The advent of the New Year is marked with a deepening of the economic crisis which began in the summer of 2007. The failure of financial institutions in the U.S. during 2008 was quickly followed by a string of economic reports across the globe pointing to a severe downswing in global economic activity. After this initial shock, a far more risk-averse market is preparing for the next phase of the crisis, and all the questions filling our inbox start with the same two words – “What if…?”
In this piece, we address common “what if” questions using most recent economic data and information. We also try to “connect the dots” so that a reader gets an integrated picture of the underlying issues and has a framework to understand the economic situation and form expectations about the future. Here are the questions we answer:
- What if U.S. consumers abstain from spending?
- What if “deflation” creeps into the U.S. economy?
- What if U.S. debt is downgraded?
- What if one of the Euro-zone countries defaults?
- What if a country leaves the Euro-zone? Can the euro survive?
- What if sterling drops to near parity with the US dollar?
- What if Asia experienced major corporate failures?
- What if the yen continues to strengthen against the US$?
- Regarding Latin America, what if commodity prices experience a severe, prolonged drop?
- What if there is a longer-than-expected suppression of external demand for Latin American exports?
- What if a Latin American country were to default?
What if U.S. consumers abstain from spending?
Consumer spending has been the engine of growth in the upswing of any business cycle. The most important characteristic during 2001-2007 is that consumer spending accounted for nearly 71% of GDP compared with the historical average of roughly 67% of GDP. But at the present time, significantly weak employment conditions, the absence of home equity withdrawals and generally bleak economic outlook are factors that have restrained consumer spending. In addition, household debt accumulated in the boom years to historical highs, creating another factor that is holding back consumer spending. These three factors in combination have and will continue to prevent near-term endogenous growth in consumer spending. In other words, it is evident that consumer spending cannot grow in the months ahead without external assistance.
Experts differ about the form and magnitude of assistance that is necessary to prop up consumer spending. The fiscal stimulus package that has passed in the House of Representatives and is being discussed in Senate attempts to directly increase consumer spending through increased food stamps, extended unemployment benefits, and tax cuts for lower- and middle-income households. Tax cuts of $140 billion directed toward individuals are part of the package. Economic theory predicts that these measures will increase income and eventually spending and saving with a small lag. However, there are mixed opinions about how much of the extra dollars actually will be spent. A recent example can serve as a guide to the likely course the tax cut would take. Congress passed the Economic Stimulus Act in February 2008 consisting largely of tax rebates (roughly $100 billion). Analysis of Broda and Parker (The Impact of the 2008 Tax Rebates on Consumer Spending: Preliminary Evidence), based on actual expenditures obtained from ACNielsen’s Homescan database, concludes that tax rebates lifted consumer spending and helped to temper the weakness in consumer spending in the second quarter of 2008. As expected, low-income households spent a larger portion of the tax cut compared with other income groups. Yet, a part of the extra money was used to help pay for higher prices of gasoline prevailing in mid-2008, pay down debt, or save. Although part of the stimulus ended up increasing saving, the fact remains that real consumer spending increased at an annual rate of 1.2% in the second quarter of 2008, which reflects the impact of the tax rebate, compared with a 0.9% increase in the first quarter. Even though this was not a robust jump in consumer spending, in the absence of a tax rebate consumer spending would have declined as has been the case in the third (-3.8%) and fourth (-3.5%) quarters of 2008.
The large degree of uncertainty as to whether consumers will spend in 2009, following support from subsidies and tax cuts, stems from concerns about the financial status and obligations of U.S. households. Currently, households have an abysmally low level of saving and their ability to rollover debt has been diminished during the recession. The personal saving rate has held between 0.3% and 0.7% during 2005-2007 compared with a long-term average of 8.6% (1960-1995). Their financial obligations are close to historical highs, leaving households in a financially strapped environment (see chart 2).
Moreover, the household balance sheet is projected to record a $2 trillion-plus loss in net worth during 2008. The high debt burden, low saving rate and loss in net worth of households is a recipe for deleveraging. Also personal saving is now drifting up. To wit, it has increased from 0.4% in December 2007 to 3.6% in December 2008.
