood –
(i) they typically involve de-leveraging, and
(ii) they typically do not respond well to monetary easing - i.e. a sharp reduction in policy rates

Risks for the UK
The imbalances that have built up in the household and public sectors over the past decade or so, coupled with an over-leveraged banking system, mean that the UK economy is acutely exposed to a further deterioration in growth prospects. Although we are hopeful that the monetary and fiscal stimuli being injected by authorities around the world will succeed in stabilising the economic environment, there is also a significant risk that the need to de-leverage is so great that it overrides such initiatives. Domestically, this could translate into ineffective monetary policy (in the sense that banks fail to pass on sufficient rate cuts or consumers do not react to them) and an ineffectual fiscal policy as consumers choose to save, not spend.

If the ongoing monetary and fiscal stimuli fail to arrest the decline in the domestic economy, investors may begin to lose faith in the UK. Consequently, a significant rise in the UK's cost of capital (higher gilt yields) and/or a further large devaluation of sterling could have very serious ramifications given the government's need to borrow nearly £500 billion in the gilt market over the next five years to fund both investment and consumption. Under this debt profile, which does not include a possible further £250 billion or so of government-guaranteed debt predominantly from the financial sector, the fiscal deficit may peak at around 8% of GDP in 2009/10. Again, the risk is that this 8% figure climbs higher, as GDP growth could disappoint further and necessitate even more borrowing.

Risks of a long term slump and the social costs of a recession

There is no reason why growth can't remain bad for a much more prolonged period than experienced in a typical recession. As for social costs, in the last recession, house prices and mortgage approvals did not trough until after the recession had ended, so housing and debt-related misery may be hard to resolve. In the last two recessions, 'UK workforce jobs' contracted by 7% and the labour force shrank by 3% – if both were to recur today this would imply a rise in the unemployment rate to c.9%.

Some reasons to be cheerful

(1) Energy prices are down a lot,
(2) Mortgage rates are down, & the December credit figures, though clearly still bad, were not quite as bad as those that preceded them.
(3) Government actions have helped to stabilize a big portion of the financial system.
(4) The weaker pound will have helped.
(5) There has been a slight improvement in the purchasing managers surveys (which are now indicating a significant fall in output and spending ahead, rather than a steep one).
(6) House prices may have risen in January

The need for a better balance

We need to move to a world of better balance between

Production
Savings
Lending
Savings
Exporting
Government
Haves
Short term

and

Consumption
Consumption
Borrowing
Investment
Importing
Private sector
Have nots
Long term