2009 will go down in my journal as the year the world didn’t end. Not that I expected it to but lots of people apparently did. I think those people who feared the end of the world, or at least the end of its financial system, were deeply distressed by the appreciable speed and depth of the downturn in the fall of 2008 and early in 2009.
Some of them may have bought into the “it’s completely different this time” theme that seems to emerge with every downturn but now that it’s apparent to most that the world is not, in fact, coming to an end, it’s worthwhile looking at what was different about the financial market crisis, the equity market downturn and the economic recession this time around and, equally important, what wasn’t. This, in turn, might help us understand why the most dire predictions didn’t come true – and help us prepare for 2010 and beyond.
What was actually different about this downturn? I suggest two things. One, and I’m going to be very polite here, was the unfortunate decision-making that was pervasive in large parts of the U.S. and European financial systems. The idea that you lend money without doing any meaningful credit assessment of the borrower is pretty hard to grasp for those of us who grew up in the Canadian financial system. It is equally hard to grasp that it is possible to repeal the laws of economic gravity through financial engineering. Yet, the sub-prime mortgage crisis in the United States wasn’t totally new in the sense that the savings and loan crisis in the 1980s and early 1990s also involved financial institutions loading up on real estate whose value subsequently plunged and left the lenders in trouble.
The second part of the downturn that was new was its global reach. If things went wrong in one part of the world, they also went wrong in another part. This shouldn’t have been surprising. It is the logical outcome of the globalization of goods, services and financial markets. We have seen this trend developing for some years, witness the Asian financial crisis in the late 1990s and the bursting of the dot-com bubble in 2000. The scope of the problems meant that the events of 2008 represented the first really major test of the ability of nations around the world to pull together a coordinated global response. I don’t think the global response deserves a perfect grade but it deserves much more than just a pass.
We need to talk more about the policy response because there is a lot about it that can potentially be misunderstood. In a sense, the policies used to get financial markets and economies out of trouble and back to normal growth were pulled out of mothballs. Not entirely of course since the U.S. Federal Reserve had dropped its benchmark Fed Funds rate to a 40-year low of 1 per cent in 2004, not a lot above the current level of 0 to 0.25 per cent but active counter-cyclical fiscal policy – governments lowering taxes and ramping up spending for the express purpose of getting economies out of recession – hadn’t been actively used for at least a couple of decades, mainly because we haven’t seen a really serious economic slump.
Even the policies that do get regular use were modified to deal with the specifics of this downturn, with some of the modifications being figured out very much on the run. For example, the Bank of Canada widened the list of eligible borrowers and broadened the types of collateral it was willing to take on these loans.
The Federal Reserve’s reach was both wide and deep in both its liquidity support (lending money) and quantitative easing (outright purchases of securities). On the fiscal policy side, perhaps the most significant modification to take account of current conditions was the speed with which stimulative policies were assembled and put in place. The very fact that some policies hadn’t been used for a long time and others needed to be modified may have resulted in some initial skepticism as to whether or not they would work, but the positive results have largely diminished that.
One of the outcomes of this extensive use of public policy is the emerging concern, last seen in the 1970s, when counter-cyclical policies were much more in evidence, that once governments pull back from their stimulus, the economy will go back into recession. In fact, there is good evidence that private sector demand is coming back. If it is slower than anticipated, it is a pretty sure bet that governments and central banks will be prepared to extend their stimulus.
What evidence do we have that the world has escaped this “near-death” experience? A little more than a year ago, we at Fidelity identified three milestones to look for as signs that things were returning to normal.
They were:
- 1. U.S. housing prices stabilize
- 2. credit markets normalize
- 3. U.S. economy resumes growth
We have passed all three. The S&P/Case-Shiller U.S. National Home Price Index has now increased for two successive quarters. The ‘TED Spread’ – the difference between the interest rate charged between banks and the 3-month U.S. T-bill rate is down to less than before the crisis. After four consecutive quarters of contraction, the U.S. economy grew at an annualized rate of 2.2 per cent in the third quarter of 2009. The passing of these milestones doesn’t mean that everything is fine. There are still some serious issues in the U.S. housing market, in particular the large number of borrowers who are unable to keep up their mortgage payments. For some borrowers, credit is still tight or impossible to obtain. And, we need to see some consistent growth in the U.S. economy to feel really confident that the economy is “fixed”.
The evidence isn’t complete yet, labour markets are still deteriorating, which is to be expected at this point in the cycle. There are still risks around the strength and consistency of the economic recovery. There are more challenges for monetary and fiscal policy, namely retreating from the stimulus while getting both the timing and techniques right. Recent events emanating from Dubai remind us that there are still some financial fires to extinguish. But so far, the world, and in particular the financial world, remains intact.
For financial advisors and their clients the evidence that the world hadn’t ended was much more focused: those with the fortitude to stay invested have likely seen their portfolio values increase dramatically in recent months. In addition to the recovery in equity markets; we have seen a narrowing of interest-rate spreads between corporate and government bonds and a recovery in the ability of companies to raise money in capital markets.
2009 was not the year in which the world ended. It was the year in which problems of extraordinary scale were dealt with using extraordinary measures. There is much more to do and we will talk about that next month.