The U.S. is trying to hold off economic disaster. If it fails, no one is safe.

STEVE MAICH February 4 2008


The U.S. is trying to hold off economic disaster. If it fails, no one is safe.

STEVE MAICH February 4 2008


The U.S. is trying to hold off economic disaster. If it fails, no one is safe.



WHEN STANDING AT THE EDGE of an economic cliff, urging consumers not to leap off, a reassuring tone and a good poker face are essential. Last Friday, with world stock markets in free fall, U.S. President George W. Bush gave it his best shot, announcing a US$150-billion economic lifeline with all the calm assurance of a father giving the kids an advance on their allowance.

“By passing an effective growth package swiftly we can provide a shot in the arm to keep a fundamentally strong economy healthy,” he said. The “vibrant economy” was undergoing an “inevitable market adjustment,” he said. It was the right message, undermined only slightly by Treasury Secretary Henry Paulson, looming over the President’s shoulder, looking grave and queasy.

It’s hard to fault him, though. As the former chief executive of Wall Street investment bank Goldman Sachs, Paulson knows better than most what the economy is up against. It took all of 2007 for the Dow Jones industrial average to post a seven per cent gain. It took 17 days of frenzied January selling to wipe out last year’s advance, and then some. He knows that this US$150-billion “shot in the arm” amounts to an all-out Hail Mary pass to save the U.S. economy from a devastating downturn that may already be underway. And he knows that international investors, once spooked, are not easily calmed.

Sure enough, Bush’s reassurances only seemed to fuel the fire. Within hours of the announcement, U.S. stocks resumed their downward spiral. When markets in Asia reopened, they immediately plunged. India’s benchmark index began this week with a record one-day decline of more than seven per cent. It followed the next day with a 10 per cent plunge at the opening bell, while traders in Hong Kong, London, Tokyo and elsewhere followed suit. On Monday morning, Toronto’s main stock index plunged 605 points, its biggest one-day drop since the immediate

aftermath of 9/lL Only an emergency 75basis-point cut to interest rates by the U.S. Federal Reserve, quickly matched by a 25point cut in Canada, eased the panic.

One pundit after another said the global sell-off was based on “growing fears of a U.S. recession.” But that pat explanation misses the broader significance of what is happening, according to a growing legion of economists and analysts. Around the world, stock markets have been in decline since early Octo-

ber—Ireland’s benchmark stock index is down more than 37 per cent in that time; Japan is off 27 per cent; London 17 per cent; and Toronto 12 per cent. That represents almost $180 billion in shareholder wealth wiped out in less than four months, in Canada alone. But all these declines are just symptoms of a sickness in the U.S. economy, and no amount of reassurance from the White House could change the slew of ugly numbers keeping economists up at night. Here are just a few:

• U.S. housing starts in December were five times worse than economists expected, and have fallen 56 per cent from their 2006 peak.

That’s the biggest yearly decline since 198O. Meanwhile, sales of new homes in the U.S. fell to a 12-year low in November.

• Holiday season sales in the U.S. rose at their slowest pace since 2002. The National Retail Federation is predicting sales in 2008 will rise at their slowest pace in six years. Several major chains, including Liz Claiborne, Macy’s, Zale’s Jewelers and Starbucks, are planning to shut stores this year.


• In December the U.S. unemployment rate

spiked unexpectedly to five per cent, its highest level in more than two years.

• According to the U.S. Federal Reserve, consumer debt levels jumped US$15.4 billion in November to US$2.5 trillion, almost double the increase that economists had expected.

Aside from rapid and drastic cuts to interest rates, Bush’s plan to head off the crisis amounts to sending tax rebate cheques of about US$800 to every person on the tax rolls, in hopes that they will run to the mall and make a big-ticket purchase. If it works, we’ll look back in two years time and see the past three weeks as a mere stumble in the

midst of a long bull market. If not—if consumers, say, decide to save the money or use it to pay off debt—this may well be remembered as the moment when the world realized it’s staring in the face of the most painful economic setback in decades. One with the potential to spread damage around the globe. One that could take years to recover from.

