There’s a specter hovering over the U.S. economy today. Like all specters, its background form may not be readily apparent. But the shadow it casts is nonetheless real. That specter and shadow are the still spreading financial crisis and the deepening credit contraction left in its wake.
Is there something fundamentally different about the current economic downturn that distinguishes it from the typical postwar recession? Could current events represent a qualitative change in the dynamic of postwar recessions? Perhaps something more appropriately called an epic recession?
Beginning of the End or End of the Beginning?
Thus far in 2008 both the financial crisis and credit contraction have continued to gain momentum. In mid-March financial instability reached a tipping point, as banks and other financial institutions began to turn on each other. Like crocodiles eating their own, investment banks (I-banks) such as Bear Stearns began calling in margins on loans to their hedge fund partners and other large investors. In response, hedge funds began playing hard ball by taking their money out of Bear Stearns and other I-banks. A feared run on the banks was imminent. Not a retail customer bank run, as during the Great Depression in 1932 and 1933, but a wholesale bank run on the I-bank sector with Bear Stearns at the center and with Lehman Brothers and other I-banks not far behind.
As George Soros, the billionaire investor, had warned just weeks earlier, the U.S. was facing the prospect of a wholesale bank run "of the type we have not seen before," a bank run that might very well "cripple the entire short term funding market."
While Congress dallied and the Bush administration opposed offering any assistance to two million homeowners facing foreclosure, over the weekend of March 15-16 the U.S. Federal Reserve, the U.S. government central bank, quickly acted to bail out Bear Stearns by effectively providing it a $29 billion guaranteed loan—in exchange for which Bear Stearns had to agree to feed itself to its bigger bank brother, J.P. Morgan-Chase.
Less well known perhaps, but more significant, has been the Federal Reserve’s making available nearly $400 billion in low cost loans to banks and financial institutions from December through April this year. More so than the Bear Stearns bailout, the $400 billion has served to temporarily prevent the wholesale bank run that Soros predicted was imminent. It probably also was central for preventing, for the moment at least, a spillover of the banking crisis to the $2 trillion hedge fund and $60 trillion credit derivatives markets, about $25 trillion of which is currently held by U.S. banks and financial institutions. (Another $22 trillion is held by UK banks.)
But the March action by the Fed and U.S. Treasury has not resolved the current financial crisis; or the associated credit contraction the financial crisis has provoked; or, more importantly, had any notable impact on the consequent downturn in the real economy.
A contrarian view increasingly promoted in the business press since the Bear Stearns bailout is that the financial crisis has now stabilized. However, that view is largely the product of bank CEOs like Lloyd Blankfein, head of Goldman Sachs, John Mack of Morgan Stanley, Vikram Pandit of Citigroup, and Richard Fuld of Lehman Brothers. All, in orchestrated fashion, trotted out in successive press conferences in early April to declare the "beginning of the end" of the financial crisis—when, in fact, events since Bear Stearns represent not the beginning of the end but rather the end of the beginning.
Financial Crises Phase Two
In April the International Monetary Fund estimated that projected losses from the financial crisis would be approximately $1.2 trillion. However, major money center banks collectively have thus far acknowledged only $200 billion in losses. Estimates of bank losses still to come are, at minimum, another $300-$400 billion. Hedge funds, insurance companies, pensions and other funds have yet to acknowledge any of their share of the still unaccounted for $1 trillion—which the IMF estimates at $280 billion, $100 billion and $110 billion respectively.
Beyond the $1 trillion are further losses to come associated with the accelerating decline in consumer credit markets now underway—in particular, markets for auto and student loans, credit cards, personal loans, and the like. A further round of consumer credit market losses will begin to impact financial institutions later in 2008 and 2009 in a feedback effect.
