The information which I’m passing along to you today might come as a shock to those listening to the usual stock market cheerleaders, who predict good times ahead. Let’s start with economist John Hussman of the Hussman Funds. For quite a while, Dr. Hussman has been warning us to avoid drinking the Kool-Aid served by the perma-bulls. In his latest Weekly Market Comment, Hussman offers yet more sound advice to those under the spell of brokerage propagandists:
I want to emphasize again that I am neither a cheerleader for recession, nor a table-pounder for recession. It’s just that given the data that we presently observe, an oncoming recession remains the most probable outcome. When unseen states of the world have to be inferred from imperfect and noisy observable data, there are a few choices when the evidence isn’t 100%. You can either choose a side and pound the table, or you can become comfortable dwelling in uncertainty, and take a position in proportion to the evidence, and the extent to which each possible outcome would affect you.
With most analysts dismissing the likelihood of recession, I have been vocal about ongoing recession concerns not because I want to align myself with one side, but because the investment implications are very asymmetric. A slow but steady stream of modestly good economic news is largely priced in by investors, but a recession and the accompanying earnings disappointments would destroy some critical pillars of hope that investors are relying on to support already rich valuations.
Yale Professor Robert Shiller is the guy who invented the term “irrational exuberance”, which was title of his bestselling book – published in May of 1996. Although the widely-despised, former Federal Reserve Chairman, Alan Greenspan is often credited with creating the term, Greenspan didn’t use it until December of that year, in a speech before the American Enterprise Institute. Shiller is most famous for his role as co-creator of the Case-Shiller Home Price Indices, which he developed with his fellow economists Karl Case and Allan Weiss. While many commentators decried the idiotic economic austerity programs which have been inflicted across Europe, Professor Shiller investigated whether austerity is at all effective in spurring economic growth, seeking a better understanding of austerity’s consequences. In a recent essay on the subject, Dr. Shiller cited the work by Jaime Guajardo, Daniel Leigh, and Andrea Pescatori of the International Monetary Fund, who recently studied austerity plans implemented by governments in 17 countries in the last 30 years. The conclusion reached by Professor Shiller should sober-up the “rose-colored glasses” crowd, as well as those aspiring to implement similar measures in the United States:
The austerity plans being adopted by governments in much of Europe and elsewhere around the world, and the curtailment of consumption expenditure by individuals as well, threaten to produce a global recession.
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There is no abstract theory that can predict how people will react to an austerity program. We have no alternative but to look at the historical evidence. And the evidence of Guajardo and his co-authors does show that deliberate government decisions to adopt austerity programs have tended to be followed by hard times.
Policymakers cannot afford to wait decades for economists to figure out a definitive answer, which may never be found at all. But, judging by the evidence that we have, austerity programs in Europe and elsewhere appear likely to yield disappointing results.
The really scary news concerning the state of the global economy came in the form of a report published by the World Bank, entitled Global Economic Prospects (Uncertainties and vulnerabilities). The 157-page treatise was written by Andrew Burns and Theo Janse van Rensburg. It contains more than enough information to induce a serious case of insomnia. Here are some examples:
The world economy has entered a very difficult phase characterized by significant downside risks and fragility.
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The downturn in Europe and weaker growth in developing countries raises the risk that the two developments reinforce one another, resulting in an even weaker outcome. At the same time, the slow growth in Europe complicates efforts to restore market confidence in the sustainability of the region’s finances, and could exacerbate tensions.
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While contained for the moment, the risk of a much broader freezing up of capital markets and a global crisis similar in magnitude to the Lehman crisis remains. In particular, the willingness of markets to finance the deficits and maturing debt of high-income countries cannot be assured. Should more countries find themselves denied such financing, a much wider financial crisis that could engulf private banks and other financial institutions on both sides of the Atlantic cannot be ruled out. The world could be thrown into a recession as large or even larger than that of 2008/09.
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In the event of a major crisis, activity is unlikely to bounce back as quickly as it did in 2008/09, in part because high-income countries will not have the fiscal resources to launch as strong a countercyclical policy response as in 2008/09 or to offer the same level of support to troubled financial institutions.
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Developing countries need to prepare for the worst
In this highly uncertain environment, developing countries should evaluate their vulnerabilities and prepare contingencies to deal with both the immediate and longer-term effects of a downturn.
If global financial markets freeze up, governments and firms may not be able to finance growing deficits.
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One major uncertainty concerns the interaction of the policy-driven slowing of growth in middle-income countries, and the financial turmoil driven slowing in Europe. While desirable from a domestic policy point of view, this slower growth could interact with the slowing in Europe resulting in a downward overshooting of activity and a more serious global slowdown than otherwise would have been the case.
In other words, Europe’s economic austerity programs could turn another round of economic contraction into a global catastrophe (as if we needed another).
This is what happens when economic policymaking is left to the plutocrats and their tools. “Those who fail to learn from the past are doomed to repeat it.” It appears as though we are well on our way to a second financial crisis – with more severe consequences than those experienced as a result of the 2008 episode.