Pulling together these opposing forces affecting consumer spending, we can conclude households are in a vulnerable position and tax cuts are most likely to raise spending. Although the precise distribution of the extra dollars between spending, saving, and paying down debt remains unclear, it is certain that the absence of extra dollars from tax cuts and other forms of support for consumer spending will translate into a larger decline in consumer spending. It is this line of reasoning which has led to observations from Prof. Feldstein of Harvard University, a strong critic of fiscal policy activism, that the stimulus package should err of the side of being large to prevent a vicious cycle of reduction in consumer spending, employment, growth, and so on. Going back to the question raised at the beginning, the larger the package to promote consumer spending, the higher the likelihood of it leading to higher private sector demand.
What if “deflation” creeps into the U.S. economy?
Deflation is defined as a sustained decline in the general price level of goods and services. A few months of lower oil prices does not qualify as a deflationary situation. There are many episodes in history of falling prices, some are associated with falling output and some with rising output. It is the combination of falling prices and output that is problematic because as prices are falling consumers delay purchases until prices fall further, which in turn reduces overall economic activity and eventually leads to a deflationary spiral and a severe economic crisis. The Great Depression in the U.S. comes to mind as example of a deflationary situation (see chart 4).
The possibility of a “deflationary” episode in the near term in the U.S. is frequently mentioned and the Fed hinted about the possibility of a deflationary situation in its January 28, 2008 policy statement. The probability of this event actually occurring can be evaluated by answering two related questions: (a) What is the message from economic data? (b) What policy actions are in place to prevent this from materializing?
The Consumer Price Index (CPI) moved up 3.8% in 2008 on an annual average basis, the largest gain for the current cycle. However, on a quarterly basis, the CPI fell at an annual rate of 9.2% in the fourth quarter.
The core CPI, which excludes, food and energy, slowed to an annualized increase of only 0.4% in the fourth quarter of 2008 from a 2.3% increase in 2007.
The CPI is most likely to post a decline in 2009, on an average annual basis. We are projecting a 0.9% drop in the CPI on average in 2009 and the Blue Chip Consensus forecast is a 0.4% decline. Therefore, deflation in the near term given the current and projected weak economic environment is reasonably established. Historically, there are only two occasions, in the history of this series which dates back to 1921, when the CPI has dropped (1949 and 1955) excluding the years of the Great Depression. Therefore, the decline of the CPI in 2009 will be a notable event. Does this imply that a deflationary situation will continue in the subsequent years?
The probability of consecutive annual declines of the CPI is low because the Fed has implemented an extraordinary expansionary monetary policy. The Fed has lowered the federal funds rate to a band of 0%-0.25% from a high of 5.25% in 2007. The programs that the Fed has implemented to provide liquidity and support to a severely impaired global financial system has resulted in the Fed’s balance sheet shooting up to nearly $2.0 trillion at end of January 2008 from $900 billion at the end of August 2008. In addition, the large fiscal policy stimulus package to promote demand should help to lift the pace of economic activity in the near term. The Great Depression has been the only deflationary event in the U.S. in roughly 90 years. Policy mistakes such as the Hoover administrations protectionist legislation (1930), higher income taxes (1931), and monetary policy errors of the Fed which raised the discount rate (1931) and reserve requirements (1937) are cited as reasons for the prolonged weakness in business activity and the deflationary environment. The policy choices made to address an economic crisis in the current period are vastly different and consistent with the exigencies of the situation. Therefore, it is appropriate to attach an extremely low probability to the possibility of a deflationary environment past 2009.
What if U.S. debt is downgraded?
The large amount of government expenditure already taken, and more in the pipeline, to support the working of the financial system and bringing about an economic recovery will inevitably result in a larger fiscal deficit and larger outstanding public debt of the US economy. At several points of the current crisis there has been concern that U.S. debt will be downgraded from the top Aaa rating, particularly after Fannie Mae and Freddie Mac went into conservatorship. The frequency of this question in discussions about the economic crisis has increased in recent months.
