Remember "decoupling"? It was the notion that emerging economies had detached themselves from the developed world, and that Asian consumers could make up for falling demand in the rich world. An Indian steelmaker would not only fail to sneeze at the first sign of a cold in the United States, but might even hold the key to a cure.
So much for that theory: emerging-market stocks have plummeted some 50 percent in the past year, even further than the S&P's 36 percent nose dive. Decoupling was a powerful myth, but only one of many in this global recession. The crisis is moving so fast, and in so many different directions at once, that the shelf life of conventional wisdom is shrinking exponentially. Just a few weeks back, analysts were saying the worst had passed for the financial sector; today Citigroup is imploding. Throughout 2008, forecasters predicted the demise of the dollar. Now it's the euro and sterling that are falling. What's behind these and other recession myths, and why haven't they come to pass? Below, we investigate.
Myth: The Credit Crisis Is Over
By early January, headlines had been free of major bank failures for a few months, and many experts had begun to breathe a sigh of relief. "We have probably seen the worst of the credit crisis from the standpoint of the banking balance sheets," said Bill Gross, manager of PIMCO, the world's largest bond fund, in mid-January. The TED spread, a carefully watched measure of risk, had fallen to more normal levels by mid-January, a sign that banks had begun lending to each other again. Most promisingly, in the first full week of January, companies sold $153 billion of debt to investors—the highest volume since the beginning of 2008.
Unfortunately, those numbers were misleading. The five biggest corporate debt sales in early January had government support. General Electric, for instance, tapped into a Federal Reserve program to borrow $9.9 billion. Meanwhile, Bank of America's recent woes provide a highly visible reminder that 2009 holds the potential for another fiery financial-sector crash. The company booked a stunning $15 billion loss last quarter, the result of major indigestion after absorbing troubled investment bank Merrill Lynch. The federal government had to step in with a $142 billion bailout in January. Citigroup, too, has gone hat in hand to the government moneymen recently, and the company—once the poster child for bigger-is-better banking—is splitting itself in two.
Globally, banks have already absorbed about $1 trillion in losses on mortgages and other bad debt holdings according to Jan Hatzius, chief U.S. economist of Goldman Sachs. That's a startling figure, but his group's models indicate the financial-sector meltdown hasn't even reached the halfway point: Goldman expects another $1.1 trillion in losses. Until that bad debt is accounted for, the memory of the collapse of Lehman Brothers will stay fresh.
Myth: All Industries Are Suffering
What's more surprising is that outside the financial sector, things don't look half bad. It's a common myth that corporate balance sheets across all industries are increasingly beleaguered. That was certainly the case in the 2001 downturn. In the years leading up to that recession, companies borrowed heavily to take advantage of new technologies and upgrade their IT infrastructure. The spending binge meant corporations had just $352 billion in cash when clouds gathered in 2001—clearly not enough to weather the storm, as the bankruptcy rate soared to 10.6 percent that year.
But natural selection has since worked its magic; the CEOs left standing are a thriftier breed. They used years of record income growth—average profits among blue-chip firms rose at a double-digit clip for 18 consecutive quarters between 2002 and 2006—to pay down debt and build up rainy-day funds. According to Standard & Poor's, the financial-research and credit-ratings firm, companies had a cash hoard of $616 billion by 2008, and debt as a percentage of net worth was a third less than 1991 levels. Smaller, debt-laden companies are still at risk, but accountants at ExxonMobil, Apple and other large, thrifty firms are, for now at least, still smiling.
Myth: The Dollar Will Collapse
In the first half of 2008, smiles were a rare sight among dollar holders. With the U.S. recession-bound, investors shunned the globe's default reserve currency, and it struck new lows against its major competitors. Gold broke $1,000 an ounce as traders stampeded away from the dollar. Steve Forbes dubbed it a "junk currency." With the Federal Reserve pumping money into the economy, the supply of dollars outstripped demand, an imbalance that weighed on the greenback's value.
But rumors of the dollar's death have been greatly exaggerated. The U.S. economy has been in free fall for more than a year now, yet the dollar has defied gravity since mid-2008. It's climbed 25 percent against the euro and 41 percent against the pound since last year's lows. Gold has fallen back to about $900 an ounce, and investors are pouring money into U.S. Treasuries and, by extension, putting their faith in the dollar.
Why is the dollar still so healthy? Hal Sirkin, a senior partner at the Boston Consulting Group and coauthor of "Globality," says that the Federal Reserve "turned on the printing presses pretty heavily" in its early attempt to jolt the economy. That led to the dollar's dip in early 2008 and gloomy forecasts from currency prognosticators, who said the U.S. current-account deficit, government debt levels and bleak GDP forecasts presaged a dollar collapse. "They were right, potentially, on an absolute basis," Sirkin says. "But recognize what was going on simultaneously … the rest of the world was also entering a recession, and doing the same sort of thing. And since all currencies trade relative to each other, [the commentators] were wrong."
In other words, other major countries are doing just as poorly, or worse. The euro zone, in particular, is dangling from a frayed rope. Standard & Poor's has already downgraded the credit ratings of Spain, Greece and Portugal, and issued a warning to Ireland. Those actions, as well as the region's relatively low interest rates, will weigh heavily on the euro's value in 2009 and make America's own fiscal woes look less troublesome by comparison.
