Epic Recession Revisited
Events and conditions since June 2008 have increasingly confirmed the prediction that the U.S. economy is headed toward a recession of unprecedented dimensions. Despite the several trillions of dollars thrown at it by Treasury Secretary Henry Paulson, and Federal Reserve Bank Chair Ben Bernanke, the real, non-financial economy continues on a deep and long downturn in the U.S. and globally, best described as epic recession. A major factor determining the economic trajectory—and whether the economy reaches a tipping point in 2009 on the road to depression—will be the fiscal policies adopted by the Obama administration. Will Obama and the Democratic Congress employ Clintonomics II or will they attempt to restructure the economic system? Will Obama and the Democrats see the current crisis as a repeat of 1993 or as 1933?
The Banking Panic of 2008
Since early September 2008, Paulson and Bernanke have thrown more than $3 trillion of bailout money at banks and financial institutions—with virtually no effect. Credit markets remain largely frozen. Long-term interest and mortgage rates have declined less than a half percent. Housing, stock, and other asset prices continue to plummet—producing deepening losses, requiring further write downs on balance sheets, and provoking the likelihood of widespread business and consumer defaults in the months immediately ahead.
Despite this historic cash injection from the Treasury and Federal Reserve, most banks still refuse to loan at reasonable rates or even loan at all, in particular to homeowners, small businesses, consumers, and increasingly to business in general. Credit did not merely contract, it crashed. Bankers have taken and pocketed the trillions, used the money to buy other competitors, or have hoarded it. This amazing response by banks and financial institutions to government efforts to provide liquidity, to refloat their technically bankrupt balance sheets, can only be described as nothing less than a bankers’ strike. Yet the response of Paulson-Bernanke has been to reward banks with trillions more taxpayer money.
From July 2007 through June 2008, Paulson-Bernanke pumped more than $600 billion into the banks to get them to open up and issue loans again to businesses and consumers—to no avail. By early September, another $200 billion was put up by the Treasury to bail out Fannie Mae and Freddie Mac. That was followed by $150 billion for the investment giant AIG, and by a $700 billion blank check written by Congress to Paulson, called the Temporary Asset Relief Program (TARP), designed by the Treasury to buy up toxic bank assets.
Paulson warned Congress that the economic sky would fall in without the $700 billion, an amount that, he declared, would also resolve the financial crisis once and for all. But neither happened: the sky didn’t fall and the financial crisis didn’t end. What did happen is that banks continued to refuse to lend money despite the more than trillion dollar infusion. The ink was hardly dry on the $700 billion TARP check when the research departments of the JP Morgan Chase bank and Bank of America estimated that $1.7 and $1.83 trillion more, respectively, would be needed by banks in bailout funding.
Meanwhile, as Paulson was acquiring his trillion for bailouts, Bernanke was busy disbursing his own trillion of additional taxpayer dollars to foreign banks and to non-banks to buy up their commercial paper and to money market mutual funds to offset their outflows. In November, he allotted another $320 billion to Citigroup—a company with $1.2 trillion in off-balance-sheet liabilities and thus technically bankrupt by any reasonable financial measure.
To make doubly certain bankers and friends had more than sufficient funding, Bernanke committed yet another $800 billion at the end of November. In short, in a 90-day period just about $3 trillion was allotted or committed. In spite of the $3 trillion injection, 30-year fixed mortgage rates at the end of November had fallen from 5.78 in mid-September to only 5.53 percent by early December.
The bankers’ strike continued. A similar drying up and tightening of credit deepened for businesses across the board after September. Mass layoffs doubled over the year previous. Consumer spending literally fell off a cliff. Business spending on new plants and equipment froze.
To better understand the nature and characteristics of what can best be described as an epic recession and, therefore, what lies ahead for the U.S. economy in 2009 and beyond, the following ten points provide a brief outline and description.
Ten Points of an Epic Recession
In earlier Z articles I noted that an epic recession shares elements of both a typical recession and a classic economic depression. Epic recession is an unstable, hybrid condition that cannot be sustained, but which will inevitably either revert back to a normal recession or else continue to evolve into a global depression. Not least, typical fiscal and monetary policies designed to contain normal recessions prove largely ineffective in the case of epic recessions.
