Finding a Strategy to Deal with the Economic Crisis

by Larry Smith

A few months ago - in May to be exact - Tough Call asked the question: are we in for a macroeconomic adjustment?

We suggested (along with others) that the world economy was about to shift gears in some fundamental ways, and it was fair to ask just how serious things could get and how we would be affected.

It seems we will soon have a definitive answer to our question.

Business Cycles are Nothing New
Economists have identified 10 boom-and-bust cycles in the six or so decades since the Second World War. On average, the contractions lasted less than a year, while the expansions ran for almost six years.

Those post-war crises included the oil price shocks of the 1970s, the Latin American debt crisis of the 1980s, the Asian financial crisis of the 1990s, and the Dot.com crash of 2000, which was closely followed by the fallout from the 9/11 terror attacks.

But those recessions pale beside the Great Depression - the longest and deepest economic crisis of modern times. Beginning in some countries as early as 1928, it led to unprecedented political and social changes and was brought to an end only by the onset of World War II in 1941 - another great catastrophe.

The American economy shrank by 30 per cent, throwing a quarter of the labour force out of work. Banks failed, businesses went under, the stock market lost 90 per cent of its value, farm and factory output plunged, and world trade collapsed. It took a full 15 years for stocks to recover to their pre-Depression level.

"At its nadir," wrote Berkeley economist J. Bradford DeLong, "the Depression was collective insanity. Workers were idle because firms would not hire them to work their machines; firms would not hire workers to work machines because they saw no market for goods; and there was no market for goods because workers had no incomes to spend."

How About that Great Depression?
What caused the Great Depression? Experts say it was brought on by the same problem we face today - banks made loans to governments, businesses and people who could not repay them. In other words, they created a mountain of bad debt, which led to a panic.

As the banks failed, there was a knock-on effect throughout the world economy. And that explains why US and European authorities have been scrambling to prop up banks that have lately been losing billions after investing in risky mortgage securities.

The current financial crisis was caused by the bursting of the US housing bubble in 2006, when rising numbers of homeowners were unable to pay their mortgages. Housing markets in the US and Europe lost trillions in value as a result, producing a credit crunch that is causing a global economic downturn.

Only a short time ago the International Monetary Fund was blandly forecasting "a 25 per cent chance that global growth will drop to 3 per cent or less in 2008 and 2009 -- equivalent to a global recession." But today the IMF says "the world economy is entering a major downturn in the face of the most dangerous financial shock since the 1930s."

What Caused the Current Problem?
Whether this is the result of market failure or government intervention depends on your politics. Those on the right argue that our economic problems are the result of government meddling with the markets. Those on the left say that greed and regulatory failures led to a financial meltdown that could send the world into an economic tailspin.

More specifically, conservatives in the US say that liberal politicians, and particularly the Clinton administration, caused the credit crisis by promoting home ownership among those who could not afford it. This led to unsustainable borrowing, which fueled the housing price bubble whose collapse created the present financial turmoil.

Liberals, on the other hand, blame the crisis on massive over-spending, over-borrowing and tax cutting by the Bush administration. They point out that in the last year of the Clinton administration, the US had a budget surplus, low inflation and a stable, strong economy. They also claim that a lack of government oversight during the Bush years allowed the financial class to behave irresponsibly, contributing to the market crash.

But regardless of which view you take, the upshot is that we may be in the same position that US president Herbert Hoover was in at the time of the 1929 stock market crash, which led to the 10-year economic trough known as the Great Depression. Some go even further. In fact, there is a whole cottage industry on the Internet projecting a global economic collapse - and it is not confined to looney tunes or conspiracy buffs. One of the most quotable experts is Peter Schiff of Euro Pacific Capital, who says we are in for much more than a mere liquidity or credit crisis.

"The current financial storm represents the death throes of the old global economic order, and perhaps the birth pains of a new one. The sun is setting on the borrow and spend culture that has all but defined us for a generation," he says. "Our long ride on the global gravy train is finally coming to an end, and once it does nothing will be the same."

Schiff is well-known for his accurate forecasts on the stock market, the mortgage meltdown, commodities and the dollar. His current prediction is for a deep and long recession culminating in a substantial decline in overall living standards. A complete loss of confidence in the dollar will produce dramatic consequences in terms of food and energy shortages, along with civil unrest, he says.

But even if you don't subscribe to this level of doom, there is no doubt that we are all in for a very rough ride over the medium term. Sixty per cent of the world's GDP is already contracting, leading worried finance ministers to meet in Washington this past weekend to craft an unprecedented joint approach to the crisis.

What Should be Done?
The question of what to do in the face of a systemic financial breakdown is complicated by the same ideological divide. Conservatives (at least those who are not in office) argue that the market should be allowed to take its course so that society can take its medicine. Liberals are more likely to support massive public spending to cushion the impact of economic decline.