A good starting point to answer the question about credit rating of U.S. debt is the relative position of U.S. debt in the G-7. In 2008, gross federal debt as a percent of GDP was 67.5%. We need to exclude U.S. securities held in Social Security and Medicare Trust funds and obligations of state and local governments to obtain a suitable measure of publicly held debt. After excluding these items, publicly held debt as a percent of GDP was 37.9% in 2008 (see chart 8). From the chart, it follows that only Canada and Switzerland are in a marginally superior position compared with others in the G-7. In comparison, the U.S. ranks equally or better among the other members of the G-7. The debt-GDP position of the U.S. among its peers suggests that the projected growth of debt of the U.S. in the months ahead is not a disqualifying factor for the top credit rating even though it is unfavorable from a long-term point of view.
In general, the reason for downgrading securities is reduced confidence that the issuer of the debt will be unable to meet obligations associated with the debt issued. If debt is downgraded, the issuer faces a higher interest cost and would be unable to raise the desired amount of credit. To date, the U.S. Treasury has not run into problems with raising debt. On the contrary, demand for U.S. Treasury securities shows a notable increase during June-November 2008 (see chart 9), in part due to the safe-haven status of these securities.
With regard to yields on these securities, there has been a strong rally in this market since mid-2008, for the most part. The increase in yields in recent days is partly related to the hesitant message from the Fed about its plans to purchase long-dated Treasury securities. In light of the relative standing of the U.S. economy among its peers, the possibility of downgrading U.S. debt is overblown.
What if one of the Euro-zone countries defaults?
This question has been triggered by the fact that the price of insurance against debt default by Euro-zone members Ireland, Greece, Italy, Spain, and even Belgium, has jumped in recent weeks; that yield spreads against German bunds have ballooned; and that the sovereign debt ratings of Greece, Portugal, and Spain have recently been downgraded. These developments do not reflect an increased risk of default by any Euro-zone member, but rather show that investors have finally woken up to the fact that not all Euro-zone sovereigns are equal. The global credit crunch has led to an overdue market re-evaluation of the Euro-zone members.
There are 27 countries in the European Union, of which 16 are members of the Euro-zone. However, while the 16 share a common currency and monetary policy, no political union preceded the monetary one, and the 16 are still fundamentally sovereign nations, with separate fiscal policies. Debt is issued by the individual countries, not by any Euro-zone institutions, although until recently the markets had acted as if all Euro-zone members were basically synonymous with Germany. The European Central Bank (ECB) is not obliged to support the debt of any Euro-zone member who gets into trouble, and the ‘zone’s members are explicitly banned from assuming the debt of fellow members in the event of default.
Most of the 16 have fiscal deficits that are swelling by the day, and some are also burdened by the domestic economic and financial sector fall-out from the bursting of their own housing bubbles – hence the recent sovereign rating downgrade in Spain and the risk that Ireland may soon be downgraded also. Some have singularly failed to enact structural reforms over the past decade and hence are saddled with an increasingly uncompetitive economy – which is a large part of the reason why Greece is now paying something like 2.5 percentage points more for ten-year debt than benchmark Germany.
The weaker ‘zone countries essentially took a free ride on a decade of cheap access to funding. But they do not control their own currency or monetary policy, which means they cannot devalue or inflate their way out of trouble now that the good times have ended so abruptly. Their only alternative is to improve competitiveness the hard way, with reform.
Even so, none of the Euro-zone members is realistically likely to default anytime soon. Spain’s downgrade by S&P only took it to one notch below AAA. Italy and Greece are still far from default-level. And while there is no obligation for any EU-based institution to bail out a member country, last October’s events involving Hungary – a member of the EU but not of the Euro-zone – show that the EU will find a way to look after its own to avoid an outright crisis. Hungary’s problems revolved around the domestic banks’ huge foreign exchange swap positions, rather than an issue of sovereign debt service per se. In October, the National Bank of Hungary reached an agreement with the ECB allowing it to draw up to €5 billion from the ECB to provide liquidity to the domestic foreign-exchange swap market. The subsequent loan agreement with the IMF to stabilize the Hungarian banking sector and public finances also included emergency financing from the EU. It is clear that the ECB and the EU authorities recognize the increasingly interconnected nature of obligations across the Union. (Note that ECB President Trichet hinted recently that he does not see such obligations extending to prospective EU members.)
So, not all Euro-zone sovereigns have the status of Germany, and some are in for a rough few years of sluggish growth while they try to implement politically-contentious reforms. Nevertheless, none is likely to default and, whatever the rules say, the EU would find a way to prevent an outright crisis – if for no other reason than that the potential contagion impact for other members after a default would be severe.