“What we fear happening is that we are in the early stages of a systemic financial meltdown,” explains Eric Sprott, renowned Toronto fund manager, well-known for his dire view on the U.S. economy. “I know those are very powerful words. But when you look around at the home builders and the monoline insurers who are down 80 per cent and the big U.S. banks down 50 per cent, those are monumental declines, and they’ve been incredibly abrupt. What’s this telling us? All these huge financial institutions are over-levered.”

A few months ago, Sprott might have been dismissed as an alarmist. But more and more of his colleagues are seeing things his way: too many people and companies with too much debt, too few assets, and a rapidly deteriorating crisis of confidence. The question is, how much worse can it get?

THE TROUBLE didn’t start in Miami, it just happened to dump a lot of the wreck-

age there. During the super-heated real estate boom of the past five years, Miami, like many U.S. cities, saw a flood of new building and thousands of condominium units financed with exotic and risky loans. When the credit crunch began to hit early last year, this is where it hit hardest. Prices have already dropped an average of 40 per cent, and analysts predict another 15 per cent drop this year. Foreclosures jumped 160 per cent from 2006 to 2007, leaving a wasteland of empty condo units. In some buildings, up to 30 per cent of all units have been foreclosed upon.

This was the first step in the nightmare

chain reaction now very much on the minds of financiers around the world. Step two is already happening: big banks, devastated by a round of multi-billion-dollar writedowns for bad mortgage loans, have begun to warn of a rapid deterioration in other types of credit as well. Citigroup has set aside US$3.3 billion to deal with delinquent consumer loans, topping JP Morgan Chase’s US$2.3-billion hit and US$1.4 billion for Wells Fargo. In response, they have begun clamping down on credit, striking even more fear into the hearts of the beleaguered middle class. The final domino is consumer spending, and the betting is that millions of ordinary Americans, rocked by the sudden drop in the value of their homes, saddled with onerous debts, and spooked by the mounting carnage on the stock market, will now retrench and refuse to spend. “The stimulus package is crap, it’s not going to do anything,” says Paul Kedrosky, a partner at Vancouver-based venture capital firm Ventures West. “The United States is already in recession, and this one is going to be a consumer recession—you have to go back 25 years to get to the last time the economy went into recession because consumers stopped spending. It’s going to feel really awful.”


Just how awful remains up for debate, but David Rosenberg, chief economist for Merrill Lynch, has gotten tired of hearing his colleagues use euphemisms like “recessionary” and “recession-like” to downplay the threat of cutbacks and turmoil facing millions around the world. “There is still so much denial out there,” he says. “Participation in the credit boom was so broad-based. It wasn’t just about subprime mortages. It spilled over into prime mortgages, credit cards, car loans, student loans. When you look at how much debt was created in the past six years, it went way over and beyond the ability of the economy to

service that debt. It was a credit binge of historical proportions. The only question is, how much of this debt is truly toxic?”

In the wake of that binge, central bankers face the same dilemma that plagued them in the late 1970s, when double-digit unemployment and rampant inflation saw thousands lose their jobs amid oil shortages and plant closures, giving life to a new business bogeyman: “stagflation”—a combination of stagnant GDP and rapid price increases. Cut rates too much and you court hyperinflation; cut too slowly and you’ll send the economy into a tailspin that might take years to pull out of.

That is more or less what happened in Japan in the 1990s, when its phenomenal growth came crashing down in a decade-long economic slump marked by chronic price deflation. In a desperate bid to stoke up business, prices were slashed on everything from electronics to furniture to cars. Shell-shocked consumers sat on their savings, fearful of the future and knowing that if they just waited, that television set would soon be even cheaper. In a classic deflationary spiral, production gets scaled back, leading to layoffs and eventually a drop in commodity prices.

