As painful as this liquidation and repricing of risk is for borrowers and lenders, those without debt, those with cash and those with essential skills that are in demand regardless of boom or bust will all benefit.
Who would benefit from a severe global recession? The typical answer is “no one,” as a drop in economic activity is assumed to hurt everyone. But it’s not quite that simple; there are silver linings for some in all those dark clouds.
When demand for energy plummets, the price of oil tends to drop dramatically. There are several reasons for this:
1. Price is set on the margins so a modest decline in demand can trigger an outsized drop in price. In the 2008-09 timeframe, oil fell from $147/barrel to the $30s on a modest decline in demand.
2. While oil producers always announce production cuts to maintain high process, they are under pressure to offset plummeting income by pumping more oil, not less.
3. Speculative capital floods into oil when prices are rising and exits when prices are dropping. This financialization of the energy markets exacerbates price movements up and down.
Dramatic declines in oil hurt producers and benefit consumers. As demand for goods and services declines, suppliers and retailers must trim prices and profit margins to maintain market share. This deflationary pressure benefits consumers.
As marginal businesses close their doors and marginal renters move out of high-cost rentals, landlords must reduce rents to avoid the eventual result of mass vacancies, i.e. bankruptcy. Reductions in rents benefit consumers.
Marginal homeowners and absentee landlords slide into insolvency and are either forced to sell their homes and real estate or their lenders foreclose on their mortgages and sell the lender-owned properties to reduce their losses. These forced sales reduce the price of these assets, benefiting those with cash who can now afford to buy assets that were unaffordable in the pre-recession bubble.
A deep recession also shifts global capital flows. As a general rule, oil/gas exporters and manufacturing exporters pile up excess savings (trade surpluses) by selling energy and goods to importing nations running trade deficits which are funded by borrowing (debt).
The exporting nations need some place to invest or park their excess capital and buying the importers’ debt yields interest income. This excess capital can also be placed in reserves (gold or foreign currencies), invested in offshore real estate, stocks, enterprises, etc., low-utility “bridges to nowhere” in the domestic economy or malinvested in grandiose malls, stadiums, palaces, etc.
It can also be spent in social welfare or high-technology programs, etc.
A severe global recession upends these capital flows. As demand craters, exporters’ surpluses drop precipitously. Rather than having surplus capital to spend/invest, the exporting nations must sell assets or tap reserves to fund the programs that the domestic populace views as their birthright.
As demand craters, importing nations import less, reducing their borrowing needs. But since the surplus capital of exporters has plummeted, the debtor nations find there are fewer buyers of their debt. This supply-demand imbalance pushes interest rates / bond yields higher, as importing / debtor nations must compete for the shrinking pool of capital sloshing around the global economy.
As marginal private-sector and public-sector borrowers default, lenders tighten lending guidelines to reduce the risk of losing money on debt offered to potentially marginal borrowers. Those seeking loans find it more costly to borrow as credit tightens, and those with cash find their capital earns a higher return as capital becomes more scarce.
These dynamics typically generate self-reinforcing feedback loops. As defaults rise, forced selling then triggers additional defaults as prices continue dropping. Heavily indebted households, enterprises and nations that suffer declines in income default on their debt, forcing a repricing of risk throughout the global credit market.
Prices that the unwary reckon have hit bottom continue to drop as the self-reinforcing dynamic of liquidation and repricing of risk feeds on itself.
