Recession On The Way?

2011-08-15T17:22:00.000+01:00

American downgrades and sluggish growth forecasts are enough alone to cause a worldwide panic. Add in some negative speculation about the future of the euro and an even bigger crisis develops. The euro has, for at least 2 years now, faced turbulent times. It was always a concern, but never a big worry. As long as leading figureheads showed confidence about it, everyone seemed to buy it. It is only now that the curtains are being slowly drawn back, revealing the mess that had been hidden from view for years.

Just last week the head of the European Central Bank (ECB) expressed great concerns over the euro. Now the head of the world bank has also lectured over the economic challenges that persist in the world. There has been a general focus on two issues, the downgrading of credit in the United States and the growing instability of the euro. Both of these problems are strong enough to start another wave of a recession and both can affect the future of the UK. I’ll focus on US credit in this post and deal with the euro at a later date.

Credit has been a remarkable symbol of wealth. The rich will have large stocks of it on plastic cards layed out in an Italian leather wallet, whilst the poor will be fighting it as a barrier keeping them from getting a mortgage, a car or anything else with any value. Up until 2008 credit was fairly easy to get ahold of. In fact, there were many people who were able to get a full mortgage from the bank whilst having: no job, no income and no assets. These ‘ninja loans’ as they were called were the foundations blocks of building an unstable financial system. People knew they could not pay their loans back, but it didn’t stop them getting it. When you are in such a poor financial position you relish at the opportunity of getting away with a stock of cash, or so it seems.

Back to the point. In the early millennium many people in the developed world felt they could take on more risk and so decided to borrow more and more without having any substantial increase in their own incomes. In a similar way, countries felt that as long as they were growing at an acceptable rate, it was okay to run up large deficits over the course of a business cycle. There was no credible threat seen ahead, which led some naive individuals such as Gordon Brown into thinking “we have broken the business cycle”. In other words, despite being a chancellor prior to the financial crisis and seeing the unstable housing bubble develop, he had the audacity to claim there was no such thing as a recession anymore.

In a nutshell America spent too much. When it came to the bailouts (which will be discussed in a later post) there was no choice but to run up a huge deficit at the expense of the taxpayer. Not only did this weaken the value of the American dollar but it crushed all credibility for the currency. America has many countries to which they owe debt to, the largest being China. Just recently, it was calculated that the US still didn’t have enough money in the economy to jump start it despite printing over $2 trillion. As a result a long-winded debate ensued for over a week regarding America raising the amount to which they could borrow – otherwise called the debt ceiling.

But how does this relate to downgrading?

Well there are three main credit agencies in the US. These are Standard & Poors (S&P), Moodys and Fitch. The role of these institutions is to give each country a score through a series of letters ranging from AAA+ to Junk. This grade is allegedly meant to represent how likely it is that a country would default on its debt. These agencies have lost a lot of credibility as many of the loans which they rated as being the best actually turned out to fail miserably in the run up to 2008. Nevertheless S&P downgraded American debt for the first time ever. This caused widespread panic throughout America. As expected, the nerves rattled through the time zones as every developed economy suffered a week of heavy losses on the stock exchange. $5 trillion was wiped off the value of companies. Bank shares fell rapidly, with Citigroup shares losing 15% of their value.

The impact was clear and frightening. Moreover, American debt only dropped to AA+. Imagine if S&P decided to downgrade it more drastically. I suppose another question that comes to mind is why this event would affect the UK? The trouble is that the US has, for a long time now, been seen as the world economic leader. If there was a problem in the US it is likely to resonate throughout the word. Just look at the sub-prime mortgage crisis and you will see this. Thus, when confidence in US companies falls, confidence in other companies will fall. For example, if the value of shares in Ford motor cars fall, then Ford may have to cut costs to remain profitable. This may mean negotiating cheaper contracts with suppliers, or dropping them all together. Quite often these suppliers are not in America and have been outsourced from parts of the developing world. So, a fall in confidence in the front office has negative effects all the way down the supply chain. This is one of many reasons why all other world stock markets suffered a bad week of trading following the American downgrade. So we are now at the stage where the London FTSE falls.

Why does this affect us in the UK?

If you have any sort of pension plan with a pension provider, the likelihood is that your cash has been used to buy shares which are floating on the stock exchange. Any fall in the share prices that your pension provider has decided to invest your funds into will drop the value of your current pension. In essence, you would be poorer. Also, many companies link wages to the level of the stock market, so a drop would have a net effect of a pay freeze or pay deduction for many workers. Ultimately, the stock market represents confidence. Without confidence, people shy away from investing. This has a self-fulfilling prophecy and ultimately leads to stagnating growth.

Recession?

It is too early to tell and anyone who does attempt to predict it will most likely be wrong or lucky. It appears that the effects of the downgrade have worn off for now. At the time of writing this post the FTSE was 5350.58, up 0.57% - nevertheless up! It is not clear yet if this recovery will be sustained. The more major issue for the week will be over the euro and its credibility.

The Kenny Edition

Recession On The Way?