Rosenberg says there are important dififer-

enees between the U.S. in 2008 and Japan circa 1990, but there are ominous similarities too. “The 1980s belonged to Japan, and in 1989 there wasn’t a person who would have believed that Japan could go through a decade oflost growth,” he says. “Now, nobody believes that the U.S. could go the way of Japan. Well, I think the U.S. could be a little like Japan. I don’t think it’ll take 10 years to clean up the situation, but it could take three to five years. You have a bubble of monumental proportions, followed by national real estate deflation, and those never end well.” To simply call this a recession is to miss the

point, says Rajeev Dhawan, director of the Economic Forecasting Center at Georgia State University. Instead, he describes this as a so-called “wealth recession” that spreads like a virus, causing consumers to dramatically reduce their spending for the long run. “Recessions are like broken bones,” says Dhawan. “They immobilize you, but if you do the therapy, you can get back on your feet again. But this may be more like a problem with your circulation system that requires you do different things to get back in shape. It can take a long time.”

There are still many who believe China, India, Canada and a handful of other countries are effectively inoculated against this kind of financial virus. The consensus among most Bay Street economists is that Canada’s growth rate will slow slightly this year, but the domestic economy will avoid recession as long as growth in China and India stoke

up demand for oil, base metals and other commodities. So far, there is much to support their optimism. As bad as the economic numbers have been in the U.S., Canada has held up well. Unemployment is still near historic lows, retail sales clocked in modest gains in December, and the domestic housing market remains a picture of health compared to its American counterpart.

But the strength of Canada’s business sector remains fundamentally tied to international trade, and it’s becoming increasingly clear that even the red-hot Chinese economy has much to lose from a prolonged funk in the U.S. On Monday, shares in the Bank of China plunged more than five per cent on reports that the bank will write down as much as $8 billion associated with the U.S. subprime mortgage crisis—a vivid reminder that the Asian banking sector isn’t immune to the North American flu. Neither, of course, are its all-important manufacturers. While Chi-

nese factories have diversified their trade in recent years, exports to the U.S. still represent roughly 10 per cent of the total Chinese economy. The bottom line is simple: if the mighty U.S. consumer sinks, millions will be dragged down in his wake. And that, in short, is why practically every major stock market around the globe is hanging on the dire economic news out of Washington. “I reject this whole decoupling idea,” Kedrosky says. “It’s a pleasant fiction, but China and the rest of the world are still just too dependant on U.S. demand. It’s wishful thinking.”


A sharp slowdown in Asian demand would certainly hobble the market for commodities like oil, copper and other base metals that have fueled Western Canada’s boom. The economy in Ontario and Quebec is even more directly exposed to any downturn in consumer spending. Already, Canadian manufacturers are struggling to cope with the effects

of the surging loonie, and lower U.S. interest rates will only intensify the squeeze. All this, when combined with a serious drought for Canada’s financial sector, produces a bleak prognosis. “I would say the risk of recession is very high, no question about it,” Sprott says. “In the U.S., it’s for sure, and I’d say it’s likely to happen here. If I were to predict, I’d say it’s over for Toronto real estate—you have a lack of financing, your lending community is in a fragile state, people’s bonuses are all going down. Why would anyone imagine this won’t have consequences?”

It’s a reality that even the resolutely upbeat federal government has begun to acknowledge. This week, David Gamble, a spokesman for the Department of Finance, said that Canada is “not immune” to the economic fallout to our south. Indeed, small cracks in our economic resiliency have already begun to appear. In December, the economy shed 18,700 jobs after seven straight months of hiring, and when the Bank of Canada cut interest rates on Tuesday, it signalled plans to scale back its growth forecasts, for both Canada and the U.S., in the days ahead.

All of which brings us back to Bush’s Hail Mary pass to U.S. consumers. If Congress moves quickly, the cheques could start arriving by spring. Will that massive flood of free cash and rock-bottom interest rates send people running to the malls and save the economy again, just like in 2001 when Bush slashed taxes after 9/11? Or is it too

little too late? Will the bailout be scuttled by huge personal debts, plunging house prices, mounting layoffs and gasoline prices more than double what they were back then? For now, the doubters speak loudest. “The stimulus package will help for maybe a quarter,” Rosenberg says. “But how much of this is going into the gas tank? How much will go to pay the third credit card bill? People think there’s a magic bullet. There’s no magic bullet.”

Nor, it seems, is there anywhere in the world to hide. M —With Jason Kirby

Jason Kirby