The Global Economic Crisis and its Canadian Dimension

Economic downturn is already as bad as in the early 1930s
July 1, 2009

There is still an air of disbelief in Canada about the severity of the current global recession — now widely accepted as the worst since the Great Depression of the 1930s — both as it is affecting Canada and as it is playing out around the world.

Perhaps it is because recession came later to Canada and is just beginning to hit hard. Or maybe it is because government leaders and media keep assuring Canadians that we are in good shape to weather the storm and the worst will be over "soon."

To be sure, for the hundreds of thousands of Canadians who have already lost their jobs and the many more who feel threatened, the reality of recession is hitting home. Manufacturing communities like Windsor and scores of forestry communities have been devastated.

But for many, at least at this early stage, the signs are subtle. There is a veneer of normalcy. Most people may still be several degrees of separation from direct experience of friends and acquaintances who are losing their jobs, losing their homes, declaring bankruptcy, seeing their retirement savings shrink. The recession is still to a surprising extent a business page story in the newspapers.

We in Canada seem far from the public outrage and popular mobilization that is occurring in Europe and elsewhere — but perhaps that's because the media spotlight has not yet focused on plant occupations, demonstrations, and other manifestations of public discontent.

The Global Crisis

Although the long view is beyond the scope of this article, the following developments over the last 40 years underpin the current global crisis:

· financial deregulation, the ascendance of finance capital over manufacturing, and, alongside it, the growth of a financial oligarchy with enormous political power;

· the global integration of trade and capital, the transfer of productive capacity (mainly to China), and the ballooning of trade and financial imbalances between nations;

· the rapid growth of inequality and concentration of income and wealth between and within nations; and

· the exacerbation of chronically insufficient consumer demand in relation to productive capacity.

Interrelated and mutually reinforcing, they are products of the rise in the 1970s of neoliberalism — a set of policy ideas that espouse self-regulating markets and minimal government interference — replacing the Keynesian mixed economy consensus.

Leading global indicators in these early days are as bad or worse than they were in the first stages of the Great Depression of the 1930s. The world's industrial output is contracting as sharply as it did in 1929. International trade volumes are falling much faster than they did in 1929. According to the United Nations, world trade declined at an annual rate of more than 40% in the first quarter of 2009.

The OECD predicts that the global economy will shrink by 2.75% in 2009, its worst performance since the Great Depression. Advanced industrialized country economies are predicted to shrink by 4.3%. The OECD and other international forecasting agencies have been revising their forecasts downwards for the last six months.

The IMF is pointing to "worrisome parallels" between the current crisis and the 1930s. It warns that, unless corrective action is taken, "the human consequences could be absolutely devastating." The International Labour Organization (ILO) predicts that the jobless numbers globally will rise by 38 million (20%) in 2009, reaching 231 million.

The UN commission of experts on international financial and monetary reform warned that 200 million people, mostly in developing countries, could be pushed into deep poverty unless action is taken to confront the effects of the crisis.

Amnesty International's annual global report says the worldwide economic decline is leading to greater repression. It says human rights and other abuses are increasing as marginalized communities demand basic rights amidst worsening economic security, and warns, "We are sitting on a powder keg of inequality, injustice and insecurity, and it is about to explode."

As in 1929, this economic crisis was precipitated by a U.S. financial crisis. Unlike 1929, the crisis followed a worldwide financial boom reflected in the explosion of foreign holdings of U.S. asset-backed securities. The global value of financial assets had grown to $160 trillion by September 2008 — three and a half times larger than the value of global GDP.

The crisis spread very rapidly from the U.S. epicentre due to the highly integrated nature of financial markets, causing a rare synchronized global economic recession. And the financial crisis and the real economy recession have been interacting in a mutually reinforcing way.

Despite tentative signs that the risk of a full-blown Depression has subsided, no one knows when this global crisis will end, whether an eventual recovery will be weak or robust, or how long its economic effects will persist. Historical research shows that recessions following financial crises are unusually severe and long-lasting.

