Downturn's roots in consumer shift back to saving from spending

A better question to ask, perhaps, would be: "Where did it begin?" A fuller understanding of the fundamentals of the crisis would almost certainly provide an insight into how it might end. Many would point to the first failed rollover of mortgaged-backed commercial paper in August 2007 as the catalyst to the crisis.

Fair enough, but the root of the matter goes deeper, and much longer ago, than that.

Arguably, the turmoil we are experiencing today is linked directly to the trauma of Sept. 11, 2001. We now know that 9/11 spawned a "live for the moment" boom in U.S. consumer spending and borrowing, the likes of which have never been seen before.

This caused a major upswing in real estate prices, on the basis of which lenders created a balloon of consumer debt, including extending credit into the sub-prime space. Key to this lending was the presumption that any future debt service difficulties could be buried in a refinancing package based on the rising equity value of the home.

Nor was this expansion of leverage restricted to the U.S. housing market. The extended period of strong global growth fostered a belief that investment risks had become a thing of the past.

Investors - particularly professional fund managers - were therefore encouraged to leverage their investments in order to boost overall returns.

Investors competed for deals, rather than deals competing for investors, and risk premiums were driven even lower in the process.

The U.S. housing bubble broke back in 2006, but it would be August 2007 before the house of cards would really start to come down. With home prices on the decline, sub-prime mortgage holders were better off simply walking away from their houses.

Doubt crept into the mortgage-backed commercial paper market, and from there, into the interbank market. We now are faced with a global desire to reduce leverage, and governments have provided mountains of liquidity to keep things orderly.

There are now signs of healing and every reason to believe that the credit crunch will fade over time.

So, where will it end? The most important implication of the above interpretation of events is that the credit crisis is the product of an underlying economic downturn, not the other way around.

At the heart of that downturn is a shift in U.S. consumer psychology, away from "living for the moment" and back to "saving for tomorrow.”

That shift will take time to complete, and its real impact is now being felt everywhere, from Germany to Chile to Russia to China and all points between.

In other words, even after the credit crunch is sorted out, we will be left with a traditional downswing in the global business cycle. Such cycles have a lot of common characteristics: Repricing of risk, widening interest rate spreads, weak commodity prices and a rising U.S. dollar.

These symptoms are likely to persist until the global business cycle runs its course - and given the revision that has taken place in U.S. consumer psychology, that bottom is likely to be at least a year away, probably longer.

The bottom line? Economists' models cannot explain consumer bubbles, tech bubbles or commodity bubbles. Nor can they predict a post-bubble future.

However, business cycles do have a natural rhythm, and that means the outlook will remain challenging for at least the next 12-18 months.

(Stephen Poloz is a senior vice-president and chief economist for Export Development Canada. He can be reached at spoloz@edc.ca)