Recessions are an unavoidable part of the economic cycle. But the current downturn may be more than just a cyclical blip. The fallout from this unprecedented credit crunch could portend fundamental changes that could curtail economic growth for years.

At the core of the global recession is the deleveraging within the financial system. In the face of huge asset writedowns and increasing pressure to build capital, global banks are reining in their lending and tightening the standards by which they provide loans.

Because companies and consumers have funded their investments and consumption with debt, this tightening of credit undermines their spending power. Combine the credit drought with declining asset prices (real estate and investment portfolios for consumers; financial assets for corporations) and growing job losses, and demand for credit is evaporating. In the words of economists at New York-based Morgan Stanley Inc., we are facing a “perfect storm.”

That scenario is unfolding in much of the developed world, to different degrees. It is particularly acute in the U.S., the world’s biggest economy. And, because so many companies rely on the U.S. market — and U.S. consumers — to drive their businesses, the effects are spilling over to the rest of the world. The Bank of Canada’s latest Financial System Review identifies weak U.S. economic growth as the greatest downside risk to corporate Canada’s financial health.

In Canada, the same basic trends are at play — although domestic financial services firms and consumer households haven’t been as reckless as their counterparts in other countries. Canadian financial services firms aren’t as heavily leveraged as U.S. or European firms. Nor were they as careless with their lending as some U.S. banks. Nevertheless, Canadian financial services companies have their share of toxic assets, deteriorating loans and reduced securitization opportunities.

Similarly, Canadian households aren’t as overextended as their U.S. neighbours. A recent BofC working paper reports that while the debt service ratio (household debt/disposable income) rose to 137% as of June 30, 2008 from 110% in 1999, this is still less than the historical average. And during that eight-year period, Canadian households were in better shape financially than U.S. households, the paper notes, and the proportion of Canadian households in the most vulnerable situations actually declined.

The lower leverage levels for Canadian financial services firms and consumers imply that the fallout from the current crisis will be less intense in Canada. But Canadian firms will feel the effects of both a domestic downturn and the retreat of the U.S. consumer.

The latest forecast from Toronto-Dominion Bank economists has Canada’s gross domestic product underperforming U.S. GDP in 2008 (0.7% growth vs. 1.1%) but outperforming the U.S. in 2009, as Canadian GDP is expected to drop by 1.4% vs a predicted 2% drop for the U.S. Others see Canada holding up even better. A Merrill Lynch & Co. Inc. report, for example, predicts that the U.S. will see a 2.3% drop in GDP in 2009, vs a slide of just 0.3% in Canada. Nevertheless, the consensus view is GDP will shrink on both sides of the border in 2009.

Of course, other countries are facing their share of homegrown problems and economic issues. The result is a very pessimistic outlook for the global economy; a global recession is a given, and many economists are expecting a deep, prolonged downturn. This could impede a return to the normal functioning of global financial markets.

More important, although the global economy will eventually regain its footing and recover, it may well come out of this episode looking fundamentally different from when it went into the downturn — and on a notably lower-growth trajectory than it has been on in recent years.

“As the financial crisis subsides in its most destructive form, the state of the world is one with lower capital at risk and lower growth,” predicts New York-based credit rating agency Moody’s Investors Service Inc. in its outlook for 2009. “The world faces a period of stagnation and deleveraging.”

This view isn’t a worst-case scenario; it’s Moody’s new base case, which it describes as “a sea change from what we have seen over the past decade,” as the global economy undergoes “a painful economic convalescence.”

Indeed, the current slowdown doesn’t appear to be one in which the economy quickly cycles back to business as usual. Although some of the demand destruction will be repaired with time — and some appears likely to be replaced by government spending in the short term — some of that demand is probably lost forever. In particular, some portion of debt-financed consumption is surely gone, as households’ behaviour must change in response to the new, less decadent credit environment.

@page_break@According to a recent report from New York-based Oppenheimer & Co. Inc., consumer liquidity in the U.S. is starting to evaporate: “We believe we are now entering a new era in the financial landscape that will be characterized by expanded forced consumer deleveraging, with a pronounced downshift in consumer spending.” That reduced credit availability and heavy job losses (533,000 in the most recent U.S. employment report and 70,600 in the Canadian report), the Oppenheimer report adds, “is a dangerous and unprecedented combination, in our view.”

The Oppenheimer report predicts that US$2 trillion in consumer credit will be withdrawn by the credit card industry over the next 18 months as firms grow increasingly cautious, face funding challenges of their own and adjust to regulatory and accounting rule changes. “The severe consequence of this cannot be overstated,” the report warns, noting that, after employment income, credit cards are the second-biggest source of consumer liquidity.

