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Recession is Not a Dirty Word - Outside View

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Recession is Not a Dirty Word
Sep 6, 2010

Most of us would agree that growth is good for an economy. In fact, we usually judge the strength of an economy by its growth rate. Higher growth rates equate to stronger economies. The inverse of that holds true too. Lower growth rates equate to weaker economies. Then it surely must be the case that if an economy is in recession, it is one of the worst possible conditions to be in.

Let's turn our focus to the stock market. Again, most of us would agree that a rising stock market is good for the economy. Why is this? A rising stock market means investors are better off. It is usually an indicator of increasing profits in the corporate sector. However, this is not always the case. The stock market can rise without any fundamental reasons for it. If this occurs, we get a bubble whereby current stock prices are not justified by their intrinsic valuations. When stock prices are at bubble levels, the markets will fall at some point. And the bigger the bubble was, the greater the subsequent crash will be. So clearly it is not the case that rising stock markets are always a good thing. A rise beyond intrinsic values is bad because it will lead to a crash.

In much the same way, economic growth can reach levels that are too high and unjustified by the underlying reality. For economic growth to be sustainable, it must be based on increases in real income and productivity. In the years preceding the financial crisis, much of the growth in the western world was a result of debt. The economy grew as a result of new spending financed by debt rather than a real increase in incomes. Home equity loans are a good example of this. When house prices were rising, people were taking out fresh loans based on the additional values of their homes. It is really like creating money out of thin air. This money was spent and it propelled growth across the economy. Of course, this is not sustainable. The moment house prices start to fall, people are in trouble. They will have too much debt.

So now imagine a society riddled with debt that has been growing comfortably in the past. Asset prices have started falling. What's the most obvious next step? Well, people will want to pay off their debts. Especially when the economic climate is fairly uncertain. Rather than spend more, individuals will use more of their money to pay down debt, and they certainly won't be borrowing more. As a result, the economy starts to slow. Sales fall, profits fall, companies downsize, and finally the economy enters recession.

Governments and central banks will do all they can to avoid a recession. They'll implement tax cuts, spending rises, interest rates cuts, quantitative easing, and a host of other tools. All have the same intended effect of increasing spending in the economy.

Is more spending really a good thing? Not if that spending is financed by debt. More spending financed by debt will just make the problem worse. In the future, these debts have to be repaid and it will simply mean we spend less later on.

Encouraging spending to stimulate the economy would be a good thing if the economy were not riddled with debt. It would be a good thing if we saved too much of our income because we were fearful of the future. It would be a good thing if the cause of the recession were too little spending.

The cause of the recessions and low growth across the developed world was too much spending financed with debt in the years prior to the financial crisis. The only way to cure this problem is to allow individuals and governments to pay off their debts. The sooner this is done, the sooner the economy can grow again; this time on a hopefully more solid foundation.

Much like a stock market fall when asset prices are too high, a recession when the economy is full of debt is not a bad thing. It is necessary for the economy to correct itself, so that in the future it can grow again. This column, A Fresh Perspective, is authored by Asad Dossani. Asad is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!

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