Is the recession really over?

Most people define a recession as two consecutive quarters of declining GDP. This definition gained popularity after it was included in a list of indications by economist Julius Shiskin in a 1974 New York Times article. Likewise, a recession is considered to be over when the streak of declining quarterly GDP concludes.

In the U.S., the National Bureau of Economic Research is the authority tasked with placing chronology on recessions. They define an economic recession as “a significant decline in economic activity spread across the country, lasting more than a few months, normally visible in real GDP growth, real personal income, employment, industrial production, and wholesale-retail sales.” Far less quantifiable than the simple two quarters of declining GDP, this definition allows NBER more flexibility.

It’s now commonly perceived the recession in the U.S. is over, yet at press time NBER had still not made its declaration, claiming using current data to determine a trough date would be premature. Regardless, most economists agree the recession in the U.S. ended sometime in mid-2009, not coincidentally at the start of the quarter that ended the streak of four consecutive declines in quarterly GDP. Chances are NBER will come to a similar conclusion eventually, but only after there’s absolutely no doubt.

Canada’s not out of the woods yet

In July 2009, Mark Carney declared Canada’s recession a thing of the past – again not coincidentally at the start of the quarter that ended the streak of consecutive quarterly GDP declines. The declines lasted three quarters, making it a relatively short and mild recession compared to the recessions of 1991-1992 (four quarters) and 1981-1982 (six quarters).

Statistics Canada apparently uses a more qualitative approach involving analysis of indicators other than GDP, but came to the same conclusion in their 2009 year-end review. Statistically, the recession was shorter and less severe in Canada than in the other G7 nations.

It’s important to note that being out of a recession doesn’t necessarily mean it’s going to be smooth sailing. Unless one can be sure the recession we just experienced was plain vanilla in nature and growth will follow the same or similar trajectory as past experiences, it’s relatively pointless to do a victory lap just because the recession is “technically over.”

In all probability, we’re entering a period that looks nothing like a normal recovery. And we’re more likely entering a relatively long period of deleveraging through a combination of debt repayment, debt default and currency debasement. In short, there’s a headwind facing global economic growth – debt. There are far too many industrialized countries carrying dangerously high debt levels that, combined, represent a large portion of the global economy. The debt acts as a ball and chain and seriously impedes economic growth even at today’s generally low interest rates.

In mainland Europe and Japan, the debt problem is at the government level. In the U.K. and the U.S., the debt problem is at both the government and consumer levels. And despite all the headlines about how our government’s relatively low debt level is the envy of the industrialized world, Canadians continue to build up personal debt at a time when most of the industrialized world is deleveraging personal balance sheets.

Time for a new approach?

The solution to the debt crisis has so far followed a Keynesian script, where the basic fiscal policy strategy is to increase public sector debt at a time when private sector debt is contracting. This is the path the U.S. has chosen, and most agree they had no choice, given the dire circumstances they faced.

Europe’s solution meanwhile is to further increase already high levels of public sector debt, with fiscally conservative countries such as Germany dealing with the problems of fiscally challenged countries such as Greece.

Europe is hoping public debts can eventually be reduced through a combination of increased revenues and decreased expenses, both of which require sacrifices from the private sector. In other words, they seem to be trying to reduce public debt in the long term with the side effect of increasing private debt. Can anyone really know the true outcome of such actions? We certainly don’t, and this adds significant uncertainty. The textbook explanation of the debt problem is the concept of marginal productivity of debt: simply put, the amount of additional GDP created by issuing an additional $1 of debt. The higher the ratio, the more GDP is created through an additional $1 of debt, resulting in higher-quality debt. If the ratio is below 1, debt is rising faster than GDP for each $1 issuance of additional debt, and if the ratio falls into negative territory, adding more debt actually causes economic output to decrease.

In the U.S. in the 1950s, the marginal productivity of debt was above 3, meaning for every $1 of debt issuance, GDP grew by $3. By 1971, the ratio had fallen to below 1. In 2006, the ratio turned negative for the first time ever. Given the long-term decline in the ratio, there’s certainly cause for concern over the U.S. strategy to fight the recession with more debt.