This gloomy view is echoed in a report by New York-based research firm CreditSights Inc., which says that a dramatically less leveraged future will not be pretty: “We believe that we are indeed going through one of those rare periods of economy-wide deleveraging, and that this means our experience of this recession is likely to exceed the boundaries set by even those recessions in the relatively recent past that we considered to be severe.

“Life after leverage looks difficult,” the report concludes. “It requires reduced borrowing, reduced consumption and greater saving — all things that are unfamiliar to broad swathes of U.S. consumers and companies.”

Adjusting to a life with much less leverage is likely to take time. According to a research report from UBS Ltd. in New York, the deleveraging process has only just begun in the global banking industry. The report says the deleveraging will probably continue through to the end of 2010 and also estimates that global banks may need to raise between US$315 billion and US$418 billion in additional capital, as well as to employ other methods of reducing leverage, such as cutting dividends and selling assets.

On the consumer side, the Merrill Lynch report says that it will take years for balance-sheet repairs to occur: “This is no mere cyclical downturn in consumer spending. The buy now, pay later days are largely gone.”

Indeed, “the great deleveraging cannot be reversed,” says the UBS report, “only contained.” It warns that the process will be over only when banks and households have rebuilt their balance sheets: “The process is going to be painful and protracted.”

The only salve for this pain is government action. But while governments are trying to offset the decline in private-sector credit with extremely loose monetary policies and promises of massive fiscal stimuli, there are doubts if these will have the desired effect.

The Merrill Lynch report points out that when Japan went through its big financial crisis in the 1990s, aggressive monetary and fiscal action by the government “was a mere palliative for the deleveraging that took place in the private sector.” Moreover: “The market won’t allow U.S. policy-makers to prevent a consumption adjustment” by meeting their stimulative efforts with either higher yields or a weaker dollar.

So far, aggressive cuts in interest rates around the world haven’t done much to bolster the flow of credit. It remains to be seen whether promises of fiscal stimuli will do any better.

For now, however, the consequences of shrinking credit and a worsening economic environment are evident in the continued deterioration in real estate prices and reduced consumer spending. In the U.S., housing prices are down by about 20% year-over-year; some analysts expect them to fall that much again. Meanwhile, according to the CreditSights report, personal consumption declined by 3.7% in the third quarter, and looks likely to shrink further in the fourth quarter.

So far, Canadian consumers have fared better. A Bank of Nova Scotia report notes that retail sales growth has slowed in recent months but is still up year-over-year. Preliminary holiday shopping reports “are reasonably good,” says the report, although consumers are shifting their buying to more practical goods and away from luxuries.

But this resilience isn’t expected to last. “Looking to the new year, however, Canadian households are expected to become much more cautious spenders,” the Scotiabank report predicts, as growth, employment and income prospects dim. “Meanwhile, with plunging equity values and softening home prices chipping away at household wealth, look for a return to more precautionary saving.”

A Royal Bank of Canada report says that the Canadian housing market is also showing signs of weakness, although it doesn’t foresee a full-scale U.S.-style meltdown. Nevertheless, it notes: “The souring of economic conditions, eroding consumer confidence and, in some instances, past excesses are creating a downdraft that the majority of Canada’s housing markets will be hard-pressed to resist.”

For now, the BofC paper says, “The financial position of the Canadian household sector remains relatively positive.” But, it warns, “Rising debt levels mean that more Canadian households are becoming vulnerable to negative economic shocks at a time when the economy is expected to slow.”

The BofC paper estimates that a protracted economic slowdown would double the share of households considered vulnerable (those with debt service ratios in excess of 40%) to 6% from 3% by the fourth quarter of 2009. And, if this happens, the paper warns, “The banking sector would suffer significant losses.”

As it is, the banks are already feeling the pain. CIBC World Markets Inc. ’s latest portfolio strategy report observes: “The sharp decline in profitability in the banking sector in the latest reporting quarter suggests that the slowdown in the North American economy and difficult market conditions are taking a toll. We expect that to continue.”

Additionally, the report cautions that writedowns for non-performing assets could increase in coming quarters. In the long run, the financial services industry faces slower growth prospects: “Even if things return to normal eventually, the sector is unlikely to be the growth play that it has been in recent decades.”

Indeed, with the deleveraging process now expected to drag on through 2010, the global economy may not produce the growth it has in recent years. Moreover, global financial and trade imbalances still need to be unwound. As a TD report warns: “In many respects, [that] situation will have become worse due to recapitalization, deleveraging among businesses and households and huge public-sector dissaving.”

Economic recession may be an ordinary cyclical phenomenon, but, this time around, the global economy and financial system will face some fundamental challenges. IE