Myth: Credit Cards Are Killing Us
Within the credit crisis, credit-card debt is widely considered to be the source of "The Next Meltdown," as one BusinessWeek headline put it. Like subprime mortgages, credit-card debt is often securitized, meaning it's packaged, sliced and resold all around the world. It's also grown at a fervid pace, increasing by roughly 80 percent since 1999 in the U.S., according to the consultancy Innovest.
With all that in mind, credit cards look a lot like mortgages did at the end of 2007, when the frothy signs of a bubble became clear. But Bernhard Gräf, an economist at Deutsche Bank Research, asks: "What credit-card bubble?" The relative sizes of the two sectors attest to that skepticism; U.S. credit-card debt, at just under $1 trillion in aggregate, is less than one tenth the size of the mortgage market. The rise in home-equity financing, which allows homeowners to borrow against their houses, contributed to the explosive growth of that sector; credit cards, on the other hand, are mostly used for everyday purchases like groceries and gasoline.
Despite some superficial differences, then, the dangers of consumer debt are overblown. "Mortgages were a bubble that had to pop," says Gräf. "Credit-card debt has not even been excessive." While aggregate credit-card debt has grown phenomenally in the United States since 1999, as a percentage of income it's stayed nearly level, hovering at about 9 percent. Mortgage debt, on the other hand, had become an overwhelming burden for homeowners by 2008, when levels hit 100 percent of annual income, up from 65 percent in 2000.
And with home values plummeting, many homeowners are doing the logical thing when they return the keys to the bank on homes now worth less than their mortgage value. Credit-card borrowers won't face the same negative incentives, since credit-card debt isn't backed by an asset with swiftly declining value. And though default rates will certainly rise, the securitization trend will give credit-card companies a little breathing room. Securitization in the mortgage market became a devil in and of itself, because, through a bit of financial trickery, subprime debts were resold as AAA bonds. But only about a third of credit-card debt is securitized, says Gräf, and since it hasn't been excessive, securitization works largely as it's supposed to, spreading risk throughout the system.
Consumer debt certainly isn't a good investment these days; Innovest estimates that credit-card issuers ate $41 billion in losses last year, and will have to face up to nearly $100 billion in bad debt this year. But compared with the mortgage sector, which has already suffered $1 trillion in losses, credit cards aren't nearly as scary as houses.
Myth: Here Comes Protectionism
Talk to any trade economist, and three words are bound to arise: Smoot-Hawley tariff. The now infamous act, signed into law by President Herbert Hoover in 1930, raised the average import tariff in the United States to nearly 60 percent. It was meant to address unemployment during the Great Depression, but far from fixing the economy, it plunged the world into a new era of protectionism and contributed to the global slowdown.
Comparisons between today's economic downturn and the Great Depression are rampant, so Smoot-Hawley is back on people's minds. While campaigning, President Barack Obama talked about renegotiating NAFTA and other trade deals. Countries like Russia, India and Indonesia have raised import tariffs, and French President Nicolas Sarkozy grandstands about protecting French companies against their foreign competitors. According to a new paper by two Stanford economists, a major factor in recent stock-market volatility has been the talk of a backlash against trade and globalization.
Yet all the rhetoric has led to only a few minor policy shifts. The stimulus bill's "Buy American" clause worried free-traders, but it was ultimately watered down by the Senate. And while the World Bank says that trade will contract in 2009 for the first time in 25 years, the dip is almost completely attributable to the economic slowdown, not to any new trade restrictions. Today's thick web of free-trade zones and globe-spanning institutions, such as NAFTA and the World Trade Organization, will almost certainly prevent a Smoot-Hawley II. Katinka Barysch, a political analyst at the Centre for European Reform in London, says Western countries would have to tear up the entire WTO rulebook for protectionism on the scale of the 1930s to take hold.
That seems unlikely, particularly since trade-negotiating incentives have changed since the 1930s, and indeed, even since the early 1980s, when a deep recession prompted President Ronald Reagan to impose export restrictions on Japanese automobiles. Today large companies produce their goods all around the world and regularly partner with foreign firms, making them a powerful bloc that would oppose any new restrictions. "It's a much more interwoven network of economic activity than it was in the 1980s," says Douglas Irwin, a Dartmouth economist. U.S. automakers, for instance, have equity stakes in South Korean, Japanese and European manufacturers. "Therefore it just doesn't make as much economic sense to block off imports." It's illustrative that in December, Detroit's automakers asked for bailouts, not tariff barriers; their foreign competitors already operate enormous plants in the American South, making protectionism pointless.
It's also worth noting that recessions can actually have a positive effect on trade. "Sometimes hard economic times can be an impetus to try to open up things further," says Irwin. NAFTA and the Uruguay Round, which created the WTO, were negotiated and finalized during an economic slowdown in the early 1990s. China and Taiwan joined the WTO in the wake of the Asian financial crisis.
None of this dispels the storm clouds gathering over the global economy. But it does remind us that in unpredictable economic times, today's conventional wisdom can turn out to be yesterday's news.