We fear in the present case the Keynesian approach won’t work, because one can’t use more debt to re-establish long-term sustainable growth in GDP at a time when the marginal productivity of debt is low. When Keynes was prescribing his theories, the marginal productivity of debt was above 1, so you could actually grow yourself out of a debt problem. But as the debt gets bigger and bigger and marginal productivity declines, the economy slowly suffocates on debt until it’s paid off, defaulted on, or inflated away.

We often see comparisons of country credit-worthiness based on the debt-to-GDP ratio – a measure of the quantity of debt. But there are limitations with this analysis. As expressed in Reinhart and Rogoff’s “This Time is Different,” each country’s debt threshold is unique and will depend on its record of default and inflation. So it’s not appropriate to assume two countries with identical debt-to-GDP ratios carry the same credit risk.

Either way, Reinhart and Rogoff make it very clear that “all too often, periods of heavy borrowing can take place in a bubble and last for a surprisingly long time. But highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked.”

The PIIGS of Europe are living this right now and some believe the U.S. will follow, but perhaps only after Japan and the U.K. have had their turn. These heavyweight champions are now seriously testing their debt thresholds.

American investment author John Mauldin provides some very good commentary on deleveraging and tends to summarize these complex subjects in ways easily understood. His free weekly newsletter at www.2000wave.com provides regular insight and commentary. In his January 22, 2010 issue entitled “Thoughts on the End Game”.

Mauldin reproduces Van Hoisington and Dr. Lacy Hunt’s Q4 2009 Review and Outlook, which provides some important conclusions from Reinhart and Rogoff’s book, including: “Once debt becomes excessive, countries do not grow their way out of the problem; they must go through the time- consuming and often painful processes of debt repayment and increased saving;

“Economic damage as a result of extreme over-leverage has remarkably similar results, whether the barometer of performance is economic output, the labour markets, or asset prices; “Government actions, even involving sizeable sums of money, are far less helpful than they appear; and “Further increasing leverage to solve the problem only leads to greater systemic risk and general economic underperformance.”

Inflation and deflation coming

So will we see an inflationary or deflationary outcome? We believe we’ll probably experience both.

We’ve already mentioned the likelihood of entering a long period of deleveraging, which could occur through a combination of debt repayment, debt default and currency debasement.

Naturally, debt repayment and debt default are both deflationary events where the amount of debt is voluntarily or involuntarily reduced. But the more subtle currency debasement method of deleveraging is by definition inflationary. Some central banks and governments seem convinced that one of the paths to continued economic growth lies in making domestically produced goods cheaper to foreign consumers, resulting in increased net exports.

Other central banks and governments want to reduce the real value of the debt they owe. If the purchasing power of a country’s currency declines, the price of a good or service denominated in that currency will, all else being equal, increase. For asset prices, this is the offsetting inflationary effect that works against the deflationary effect of debt repayment and debt default. Most likely, it’ll go largely unnoticed in the short to medium term, as the deflationary factors overwhelm the inflationary factor.

By now, the consensus is the global recession is long over. However, there’s significant debate about the type of recovery we’ll experience. The policy response to the recession has been very accommodative and has followed a largely Keynesian approach. Whether such an approach will work over the long term is up for debate, given the high levels of debt in both the public sector and the private sector.

Most people feel there was little choice in the policy response, given the urgent state of affairs during the height of the recession. Yet it can’t go unnoticed that the policy response means increased debt at the government level over the short term. This will stymie the expected future growth in economic output, as the quality of debt continues to be poor.

In other words, there is reason to believe many industrialized countries have hit a debt wall where debt servicing costs, even at today’s low rates of interest, become too onerous to grow out of. The end result is likely a long period of debt deflation (or deleveraging), causing global economic growth to stagnate at levels below historical norms.

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Kash Hashemi, CFA, MBA is a portfolio manager with Nicola Wealth Management.

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Kash Hashemi