Obama administration response

Financial deregulation fever reached its peak in Washington in the late 1990s and early 2000s. Two measures stand out, both undertaken by the Clinton administration and Congress: 1) the repeal of the Glass-Steagall Act, in place since the Great Depression, which ensured the separation between deposit-taking commercial banking and risk-taking investment banking; and 2) the decision not to regulate the burgeoning derivatives market.

These decisions set the stage for the massive run-up in debt: the creation of mega-financial institutions like Citigroup and AIG, even faster growth of the shadowy banking world of hedge funds, private equity funds, investment banks, tax havens, etc., and the dramatic expansion of credit derivatives, credit default swaps, and other financial products.

The financial boom was fed by:

· the massive inflow of capital from surplus countries, notably the Asian and oil exporting countries;

· the rapid growth in disposable income of the very rich -- aided by tax cuts and tax avoidance through secretive tax havens (mainly in the Cayman Islands) — which fuelled a tsunami of speculative investment;

· the resort to debt by low and middle-income American families to maintain living standards in the face of stagnant or falling incomes; and

· the lure of home ownership by millions of people via unscrupulous mortgage contracts they didn't understand and couldn't afford.

This boom was overseen by Alan Greenspan, chairman of the U.S. Federal Reserve, who believed that markets knew best how to evaluate and manage risk without the heavy hand of regulation. Greenspan kept interest rates low and allowed a housing bubble and a stock bubble to develop. He supported unregulated sub-prime mortgage lending and derivatives.

The biggest culprit, however, was Wall Street, which, with its enormous political influence, successfully lobbied for financial deregulation and created the financial instruments and their complex — supposedly risk-reducing -- mathematical models that drove the boom to dizzying heights.

Two key financial innovations were at the heart of the crash. The first, securitized mortgage derivatives (also called collateralized debt obligations, or CDOs), were invented by a team at investment bank J.P. Morgan in the late 1990s. Individual mortgage loans were pooled and packaged into new cash-flow-producing assets – mortgage-backed securities — and then sold to investors. They were presented as instruments that would spread and thereby reduce risk, and bank regulators were persuaded to lower the threshold of capital reserves that banks were required to hold against default on these derivatives, compared to traditional loan requirements.

Securitization severed the traditional direct link between lender and borrower. Purchasers of these bundled mortgages had no idea of their quality. As business boomed, credit derivatives were extended to sub-prime mortgages, put into what Nobel Prize-winning economist Paul Krugman called "the financial juicer," and came out the other end guaranteed AAA by deeply conflicted credit rating agencies whose incomes were paid by the very institutions whose financial products they were evaluating.

They offered higher returns than Treasury bills and other conventional securities. The promise -- that this would make the financial system stronger by spreading risk widely -- was a lie. Far from reducing risk, securitized mortgage derivatives increased risk and made the financial system more prone to crisis.

Securitized mortgage derivatives were sliced into portions that were assigned a hierarchy of different risk levels and different rates of return. Investors could choose their preferred level of risk within the bundle. From the original derivative, other firms created a complicated pyramid of secondary derivatives, repackaging its high-risk slices and selling them to unwitting investors as low-risk slices.

A Wall Street investment manager used a poultry analogy in describing them to the New Yorker magazine:

"You can turn a whole bunch of chickens into bundles of chicken parts, of ascending quality from gizzards to breasts, and charge a premium for the best cuts. The butcher gets paid, and the shopper gets what he wants. The problem was, eventually, that gizzards were packaged as breasts. And then there was salmonella." (May 2009)

The notional outstanding value of credit derivatives (including mortgages and other debt, from car loans to credit card debt) had, by end of 2007, reached a mind-boggling $596 trillion, almost four times the value of all global financial assets, and more than 10 times the value of world GDP.

The other financial villain was credit default swaps (CDS). These insurance-like contracts — also invented by J.P. Morgan — were used by investors to hedge against default on their mortgage-backed derivatives. Buyers of credit default swaps could then move these assets, and the accompanying risk, off their books. Compared to the (now) lower capital requirements for the original mortgage derivatives, CDS sellers like insurance giant AIG were required to post even less capital reserves against default. Secretive and largely exempt from regulation, these phony insurance contracts — which Warren Buffet called "financial weapons of mass destruction" — greatly magnified the credit derivative bubble. By the end of 2007, the CDS market had reached $62 trillion, larger than the world's total GDP.

As U.S. housing prices continued their slide and the magnitude of sub-prime mortgage defaults became known in mid-2007, those who had sold CDS insurance to investors holding now worthless mortgage credit derivatives could no longer meet their obligations to compensate these investors, and either went bankrupt, like Lehman Brothers, or were bailed out by the government, like Bank of America, Citicorp, and AIG.

In the wake of the September 2008 financial crash, the IMF now estimates that there are $4.4 trillion worth of toxic assets (bad debt) held by investors in the U.S. and around the world. And the figure will undoubtedly grow as more toxic debt is uncovered.

The Geithner plan

Leading economists generally support the fledgling Obama administration's $787 billion fiscal stimulus plan, even as many deplore the disproportionate weight of tax cuts over spending, and call for a second stimulus package. And they support his first budget as potentially the most far-reaching effort to reform American health care, education, and environmental policies in many a generation.

Since the crisis began, the massive financial bailout by the U.S. Treasury, the Federal Deposit Insurance Corporation, and the Federal Reserve — money spent, lent and committed — is estimated by Bloomberg Business News at $12.7 trillion. The latest round in the bank bailout saga — the Public–Private Investment Program (PPIP) announced in March by Treasury Secretary Tim Geithner — has drawn enormous criticism from economists who were otherwise supportive of the new administration.

They argue that the PPIP is in denial of the fact that many of the major U.S. financial institutions are holding so much bad debt that they are effectively insolvent. The problem with the Geithner plan, according to Nobel Prize-winning economist Joseph Stiglitz, is that it's like giving a massive blood transfusion to a patient suffering from internal hemorrhage and doing little or nothing about the internal bleeding. Not only is this extremely costly -- $1.5 trillion – but it will also fail to solve the basic problem.

Many believe this public-private partnership — where the government commits to buying up banks' toxic assets at far above their market value — places the government at risk to assume huge losses that may ensue as these toxic debts are expunged from the system, while setting up the Wall Street players to reap potentially huge profits. This amounts to privatizing the gains and socializing the losses. These costs will ultimately leave the American taxpayer on the hook, reducing the government's capacity to invest in education, health care, environment, infrastructure, etc.

Critics charge that the power of Wall Street financiers in Washington has paradoxically increased, despite their own culpability and despite popular outrage, and that they are effectively exercising a veto over the needed government intervention. They say the Obama administration is either intimidated by, captured by, or, more ominously, in collusion with Wall Street on this plan. As Stiglitz declared: The people who designed the plan are "in the pocket of the banks or they're incompetent."

The U.S. financial bailout plan may ultimately be the Achilles heel of the Obama presidency -- the deciding factor on whether it succeeds or fails.

International Response to the Crisis

On the positive side, governments do not seem to be repeating the worst mistakes of their 1929 counterparts. In response to the crisis, interest rates are being cut more rapidly and from a lower level. Central bankers are rapidly expanding the money supply, unlike their Great Depression predecessors who cut the money supply early, with catastrophic economic consequences. And governments today are much more willing than their 1930s counterparts to run fiscal deficits, though stimulus spending to date falls far short of what is required.

The G-20 leaders met in London last April to take the first formally coordinated steps in confronting the crisis. There are major differences in how participating nations perceive the nature and severity of the crisis, as well as the necessary solutions. The United States, China, and Japan are the leading proponents of boosting aggregate demand through aggressive fiscal stimulus. Germany and France are leading the group of European Union countries that think the main focus should be financial stabilization, reform, and re-regulation.

The final G-20 communiqué begins the process of creating a new regulatory architecture for global finance, including regulatory frameworks for hedge funds and credit-rating agencies, a framework for CEO pay, greater transparency from tax havens, and commitments from governments to backstop their banks with capital, if necessary.

It also commits to an injection of short-term trade finance, as well as a major increase in resources for the IMF, including funding for a new issue of Special Drawing Rights (SDRs). How effective this will be in meeting the severe economic and financial challenges facing emerging and developing economies will depend on the degree of conditionality associated with this finance. Whether the IMF will depart from its traditional demands -- for public spending cuts and other anti-stimulus measures -- remains to be seen, though recent loans to Ukraine, Latvia, and Pakistan are not encouraging.

Although the G-20 communiqué makes important commitments, these commitments are not only voluntary, but they also fall short of what is needed. Many are vague, and there are no collective enforcement measures. It remains to be seen whether nations will live up to their pledges. More fundamentally, it casts doubt on whether the current system will be sufficiently transformed to prevent future crises.

The biggest shortcoming of the G-20 is the inadequacy of the fiscal stimulus response to the collapse of global demand. Most major industrialized countries, including Canada, have fallen short of the IMF target. As economist Robert Schiller points out, "The greatest risk is that appropriate stimulus will be derailed by doubters who still do not appreciate the true condition of our economy."

The G-20 communiqué takes a strong stand against trade protectionism, but ignores the threat of protectionist measures that could occur as a reaction to nations that do not pull their weight on the fiscal stimulus front and are seen to be free-riding off nations that do. An important lesson of the Great Depression is not that protectionism made things worse (which it did), but rather that it was the macroeconomic policy failures that created the conditions that made protectionism inevitable. Protectionism, like currency wars, was a second-order effect. Under these circumstances, protectionism was a rational reaction; and it took a long time to reverse.

The Crisis in Canada

Canada went into recession in October 2008, later than the U.S. and many other countries. However, Canada's recession is now in full swing, with a force similar to that battering other industrialized countries.

Eight months into this recession, the rate of job destruction has been as great as it was in the 1981-82 recession and greater than 1990-91 recession. Since last October, job loss in Canada has been proportionally greater than in the United States, although the recession there has been going on for over a year.

Almost 406,000 full-time jobs were destroyed in Canada between October 2008 and April 2009. Part-time jobs are rising, a sign of stress in the labour market; people are scrambling to stay afloat. The official unemployment rate has risen to 8.4%, with more than one-and-a-half million people now looking for work. Counting those who have given up looking and have dropped out of the work force, those working part-time but who want full-time employment, 12.4% of the work force, or 2.3 million Canadians, are unemployed.

Personal bankruptcies are climbing, as are credit defaults and house foreclosures. Retirement investments have taken a beating and private sector defined-benefit pension plans are under threat.

Exports are plummeting -- by almost one-third from July 2008 to April 2009. Manufacturing sales have fallen by 25% since August 2008. Business investment in machinery and equipment has fallen 20% since the first quarter of 2008.

The economy (GDP) shrank at an annualized rate of 3.7% in the fourth quarter of 2008, and by 5.4% in the first quarter of 2009. It is contracting twice as fast as the previously deepest recession in 1981-82. In both Canada and the U.S., the fall in industrial output is closely tracking the decline of the 1930s.

By several measures, Canada was seen to be well-positioned to provide a more effective policy response entering this recession — on both the monetary/financial and fiscal fronts — than most other countries. Our comparative advantage derives from our strong banking system and low government debt/GDP ratio. Although the latter gives us the fiscal room to implement an aggressive stimulus package, this capacity is meaningless unless it is used effectively. (More about this later.)

Despite the chest-thumping about Canada's sound economic fundamentals going into the recession, a number of inconvenient facts contradict the dominant narrative. Canada's dirty little secret is that, by some very important measures, it entered this recession in a far more vulnerable state than in past recessions. Three underlying weaknesses bode ill for the prospects of a rapid Canadian recovery.

1. Rising income inequality

Since the mid-1990s, inequality in Canada has grown faster than in most OECD countries, including the U.S. Canada's richest 10% of its citizens captured the lion's share of the country's productivity gains and income growth, while the inflation-adjusted incomes of the large majority stagnated or fell.

The reasons for this disparity lie in the declining power of Canadian workers in an era of free trade, capital mobility, and deregulated labour markets. The "offshoring" of manufacturing jobs, de-unionization, concession bargaining, the proliferation of low-wage precarious service jobs, and the weakening of worker protections have been among the most notable consequences.

For many Canadian households, stagnant wages led to the ballooning of debt to help maintain their standard of living. Household debt has increased six times faster than incomes since 1990.

Although unemployment fell to a low level in 2008, about 20% of the Canadian work force is now in precarious forms of employment: part-time, temporary, and self-employment. About 40% of women in paid employment are in these kinds of jobs.

The proportion of workers in low-wage jobs is high, second only to the U.S. in the advanced industrial world. And 20% of women with full-time jobs are in low-wage occupations, compared to 10% of men.

So Canada entered this recession with greatly weakened household incomes, reduced wealth, debt levels higher than at any time since the 1930s, and rising economic insecurity that is causing people to save rather than spend. Households are not well-positioned to be engines of recovery.

2. A weakened public sector

This weaknessincludes the shredding of Canada's social safety net and the overall contraction of the public sector.

Automatic stabilizers, which kick in during recessions to cushion the blow for vulnerable citizens and keep a floor under consumer demand, are only half as large as they were during the 1980-81 recession. The most important of these is employment insurance (EI).

In the recession of the early 1980s and 1990s, over 80% of unemployed workers — both men and women — were able to collect EI. In this recession, as a result of changes made by the Mulroney and Chrétien governments, only four in 10 men and three in 10 women are eligible for EI benefits. Eligible recipients also get less income and can collect for a shorter period than in previous recessions. Not since the early 1940s, when unemployment insurance was introduced, have Canadian workers been so thinly protected against job loss.

More generally, in previous recessions a much larger Canadian public sector — providing stable jobs and public services — was an effective counterbalance to contraction in the private sector. This stabilizing anchor in the Canadian economy is now hundreds of billions of dollars smaller and a less effective counterweight against recession.

3. Hollowing-out of manufacturing

Changes over the past decade in the structure of Canadian production (driven by the energy boom and soaring exchange rate) have resulted in a dramatic rise in resource exports and a corresponding decline in manufacturing production and exports.

Manufacturing sector GDP, in decline since 2006, has accelerated: 772,400 jobs have been wiped out since August 2002 — almost one-half (337,000) since the recession began. In the 1990s, we saw a hollowing-out of the economy as foreign takeovers rose and Canadian head offices were closed. Now the entire manufacturing sector — especially the Ontario heartland --is being hollowed out. The manufacturing work force has shrunk by a calamitous 30% in just under seven years, its lowest level since data started being recorded in 1976.

Highly trade dependent, Canada has regressed to a more resource exporting economy, more vulnerable to volatile resource price and volume swings. And distortions caused by the resulting exchange rate fluctuation discourage the diversification of the country's manufacturing base.

Conservative government response

The Conservative government has been pursuing very aggressive monetary and financial stabilization policies since the fall of 2008. The Bank of Canada's prime lending rate is now close to zero and it is preparing to implement "non-traditional" measures such as buying Government of Canada debt and lending directly to non-financial entities.

The government has committed $200 billion in support for the banks. It issued new bonds, then gave the money to the banks – either as short-term low-interest loans, or as asset swaps taking over the CMHC-insured mortgages that the banks had on their books.

Unlike the far lower amounts and stringent conditions (e.g., workers' pay and benefits concessions) attached to the auto sector restructuring package (which are also made up of loans and guarantees), the bank bailout has come with virtually no conditions.

It is curious that the country with "the best financial system in the world" has, according to the IMF, incurred the third highest financial stabilization costs in the G-7, behind the U.S. and Britain.

These measures are considered "non-budgetary" or "off book." They do not show up as expenditures, which increase the federal deficit and debt. Rather, they appear on the books of CMHC and the Bank of Canada. But they have increased the government's borrowing from $13.6 billion in 2007-08 to $89.5 billion in 2008-09, or double the fiscal deficit now projected for 2009. (Note: The government has arbitrarily chosen to expense $8 billion of the auto restructuring package — normally an off-book expense — as a one-time loan loss provision.)

The contrast with the government's fiscal stimulus plan is striking. The economy continues to slide. Output is shrinking. Prices are falling. Consumer borrowing and spending has plummeted, along with business borrowing and investment. Personal saving rates have more than doubled over the last year. The economy is trapped in an excess of saving over investment; or, to put it another way, in a shortage of demand.

At a time like this, government is the only player with the capacity to borrow these savings and convert them into investment, to borrow and inject additional demand into the economy. It is the government's role to step in to free the economy from this trap.

The Harper government claims to have brought in an aggressive fiscal stimulus program. Of course, the (much weakened) automatic stabilizers now kicking in — notably lower business tax revenue and higher unemployment insurance payouts — will produce a deficit estimated at more than $50 billion for 2009-10, and which TD Bank economists estimate will accumulate to $167 billion over the next five years. (They conveniently ignore that the Conservative government's reckless and ideologically motivated tax cuts have blown a $191 billion hole in the federal Treasury over the same period.)

Beyond this, however, the additional federal stimulus measures are largely smoke and mirrors. It is worth noting that, in the six months that the country has been in recession (October 2008-March 2009), the government has actually cut program spending compared to the same period a year ago.

Let me briefly enumerate its flaws.

1. Too Little: The Conservatives' stimulus plan (which they say is now $62 billion over two years) will in reality deliver far less net stimulus dollars to boost output and employment than it claims -- as little as one-third, according to some estimates.

2. Fails to target those most in need: The most glaring omission is its failure to expand the eligibility of those losing their jobs to collect EI. Thus, well over half of those who have, or will, lose their jobs in the coming months will have to rely on their savings, their families, or on provincial welfare.

3. Ineffective: The stimulus package also falls short on the so-called "bang for the buck" scale. Economists use multipliers to measure the stimulus impact of a dollar of spending on output (GDP) and employment. The Conservatives' plan is tilted toward broad-based tax cuts (very low bang) as opposed to spending (high bang). The physical infrastructure spending (high bang), besides being too small, is contingent on matched funding by provinces and municipalities — limiting both its magnitude and timeliness. And little can be classified as green infrastructure. Eight months into the recession, infrastructure spending was still just trickling. As of May 2009, by one estimate, only 5% of the promised funding had gone out the door. Furthermore, there is no soft infrastructure spending (health, education, child care, etc) in the government's stimulus plan — sectors where job creation will benefit women.

4. Poor Timing: The federal government is quickly implementing the least effective tax cuts and delaying measures that have the largest stimulative effect.

5. Wage cut pressure reinforces deflation risks: As the danger of deflation increases, the federal government is undermining the effectiveness of its own stimulus efforts by freezing the wages of its own employees and by forcing massive auto sector wage concessions in union negotiations with the auto companies. As the player responsible for the overall management of the economy, only government is capable of overriding the destructive (if rational) contractionary impulses of businesses and households, and preventing a general wage-price-purchasing power spiral from deepening the recession, as happened in the 1930s. Instead it is reinforcing them.

6. Advances the Conservative small government agenda: All the spending measures are designed to be temporary, while the tax measures are permanent. The Harper government is also using the stimulus to reduce environmental assessment requirements for in