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A user’s guide to the financial crisis

Making sense of the tough times ahead


 

A user's guide to the financial crisis

What’s a credit crisis?
It’s when the credit system becomes paralyzed by too much bad debt. When consumers stop paying back money they’ve borrowed, banks have less money available to lend to businesses and consumers. Eventually the supply of credit dries up, and so does spending, especially on big-ticket items that depend on credit. At the same time, businesses put a halt to major projects that require financing, putting more and more people out of work and stifling economic growth.

Can’t we just print more money?
Yes, and central banks like the U.S. Federal Reserve are effectively doing just that to ease the credit crunch. The risk, however, is devaluing the currency. The value of currency, like anything else in a market economy, is determined by supply and demand. If supply of money exceeds demand, then every dollar becomes worth less, which means you’ll need more of it to buy everyday items. This can quickly spin out of control: Zimbabwe’s annual inflation rate, for instance, has reached 516 quintillion per cent—that’s 516 followed by 18 zeros. In real terms, it means prices are doubling approximately every 1.3 days.

If I hunker down and save, am I making it worse?
Scrimping and saving does indeed hurt the economy—it’s part of the deflationary cycle. “If you don’t buy that car, even though you can actually afford it, if you don’t buy that fridge, if you don’t shop at Christmastime, it can actually put us in a bit of a downward spiral,” Ontario Premier Dalton McGuinty warned last week. But having helped the economy will be of little comfort if the worst should occur. Most experts advise basic, conservative economic measures:

-Eating out less.
-Finding simple ways to cut back—turning down the thermostat, for instance.
-Paying down debt.
-Creating an emergency fund.
-Seeking out alternative sources of income, even if you’re still employed.

Worst case scenario if you follow those rules: you come out of the recession with a whack of cash.

I don’t own any stocks. Why should it matter to me if the market tanks?
You might not care, but those who run public companies sure do. As the recession settles in, expect to see wages drop and layoffs increase. And many Canadians have an indirect stake in stock prices, even if it’s just through their pension. The Ontario Teachers’ Pension Plan, for example, owns nearly 51 million shares of BCE, which is currently down almost 40 per cent from its 52-week high. The Teachers’ 66.5 million shares in the Royal Bank of Scotland, meanwhile, are worth less than 15 per cent of what they were a year ago. But even if you’re not invested at all, those who are—and the companies to whom they’re accountable—wield enormous power over the economy. As stocks decline in value, shareholders demand that costs be cut, often leading to layoffs or salary cuts, which will in turn exacerbate recessionary tendencies.

How will I know if the recession turns into a depression?
If you find yourself wearing a barrel around your midriff to preserve what’s left of your dignity, that’s a dead giveaway. But seriously, there’s no commonly agreed upon definition of a depression. One rule of thumb involves a decline in a nation’s GDP of more than 10 per cent in a year. But we’re nowhere near that. The OECD projects a .5 per cent growth in Canada’s GDP in 2008, followed by a .5 per cent decline in 2009 and a return to growth, 2.1 per cent, in 2010. Even the most dire projection for an OECD country—Iceland’s 9.3 per cent decline for 2009—falls short of this depression threshold. And while comparisons are frequently made between today’s situation and the ’30s, the key economic indicators of the time dwarf anything projected today. In 1933, Canada’s gross national product was down 43 per cent from 1929, exports by half and unemployment was 27 per cent—today it’s 6.2 per cent.

Why are so many investment banks collapsing?
Two events precipitated the collapse: housing prices fell dramatically and once cheap subprime mortgages became expensive. The drop in housing prices wiped out the gains people had made on their homes—gains against which many homeowners had borrowed heavily with the expectation of ever increasing house prices. Meanwhile, subprime loans that were initially affordable thanks to teaser rates quickly became too expensive once the promotional period ended, and homeowners began defaulting on their mortgages en masse when it became obvious they could no longer afford the payments. During the boom, those mortgages had been repackaged and sold to investors as mortgage-backed securities. Investors bought the debt off banks expecting to profit from the interest. The massive wave of defaults and foreclosures effectively made those investments worthless, and investment banks like the 150-year-old Lehman Brothers were crippled by the huge losses in the sector.

What happened to gas prices and how do they impact Canada?
Cheap gas is a good thing, right? Well, not always. Gas prices have come down sharply since hitting record highs this summer, though they were still up 13 per cent over last year in October. And while most drivers may appreciate the sudden reprieve at the pumps, it’s not necessarily good long-term news. The tumbling prices are sparking fears of deflation. According to Statistics Canada, the drop in gas prices was the most significant factor contributing to the biggest drop in Canada’s inflation rate in nearly 50 years between September and October. The steep drop in the price of oil has also hurt Canadian companies. Combined with tightening credit restrictions, it’s led many in the oil and gas industry to scale back their projects, meaning fewer jobs for Canadians and less tax money for the government. By late October, $29 billion worth of investments in oilsands projects in Alberta had already been shelved.

