On March 11 “The US economy at Defcon 2“ said “The deleveraging of the US economy is putting “torque” on the US financial system. This is a process which cannot be stopped prior to completion, although the government will try. The US economy resembles a rock balanced at the top of a cliff. It was stable hanging on the top; it will be more stable at the bottom. Hence the need for Defcon 2 — defense condition 2, one level below the maximum. ”
On October 3 “The last opportunity for effective action before disaster strikes” said “The financial system has had a cardiac arrest. … Restarting the necessary flows through the business credit system must be done immediately, and will require drastic measures.” Such as “Massive fiscal stimulus” since “The full effects of the recession will hit in the next few quarters”.
Now the effects ripple from the virtual economy (financial markets) to the real economy. Americans have reduced their spending. Hundreds of companies around the world have announced falling revenue — and responded with cutbacks in employment and capital expenditures. Tens of thousands are doing the same, but outside the media spotlight. Most of this will hit in the early months of 2009. We must move the US to Defcon One, a war-like mobilization of resources.
The unmentionable history
Before looking ahead, we must put these events in a historical context. Two aspects of our situation are unmentionable, upon pain of becoming an outcast among respectable people.
First, US government’s response has mirrored that of 1929-1932 (although current events cannot be closely mapped onto that timeline). Bernanke, whose reputation was built on his criticism of the Hoover Administration’s handing of the crisis, must find that baffling. These things probably seemed so simple when writing about them at Princeton.
Phase I: Worrying about inflation during the early stages of the debt deflationary collapse.
Phase II: A slow, inadequate response to the collapse of the financial system. Then it was the banks; now it is the “shadow” financial system — a complex network of banks, brokers, leasors, credit insurers, mortgage brokers, hedge funds, and private investors. The results are pervasive and serious, as seen in the collapse of the corporate bond market (esp for bonds over 1 year), and shippers’ difficulty in obtaining letters of credit.
Phase III, now in progress: A late, slow, and small fiscal stimulus to offset the collapse of credit.
Second, that the US economy might be less stable than that of 1929, and our knowledge of economics as inadequate vs. the situation as it was then. That is, we know much more — such as how to prevent the mistakes of 1929 – 1938 — but not necessarily more vs. the more complex global economy of today.
Note others share this fear, such as former Goldman Sachs chairman John Whitehead at the Wednesday’s Reuters Finance Summit: “Whitehead sees slump worse than Depression“, Reuters, 12 November 2008.
What might happen in 2009?
- Rapidly rising unemployment
- More household bankruptcies
- More business bankruptcies
- Result: a collapse of business and consumer spending
1. Rapidly rising unemployment
Businesses cannot all improve their financial condition by cutting costs. Your expense — spending on vendors and wages — is somebody else’s income. Simultaneous cutbacks just ratchet the economy to a lower level of activity, with almost nobody better off.
2. More household Bankruptcies
Much of the most important economic research predicting this downcycle was done by the Levy Institute. Perhaps the single most important was Asset Poverty in the United States, Asena Caner and Edward N. Wolff, Levy Institute, April 2004. It showed that roughly 40% of US households are 3 months or less from bankruptcy. That is, their high debts and low savings mean they cannot withstand even brief periods of unemployment.
Consider an average blue collar (3rd quintile of income) family in 1980. Husband working full-time; no debt except for the mortgage (30 year fixed, 20% downpayment) and car loan (2 year term). Plastic meant a Esso or Texaco card to buy gas. A savings rate of 15% or more, with 6 months cash in the bank. Unemployment meant tough times, but unemployment insurance and savings — plus sustenance spending — could get them through 6 – 12 months.
Their 2008 equivalent has both spouses working, revolving credit greater than savings (excluding retirement accounts), and far larger home and car loans vs. their income. One spouse losing a job means bankruptcy in 3 to 6 months. Esp if that person is a one of the new entrepreneur class, perhaps an independent contractor — not covered by unemployment insurance.
What about economists’ assurance (often with graphs!) that US household balance sheets are in fine shape? True, in aggregate. So long as Bill Gates shares his wealth with the newly unemployed. Aggregate data tells us nothing in a society like ours with such concentrated wealth and income.
3. More business Bankruptcies
Businesses are in just a fine condition as households. That is a small number have sound balance sheets, while most are dangerously levered. The bankruptcies have all ready started, and will accelerate in 2009. Developers and construction companies. Retailors, esp if the Christmas season is a bust. Auto companies and their suppliers. It will be a long list.
