Tuesday, November 25, 2008

Are We Headed for a Depression?

The economy, virtually all major asset classes, consumer spending, and manufacturing are all shrinking. The question of the day is whether we will have another Depression. Things are already worse than the average recession in the post-World War II era. Only the deep recession of 1981-82 was more severe; and the current downturn may eventually exceed that one. Is the economy about to take a bungee jump without a rope?

Reasons to Expect a Depression.

Bank Failures. The Great Depression was heralded by thousands of bank failures. We have had only a handful thus far. Losses to depositors have been minor, since the big banks that got into trouble have been acquired by stronger banks, with all depositors protected. Although the number of troubled banks is growing, it doesn’t look right now like we’ll have a failure rate anywhere close to the levels of the 1930s.

But there’s more to the story. The banking system circa 2005-06 was far different from the banking system circa 1929. Banking, in its most elementary form, involves intermediaries (i.e., bankers) taking money from savers and lending it to borrowers. This intermediation was done by bricks and mortar institutions in every small town and city in America in the 1920s and 1930s. However, by 2005, the process of banking had bifurcated. Loans were initially extended by the bricks and mortar places. But the loans were then bundled into packages and sold to investors. This is known as securitization, and involved trillions of dollars. Most mortgage loans were securitized, and large quantities of car loans and credit card balances were securitized. In essence, savers provided the money used by mutual funds, pension funds, hedge funds and other investment vehicles to invest in securitized debt. These investment vehicles played an intermediation role in funding the loans. The savers’ “deposits,” if you will, consisted of their interests in securitized debt, which were not federally insured.

Since the mortgage debacle began in 2007, many investors in securitized debt have taken mega losses. With the economy receding, the prospects are for more losses as borrowers of all sorts become increasingly likely to default. The securitization market has come to a screeching halt. Virtually the only mortgage loans being made are those underwritten or bought by government controlled entities, like Fannie Mae, Freddie Mac and the FHA. Consumer credit is shrinking rapidly as banks cut back on credit lines of all sorts (home equity, credit card, etc.); car loans are hard to get except for the most creditworthy. The result is that a major part of the de facto banking industry circa 2007 has collapsed. Jimmy Stewart wasn’t a debt securitizer and there’s no one comparable who can restore confidence. In reality, the collapse of the securitization market constituted a multi-trillion dollar banking failure.

Bursting of Asset Bubbles. Really bad economic downturns, like the Long Depression of the 1870s and the Great Depression of the 1930s, have been preceded by the bursting of big asset bubbles. Speculative excess in railroads and other investments played a major role in triggering the downturn in the 1870s. Investor over-exuberance in the 1920s real estate and stock markets did much to instigate the Great Depression. Today, we’ve had bubbles in real estate, stocks and, most recently, commodities like oil, fueled by easy credit. Indeed, the securitization market was a big credit bubble that burst painfully. Trillions of dollars have been lost in the last two years as these asset classes have sunk in value. These losses continue, and more will be sustained in the foreseeable future.

No Exit. The most recent economic trauma that may be comparable to ours today is the Japanese economic crisis that followed the collapse of its real estate and stock markets in 1989-90. The Japanese stock market fell around 80%, and the banking system was saddled with bad real estate and commercial loans for years. The Japanese economy has stagnated since then, even to this day. But Japan did not experience anything approaching a depression. Perhaps one of the most important reasons for this was that Japan was able to maintain large export markets, and thereby sustain many major industries. Most importantly, this included its automobile manufacturers, which have worldwide markets. The United States doesn't have supersized export markets that can compensate for its economic failures at home. Such was also the case in the 1930s, when any attempt by the U.S. or other nations to export their way out of their problems was met by stiff national trade barriers imposed in an excess of protectionism. The U.S. economy was like a closed loop, left with only its internal resources, and those had been too badly damaged to support a recovery.

Thus, the current situation in some ways bears an eerie resemblance to the early 1930s.

Reasons Not to Expect a Depression.