In Washington, world leaders pledged to take whatever steps are necessary to restore health to the financial system, including a promise to protect savers' deposits and to recapitalise struggling banks through partial nationalisation. In other words, they will suspend the market and transfer risk to the taxing authority of the state. This is radical new territory, and policymakers seem to be unsure how it will all work out.

The weekend meeting was part of the annual conference of the International Monetary Fund and World Bank. Prime Minister Hubert Ingraham (representing Caricom) and State Finance Minister Zhivago Laing took part in these meetings, and they have announced a number of initiatives to address the economic fallout in the Bahamas.

They include an as yet un-costed plan to help homeowners pay their mortgages, a $4 million programme to cap BEC's fuel surcharge and reconnect non-paying consumers, extra mailboat subsidies, accelerated public spending on infrastructure and housing, more welfare handouts, and new promotional strategies to counter the decline in tourist arrivals. For obvious political reasons there will probably be more giveaways as conditions worsen.

How will the Bahamas be Affected?
Experts say the Caribbean banking industry is relatively insulated from the current crisis because of its size and lack of sophistication, and local bankers insist that our (mostly Canadian-owned) financial system remains strong. In a recent interview, for example, Commonwealth Bank chief T. B. Donaldson used almost the same reassuring words as Treasury Secretary Hank Paulson did when talking about the safety of the 8500 American commercial banks.

Nevertheless, our Central Bank reports that loan delinquencies are rising and 28 per cent of government mortgages are already in arrears. And it is a well-known fact that most Bahamians are over-leveraged to the hilt (to use a favourite financial term). Meanwhile, business sources say the high-level real estate market has stalled and mid-level movements are falling, with implications for the wider economy.

'I don't think a lot of us recognise how significantly what is happening in the capital markets will affect our economies -- affect them in ways that we are yet to identify," said Donald Brunton, vice president of the Caribbean Development Bank, recently.

But the prime minister is trying to paint a rather more optimistic picture by suggesting that the downturn will be shortlived and manageable, with recovery beginning by the middle of next year. In a recent statement, he expressed confidence that any potential government shortfalls could be covered by borrowing from local banks rather than submitting to more rigorous IMF balance of payments support.

Others are not so sure. The drying up of credit is starting to affect the real global economy and can be expected to exacerbate the effects of the energy crisis and high oil prices. The fall-off in tourism and investment as Americans and Europeans cut back on spending will cause job losses and a general business downturn in the Bahamas, as well as put pressure on foreign reserves.

What the Future Holds
Unfortunately, a look back at the last recession is not very helpful. It began in early 2001 following the Internet stock crash, and was both short and mild - although made briefly worse by fallout in the travel industry due to 9/11. The Bahamian economy shrank by a percentage point that year. Stopover visitors fell about 3 per cent, unemployment went up, and government revenues dropped due to a credit freeze that restricted imports. But by 2002 the economy was growing again.

The recessions caused by the oil shocks of the 1970s are a more realistic precedent for what we can expect to happen in the near future. Back then, rising fuel costs led to annual inflation rates of more than 14 per cent, gasoline was rationed, airlines stopped flying, unemployment soared and US economic output fell about 5 per cent, producing the worst economic crisis since the Great Depression - until now.

Oil is expected to hover around the $100 a barrel level, more or less. And the price of oil affects just about everything, from the household expenses of Bahamians to the travel costs of tourists, the effects of which continue to percolate throughout our economy.

What can we do? Well, as the minister of tourism recently suggested, we should concentrate on improving our tourist product and making it as easy and as inexpensive as possible for people to visit. And priming the economic pump should be relatively easy since we have yet to draw down even half of the $460 million-plus in approved loans from the Inter-American Development Bank.

But arguably, the most effective strategy would be to implement a national energy policy that would transform our economy by cutting our reliance on costly fossil fuels and stimulating new investments in renewable technologies and businesses - something which Tough Call has been writing about for three or four years under two successive governments as oil prices have steadily risen to unsustainable levels.

To paraphrase former US vice president Al Gore, it is clear that the solutions needed to renew our economy are the same solutions we need to escape the trap of ever-rising energy prices. It is urgent that we deal with this issue now and not let it descend into a bureaucratic boondoggle.

Comments

[Keith Major]

I read this article with interest.

Thanks for the historical perspective, the comparative analysis of corresponding periods and so clearly articulating the problem and possible causes.

I would have liked to have seen more concrete advice on getting through this. Your solution of a national energy policy to be implemented to reduce our reliance on costly fuels seems to be inadequate in that the reality of this is so far fetched.

A lot of rhetoric about alternative sources have been spewed in the press by politicians. I ask you to investigate where we truly are in this process. I would venture to suggest many years off.

Also the belief that our mortgages are sound should be investigated. Do government borrowers pay their mortgages? Wasn't the Mortgage Corp bankrupt? Didn't they suspend foreclosure of homes recently? Have you checked local mortgage companies who also lend people the 5 per cent downpayment in addition to the mortgage to see if the loan is over 100 per cent? Didn't the pm just announce a plan to assist mortgagers from losing homes? Why? How deep is the real problem?