1. Duration: Each of the nine post-1945 recessions did not extend for more than three consecutive quarters. At the other extreme of the spectrum, depressions that occurred in 1930s, 1890s, 1870s, and 1830s in the U.S. all lasted 36 months or more. The organization currently responsible for identifying recessions—the National Bureau of Economic Research (NBER)—this past December 1, 2008 officially declared that the present recession began in the fourth quarter of 2007. That means the current recession is already longer than 12 months. The fourth quarter 2008 will undoubtedly record further economic decline, and most predictions are the economic slide will continue at least through the first half of 2009 at minimum, and quite possibly longer. That means the current downturn will last 21 months at a minimum. That’s already twice that of all prior postwar recessions—clearly qualifying as an epic event in the duration category.
2. Depth: There are two fundamental ways to measure depth: the decline in gross domestic product (GDP) and the rise in the level of unemployment. A number of problems exist with GDP as a measure of economic decline, in particular the way it is calculated today after decades of revisions from Reagan through GW Bush, which have served to minimize GDP fluctuations. However, typical postwar recessions have been associated with drops in GDP of typically no more than 5-6 percent in any of the quarters. In contrast, depressions are associated with declines in GDP-equivalent statistics of more than 20 percent and much more in most cases. An epic recession would thus be accompanied by GDP declines from peak to trough between 10-20 percent.
A better measure of depth is the level of unemployment. In the four recessions since the mid-1970s (1974-75, 1981-82, 1990-91, 2001) the number of unemployed increased by about 3 million. But that growth in unemployed in each recession took three years to reach the three million additional level. The current downturn is already almost three and a-half million additional unemployed in just one year. And at least another one to one and a-half million will be added to the unemployed when results for December and January 2009 are calculated. That’s about five million additionally unemployed officially since November 2007.
However, that five million is really six and a-half to seven million more unemployed, if the huge increases in involuntary part-time employed are counted. One of the hallmarks of the past year has been the hiring by business of more than three million part-time workers, while simultaneously laying off five million full-time employees. That means millions more full-time employees are actually being laid off and rehired as part time. Two part-time conversions should be counted as one full-time layoff, but the government considers anyone working part time fully employed no matter how few hours they actually work. Thus the massive shift to part time now underway is masking and underestimating the true unemployment level by millions. To that six and a-half to seven million should be added still another 700,000 to reflect the net increase in workers without jobs and willing to work but who have given up looking. So the real increase in total unemployed over the past year is easily more than seven and a-half million.
Given the rapid rise in mass layoffs and announcements in the fourth quarter of 2008, it is likely that an additional four to five million will lose jobs in 2009. Never before in the course of a two-year period has the level of unemployed risen by more than ten million. The unemployment rate by year end 2009 could easily exceed 10 percent even according to official estimations (which would be the equivalent of 13-15 percent if accurately calculated). An epic recession is associated with unemployment levels of five million, plus net annual increases and double digit unemployment rates. The current downturn is on track to attain those levels.
3. Debt: A particular characteristic of depressions is the buildup of massive levels of speculative debt just prior to the economic collapse. All the great depressions in the U.S. in the 19th century and the 1930s were associated with speculative debt excess, in particular speculation and unsustainable debt in land and housing. When the speculative bubbles burst, the economic decline occurs more rapidly and deeply than normal recessions. Typical recessions are associated with causes largely unrelated to financial and banking instability, but depressions are almost always associated with financial crises brought on by (speculative) asset busts, especially when system-wide in nature. The current recession has been associated clearly with speculative debt buildup. In that sense, the current recession looks more like a depression event than a normal postwar recession.
For example, more than $22 trillion of the current total U.S. $49 trillion debt (i.e., government, consumer, financial institution, and non-financial corporate combined) has been added just since 2001. The current financial crisis is due to the unwinding of that excess debt, $18 of the $22 trillion of which is corporate (financial and non-financial) debt. The financial crisis is proving particularly intractable due to this huge volume of unwinding debt. The $4 trillion allotted to date is likely just half that which will eventually be required.