What if a country leaves the Euro-zone? Can the euro survive?
The global credit crunch and ongoing recession have thrown into high relief both the benefits and the costs of membership in the Euro-zone. Widening debt spreads (see above) and a deepening recession have placed into stark relief that there are still fundamental macroeconomic differences between the 16 member countries. Nevertheless, the cost and practical difficulties of leaving the ‘zone far outweigh any pain associated with staying in.
The question of leaving is being raised because countries such as Italy and Greece can no longer devalue or inflate their way out of their current problems. This causes some local politicians to blame the ‘zone for their countries’ sliding exports or rising unemployment. However, being a part of the Euro-zone is only proving painful for those countries that have failed to improve their competitiveness in recent years. For example, German exports have surged over the past decade while those from Italy (and France) have not. The discipline of a single currency was supposed to unleash a wave of supply-side reforms, but some countries used the protection of the ‘zone to avoid the politically-difficult decisions needed to make their economies flexible and competitive, i.e., structural reform and control of public finances.
On the other side of the coin, the ongoing crisis has reinvigorated the debate on the merits of membership for those EU members who are not yet in the ‘zone, such as the Czech Republic and Poland. Even Denmark, which (along with the UK) has an opt-out from having to adopt the common currency, looks to be moving toward holding a referendum on joining, probably later this year.
While the likes of Italy and Greece are now waking up to the costs of a decade of avoiding reform, Euro-zone membership has undoubtedly protected some small, open economies with big banking sectors, such as Belgium and Luxembourg, from suffering runs on their currency during the current turmoil. It has also protected Spain and Ireland, as their housing bubbles burst, from either having to hike interest rates going into a recession in order to protect their currencies, or having to allow a hefty devaluation that could further exacerbate debt service costs. Even the less-afflicted members have benefited over the past year or so – over half of all Euro-zone exports are to other Euro-zone countries, so sharing a common currency has helped to prevent market disruptions at a time of crisis.
The biggest problem for the euro is not that some members will really try to pull out of the currency zone, but that membership becomes an easy scapegoat for some politicians when the going gets tough.
What if sterling drops to near parity with the US dollar?
Sterling is trading at a 23-year low versus the dollar as investors get increasingly nervous about the UK’s economic prospects, the liabilities in its banking system, the increasing national debt, and how much lower interest rates may go. Are Britain’s policymakers really content to let the pound keep falling?
Unlike Italy or Greece, the UK has gone a long way in implementing structural reforms over the past 20 years, and its economy is much more diversified than the likes of Ireland or Spain. Nevertheless, the UK undoubtedly is suffering its worst recession in many years, thanks to the triple blows of the global drop in export demand, the bursting of its own housing market bubble, and the turmoil in the global financial system – with the latter hitting the UK particularly hard thanks to London’s prominent role in global finance. Real GDP shrank at its fastest pace since 1980 in the three months to December. Recovery is likely to come slower than in the rest of the EU, with a return to growth delayed until 2010.
And unlike some of the aforementioned countries, the UK is not a member of the Euro-zone, meaning it has the option of letting its currency slide – not as a way to avoid the hard decisions about reform (although it could be argued that the government has not done enough to tackle the fiscal deficit in recent years), but as a way to support the economy while meeting the hefty costs of supporting the financial sector. A weaker pound does mean that the banking system’s debts are more expensive to fund, but bear in mind that much of the foreign currency debt in the UK banking system is held at the UK-based branches of foreign banks; and that the domestic banks, and indeed the system as a whole, has foreign currency assets that meet or exceed their liabilities.
Prime Minister Gordon Brown and Bank of England Governor Mervyn King have unequivocally and repeatedly stated that the UK does not target the exchange rate as a matter of policy. The inflationary consequences of a weaker currency will have to be faced at some point, but for now both men are reiterating that a weaker currency will be good for the country’s exports (assuming global demand returns at some point). France has started to demand that the UK support the pound, apparently worried that sterling’s slide is a further threat to France’s already-weak global competitiveness. British policymakers are likely to conclude that if Paris is getting upset, then the UK must be doing something right.
What if Asia experienced major corporate failures?