4. Result: a collapse of business and consumer spending and investment
The resulting collapse of aggregate demand might initiate positive feedback. A collapse of economic activity, feeding on itself and spreading throughout the economy. It will eventually burn itself out, the economy restored to equilibrium. This equilibrium might be at a substantially lower level of national income.
Unfortunately that leaves the government as the only entity both willing and able to borrow and invest during the next year or two. The necessary government action must be on a scale seen in the US only during of wars – and the 1930’s.
The governmen’s response
So far our strategy is deny and pretend. We are like children playing on the beach while a tsunami approaches. “Look at the giant wave. Cool!”
The government has responded with twenty complex and small programs, all doomed to fail, with an emphasis on manipulation of public opinion. At all costs they avoid telling the truth about the situation (and the cost will be high). The current fight to reveal the objects of Fed’s largess (source) is symptomatic of an upside-down strategy. While it might alarm the public to reveal that so many of America’s top corporations require emergency aid to avoid defaults, keeping it secret diminishes public trust and cohesion that we absolutely require to survive the coming crisis.
Worst of all is the government’s obvious lack of a plan — or even a coherent strategy. Without that even measures on an adequate scale would have failed.
Time is not our friend. Not only is this a bad thing, but Martin van Creveld says is symptomatic of a fundamentally flawed strategic posture.
There is no point repeating what I and others have said about the necessary measures. To mention two of the most obvious:
- An large-scale fiscal stimulus program is needed Stat. A big one in November, giving local governments money to spend right now. Pay contractors to fill in potholes, build playgrounds, paint buildings. Small projects that can be started now, with a minimum of time-consuming paperwork. A much larger program will be needed in February to fund large-scale infrastructure projects.
- Immediate cash-out of OTC derivatives, esp equity, commodity, and credit default swaps (interest-rate swaps are by far the largest segment, but probably have the least risk). This might be legally difficult to do, and perhaps operationally complex. But it is imperative, as these are burning fuses to very large bombs.
Unseen obstacles lie ahead
While economists express confidence in fiscal and monetary policy to mitigate the downturn — they have always worked for us — there are possible obstacles ahead.
First, theory and experience say that the government can borrow any necessary sums during a recession. Other parts of the economy either do not need to borrow — or cannot borrow. Savings rates rise, as do risk premia (a fancy way of saying that people only want to lend to the government). The US government is about to test this belief, attempting to borrow many trillions of dollars during the next two years.
Second, moral hazard might make large-scale bailouts impossible. How does one limit government aid? For example, if we say households with incomes under $50,000 can get cheap new mortgages if they need them — need shown by defaulting on their current mortgage — what stops everyone eligible from defaulting? It’s like a government-run intelligence test, with free money as the prize. Once people realize this — as I think they will — the cost of the bailouts will quickly become infeasible.
And not just households. Now the line forms behind the banks for government handouts to corporations. Even the government cannot bailout everybody.
The situation is complex, the appropriate remedies uncertain, the consequence of failure perhaps horrific. Interesting times, indeed.
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To read other articles about these things, see the FM reference page on the right side menu bar. Of esp relevance to this topic:
about the Financial crisis – what’s happening? how will this end? about the End of the post-WWII geopolitical regime some Good News about America! Some solutions
- A happy ending to the current economic recession, 12 February 2008 – The political actions which might end this downturn, and their long-term implications.
- Slow steps to nationalizing the US financial sector, 7 April 2008 — How this will change our society.
- Slowly a few voices are raised about the pending theft of taxpayer money, 21 September 2008
- How should we respond to the crisis?, 24 September 2008
- A solution to our financial crisis, 25 September 2008
- A quick guide to the “Emergency Economic Stabilization Act of 2008″, 29 September 2008
- The Paulson Plan will buy assets cheap, just as all good cons offer easy money to the marks, 30 September 2008
- The last opportunity for effective action before disaster strikes, 3 October 2008
- Prof Roubini prescribes first aid for America’s economy, 4 October 2008
- Effective treatment for this crisis will come with “The Master Settlement of 2009″, 5 October 2008
- Dr. Bush, stabilize the economy – stat!, 7 October 2008
- The new President will need new solutions for the economic crisis, 9 October 2008
- Results from the IMF meeting – just thin gruel, 12 October 2008
- The G-7 meeting was the last chance for action before the global recession, 12 October 2008
- A brief note about our financial system: Intermediation, disintermediation, and soon re-intermediation, 16 October 2008
- New recommendations to solve our financial crisis (and I admit that I was wrong), 23 October 2008
- A look ahead to the end of this financial crisis, 30 October 2008