LIKE an unending chain of explosions, markets and economies continued to slump last week. Stock markets are tumbling to multi-year lows and some of the world's biggest brand names saw their shares plunge on profit warnings and news of labour shedding.
Why is it that governments in America, Britain and Europe have saved their banking systems, and interbank lending rates have begun to come down, yet fears of global recession have heightened in intensity? How do we seem to have rescued the banks but
are unable to save the world?
The lesson from a detailed International Monetary Fund study of bank failures and rescues is that while financial markets may be pulled back from the brink of a catastrophic collapse, the process of deleveraging continues to hit the 'real' economy for a long time afterwards.
If past form is any guide, it may take more than a year for equity markets to begin a durable recovery – as opposed to a short-term bounce. And it will take a full four years after a bank recapitalisation for house prices to recover.
There is no quick solution to a credit correction. And on the evidence that is mounting by the week, recession is going to stretch well into 2010 before there is any evidence of an economic recovery. By that time, enormous amounts of economic, financial and social damage will have been inflicted.
This is the bitter truth that markets and the wider public are only now beginning to discover. And it is a particularly rude awakening for those who thought that the drastic action taken by governments to recapitalise their banks would bring about an immediate restoration of confidence and recovery.
Instead, markets have tumbled even lower on concerns of a deep and prolonged global recession. Nor is the selling confined to small companies or specialist businesses. Last week saw some of the world's biggest blue chip companies being brought low. Profit warnings, poor sales figures, earnings downgrades and news of lay-offs and redundancies: each new chilling announcement sent their shares plunging further.
Last week US car giant Chrysler said it will cut a quarter of its white-collar workforce, starting next month. "These are truly unimaginable times for our industry," said Chrysler's chief executive Robert Nardelli.
In Japan, electronics giant Sony shocked the Tokyo stock market with news of a 40% downgrade in its profit outlook. The shares plunged 14% to a 13-year low. In South Korea, Samsung, the world's biggest manufacturer of memory chips, liquid crystal displays and flatscreen televisions, warned of a 44% plunge in profits. The shares plummeted 14% to take the fall on the week to 22%.
In France, car maker Peugeot Citroën sees "massive production cuts" after revealing a 5% fall in third-quarter earnings. For the current quarter it is talking of a "collapse" of the European car market. Photocopier group Xerox is cutting 3,000 jobs due to "the tough business environment", while Merck is cutting 12% of its workforce, saying it has to change its model to survive. Volvo of Sweden slashed 850 from its workforce last week after announcing a 37% plunge in third-quarter profits. Kia Motors, Korea's second-largest car maker, has posted more losses in the third quarter, while stark profit warnings have come from Air France/KLM.
The good news is the banks appear to be more securely financed – for now. Last week saw a narrowing of spreads in the interbank money markets, with falls both in the overnight and three-month rates in the wake of the government recapitalisation and liability guarantee schemes.
However, a global recession has now arrived, led by developed-country economies such as the US, Britain and almost all the major economies on the continent. Most developing economies are likely to slow considerably further, particularly those with a high exposure to world trade and which have high debt-to-GDP ratios.
Investment bank UBS has drawn on extensive studies by the IMF on previous periods of financial stress and subsequent economic downturns to try to discern what may now lie in store.
The conclusions are not comforting. Episodes of financial turmoil characterised by banking sector distress are more often associated with severe and protracted downturns than episodes of stress centred mainly in the stock and bond markets. Episodes of financial turmoil preceded by high household sector borrowing – both mortgage borrowing and resort to credit cards – are even more likely to result in severe and protracted economic downturns.
Finally, government-led recapitalisation of the banking sector has not, in the past, led to a quick turnaround in the real economy. After the recapitalisations in the aftermath of the US savings and loans crisis in the late 1980s and early 1990s, and the Nordic banking crisis of the early 1990s, economic activity and domestic housing markets remained depressed for considerably longer. Disinflationary pressures intensified and interest rate cuts were not immediately followed by any recovery. UBS economists are also sceptical of the benefits of Keynesian pump-priming: "Fiscal policy expansions will not prevent an economic downturn from unfolding, though they ought to alleviate the pain."
Their research finds that equity markets bottomed on average one quarter after the recapitalisation plans were enacted, though a more durable recovery only occurred more than a year after recapitalisation and, surprisingly, only took place in tandem with a recovery of economic activity, not before it.
Real house prices continued to fall for more than six quarters after the recapitalisation and did not stage any recovery for another two and a half years. In other words, says UBS, "real house prices did not stage a full recovery until four years after government-led rescue packages had been announced. Unsurprisingly, household savings rates rose for a prolonged period in all cases, suppressing consumer spending relative to GDP."
As for the economy overall, the average level of real GDP found a bottom about six quarters after the respective recapitalisation packages were announced. Headline inflation rates fell for at least five years after the rescues, suggesting a great deal of disinflationary pressure.
A short sharp recession? Not on this evidence. We are now in the grip of a global deleveraging which will be severe, unsparing and prolonged. Interest rate cuts may alleviate some of the pain.
The reason that the UK economy is especially vulnerable is, first, that it entered this crisis with high levels of both household and government borrowing, and second because of the structure of the economy itself. Financial services, which formed the fastest-growing sector of the economy overall in recent years, is facing a severe contraction. Retail, business services, property, construction and housebuilding are all now being hit hard. That leaves manufacturing, but we have little of that left after the two previous recessions. We will now see rebalancing – with a vengeance.