Even though Asia’s major export economies have all been severely impacted by the sharp, sudden decline in global trade, their capacities to withstand such shocks and possible financial sector damage differ markedly. Some developed Asian economies are considered (or perceived) vulnerable, while others appear all-but-bulletproof. We see two countries that have a degree of vulnerability worth noting – South Korea and China.
Right now, the economy within developed Asia with the most perceived risk of experiencing corporate failure is South Korea, and not without precedent. Almost twelve years ago, many highly-overleveraged mega-corporations fell into the red in the wake of the Asian financial crisis and the government required a $45 billion bailout from the IMF to remain solvent. Most countries through the region suffered significant damage from the crisis, but South Korea captured the headlines as the most high-profile casualty. Now the term ‘regional pandemic’ is synonymous with South Korea, although the country’s situation is far more secure. The mega-corporations still exist, but not as the overleveraged behemoths that roamed the country during the last decade. The government has also reformed its institutions to better supervise the business environment. The corporate landscape for the 21st century is still far from perfect, but better suited to handle a crisis. Also of note is the country’s macroeconomic stability. The current account is usually in surplus and financing requirements are easily met, the country has over $200 billion in foreign reserves, and the government runs a regular budget surplus and carries a low level of public debt. This places the country’s finances in much better shape to contain a crisis – far from perfect, but perhaps in a better position than what today’s markets are pricing in.
The riddle that is China remains difficult to decipher in these trying times, as evidence of structural weakness is at the same time both convincing and contradictory. Plenty of statements from Beijing give the impression that while the economy is slowing and measures are being taken to stimulate growth, the financial system is stable and there is no risk of economic imbalances causing major business failures that would threaten China’s prospects. Recent data releases back these statements, but it would be rash to suggest from all this that everything is well.
China’s reforms of the past decade have shown impressive results, but they cannot all be taken at face value. The financial system continues to lend in the face of the current credit crisis, suggesting that local banks have not been impacted, but these growing loan portfolios have an unknown degree of risk. Chinese accounting and finance exist in a very opaque environment, and pinning down whether or not a company is bankrupt is next to impossible. However, the state also has every interest in keeping public institutions afloat, and is likely to mobilize whatever resources are necessary to keep a bank or a major corporation afloat and maintain social stability. So, while China’s corporate sector is likely to come under severe strain from slower economic activity, we feel that the Beijing government will do whatever is necessary to maintain the appearance of stability. Risks will abound, and in the near-term there could be significant failures, but the state will make every effort and utilize every resource to keep these matters out of public view.
What if the yen continues to strengthen against the US$?
On September 15, 2008, the yen stood at ¥110.5/US$ at the end of Tokyo trading – just before the Lehman Brothers collapse. In the months since then, the yen has surged against the dollar, briefly touching ¥88.1 earlier this month and on a trajectory to pass its all-time level of ¥79. During Japan’s last two recessions, the yen weakened until export growth recovered and dragged the economy back into positive growth. This time, however, the yen is appreciating while exports fall precipitously. Japan’s near-term hopes require exports to rebound, which depends on the yen and its trade partners. The recovery of one will in turn benefit the other, but neither is heading in the right direction.
For December, Japan’s exports fell 35% on the year to ¥4.86 trillion on a seasonally-adjusted basis, a level not seen since January 2004. Exports accounted for about 16% of GDP last year, so the sharp decline witnessed over the past quarter has impacted a significant amount of the economy. This damage will not be fully expressed in the Q4 GDP figures, as reduced imports will partly offset the impact in the national accounts. However, it is clear that the strong yen and falling demand throughout the world are taking their toll.
Looking forward, a strong yen will only feed into deflation through cheaper imports while reducing global competitiveness for what remaining exports the country produces this year, so Tokyo’s policymakers will try to drive down the currency. However, their capacity to do so is limited – interest rates are just about zero, the government is unwilling to issue excessive inflationary debt and add to its ever-growing public debt obligations, and for all its shortcomings, the yen fares well against the dollar because the US is in a dire situation as well. All these factors combine to create quite a grim scenario for Japan, even if the yen never pierces the ¥80/US$ level. The Bank of Japan (BoJ) suggests the country’s current recession will last into 2010, with deflation carrying on to 2011. If the yen continues to rise throughout 2009, by December the BoJ’s glum forecasts might just seem rosy in hindsight.
