The Real Recession Has Yet To Come

Since the start of 2021, the question that appears to be on everyone’s mind is “Will this year be any better than the last?” When it comes to the economy, the IMF certainly seems to think so. In an update last month the fund reiterated the forecast it made in April of last year, assuring that global economic conditions would recover in 2021 to their best since 2010, the year after the great recession.

Compared to 2008/9 however, 2020 can hardly be said to have seen a proper recession. While real GDP growth rates in the advanced countries indeed collapsed to their lowest since WWII, the asset destruction that usually takes place during a recession has so far been absent. In other words, the abundance of productive capacity that caused the economic downturn in the first place is still intact. The clearest indication of this is that instead of an increase in the number of bankruptcies that is usually seen during a recession, the amount of global bankruptcies actually decreased in 2020, with the US, Germany, and Japan seeing the lowest numbers in decades.

As the IMF points out, this is largely due to the unprecedented monetary and fiscal stimulus introduced by the major governments in early 2020. However, judging from its five-year forecast of stable growth for the global economy, the IMF fails to understand that the recent stimulus has only delayed the true recession. As long as there is no asset destruction the global economy cannot hope to experience a substantive recovery.

Why recessions are necessary for capitalism

Up to this day, the dominant view on recessions among economists is that they are the products of random shocks to the economy causing unfortunate and avoidable destruction. But the evidence suggests otherwise: Although varying in their severity, recessions occur with a marked regularity in between periods of expansion lasting 7-11 years, as is well documented by the NBER in the case of the US. What is not well documented and indeed appears to be misunderstood by policy makers, is that these recessions are necessary for the system to thrive.

In essence, the economy needs to clear itself of deadwood from time to time. When too many companies have expanded their production in excess of what is being consumed, the system eventually grinds to a halt and falls into recession. When that happens, it prompts the destruction of those companies that are weak and unproductive to make way for those that are more competitive, in a process famously described by economist Joseph Schumpeter as “creative destruction”. It is this process that lies at the heart of the economy’s cyclical movement.

When the global economy experienced a crisis in 2008/9, the destruction that took place then allowed for the expansion in the years that followed. By the end of 2019, it was already clear that the system was once more grinding to a halt, and that―with or without COVID-19―another recession was inevitable, and indeed necessary.

How to delay a recession

When the recession arrived in 2020, governments world-wide were quick to introduce a barrage of measures in order to prevent (or indeed delay) the destruction that was looming. Fiscal and monetary stimulus implemented were unprecedented in terms of size and coordination on a global scale. Governments supported their companies directly with cheap loans and tax concessions, while indirectly supporting them by boosting the demand for their products through income support. But perhaps most important is that all of the measures put together managed to revive the global economy by boosting the country that is now undoubtedly its main driving force: China.

As the largest manufacturer in the world, China was the main beneficiary of the global measures that saw spending on services such as restaurants, tourism and public transport redirected towards manufactures such as home appliances, electronics, furniture, and even cars. At the same time, total spending, or aggregate demand, was boosted in the advanced countries by what could be described as the beginnings of a basic income scheme, involving for the largest part cash transfers in the US and employment retention schemes in Europe and Japan.

In itself, this prompted a development that has never occurred before during a recession: a rise in income. In the US this was the most extreme since employee compensation (including government transfers) did not only increase, but actually saw the biggest jump since the post-WWII rise. Again the question emerges: have we truly seen the worst of the recession yet?

Another development that has never been seen before during a recession is an acceleration of credit extended to companies, considering that banks are usually weary of lending during uncertain times. In the first half of 2020 however, the financial markets were flooded with cash as the five major advanced country central banks injected $5.5 trillion worth of liquidity. The Fed led the charge by adding $3 trillion and eliminating the reserve requirement ratio (the amount of cash banks must hold relative to their deposits) for American banks.

As a result of the monetary easing, banks had more than enough cash to lend to companies and keep them going, no matter how insolvent they had been even before the emergence of Covid-19 (more about that below). What the Fed’s stimulus also managed to achieve and has gone largely unnoticed was that the black hole that had emerged in US money markets in September 2019 finally disappeared in July 2020.

2020 was just more of the same (stimulus)

Economists were quick to give their two cents on the fiscal and monetary stimulus introduced in early 2020, with many agreeing it was necessary as they commended governments for their “quick and decisive response”. Concerns regarding the costs of the policies (considering, for instance, the high levels of government debt) were dismissed with claims that this was just a one-time emergency response needed to deal with an extraordinary shock.

