Back in January, I indicated that the fact the Canadian economy had not “reset” was keeping me awake. I was worried that the recession which had just ended had not reset economic and financial activities and that recovery had taken place almost instantaneously. If such thoughts were keeping me up then, I must admit that I am in worse shape now as we look to 2011.
In January, I believed the resetting had been delayed for a few years, but it may actually happen sooner than later. This is because monetary and fiscal authorities have used most of their cards to fight the freakish events and panic that followed the bankruptcy of Lehman Brothers in September, 2008.
There is now little ammunition, both politically and economically, for monetary and fiscal policies to save the day if the financial rescue packages and increased liquidity of the past couple of years do not produce the necessary multipliers to get the economy going. With interest rates close to zero and skyrocketing fiscal deficits, there simply isn’t enough flexibility.
Normally, recessions clear out excesses that previous recoveries generated. But none of the excesses have been extinguished. Consumers are still heavily indebted; house prices are still higher than fundamentals dictate; luxury cars are flying out of dealerships; and so on. The stimulus packages around the world did not change the underlying structure of the economies.
Could the short, sharp economic decline of 2008 and ’09 lead to a sharper, more prolonged real recession in 2011?
Economies are still extremely vulnerable to speculative bubbles and dips and increased volatility. The panic of 2008 and the subsequent rescue packages did not provide the necessary catharsis that recessions bring to economies. Demand for broader reforms has also waned as a result of the rescue of the economy from the panic of 2008. If this were not enough, economies have become addicted to low interest rates and to liquidity infusions.
If it looks as if these are in danger of disappearing, all hell breaks loose in the markets causing politicians and central bank governors to panic before they offer solutions that include lowering interest rates and providing adequate liquidity. This has to stop at some point as the bubble keeps inflating; the larger it becomes the more sharply it will deflate.
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Bubbles
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Make no mistake, the resetting has to happen if we are to break free from the straightjacket in which we find ourselves. Could the short, sharp economic decline of 2008 and ’09 lead to a sharper, more prolonged real recession in 2011?
This reminds me of the short, sharp, liquidity-induced 1980 recession which was followed by a sharper and more prolonged recession in 1981-82. The January-to-July recession in 1980 affected interest-rate sensitive sectors, such as housing and autos, as interest rates increased and liquidity was restrained by then-U.S. Federal Reserve chairman Paul Volcker, who turned off the liquidity spigot.
He used “open market operations” to curtail credit that commercial banks could make available. This affected the interest-rate and credit-dependent sectors of the economy and led to the early 1980 recession, which for political reasons was kept short. But as inflation remained unacceptably high Mr. Volcker once again tightened the money supply which, in the face of high unemployment and already high interest rates, caused the severe 1981-82 recession.
Markets and economies around the world are hooked on low interest rates. This has created a fertile ground for bubbles in the bond market, real estate and all sectors of the economy that depend on leverage and feed on low interest rates.