4. Deflation: In order to rid themselves of the excess debt on their balance sheets, financial, bank, and non-financial corporations alike begin dumping their various debt-accumulated assets at firesale prices just to get them off their books. Or, if they are banks and have banker friends at the Treasury and Fed, they get the government to buy up their bad assets, or buy their bank preferred stock to offset the bad assets, or insure them for losses as their bad assets decline in value (the Citigroup formula). But not all asset price deflation can be contained thus. Asset prices begin to collapse, as in the housing asset market, then spread to commercial property asset markets, then to various other forms of financial assets like commercial paper, money market funds, and so on.
The great danger of deflation is that it eventually spills over from asset prices to other prices in the mainstream economy. Product or goods prices then begin to decline across the board and, as non-financial businesses face an economic crisis and start to lay off employees in mass numbers (now happening), wages begin to decline as well (wages are just prices for labor services). So deflation begins to generalize, and deflationary expectations take hold, driving down prices further.
The above scenario always occurs in depressions and never in typical recessions. During the depression of the 1930s, asset prices collapsed more than 50 percent on average and product and wage prices by nearly as much. The current recession is now beginning to experience the early phases of deflation. It is already rampant in asset price markets from housing to bonds to stocks to other financial instruments, and is rapidly spilling over to product prices. Autos, consumer durable goods, home repair, commodities, big box retail, restaurant, entertainment and personal services, are all beginning to experience deflation. On the labor markets side, wage deflation is showing up in conversion to part-time employment, elimination of overtime pay, non-paid vacation, plant shut downs, cuts in company contributions to 401k pensions and benefits, and even outright direct wage cuts as in the auto industry, construction, and elsewhere. In other words, the current recession shares excess debt characteristic with depressions and the consequent deflationary characteristic as well.
5. Defaults: Defaults occur when a company or consumer cannot service debt payments—that is, cannot make interest payments on the debt and thereby default due to inability to pay. Defaults result in two things. First, the bank or whoever provided the loan or bond financing is forced to write-down the value of the loan or bond, which means a loss on their own books. The asset is thereafter then sold off at well below market prices. Second, consumers in default lose their home or auto while companies in default go out of business or reorganize with all or a large part of their workforce typically laid off, adding to the economic downturn. It is estimated that five to seven million homeowners will default in the current downturn—not your typical recession. Corporate rating agencies like Standard & Poors estimate a minimum tenfold increase in corporate defaults and bankruptcies as well. Debt-deflation thus drives the defaults and the latter in turn further drive deflation and still additional losses by banks and other financial institutions. (Paulson and Bernanke then throw additional money into the growing hole in bank balance sheets, temporarily offsetting the losses, but never closing the hole that continues to grow larger as housing and other asset prices continue to fall, driving further bank losses and write-downs.)
Some companies at present high on a list of potential defaults, and consequent bankruptcy and reorganization, include one or more of the big three auto companies: GM, Ford, and Chrysler. The latter will almost certainly default, as may GM itself, failing a direct bailout. Within 18 months there may be only one large U.S. auto company in the U.S., and possibly one less Japanese company as well. Commercial building companies (malls, office buildings, hotel, builders) will experience several defaults, as will hotel chains, restaurant chains, resorts, and one or more name retail companies like a Sears or JC Penneys. Many smaller retail chains will go under and countless small businesses. Many more will avoid default by merging with competitors (de facto default). Scores, and perhaps even hundreds, of smaller community and regional banks will go under, as may several large service companies like Sprint.
6. Financial Credit Instability: Financial institution collapse is rarely the cause or consequence of recessions in the normal sense. Occasionally a particular bank may go bust, as was the case of Continental Illinois in the early 1980s. Even a credit market or two might experience severe stress, as did the Savings & Loan industry in the late 1980s, which no doubt contributed to the 1990-91 recession. But a generalized, systemic bank crisis is not a characteristic of normal recessions. In contrast, the great depression of the 1930s was directly related to a series of banking crises and panics, which followed the stock market crash of October 1929. The first bank crisis occurred in late 1930, a full year after the stock market crash. The second, a year after that, in late 1931, and was more severe. Still more severe bank crises occurred in mid-1932 and then in the spring of 1933, resulting in a banking industry shutdown by President Franklin Roosevelt. Each crisis was more severe. In between each, the drivers of debt-deflation and defaults created the conditions for feedback and more serious banking losses, write-downs, and financial defaults.
