Financial markets have calmed in recent weeks and there are some signs the financial crisis may be in its later states (though, there are plenty of danger signs too). But will this crisis will bring about a big economic slowdown? While there is pretty much a 100% correlation between financial crises and predicted recessions, the correlation with actual slowdowns is much less direct. During the author’s career, crises have occurred in 1987, 1990, 1994, 1998, 2000-2001 and 2007-8. Each was accompanied by predictions of a major recession, but this only occurred twice (so far) and each of these recessions was rather shallow lasting just eight months.

In considering the link between financial crises and recessions, I’d propose looking at the following factors:

Size of the crisis.

One thing which distinguishes the current situation is its sheer magnitude. By all measures, the current credit crisis is huge. The write-downs by major financial institutions, the failure of a major Wall Street firm, the stimulus by the Fed and the bailout of the securities industry combine to make this the most important financial crisis in a generation. This would argue for a bigger than usual likelihood it could have a meaningful impact on the economy.

Nature of the crisis.

Some crises seem to cause more problems than others. During the past 20 years, for example there have bee several crises set off by over-valued equity markets. Despite predictions, they didn’t result in major slowdowns. Debt crises overseas (Russia (‘98), Mexico (‘94), Brazil (‘70’s) were also fairly well contained. Currency crises (Asia ‘98) were also contained as well, although the locals may not agree. On the other hand, the U.S. commercial real estate slowdown in the early 1990’s did impact the economy. The current residential real estate slowdown may have a similar effect.

Potential for additional problems. Whenever there is a crisis, there is a tendency to predict that it will escalate. This time is no exception; the bears have some good points. Certainly the problems seen in residential real estate could be extrapolated to other areas of consumer lending like credit cards and autos. Huge amounts were also lent to finance private equity buyouts over the past few years. Guess who holds these loans? If you answered the same institutions who owned all the sub-prime debt you are correct. The concern is that the system is vulnerable now and another crises would be hard to deal with.

Fed Policy Errors.

The Fed has a colorful history of turning financial crises into economic recessions or worse. It is widely believed that Fed tightening after the stock market crash in 1929 tipped a weakened economy into what became an economic debacle. Fed policy in the 1970’s helped turn a commodities boom into a generalized inflation (inflation reached 13% in 1980) which was followed by a severe recession as the new chairman Volker reversed course and inflation was contained. During the Greenspan era the Fed was generally successful in containing financial crises. The “formula” was essentially to supply ample liquidity to the financial system during times of crisis. Unfortunately, too much money can also cause rising prices and a declining currency. This may be the time that the formula doesn’t work. If so, policy makers will be in uncharted waters.

Other Factors.

Financial crises don’t take place in a vacuum. In the current case, I think a big positive is the remarkable growth seen in developing economies like India, Brazil and China. This could mitigate the effect of the crisis. Keep in mind that in addition to exports, countries like Mexico, Brazil and Chile are commodity driven, and are benefiting from the boom in this sector. And Asian economies like China and Korea have growing domestic markets. Exports are still holding up as well. Figures from Korea recently showed exports still very strong, with Asia and Latin American growing and the U. S. slowing.

Long Term Cycle.

Analyzing long term cycles is notoriously difficult, and potentially useless: Get a 50 year cycle wrong by just 10% and a forecaster’s career can suffer a big setback. That said, the global economy has seen 26 years of remarkable growth in earnings, stock prices, GDP and most any measure you can think of, including debt. Even our own system of economics has undergone a boom and been adopted virtually worldwide.

It is easy for investors to become too negative at points such as these. The evidence regarding the current situation and future expectations is mixed. At the very least, markets may have a substantial rebound as excess pessimism is unwound. At best, the positive factors noted above will continue and the negatives will eventually be worked through.

Bill Andersen, CFA