WHY A NEW ECONOMIC CRISIS WOULD
BE WORSE THAN 2008
BY PETER MEECHER
BE WORSE THAN 2008
BY PETER MEECHER
When the world economy collapsed in 2008 it brought a banking crisis, large scale unemployment, a fall in living standards and, in many places, political instability. Some countries were impacted more than others, the southern states of the Europe were particularly affected, Portugal, Spain, Italy and notably, Greece. That said, no nation in the Western world has managed to achieve any decent level of growth since 2008 and almost all dipped into recession for a prolonged period of time. The US economy was in recession for a full 19 months. Even now approximately 7 and a half years after the financial crisis and start of the ‘Great Recession’ economic growth and unemployment levels have still in many places not returned to their pre-recession level and the world economy is still regarded as both weak and unstable. On top of this nations, as a result of low-growth and the bailing out of financial institutions, are saddled with large amounts of debt. The reduction of debt is central to the austerity measures that are continuing across many states.
While there is no doubt the Great Recession has a huge impact many states appear at least on a superficial level to be recovering and making their way back to pre-recession positions. Such optimism may not though be credible and many economists are now beginning to point out that the world economy may be ready to face a much worse crisis.
Here is outlined in the simplest manner possible why the world economy may be on the verge of another economic crisis and why it may be much worse than the 2008 collapse.
THE AMMUNITION FOR FIGHTING ANOTHER ECONOMIC CRISIS HAS RUN OUT
The business cycle, where there is a to-and-fro over time between a ‘boom’ or ‘peak’ = an increase in investment, growth and employment followed by a ‘bust’ or ‘trough’ = a fall in investment, growth and employment has been recognised by economists since the earliest days of modern economics. It should not be thought however that the ‘bust’ or ‘trough’ necessarily means a return to pre-‘boom’ or ‘peak’ levels but rather that as a general trend the economy grows over the long-term but that during ‘busts’ it grows at a relatively lower rate, and sometimes stalls or contracts – a period known as a ‘recession’. What this means is that even though there may be ‘booms’ and ‘busts’ the economy as a general trend has grown over time.
THE GENERAL PRESCRIPTION to ‘busts’ and ‘troughs’
Generally the ‘monetary policy’ prescription for assisting the economy during a ‘trough’ is to lower interest rates and increase interest rates during a ‘peak’. This is in theory meant to smooth out the business cycle and make the peaks and troughs less dramatic and therefore increase overall economic stability. Interest rates are lowered during a ‘bust’ so that it becomes less attractive to keep money in the bank and cheaper to borrow money to invest in business projects. Likewise home owners, and other borrowers, pay less on their loans when interest rates are lowered meaning they have more money to spend in the economy, thereby stimulating demand and assisting the economy out of its business cycle ‘bust’. Similarly during a ‘peak’ higher interest rates may be deployed, to control inflation, and because interest rates must rise at some point. If rates are not risen during ‘peak’ times then at the point of the next ‘bust’ it will not be possible to lower them. Think of it like this, if during a ‘trough’ rates fall from 5% to 2% to stimulate the economy, and are maintained at 2% through the ‘peak’ then there will be less room to move come the next bust (i.e. first bust could move from 5% to 2% - a 3% switch, but if interest rates do not rise again at the next bust there is only the space of 2% to 0% to move). Therefore interest rates have to rise.
Many economists believe that keeping interest rates ‘too low’ for ‘too long’ can in itself lead to greater booms and busts. This is because interest rates being too low for too long distort market prices and make investments appear more lucrative than what they actually are. In simple terms money is pumped into unsustainable businesses and investments which will ultimately collapse. This was the case with the US sub-prime mortgage crisis (seen by many as a precursor to the Great Recession) where due to low interest rates unsustainable loans were made when interest rates were low and when interest rates began to rise again this resulted in millions of people losing their homes and/or being financially destroyed, which in turn had a knock-on effect on the rest of the economy.
Currently interest rates, in order to fight the Great Recession, have been low for unprecedented levels of time across the world. Policy makers fear that any rise in the interest rate will result in further economic stagnation as home-owners have less disposable income, business people are swayed away from investment and that a rate rise may make the ‘debt-crisis’ even worse.
The ‘debt-crisis’ originating from the huge amounts of debt racked up via bank bail outs and huge pre-recession public and private lending, means that many policy makers are terrified of increasing interest rates. If interest rates are to be raised, as is required to avoid unsustainable investment in the long-run, then this raise in interest rates increases both the national debt problem, which austerity is intended to remedy, and the private debt-problem which sucks away demand in the economy. Almost all debts, national and private, are increased as interest rates increase and so by raising interest rates these problems are exacerbated. While debts are at a historically (at least since the post-war period) unprecedented level any interest rate rise could severely damage such indebted economies.