I teach an introduction to business course at the College of the Bahamas Continuing Education Dept on Thursdays and we will use this article to form the basis of discussion.

Thanks again for stimulating my thinking this morning. And please continue to educate us and challenge us in the area of business.

[larry smith]

Thanks for your comment. The purpose of my article was to attempt a broad understanding of the economic crisis, from a local perspective.

Your suggestions for further research on mortgages and lending in the Bahamas are entirely valid.

I recently spoke with the gm of a major government corporation (which pays exceedingly generous salaries and benefits) who told me that his employees took home only nominal amounts of pay because of all their loan deductions.

I did refer to this situation in my piece. Is our highly leveraged society facing the same potential meltdown as the subprime market? That's a good question, but most top bankers and official spokesmen deny that there is a problem locally.

However, I am more convinced than ever of the need for us to shift gears on the energy front - for all sorts of good reasons.

Al Gore's challenge (http://www.wecansolveit.org) calls on the US to adopt clean energy solutions within 10 years:

"Thousands of new companies, millions of new jobs, and billions in revenue generated by solutions to the climate crisis -- this is the clean energy economy we can adopt with today's technologies, resources, know-how, and leadership from our elected officials.

"Global investment in renewable energy climbed 25% in 2006 (from $80 billion to $100 billion). Three clean-energy industries—biofuels, wind, and solar photovoltaics—each surpassed $20 billion in revenue in 2007. Just last year, clean energy received $2.7 billion in US venture capital investment."

And I would add that BEC recently received a good number of excellent proposals from renewable energy providers in several different fields - waste to energy, wind, solar and others.

But we need our elected officials to take action. The national energy policy that both the PLP and FNM have been talking about for years (with the help of the IDB) seems to have dropped into a bureaucratic hole - like so many good proposals do in this country.

There never seems to be enough political will to make things happen in a reasonable space of time.

BEC spends hundreds of millions a year on fuel that causes pollution and contributes to climate change - that's a lot of foreign exchange for our little economy. Stimulating a solar hot water heater industry here (to use just one simple example) could provide jobs and entrepeneurial opportunities that don't exist right now.

Take a look at the web site I created earlier this year to cover this subject:

http://www.bahamasecoforum.com/

[Youri Kemp]

Hi Larry,

Nice article and a wonderful historical backdrop added to it. But, there is something in the first paragraph I had an issue with--Business Cycles. And that being that they are nothing 'new'. The thing is, there is really no such thing as a Business Cycle, but rather pendulum swings in commercial activity. So, the 'boom and bust' we talk about, are nothing more than shifts in production, for any amount of reasons. The word cycle, lends itself to the concept that it is predictable. Well, if the US and the world, predicted any which one of the collapses, we would have not had them to discuss, really.

But, in the totality of your argument and to put it into perspective, you are spot on in other areas. In particular, this is a macro-economic shift and some would call a "New World Order" or "A New Generation" or, more technically, "A New Global Governance"...fact is, everyone says that. But, nothing much as been done, or, the thought put forward to have the political clout and power to have wanted to have it done. Until now! Or, so it seems!

The last bastion of total and wholesale economic production, financial products, has hit a snag. The snag being that it can't operate, without the value added to the resources it is trading or which has real value, for it to place a price value on it. So, they [financiers] started to trade people's debt. What happened? People got an appetite for debt and sought to put people in more debt. The more the debt attached to CDS and other derivatives traded debt, the riskier the portfolio and the greater the profit.

So, everone [financiers especially] need to find another place to hide. Another revenue stream, is what in its simplest essence, is what is needed now. That does not neccesarily come with a "business cycle" and it does not have to- but, if you diversify your portfolio, you mitigate the total risk exposure of one aspect from the rest of the portfolio.

People, now, are wanting to go back to commodities based trading and valuations, but the same political and economic risk in Africa and the Middle East, has not yet gone and will be the same old money, for the same old set of guys who have it. On top of a growing middle market in the emerging markets, where indigenous folks are grasping more and more control of the means of economic production, and for profit, in their own country.

Tech is the way to go, in the western hemisphere. Not physical technology, but, rather, intellectual technology- knowledge based economies- in addition to securing and advancing sophistications, in other established modes of economic production. Education? In a simple term, yes! Intellectual tech, in regards to the enhancement, by any means necessary, the tools for production we have now- before we go looking for the magic new thing, which will create the same bubble five years from now.

Someone said energy. Yes. Clean energy should have been on the front burner, 20 years ago, like how Brazil has. Now is the perfect time to do it-- for the obvious reason that fossil fuels are dirty, they are expensive, they cannot yield as much out of the commodity base as new tech surrounding energy, can. And, they can be adapted, like how car manufactures have differentiated their products from one another in the market.

Best,

Youri
http://globalviewtoday.blogspot.com/