The U.S. economy has just experienced its first banking panic and crisis set off by the chain of events precipitated by the near collapse of Fannie Mae and Freddie Mac. The forced bailout of Fannie/Freddie by the Treasury in turn set in motion the collapse of the investment bank Lehman Brothers, and thereafter in sequence AIG, Merrill Lynch, Wachovia, Washington Mutual—the latter of which were forced into acquisition by the remaining large banks in order to prevent further defaults. The current banking panic, still running its course, is on track to precipitate spreading business and consumer defaults in 2009. Should the latter occur in sufficient number, it will lead to a subsequent, more serious banking panic in late 2009 or early 2010. In short, the current epic recession appears to be following a trajectory similar to events in the early 1930s.
The nexus between the current banking crisis and subsequent defaults is the sharp contraction of the credit system. During normal recessions credit contracts, causing businesses and consumers to reduce borrowing and thus spending. But the credit contraction is never so severe that businesses must dump assets at firesale prices or sell products below market prices to raise operational cash or service debt, whereas in both epic recessions and depressions that is precisely what happens. Thereafter, even if resurrected, credit remains severely restricted and a vestige of what it once was. The difference between epic recession and depression is thus largely a matter of magnitude and degree.
7. Monetary Policy: Yet another key characteristic differentiating recessions from epic recessions and depressions is the relative effectiveness of government monetary policies in containing the economic downturn. In a typical recession, traditional monetary policies by the Federal Reserve are able, with a lag, to slow and halt the contraction and re-stimulate the economy—particularly when combined with counter-cyclical fiscal policies. Monetary measures reduce short-term interest rates, which eventually bring down longer term rates, that in turn stimulate investment in housing and capital equipment, generate hiring, more consumption, and recovery.
In depressions the severity of banking losses, deflation, and defaults results in traditional Federal Reserve monetary measures becoming ineffective. The Fed finds itself lowering short-term rates to near zero with no resulting stimulation of bank lending to businesses and consumers. Banks end up hoarding cash. While short-term rates drop to zero, long-term rates (mortgages, bonds, etc.) remain at high levels—which is another way of describing credit contraction. In fact, as price deflation occurs real levels of debt actually rise, worsening the debt-deflation dynamic. Businesses are forced to pay off rising real levels of debt with less cash on hand, thus creating a greater debt repayment stress. Monetary policy becomes essentially neutralized and ineffective. It may even become counterproductive, exacerbating the situation.
In the current crisis, the Federal Reserve, the U.S. monetary policy authority, is approaching the threshold of ineffectiveness. Short-term rates are near zero and provide no further stimulus to economic recovery. Long-term rates have been largely unresponsive to the Fed’s cutting of short term rates from 5.25 percent to less than 1 percent. As of December 1, 2008, for example, 30 year mortgage rates (long-term) have declined only about 0.5 percent compared to levels a year previous and only 0.25 percent since mid-September 2008, despite the drop in the Fed’s rate and the more than $3 trillion direct injection of funds into the banking system. The Fed’s monetary policy can only be described as a total, utter failure so far in stimulating economic recovery.
8. Fiscal Policy: Defined as tax cuts and government spending, fiscal policy in past postwar recessions has often been combined with monetary policy to help restimulate recoveries. Whereas Fed policy aims at interest rate reductions as a path to stimulus, fiscal policy might supplement that with tax cuts and/or government spending programs. In all instances since 1947-49 some combination of monetary with fiscal stimulus has proved successful in generating economic recovery, although the long-term trend over the postwar period has been the need for ever-increasing amounts of fiscal and monetary stimulus to generate a given recovery.
It still remains to be seen how effective fiscal policy might be in 2009, depending on the eventual Obama economic program still in development. But never before has the government had to undertake fiscal stimulus with such a large pending budget deficit. Nearly $500 billion in deficit was anticipated for 2009 and more for 2010—and that was prior to the $3 trillion handouts to banks and financial and non-financial institutions in 2008. And, of course, the fiscal stimulus plan will add further to the deficit in 2009-2010. It is largely an unknown what the consequences will be for a massive $500 billion to $1 trillion fiscal stimulus bill in early 2009, given the already anticipated trillion dollar deficits.
In the 1930s the U.S. government embarked on fiscal deficit spending in the form of the Roosevelt New Deal programs. But that did not come until 1935, was not all that large in terms of government spending, and occurred when the government had nowhere near the deficits it now has. Multi-trillion dollar deficits in 2009-10 may even result in the federal government being unable to borrow the money to finance its deficits from foreign banks, central banks, and investors. The U.S. government may have to raise interest rates to do so, which will slow the economic recovery, not hasten it. It may also result in a collapse of the dollar as currency in world markets. Which brings us to yet another characteristic of epic recessions.
9. Currency Instability: Volatility and instability of exchange rates in the key currencies of world markets is a characteristic of depressions, as well as epic recessions, while not a factor in normal recessions. The Great Depression of the 1930s was marked by a dramatic drop in world trade between nations. As domestic economies declined, each responded by trying to offset domestic decline with stimulating export sales. Tariffs and quotas were used to gain an export advantage at the expense of competitors. But all could play that game and did. Competitive tariffs led not only to declining world trade but set off corresponding currency fluctuations. In normal postwar recessions currency value volatility was not a factor. However, in today’s epic recession there are indications of growing currency instability among the leading global currencies: the U.S. dollar, the British pound, and the Euro. The mechanism driving the instability, however, is not competitive tariffs, but rather rolling, competitive interest rate reductions. In addition, the role of interest rate derivatives and speculators appear to be exacerbating the currency fluctuations. This is very unlike a typical recession, while not as severe in its impact as currency fluctuations in response to competitive tariffs, as during the last depression.
10. Synchronized Global Downturn: Typical postwar recessions have occurred in one or a few economies at a given point in time, while other economies have continued to grow. Thus, while the U.S. may experience a downturn, Europe or Asia may have actually been expanding. The expansion in the latter served to soften the downturn in the former, and hastened economic recovery. No such thing for a depression event. Depressions are always global and increasingly synchronized across economies. As such, an economic slowdown in one country not only fails to dampen the downturn in another, but actually serves to exacerbate it. The economic contractions feed back on each other and accelerate and deepen.
The current recession shows signs of becoming increasingly synchronized. The U.S. recession has clearly been followed within a matter of a few months by recession in the UK, Germany, in the European Union’s smaller economies, in Japan, and elsewhere. For a time, economists argued that the so-called emerging economies, in particular China and India, would continue to boom and were decoupled from the U.S.-Europe-Japan slowdown. China-India would consequently serve as a counterweight to the former and dampen the downturns. However, by year end 2008, it is clear no such decoupling exists. China, India, and other emerging economies are now also rapidly slowing down and about to contract as well. The current recession, as an increasingly synchronized affair, appears more and more like a classic depression in that sense. While still in the early stages of such the current downturn is thus epic in character and not like a typical postwar recession.
There is an historical example very much like today’s epic recession. That is the U.S. economy immediately following the 1929 stock market crash but before the banking panic and crises of 1931-32. In many ways that too was an epic recession, a very serious economic downturn, driven by debt-deflation but not yet generating the magnitude of defaults that would eventually provoke the more serious banking collapses of 1932 and 1933.
Observers and participants at that time, in late 1929 to early 1931, did not see themselves in the midst of a depression. They rather thought themselves in a serious economic contraction but one that would relatively soon be contained. They did not understand the fundamental dynamic of epic recession: an unstable, hybrid condition and state that could not be maintained as an interim condition. Rather it was a condition or state that must inevitably evolve, either reverting back to a normal recession, or else further toward the great depression of the 1930s.
History shows how that particular unstable state of 1930-31 eventually evolved. How the current, similar unstable state also evolves will be largely determined by government policies and events forthcoming in 2009. Much will turn on the future economic stimulus program of president-elect Obama in early 2009, as well as on the potential contradictions of that program given the already massive U.S. budget deficits. This is new ground for fiscal policy, not even experienced in the 1930s. It remains to be seen whether fiscal policy in 2009, like monetary policy in 2008, was in effect too little too late. Or whether, given the pending massive, multi-trillion dollar annual budget deficits, it may already be too late.
Jack Rasmus’s writings, lectures, and interviews on the economic and financial crises can be viewed at www.kyklosproductions.com and in his book Epic Recession and Global Financial Crisis (forthcoming).