The problem is though, as already stated, that if another economic downturn were to occur now policy makers cannot put interest rates any lower on account of them already being at zero. The conventional monetary policy tools are essentially out of ammunition. This zero-interest situation occurred in Japan in the 1990's and lead to what was in effect a decade of lost growth and economic stagnation.
Being out of conventional armoury policy makers have swayed towards unconventional tools to stimulate the economy, namely ‘Quantitative Easing’ (QE). QE is where governments print money in the hope that it will be utilised to stimulate the economy. On a grand scale QE is the last ditch tool at the disposal of desperate monetary policy makers. Almost all central banks have now employed QE in some way or another from the Federal Reserve in the United States, the European Central Bank (ECB) and the Bank of England. QE is not though without problems, in the long run it can lead to inflation as the economy recovers, as famously stated ‘inflation is always a result of the printing of money’.
Two clear problems with QE:
- IF QE stimulates the economy effectively and growth occurs, then interest rates must rise more dramatically as a way of combating inflation, and may result in a stagnated recovery
- QE, like too low interest rates can result in mis-investment and investment bubbles. It is currently feared that QE may lead to a housing bubble resulting in another economic shock.
- The tools available to the state are diminishing in their usefulness or have already been used up
- Many of the remedies available in themselves can exacerbate many issues that were to blame for the Great Recession and the Financial crisis in the first place
WHY A NEW CRISIS MAY BE ON THE WAY:
7 and a half years on from the Financial crisis and the Great Recession new problems appear to be on the horizon for the world economy. One particular problem at present is the slowing growth in emerging economies such as India, Brazil and China. China, an industrial powerhouse producing vast amounts of cheap consumer goods for the West has this year seen its growth fall to its lowest level since 1990 and is expected to see falling growth until at least 2018. As a result of this China has devalued its currency (to make its goods cheaper abroad) and cut interest rates to stimulate the economy, overtime the Chinese interest rate has moved from 7.5% at the time of the Great Recession to below 4.5% today. As China is now the world’s largest economy any economic faltering could have massive global impacts. Some economists have suggested that a long-term Chinese bubble has been built and that vast growth over the past 25 years has been unsustainable, built largely upon foreign export with relatively weak domestic consumption.
As already stated economies tend towards cycles of boom and bust. Much debate in economics is situated around what causes these booms and busts. However general trends have been noted in the frequency of such peaks and troughs. In the US economy from trough to peak to trough takes on average between 5 and 9 years (in the post-war period). What this means is that if all things were equal, and the 2008 recession was similar to those seen in the past, we would roughly expect another recession to occur soon. That said comparing past situations with the current situation, which is largely unchartered territory, may mean we are comparing apples and oranges and therefore no recession should be expected on this basis alone. As debate is open over what exactly causes recessions or troughs the likelihood over another recession occurring ‘naturally’ soon can not be answered precisely but if it did its affect would be catastrophic.
REMEDIES THAT HAVE SAVED US SHORT TERM INCREASE CHANCES OF ANOTHER RECESSION:
As stated above many of the remedies such as low interest rates and QE may have mitigated and, in some nations, begun to soften the worst effects of the Great recession but it has also been shown how these remedies can in themselves result in economic shocks. QE, low-interest rates and bank-bail outs have saved the economy in the short-term but QE and low interest rates may cause further recessions and bubbles. As stated low-interest rates led to the sub-prime housing crisis in the United States and interest rates have now been much lower much longer than before the 2007 collapse. Such remedies have not been used in such high doses in the post-war period and the question as to whether these policies, low interest-rates and QE, result in short-term success but greater problems in the longer-term will only be understood as the years ahead unfold.
WHY THE NEXT RECESSION WILL BE WORSE:
If a new crisis is to strike for any of the reasons above in the short to medium future its effects could be far more catastrophic than the 2008 collapse as the tools to combat a recession in the form of low-interest rates and QE have been exhausted and require time to recover. Unlike in 2008 nations are now saddled with huge debts, this means that any economic slow-down will be amplified as governments continue to make attempts to clear their debts, cutting consumer demand, whilst also losing their ability to borrow for investment. Similarly the ability to bail out the banks in the event of another crisis may be next to impossible with debts as high, or as close to as high as they currently are, which would in turn lead to a full meltdown of the financial and wider economic system.
Time will tell…