Kinder, Gentler Government. Over the course of the 20th Century, governments in the United States and other capitalist nations learned that sustaining democracy along with free enterprise requires the government to soften the harshness of capitalism. The free enterprise system is a great motivator, and rewards winners handsomely. But losers are given short or no shrift. There was little social safety net in the 1930s, and, as the Depression descended, discontent grew. Socialism and even Communism gain traction in America. In Europe, even darker clouds rolled in as fascism attained dictatorships in Germany and Italy, and provoked a devastating world war that killed tens of millions.

Franklin Delano Roosevelt may, as his critics charged, have had a mediocre intellect and been a traitor to his class. But he made capitalism safe for democracy. With public works programs, public employment programs, Social Security and other measures, he took people off the soup kitchen lines and put them to work or pulled them out of poverty. Unemployment and workers compensation, Medicare, Medicaid and other such programs were instituted to further buffer the unfortunate from the hard laws of the markets. Today, unemployment compensation has become increasingly generous, and COBRA rights extend the health insurance benefits of those that are laid off. Various government programs provide for worker retraining and health insurance for underage children and those who can't find private coverage. Although job loss remains a very difficult experience, it doesn't today usually have the devastating impact that it had in the 1930s.

Proactive Central Banks. The Federal Reserve and other central banks around the globe have been on the job since the early stages of the crisis. Although they seemed to be initially in denial about the size of the problems, they now fully appreciate that a lot of stinky stuff is hitting the fan fast. They've been working together to keep the financial system on life support, and prevent bank failures from cascading. They couldn't prevent the biggest bank failure of all--the collapse of the securitization market--because it is largely unregulated. But they've helped regulated institutions absorb the body blows from that collapse.

Bailout Binge. Along with liquidity transfusions provided by central banks, the U.S. Treasury Department and equivalent bodies of foreign governments have been recapitalizing, nationalizing or otherwise bailing out ailing financial institutions. There are principled reasons for concern about the extraordinary extent of the bailouts--we're talking trillions--but principles sometimes become a tad hazy when your stomach is growling. Rightly or wrongly, there's no end in sight to the bailouts, and they will soften the impact of the economic downturn.

Fiscal Stimulus. The government has, to date, focused almost entirely on preventing a collapse of the financial system. That's important, but the financial system can't be sound unless the real economy is healthy. Some in government seem to have finally realized this. President-elect Obama is proposing a massive government employment program. The Federal Reserve and Treasury Department have announced a program to use government funds to bring relief to the ice cold consumer credit market. Broadly focused government spending will provide more widespread relief and restore a measure of confidence in the government that has been lost by its almost obsessive focus on the well-being of Wall Street.

There may be an exit. All of the government's spending will require more federal borrowing. Since Americans have largely forsworn saving, the funds will have to be borrowed overseas. Nations with capital surpluses, such as China and Japan, have been notably understanding about funding the U.S. government's deficits. Although they have obvious self-interest--a healthy U.S. provides much of their export markets--they are taking some significant risks by continuing to buy U.S. government debt. Since the U.S. can obtain funding from outside its weakened internal economy, it has a chance to work its way out of its problems. Imagine a family burdened with education debt, a mortgage, car debt and credit card debt. A well-off relative lends them, say, $25,000 to help sort things out. This money, which comes from outside their world of never-ending debt payments, lets them get back on their feet and stabilize their finances. Loans from China, Japan and other creditor nations are an external factor that may have a similar benefit for the U.S.

All in all, it's unlikely the U.S. will go into a downturn like the Great Depression. The cost of avoiding such an outcome, however, will be a massive increase in federal debt. Taxpayers for a long time will bear the costs of such borrowing. These borrowings are also likely to push up longer term interest rates, thus depressing commercial activity and long term economic growth. Higher interest rates also dampen housing and stock prices. And if the Fed manages to keep long term interest rates down, all the liquidity it's now pumping into the economy could either produce price inflation or stimulate another asset bubble and burst that will once again push the economy down. We may end up with a long period of stagnation or slow growth like Japan post-1990. There still is no free lunch. That's one lesson that the credit-driven boom of the early 2000s and the subsequent collapse teach us. This time, though, we should take the lesson to heart and try moderation instead of irrational exuberance.

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