The Credit Crisis – What to expect and what to watch.

June 8, 2010

As the world comes to grips with its unsustainable credit expansion of the last decade, a harsh new reality awaits many that assumed that this past period was a normal economy. Rooted in the widely adapted theory of Keynesian economics (save in good times, spend in bad times) boosting the economy has been a priority. Unfortunately, this theory does not work well in today’s reality. The difficulty in determining when the economy should be held back is secondary to the main problem. Elected politicians rarely receive enough general public support to propose budget surpluses that pay down national debts and hold back hot economies. It’s far too tempting to cave to special interest groups using future taxpayer dollars, thereby bolstering (re)-election support. They do so because there’s little opposition to be found when the taxpayer is bled little by little. Only when catastrophic changes like austerity measures are required does the ordinary citizen seem to care.

As austerity becomes the new keyword, and governments struggle to lower their deficits, recessions will become inevitable. Even the US will be forced to question its overspending as being detrimental, likely in time for the 2012 elections. In the meantime, America’s calls for additional stimulus around the world are being laughed off as the sovereign debt crisis takes precedent. This crisis has now taken on enough momentum that it appears unstoppable. Rising bond rates are increasing interest costs, which in turn increase deficits and reduce credit worthiness – a vicious cycle. Just the thought of a renewed crisis has caused Eurozone retail sales to plummet in May, much like they did when the 2008 subprime crisis hit.

But this problem is not just limited to governments. Individuals, especially here in Canada, have indulged in credit to the extent we are now the worst country for individual debt in the G20, worse than Greece.

In the coming years it’s important for people to get control of their debt levels and prepare for higher government taxes and lower levels of disposable income. Unfortunately, this will have a compounding effect on GDP for countries mired in debt. A look at the US (approximately 5 years ahead of Canada) shows that when consumers cut back on spending, such as housing, there is a significant negative impact on GDP. Canada is poised to follow with unsustainable individual debt levels. In turn, our national deficits will be revised upwards as lower GDP and tax revenues become apparent. We are not nearly as insulated as we were led to believe.

As unsustainable markets begin to crumble, the decay will take hold in the market’s weakest areas. Countries the most at risk will suffer rising bond rates and not everyone will be so eager to avoid defaulting only to accept an IMF loan with strings attached. Bailout talks will continue being futile without monetizing debts and confidence in paper currencies will be shaken. Gold will flirt with reserve status and sovereign defaults will become inevitable despite “bailout” loans.

Be prepared for deflation as economies contract. Austerity, higher tax rates, rampant global bank failures, pre-boom housing prices, high levels of personal and corporate bankruptcies, amazingly low share valuations, and new gold highs. Then, with the continued monetization of debt, inflation will take hold. In the end we should all have learned a valuable lesson about misusing Keynesian economics.

After all, the solution to a debt problem is not more debt. It’s a balanced budget that takes into account the double whammy that cutbacks will have in times of recession. It’s not necessarily a popular position to take, but it’s the only viable solution. The sooner we accept that notion the less pain we’ll have to endure.

Solomon Nordine, MBA

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