As a rough idea of the potential scope of this second phase, consumer indebtedness ballooned from 2001 to 2007 from $5 trillion to $10 trillion in the U.S., about half of which, more than $2 trillion, was non-housing related. The size of the consumer-related losses and credit contraction to come may thus be at least as large as the subprime mortgage bust of 2007-08. That would mean at least another $500 billion in losses to come. In addition, experts on corporate defaults and bankruptcies estimate a minimum of another $220 billion in losses due to corporate defaults in 2008, with at least another $200 billion in 2009. Together with consumer credit losses, that’s nearly another $1 trillion to be added to the IMF’s projected losses.
Worth noting as well, is that the U.S. Federal Reserve currently has total available bailout funds of around $800 billion. If it has already committed $400 billion to mainstream banks (smaller regional and local banks are out of luck), that leaves the Federal Reserve short of funds for bailout purposes by approximately $1-$1.5 trillion. If faced with further runs on financial institutions as occurred in March, the underfunded Fed will have to seek an emergency loan from Congress as the Federal Reserve has already shot off its big cannons and has little in the way of effective ammunition left. Knowing this full well, it will now most likely retreat and turn over primary responsibility for the crisis to Congress and the U.S. Treasury.
Recession or Depression?
Since 1945 the U.S. economy has experienced a number of recessions, but not yet anything that could be called a full-fledged depression. Recessions are officially defined as two consecutive quarters of declining total output of goods and services in the economy. Thus recessions are relatively short. While they may extend beyond two consecutive quarters, they seldom last more than three. And the magnitude of economic decline is typically in the range of a few percentage point drops in total economic output, while unemployment levels rise at most to the 8-10 percent range and quickly retreat to lower levels in a matter of months. Recessions are never associated with sustained or deep declines in prices. Nor with system-wide crises in the banking and financial system. Moreover, monetary policy designed to lower interest rates and fiscal policy by government in the form of cutting taxes or increasing spending typically have a positive impact within months, thus checking and reversing the economic decline.
Describing a recession as only two consecutive quarters of contraction in the real economy is rather arbitrary. But definitions of a depression are even more imprecise. Economists concur that a depression is worse than a recession, in the relative sense of being deeper, longer, and having a more negative impact.
The last generally acknowledged depression in the U.S. occurred between 1929-1934. It was followed by a brief period of recovery, 1935-37, but quickly followed by a downturn in 1938-39 nearly as severe as the earlier period of the decade. Less well known, but no less devastating for their time, were depressions in the U.S. that occurred in the 1890s, 1870s, and 1830s. During the Great Depression of the 1930s the economy declined 30 percent, compared to the typical 2 percent for a postwar recession. Unemployment levels reached more than 20 percent. The decline in the economy and jobs lasted over a course of nearly five years, compared typically to less than one year.
Some Characteristics of Depressions
All the identifiable depressions in the U.S. since the 1830s were preceded, and to a great extent provoked, by periods of intensive financial speculation, accelerating price increases for investment assets, and excessive accumulation of investor debt, followed by an eventual blow up of the banking and finance systems as the excess speculation and debt peaked and then busted. From 1945 to the 1980s recessions were essentially de-linked from financial crises and there were no financial crises of any note, apart from an occasional bank or other major company going bankrupt. Since the 1980s, however, recessions have been increasingly linked with financial crises that, while not yet system-wide, have been growing nonetheless in intensity and scope. The current 2007-08 crisis represents the closest and most intense integration of financial instability and recession since 1939. Compared to prior postwar recessions, today’s financial instability also appears to be system-wide in scope.