Why is deflation a bad thing? As a consumer, shouldn’t I be happy?
Not if you owe money. (As Richard Evans notes in The Daily Telegraph, deflation means “the real value of your savings would rise even if you earned no interest, but debts would become more onerous as their value in real terms also rises.”) And not if you have a job connected to the retail sector since deflation negatively affects the consumer economy in a self-perpetuating way. When businesses habitually lower prices to encourage sales, consumers tend to wait longer to spend in the hope that prices will drop even further. Sales or profits—or both—suffer and manufacturers scale back production and cut wages or jobs. In theory, the solution is to lower interest rates, thus encouraging people to borrow and spend. But these days, interest rates don’t have much more room to go down before they hit zero.

What happened to the loonie? Does it have anything to do with the economic crisis?
Because Canada is a major exporter of commodities (in particular, oil), the dollar is often affected by shifting prices in the sector. Likewise, economic woes have driven up demand for the U.S. greenback by comparison. David Watt, senior currency strategist with RBC Capital Markets, explains the uptick: “Where do you want to sit to ride out this crisis? Most people are choosing the deepest and most liquid market in the world, because almost every other asset seems toxic.”

Why does the auto industry seem so damaged by the recession?
The overall decline in consumer spending has left the automakers reeling, especially in the high-margin SUV/light truck segment. In October, vehicles sales in the U.S. were the lowest they’ve been in 25 years, leaving an already struggling industry on the brink of collapse. A lack of interest in what they’re making doesn’t help. Forty years ago, nine out of 10 cars on U.S. roads were manufactured by the Big Three. Today, it’s only about four in 10.

What’s the basic theory behind “stimulating” an economy? Where does the money come from? Where do you “insert” it into the economy, what does it do, and where does it come out?
Stimulating the economy is like jump-starting a car. Once the economy gets an initial boost, the hope is that it will be able to generate its own sustainable power. Government money can be disbursed in a number of ways—through tax breaks and rebates, a boost in unemployment insurance and food stamps, or through a significant investment in infrastructure. Or it can mean investing in sectors that have a trickle down effect, such as banks—which theoretically pass on the savings to citizens in the form of loans—or, more controversially, the auto industry. Paul Krugman, the renowned liberal economist, argues that focusing too much on tax breaks is why stimulus efforts have failed in the U.S. Too many people, he argues, squirreled the money away rather than spending it. He advocates a plan that focuses on “sustaining and expanding government spending—sustaining it by providing aid to local governments, expanding it with spending on roads, bridges, and other forms of infrastructure.” The money would “actually be spent,” he argues, and “something of value…would be created.” Some argue infrastructure spending takes too long to yield results, but Krugman says such a quick recovery “doesn’t seem to be a major worry now.


 
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A user’s guide to the financial crisis

  1. What a great post. It make a lot of sense. What happens next? What do you think is likly to happen next? Will any one befite from this?

  2. Stimulate the economy with a tax rebate?? Whoa, in Canada?? That would mean that average Canadians would get back taxes to spend spend or pay down debt as they wish right? But all I hear is politicians like Miller talking about spending on road construction and increasinng taxes. A tax rebate seems like the best way to stimulate the economy since the Reganomic trickle down never makes it past the upper echalon that casued this mess and more tax increases at a time like this seems rather insane doesn’t it? Would a Canadian politician give up their power by rebating taxes?? Hard to imagine.

  3. The fiddlers in Ottawa will bicker while the world burns. If a stimulus package does gets off the ground, it won’t stimulate the economy for long. It didn’t work for Bush why would it work for us? We are in for a 5-10 year recession/depression and there is no quick fix. What good can come out of this downturn? Canadian families will find out that matching bedding with towels is an idiotic puruit. This financial crisis will turn residents sharing an address back into families. Pulling together against poverty will do wonders for each generation that survives. Kids not willing to rake leaves or shovel snow will be out in neighbourhoods knocking on doors trying to earn a few bucks for milk and bread. Its the seniors I worry about. They’ve been hustled by the best con men the world has ever seen masquerading as investment dealers. This fiasco was anticipated by these bozos in Zegna suits,as was the crash in 1929. Seniors don’t have 5-10 years to wait for an upturn. Any stimulus should be geared to them. The rest of us will survive and be stronger for it.

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