Economy: End of the beginning

Why I’m afraid that the economic fallout from the financial crisis may have only just begun.

The desperate market action of October — a deep freeze in the system’s money-market plumbing, historic plunges in equity markets around the world — finally prodded governments into aggressive co-ordinated action. Interest rates have been cut, liquidity pools deepened, bank debts guaranteed and capital injected. These actions, each more extraordinary than the last, suggest policy-makers are now committed to the “by any means necessary” approach to saving the financial system.

Yet saving the system does not mean restoring the system. The quid pro quo of governments saying, “We’ll save you,” is a warning: “We’ll never allow you to put us in this position again.” No doubt, leverage and risk-taking in the financial sector will be significantly constrained. Less risk will mean less reward, for financial firms and for households and businesses who find capital more difficult and costly to come by.

The transition to a world of more constrained credit will be difficult economically. The asset price inflation of recent years owed to the availability of cheap and easy credit. Those rising asset prices, in turn, provided substantial impetus to household and business spending. These effects will now work in reverse. Equity prices have already deflated markedly — as we write, the TSX is down 38.5% from its peak in mid-June, destroying more than half a trillion dollars of household wealth. Canadian house prices have fallen by much less than that, but even just an end to the steady appreciation of recent years will likely further weigh on the consumer and bring an end to the residential investment boom that has supported economic growth this decade.

As a small, open economy, Canada is also highly exposed to the financial crisis and asset deflation fallout elsewhere. The U.S., the U.K. and Japan are Canada’s three largest export customers, buying roughly 30% of total Canadian economic output. All three are now in recession or rapidly heading that way. Emerging markets are faring better, but my colleagues expect growth to slow next year in 34 of the 38 developing economies we cover at Merrill Lynch, including all four BRIC heavyweights (Brazil, Russia, India and China). Even if direct exposure to these markets is small, the indirect exposure is large, as strong demand growth in the developing world had boosted commodity prices until this summer. Those prices have now tumbled, which will reduce Canadian national income. Indeed, we now expect nominal GDP — the total dollar value of goods and services produced in Canada — to decline outright in 2009, for the first time since 1933.

This decline will be a challenge on a number of fronts. Wages are likely to grow more slowly. Profits are virtually certain to fall. Government revenues will come under pressure. Indeed, our economic forecast implies a federal deficit of roughly $10 billion next year, absent a change in policy.

The fiscal shortfall may yet be larger. So far, Canada’s more robust banking system has let the government intervene less aggressively than in the U.S. and Europe, with the response limited to a $25-billion mortgage funding program. That scheme was sold as an asset swap with no added taxpayer risk, but that’s only because the government is already responsible for that risk via Canada Mortgage and Housing Corp. insurance. More generally, a global theme of this crisis has been the public sector scrambling to lever up its balance sheet to offset the devastating deleveraging of the private sector’s balance sheet. That process may yet have further to go here, too.

Canada may have fared better than most through the acute phase of the financial crisis, but don’t rely on that continuing through the global fallout that still largely lies ahead.