In depressions, the accumulation of excessive debt and intensifying speculation go hand in hand, the one feeding upon the other in turn, until the speculative bubble bursts. The bust then quickly leads to a rapid fall in asset prices (i.e. investments) and then spreads eventually to general product prices, and thereafter to wages. The combination of excessive debt and falling asset prices results, in the initial phase, in a crisis in the finance and banking sector. Bank losses quickly pile up. Banks in turn reduce or stop loaning to businesses, and even to each other, or else raise interest rates to levels to discourage loans to all but those businesses most desperate to borrow. The system of credit freezes up. A general contraction of credit then follows. Non-financial businesses are subsequently impacted and can’t get loans at reasonable rates to keep their businesses going. The shakiest and least financially able companies are forced to borrow at the higher rates. Meanwhile, prices for their products also begin to fall, creating a double problem as revenues decline while costs rise. During the depression of the 1930s general prices fell by more than a third. Increasingly short on cash, businesses then cut costs. Layoffs occurred first in smaller numbers then massively. As revenues continued to drop and debt and costs rose, the most exposed businesses began to default on their previously borrowed loans to banks, causing a further round of bank losses. Banks in turn tightened credit further.
Thus a spiral of declining prices (called deflation) and rising debt and costs leads increasingly to more and more defaults on loans and to bankruptcies—both consumer and business. Defaults and bankruptcies lead to more losses for banks and a second phase of financial crisis. The downward cycle of debt, deflation, layoffs, credit contraction, defaults and bankruptcies continues, followed by a series of banking crises and an ever-deepening crisis of confidence in the financial system.
Depressions are further characterized by having a global dimension. Depressions are always global events and the economic declines in countries are transmitted by one or more financial mechanisms between countries. In contrast, recessions are typically restricted to a given country’s economy. In addition, depressions are typically associated with currency crises. During the 1930s, the U.S. dollar plummeted in value, as did other currencies. In contrast, currency crises and a precipitous fall in the value of a country’s currency are not normally associated with recessions. Finally, the depression of the 1930s was notable for the failure of the Federal Reserve bank to stop the downward spiral, despite having lowered interest rates to virtually zero. Monetary policy thus proves largely ineffective in stemming economic decline in a depression.
In a depression, government spending has to assume the task of restoring growth and jobs. However, government spending in the 1930s was not hampered by a $10 trillion dollar government debt level, such as is the case today. Just as banks and businesses took on trillions in additional debt since 2000, and consumers added $5 trillion in debt, the U.S. government since 2000 has also borrowed $5 trillion in order to finance war and tax cuts for the wealthy and corporations.
Thus between $13-$15 trillion in debt at all levels of the U.S. economy—business, consumer, and government—has been added since 2000, a development similar to what occurred in the 1920s in the runup to the Great Depression. In fact, the unwinding of massive excess debt levels is one of the major hallmarks of depressions compared to recessions.
Some Characteristics of Epic Recessions
An epic recession shares some—though not all—characteristics associated with a depression. An epic recession would typically last beyond three quarters, but probably fall well short of the 12-20 successive quarters of economic decline often associated with a depression. However, the 4-12 quarters of decline in an epic recession could take the form of a long stagnation—i.e., somewhat similar to what occurred in Japan in the 1990s. Unemployment might range between 10-15 percent properly estimated (not underestimated as it is currently in the U.S.). Price deflation might occur in at least a few select major markets or sectors, although not as a general rule throughout all sectors. Or, consumer and wholesale product price levels might stagnate or decline mildly for an extended period of time. Workers’ real wages and weekly earnings would decline. Corporate defaults and bank failure rates would exceed historical averages. There would have to be evidence of a cross country transmission of economic decline, with some identifiable mechanism for the transmission. Exceptional volatility in the country’s currency (either excessive decline or rise) would be another characteristic of epic recessions, as well as increasing ineffectiveness of lower interest rates in stimulating recovery.
Based on the above short list of characteristics it is clear the emerging recession in the U.S. shares significant common ground with an epic recession.
First, the current recession is characterized by a massive debt overhang of more than $13 trillion that has already begun to unwind in the form of significant deflation in the residential and commercial property investments markets. For example, as a direct consequence of excessive debt levels, U.S. residential housing prices have fallen dramatically. Moreover, they are projected to continue to decline at an even faster rate over the next year. Only 200,000 of the anticipated 2 million foreclosures have occurred to date. That means as foreclosures accelerate in coming months, further significant price declines are inevitable. It appears, in addition, that commercial property price declines are close behind. In 2002, the U.S. economy came perilously close to deflation in product markets and it may well return to that threshold in the near future, given current conditions—although the price declines may also be cloaked by rising prices for oil, food, and commodities for a number of months to come. In terms of workers’ pay, real wages today are clearly stagnating at best while, in auto and other select industries, wage deflation is occurring. In terms of deflation, conditions of epic recession are evident in the current downturn.
