Wednesday, September 9, 2009

Why Is It So Difficult To Avoid A Recession?

Recession generally refers to overall slowdown of economic activity over a period of time or a business cycle contraction. Officially, it is defined as two successive quarters of negative economic growth. During this period, many macroeconomic variables coincide in similar ways. National output (GDP), employment, household spending, investment spending, capacity utilization and corporate profits will all fall

In some circumstance, economists often associate recession to alphabetical shapes. We have ‘V-shaped’ recession, a period where short and sharp contraction is followed by a fast and sustained recovery. ‘U-shaped’ is where the recession is prolonged. If serious it may lead to economic depression. Then we also have ‘W-shaped’, the double-dip recession and ‘L-shaped’ is where a continuous 8-9 quarterly GDP contraction before bottom out.

Which ever type of recession we are talking about, they have something similar in nature and that is INEVITABILITY


(1) Human nature. This is what we are. Even long ago during the Great Depression, Keynes in his masterpiece (The General Theory of Employment, Interest and Money) had warned us about the ‘dark animal spirits’ that each of us have. It is undeniably the mindset and self-soothing believes that all economic prosperity will last ‘forever’. As such, majority of investors jump into the stock market when it is already at its all time high and rush into buying assets in strategic location when the price is fast becoming unsustainable. Bankers on the other side, relaxed certain lending rules to fatten their profit margin at all cause. Regulators became complacent and lazy to run new numbers. Real estate agents only care about their personal commission. AIG and other insurers were blinded by instant profits, hence lazy to really find out what they are actually insuring. By the time they realize, it is too late since the bubble had burst

(2) Lag effect of a policy. One main problem with fiscal policy (especially in US) is that the decision-making process can be long and unpredictable. Once an executive branch proposes a solution, it must go through various stages of debate on the floors of House and Senate. To make things worse, there are often last minute alterations to the President’s original proposal either by economic principal or vested interests. If the legislative branches are in ‘good mood’, the process may be fairly quick. However if there are any conflicts, as it used to have, a simple process which usually takes months may be dragged to years. By the time the policy is put into action, recession may have begun or worsened and the economics antidote could turn into poison

(3) Overdependence. Early 2000s, banks in US were too generous. They lend money to anyone who wished to own a property without checking their creditworthiness. Banks through their creativity bundled the loans into some form of securities which were then sold to many other investment bankers (IB) and financial institutions (FI) in US. With the money raised from selling these securities, banks’ liquidity further increased and the vicious cycle repeated itself. Many of these investment banks who hold the toxic assets at the same time, have investment in other nations through direct investment or share market of the nation. When default in loan repayment started, these IB, FI and many other rich investors who thrown their life savings into these securities began to feel the crunch and withdraw from capital market worldwide. This explained the nose-diving performance of share market in South Korea, Japan, Singapore and many other developing nations. Companies are reporting heavy losses and begin to shed workforce. The larger the exposure, the greater will be the effect. This is one of the disadvantages of globalization in capital market

There is another way of contamination. Some export driven economies such as Singapore is said to be largely dependent on rich Western economies like US. Its economy depends a lot on exports and the manufacturing sector is more than 25% of her GDP. Most of the exports are high-tech capital equipments. It is not difficult to see the logic. A collapse in large economies implies that businesses will slow down markedly and demand for capital equipments will therefore collapse. Germany is not spared from this too. However, the Chinese economy once again exhibit miracle being able to escape the wrath of recession

(4) Banks not learning the lesson. Despite a close shave due to the unthinkable financial blowout, top banks still seem to be hard-headed. With the abysmal performance reported last year, they still pay out billions of dollars in the form of fat bonuses, most which I believe go to the pocket of top executives. The original nine banks that received TARP (Troubled Asset Relief Program) were reported to have paid out bonuses that are nowhere near to their overall yearly performance. Citigroup, for example suffered more than $27 billion losses last year, amazingly able to grant $5.3 billion worth of bonuses in the same period. Some like Goldman Sachs was paying out of their coffer. Despite earning of $2.3 billion, they distributed $4.8 billion worth of bonuses

Why is this so? I believe that the answer is banks are too large to fail. They know that the government will not allow the banks to collapse. It will be a hefty price to pay for seeing the whole financial system melts down just like that. Indirectly, US government is being held ransom. So they take things for granted. Some quarters therefore suggested the ‘‘clawback’’ provisions, which would reclaim pay from employees whose actions may damage the firm’s long term financial health. Personally, I think that these banks are closely regulated just for now. Once recovery takes place, regulators again will become lax. Banks with their creativity will play around with the loopholes in the new system

(5) Inheriting flawed policies from predecessor. These days, everyone seems to want a piece of Greenspan. He is said to be the main culprit behind the asset bubble. During his tenure as the boss of Fed, he implemented a series of expansionary monetary policy and interest rates were set at low level for a considerable period of time. Because the Fed rates stayed at that level longer than necessary, too many people had rushed into the asset craze thereby creating a bubble. Banks in market economy further relax lending policies to harp more profits. The wealth-effect soon spread into the economy. When new boss, Bernanke took over he is trying to cool down the overheating economy. So rates were raised causing some people to default. The bubble burst began. In such case, there is nothing much that can be done to prevent the recession time bomb. Only the aftermath can be minimized

No comments: