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On This Day - 12 AUGUST 2011
This global crisis is not just a 'Great Recession'
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But, the roller coaster ride hasn't ended yet. The global economic landscape seems shrouded with extreme fear and uncertainty. Though the Indian economy is not significantly impacted by the global economic turmoil, it cannot totally escape the mess. Thus, investors would be better off if they have a grasp of the big picture.
So let us get some basic understanding of what's really happening out there. Many economists have called the current economic condition of the developed world as the "Great Recession". However, that is a grave mistake. A recession implies a temporary cyclical economic downturn. By adding the adjective 'great' before 'recession', it only means that the downturn would be severe. Now, you may ask why the name matters so much. Kenneth Rogoff, co-author of the book This Time is Different presents a very apt analogy. Say, for instance, you have pneumonia but you only think it's a very severe cold. In that case, you go on a completely wrong medication which instead of curing your disease further aggravates your woes. In a nutshell, this is exactly what happened with the developed world. They misjudged the real problem. Governments and central banks used the wrong medicines. They tried to treat a debt-problem with more debt. No wonder the health of the economy became bad to worse.
The term "Great Recession" totally missed the real culprit of the current global financial crisis- "Overleverage"! The developed economies went through a massive credit expansionary phase that created an extreme imbalance between lenders and borrowers. With the economies slowing and the debt-burden mounting, borrowers are having a hard time returning the money. The recent downgrade of the US debt was not the climax and in fact, only the starting point. There is much more severe turmoil yet to come. The imbalances will find their way out through a series of defaults, financial repression measures and not to mention, inflation. The world economy is likely to experience an extended period of contraction and deleveraging.
There is an important lesson for investors in this macroeconomic story. Be it a company or an economy, the same rules apply for both. Though leverage can be a catalyst for growth, the same can spell doom if not handled well. As such, we strongly believe that while evaluating stocks for investment investors should be wary of heavily indebted companies.
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