In terms of general economic output, of course, the current recession is just beginning and it is difficult to determine how long it will last. On the employment side, the economy is migrating toward very large job losses and unemployment over the next 18 months. Every month the U.S. economy must create 150,000 jobs just to absorb new entrants to the job market. Instead, it has been losing on average nearly 100,000 a month. That means a quarter million without jobs every month, or about 2 million more unemployed during the first half of 2008—all that before announcements of mass layoffs begin to occur in the second half of 2008. It appears the current recession might attain 10 percent-plus levels of unemployment.
With regard to corporate defaults and bankruptcies, recent estimates by Standard and Poor’s, and other rating agencies, are that corporate defaults will rise tenfold in 2008-09.
Meanwhile, credit card companies and banks are preparing for billions of dollars in losses from additional consumer defaults as well. The student loan market has virtually dried up, requiring a Congressional bailout. Auto loans are projected to default at record rates in 2009. Consumers are turning to food stamps in record numbers and drawing down their 401k plans to cover daily consumption needs as their wages stagnate and fall, mortgage refinancing dries up, and credit card terms and usage are tightened. Both consumer and business confidence are now in freefall by all official estimates. Consumer spending has hit a wall and is rapidly decompressing. The wall is about to collapse on them as oil prices will continue to rise to more than $150 a barrel, and perhaps as high as $200, which will result in gas prices at the pump approaching $5 gallon by year end.
In the 1930s the depression was propagated and spread by the financial system, in particular the gold standard at the time. Today, once again, it appears the financial system is spreading the crisis, but with a different transmission mechanism. This time it’s the global integration of financial markets, technology, and the securitization revolution of the past decade replacing the gold standard as a pro- pagating mechanism spreading the downturn. It is not by accident that the two economies suffering the worst of the financial instability—the U.S. and the UK—are the two now experiencing the fastest real economic slowdowns. Moreover, their respective currencies are plummeting while the euro rises to record levels, which will soon tip the economies of continental Europe into recession as well.
In yet another characteristic of epic recessions, the declining effectiveness of monetary policy in the U.S. is also becoming increasingly apparent. The Federal Reserve began rapidly lowering short term interest rates in September 2007. Despite that effort, the real economy continued its momentum toward recession. Short term rates today are about as low as the Fed dares to go, at around 2 percent, and the Fed has all but admitted they won’t fall much lower. The Fed’s dilemma is that, while it has lowered short term rates, long term interest and bond rates have either not moved or have risen. And it is long term rates that businesses and corporations borrow at in order to finance their continuing day-to-day operations. For example, 30-year mortgages have moved a miniscule 0.10 percent despite a full 5 percent drop in short term rates. The Federal Reserve interest rate policy has thus served only to fatten bank profits and balance sheets, allowing banks to borrow at super low rates while continuing to charge unchanged high long term rates to businesses and other customers. But the effort hasn’t helped the general economy recover at all.
What the preceding brief and general overview reveals is that the current economic downturn is quite unlike typical postwar recessions. The fundamental forces driving the current recession include:
- forces associated with excess debt
- deflation in housing and construction
- strong job losses
- rates of corporate and consumer default well above historical averages
- extraordinary pressures on consumer incomes and spending
- a major decline in the value of the U.S. dollar
- spreading slowdown to other economies
- increasing ineffectiveness of monetary policies
These all provide strong evidence that the current recession is transitioning to an epic recession. The underlying factors that will continue to drive these forces will be the protracted financial instability, driven by a projected $1.5 trillion in losses yet to impact the U.S. economy.