The Next Great Depression around the corner? news
Vivek Sharma
24 December 2007

Some columnists are predicting the start of a depression in the US next year. They might be jumping the gun.

With only a week left for 2007 to wind down, prognoses for the next year have started in full swing. Apart from providing helpful lists of top-10 this and top-10 that for 2007, the 'to do thing' for most columnists at this time of the year is to forecast what to expect next year.

Trend forecasting is often the last resort of columnists struggling for topics to keep editors in good humour. Unlike most readers would imagine, it is pretty easy to do it. I can give a forecast on anything from Global Warming to what George Bush will do after he leaves the white bungalow in Washington. I don't need to be a 'subject matter expert'. There is no science behind any of these 'forecast columns', only art. The art of weaving a pleasant or frightening - story around a buzzword or two, and make it sound convincing enough to the readers.

The trick is in selecting the buzzword, but it is more of a gamble. The columnist has to find a word or a phrase which is most likely to catch the world's imagination, in the following year. In fact, that is the only 'forecast' a columnist needs to make! If the columnist gets it right, the reward is an invaluable opportunity to remind readers 'I told you so' in every future column for the rest of his or her career.

The buzzword for financial columnists in 2007 has been 'sub-prime', though 'credit squeeze' built up a strong case in the second half of the year. 'Credit squeeze' is a strong candidate for 2008 as well, but there are other contenders.

Going by the recent writings of financial columnists, many seem to be betting on 'Depression' as the buzzword for 2008. In just over a week, I have read more than a dozen columns couple of them in Indian publications - speculating on the possibility of a US economic depression next year. Are these columnists going to hit the jackpot?

Until the beginning of this month, analysts were discussing the possibility of only a 'recession', a very mild form of depression. But the environment has apparently become worse, as evidenced by desperate acts like the ECB pumping in more than $500 billion half a trillion dollars!! to ease liquidity. In such a scenario, 'recession' is not frightening enough and only the 'D word' would suffice. One Indian columnist says this could be equally bad, if not worse, than what the US economy went through in the thirties The Great Depression.

The factors which these columnists list to support their dire prognosis are similar worsening US housing market, which will lead to lower consumer demand, to weak business sentiment, job cuts, even more housing weakness and the cycle will continue. Rising mortgage defaults will see the credit market troubles worsening, investors will flee from dollar assets and the dollar will crash. The Fed will be forced to hike interest rates to save the currency and control inflation, but inflation will rise as food and commodity prices surge as the dollar slips. So the Fed will have to keep hiking, killing any chance of a recovery. Before we know it, hapless Americans will have 'The Next Great Depression'!

Sounds convincing, doesn't it? Now you know how easy it is to write a 'forecast column'. Read again, and you will realise why much of these forecasts are highly alarmist and unlikely to turn true.

US housing market can, and is very likely to, slip further. Prices have to fall further to revert to their long term average, and that process is likely to be a slow one possibly another couple of years. But, housing weakness alone will not pull down US consumer spending as much as feared. If it had to happen it should have happened by now. US home prices have been declining since early 2006, but consumer spending has held up even though fuel prices have also gone up. Yes, Americans did refinance their homes before the price-correction started and splurged the surplus cash. They don't, or can't, do that now but they seem to be getting along fine as their jobs and incomes remain mostly unaffected.

If housing turns even worse, mortgage defaults will rise and that could mean more trouble for the credit markets. It is true that the number of mortgages resetting to higher interest rates will go up substantially in 2008. But, there is already a plan which will delay the rate reset for many borrowers. Yes, the US government initiated plan only delays the reset, does not altogether avoid higher rates and borrowers will see their mortgage tenures extended. But, the plan will help many borrowers to keep their houses. Which means those many houses will not enter the resale market, less pressure on home prices and therefore better chance for a housing recovery.

If the current plan doesn't work as well, the US government will be forced to do more irrespective of the cost. The government will have no choice but intervene, as it has already committed itself.

The credit squeeze is likely to persist for many more months. Not because there is no money in the system, central banks have pumped in more than enough, but only because banks are reluctant to lend to each other. The reluctance is because nobody knows if there are any more skeletons on bank cupboards and hence cannot estimate insolvency risks. Confidence will return if things don't worsen for a couple of quarters.

Next nightmare scenario is a dollar crash. No doubt, there is scope for the dollar to fall further as long as US deficits remain. But that is likely to be an orderly and long term process, and is unlikely to cause any major disruptions. A sudden fall, which will be disruptive, can happen only if foreigners holding dollar assets dump them or many of the countries with their currencies pegged to the dollar suddenly decide to change that. Neither is likely to happen in 2008.

Investors may dump dollar assets if the credit market crisis worsens and a couple of financial institutions become insolvent. There is some talk about potential trouble at bond insurers, as the credit rating agencies are said to be reviewing their ratings. If bond insurers lose their AAA rating, it means they cannot be completely relied upon if the bonds insured by them see defaults. All bonds insured by a bond insurer who loses its AAA rating have to be downgraded, and that would mean disaster for investors holding those bonds.

Investors will lose hundreds of billion dollars if a major bond insurer is downgraded. Commercial banks will be the worst hit as they hold substantial holdings in bonds and credit derivatives, and some banks may become insolvent. If that happens, there could be a massive sell-off and a dollar crash.

Bond insurers can avoid a downgrade if they can raise additional capital. The fear is that they may find it difficult to do so when funds are hard to come by. But, that fear is misplaced as long as there are sovereign funds with their ever swelling kitties. They have been busy pumping in billions of dollars into Citigroup, UBS, Morgan Stanley and Merrill Lynch. There is no reason to fear that they will stop doing so anytime soon. The bottom line is, capital is available to those who need it - though it may come at a higher cost.

The last big fear is inflation. Prices have moved up in the US recently and inflation will remain a major concern for the Fed next year, especially if employment data remains strong. The question is whether prices will move up substantially and force the Fed to hike rates.

The biggest risk on the price front is a sustained rise in oil prices, well beyond $100 per barrel. Demand outlook for oil is rather subdued as global economic growth is expected to slow down. Even if the dollar falls, which will make costly oil less painful to non-US consumers, oil prices are unlikely to rise much higher. After the spectacular run in 2007, oil speculators are less likely to remain so bullish next year. Therefore, further rise in oil prices can happen only if there are major supply shocks. Given the improved political climate in the Middle East, 2008 may prove to be a relatively calm year for oil supplies - unless the next Atlantic storm season comes up with another Katrina.

Most non-food commodity prices have corrected in recent months and the price forecasts for non-ferrous metals are not so positive. Food prices will remain firm because of increased global demand, and not because grains are diverted to ethanol production. But, higher food prices alone will not scare the Fed into hiking rates. At worse, the Fed may become less enthusiastic about cutting rates though that would disappoint equity investors who expect aggressive rate cuts next year.

Now that I have detailed my reasons for staying out of the 'depression camp', let me give my own prognosis for the US economy in 2008. Next year is likely to be very interesting, but devoid of this year's drama. After-effects of this year's financial upheavals will unfold next year, in the form of better risk control, conservative business practices and tighter regulation. How businesses, consumers and financial markets react to these developments will determine how soon the economy starts its recovery. If any of the earlier discussed disaster scenarios occur, the recovery will definitely be delayed and there will be more pain.

In other words, the real action may be in 2009 and next year is likely to be a prelude.


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The Next Great Depression around the corner?