Regarding Latin America, what if commodity prices experience a severe, prolonged drop?
The Latin American region is quite dependent upon commodities as a source of income. Boom-time has truly been good to both hard and soft commodity producers, and the smart ones, like Chile, siphoned record profits into rainy-day funds. Others, like Venezuela, squandered these funds on populist programs including massive subsidies and social agendas.
Already, we have seen prices for many of these goods collapse from the astronomical levels of last summer. Oil, copper, aluminum, corn, wheat, soybeans, etc. have all plummeted from summer prices, with gold seemingly the standalone that hasn’t literally fallen off the edge due to safe-haven status.
The answer for most Latin American countries is “So what?” Boom-time was a fairly recent development for most of these commodities, so the prudent governments did not permanently price in the unrealistic gains. Truth be told, “a severe, prolonged drop” is actually just these natural resources reverting back to pre-bubble prices, and thus, not a fundamental difficulty for most of these producers to overcome.
For Argentina and Venezuela, however, and a few smaller markets, the answer has been quite painful to admit. Already Argentina has been put on watch for default and has nationalized some private assets. The price of soy (a main export) has tumbled along with most soft commodities, and the government has been attempting to raise taxes on the export to make up for collapsed prices (which led to collapsed tax receipts). In Venezuela, oil makes up over 50% of government revenues, and we all know what happened to that bubble. Chávez’s daily pleading for OPEC cuts says it all.
In short, most of Latin America has shielded itself from the commodity price fall-out. The “ambitious” ones, however, might have a more difficult time adjusting to the way things are going to be.
What if there is a longer-than-expected suppression of external demand for Latin American exports?
We are beginning to see the effects of this deterioration in external demand. Export sectors are just now beginning to contract in Latin America as the developed world cuts back on consumption. This drop in demand will cause a pullback by producers in manufacturing, mining, and harvesting, leading to widespread job losses. Finally, a rising unemployment rate will hit domestic demand and pull many of these markets into recession.
The risk lies in a longer-than-expected world downturn. The discouraging part is that it’s tough to see a way out for these export-dependent Latin American nations without an upturn of external demand. Fiscal and monetary stimulus will likely not lead to full recovery. Thus, it seems reasonable to say that a rebound of Latin America will coincide with an increase in consumption around the world.
What if a Latin American country were to default?
In December 2008, Ecuador’s president, Rafael Correa, chose to voluntarily default on $30.6 million in interest payments on its 2012 global bonds, declaring the debt “immoral and illegitimate”. The damage appears to have been contained to just Ecuador, as well it should be, and did not cause large-scale panic over Latin American debt. If anything, the collapse of Lehman Brothers in September is what pushed up emerging market bond yields the most. However, besides the obvious downgrade of Ecuador’s sovereign debt, the impossibility of obtaining trade finance has become the biggest issue. The export-dependent nations of Latin America should all take heed of this tough lesson learned.
Now, were a larger default to take place (i.e. Argentina’s $23 billion falling due within two years), panic would likely ensue. There is a big difference between this and a $30 million voluntary default due to ideological differences. Latin America would enter a long period of credit and FDI drought, and trade finance would be tough to come by. Borrowing costs would spike through the roof, creating a much sharper-than-expected downturn in the region. In sum, a large sovereign default would exacerbate an already-bad regional downturn and likely prolong the economic hardship.
The big question really is one of contagion, and most importantly, would Brazil get caught up in the liquidity crunch? The truthful answer is ‘probably’, although it is much better off to weather an extended crisis than most other Latin American nations. (Only Chile and Mexico appear to be better prepared.) However, Brazil boasts the seventh-largest stock of foreign reserves in the world at around $200 billion, which amounts to almost 11 months of import cover or close to 13 times short-term debt. In a pinch, these reserves provide excellent access to funding to protect the Real, meet debt obligations, and/or reconcile a financing deficit. Moreover, three of Brazil’s four top export markets are in other regions of the world, meaning a larger Latin American default would not be a huge drag on exports, which are going to be key in reviving the Brazilian economy. The short version: we are not particularly worried about Brazil in the event of a larger Latin American default.