Contrary to the claims that these policies were unique, they did not come out of the blue. Over the past few decades the advanced economies have grown increasingly weak and in response, their governments have ramped up fiscal spending while central banks have continuously expanded their balance sheets since 2008. In fact, 2020 was just more of the same.

The shift to this new paradigm of policy-making has brought back the Keynesian view that government has a big role to play in the economy. Indeed, fiscal deficits now are of comparable size to what they were during the 1930s and 40s, when Keynesianism started to take hold and was credited for the booming period in the decades after. Those who are expecting the same results from the government’s current policies, however, are in for some disappointment.

The crucial difference with the current policies is that they were introduced prior to the asset destruction that is yet to come, rather than afterwards. It was the asset destruction that took place during the great depression in the US, and during WWII in Europe and Japan, that allowed for the global economy to prosper in the years and even decades after.

The cost of postponing the necessary destruction

What is becoming clear now is that in their attempts to delay the asset destruction that eventually has to occur, governments have made the situation worse. Their policies introduced over the last decades have led to major adverse implications. 

The most direct manifestation of preventing the system from clearing out unproductive companies has been the rise of the so-called ‘zombie corporations’, which refers to those companies that do not earn enough to even service the debt they hold and can only survive through more debt accumulation. Although slightly apocalyptic in name, the term ‘zombie‘ seems appropriate given that in 2017 already 15% of companies in the advanced countries were given zombie status by the Bank of International Settlements. The current figure is likely to be closer to 20% as American zombie companies accumulated a record $2 trillion worth of debt in 2020.

The historic build-up of zombie corporations would not have been possible without the extraordinary monetary policies of the major central banks. While cash injections into the global financial markets provided the necessary liquidity for private banks to lend to companies with increasingly bad credit scores, historically low interest rates on government bonds and deposits provided the incentives for banks and investors to shift to more speculative investments.

Aside from high-risk lending (see CDOs and CLOs), investors in search of decent returns have flocked to equities, with most ending up in the highly liquid US equity market. Price-to-earnings ratios on American stocks are currently at their highest since the 2000 dot-com bubble and suggest another stock market bubble is building.

In fact, there is a gigantic bubble building, and not just in the stock market but in all financial markets. From an average of three times the size of the US economy between 1950 and 2000, the value of American financial assets has skyrocketed to an all-time high of six times the size of the economy in 2020. The meteoric rise of assets such as Bitcoin and Tesla’s stock is a perfect illustration of the excessive liquidity and out-of-control speculation that is prevailing, largely as a result of central bank policy.

Ultimately, the incessant rise of financial assets has contributed to what is perhaps the most pertinent consequence of government policies in recent times: rising inequality. In the US this is now reaching extremes, where since the government introduced its measures in mid-March the American billionaire class has managed to enrich itself by more than a trillion Dollars (a 40% increase over the previous year). In stark contrast, 20 million Americans continue to claim unemployment benefits with most of them having no savings to fall back on. It is no wonder social unrest is on the rise.

Aside from any moral objections one might have to the above, such extreme wealth inequality is hardly sustainable for a capitalist system. Mainly, where is the demand for products and services produced supposed to come from? The quick-fix solution has been transfers to individuals and job retention schemes, but these come at the cost of public debt accumulation which cannot go on forever.

The parallels with the 1930s and 40s are no coincidence

In addition to the adverse implications mentioned above, the latest round of measures came at a high cost for the advanced countries as it resulted in an acceleration of the ongoing global wealth transfer from West to East. Illustrating the point is that China’s economy was the only major economy to grow in 2020, while for the first time in modern history the country became the world’s largest importer and exporter of goods. Much like when the United States started to replace the United Kingdom as the dominant global economic power in the in the early 20th century, China is now replacing the United States.

It is no coincidence that so many parallels exist between the current global economic situation and that of the early 20th century. Just as the long cycle had reached a bottom then, so it has arrived at a bottom again, and it is at this point that recessions are typically most severe. Keynesian thinking becomes increasingly popular with more and more calls for government to counter the growing weakness but paradoxically, it needs to allow the necessary destruction to take place.

At no other moment in the long cycle is asset destruction as vital as during the bottom, when major technological changes need to take place for the cycle to embark on its upswing. However, unlike the advanced economies, emerging economies like China have little problems implementing these new technologies because they do not have the old infrastructure and production processes in place. Indeed, it is the advanced countries where most of the destruction needs to take place, and until that is allowed to happen, things are likely to get worse for them.

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