The United States housing market started heading down in the middle of 2006 in response to the Federal Reserve increasing its funds rate from 1% to 5.25%.
The sharp increase in this interest-rate proved too much for the many sub-prime borrowers who had taken advantage of extremely low teaser interest rates offered by banks between 2003 and 2005.
As these very unworthy borrowers started defaulting on their loans, banks had to start taking these losses onto their books. These losses started to get revealed in the middle of 2007 and, at the same time, investors around the world who had bought securities issued by US banks to finance their sub-prime lending found that they were in loss-making positions as well.
So what started as a simple downturn in an overvalued US housing market by the middle of 2007 had turned into a global liquidity crisis whereby investors became less willing to fund the lending activities of US banks.
To try and improve the confidence of investors and reduce the losses of American banks, the Federal Reserve cut interest rates last year and, particularly aggressively, this year. Their funds rate now sits at 2.25%.
At the same time, the Federal Reserve has been coming up with more ingenious methods of providing extra liquidity to American banks. Essentially what they have been doing has been acting as investors supplying funds to American banks at a time when investors only want to hold on things like cash or gold.
The problem, however, is that investors and banks knows the situation is unsustainable and it is because of this awareness American banks have been cutting back on their lending.
This is affecting all borrower types stretching from those wanting a student loan, people wanting to finance a motor vehicle, purchase or buy a home, or finance their business, whether it be small, medium-sized, or extremely large.
The stage we are at now is one where the liquidity crisis has turned into a credit crunch, where banks are unwilling to lend because they cannot sell securities to fund that lending on the other side.
The longer this goes on the worse will be the reduction in economic activity in the US economy and therefore the worse the downturn in overall world economic activity.
It is possible that by the time you to read this the situation will have started to improve with investors moving away from increasingly over-priced commodity assets back towards undervalued equities and high yielding government and private company securities.
Then again, the situation may not resolve itself until very late this year. If it takes that long for investors to regain confidence in the capital bases and lending policies of American banks then we could be looking at a very weak environment internationally, which would drive the New Zealand economy quite easily into recession.
There is still a lot of water to go under the bridge and even if things do weaken further overseas we must remember that here in New Zealand we do have reasonable insulation for our economy from things such as infrastructure spending, a backlog of construction orders, an extremely tight labour market, easing fiscal policy likely to involve tax cuts this year, and businesses simply having to invest because they cannot get the labour they want.
This means that even if we do have a recession this year it is likely to be an extremely shallow one and not the sort of downturn which many business people will have seen in the past in this country.
That means the previous rules for how to handle a recession may not necessarily apply. And, in particular, the big rule to be broken this time around would be the one regarding laying off excess labour. It is very unlikely you will have excess employees this time around and, in fact, you may want to take advantage of layoffs happening in areas like residential construction to get on board some extra personnel.
In fact, in the capacity-constrained economy we now have, a weak growth or recessionary period may be the only opportunity you get to secure valuable resources like people and premises at reasonable prices for the next five years.
