The Economy: The case for (relative) optimism

During the past few years, I often felt I was the sole economic pessimist. I urged my friends and whoever would listen to rent and not buy their apartments (Rent … unless you want to buy, I professed that the current economic imbalances would lead to disaster (Macro Perspectives on Global Liquidity) and that the downside risk to the economy was much greater than people expected (A Different Perspective on the Global Economy).

How times have changed. There is palpable fear in the air and many seem to think we are headed for another Great Depression. Shockingly, by sheer relativism I now find myself among the optimists. I am not saying things are about to get better, quite the contrary, but I am reiterating my analysis that we will have a rather prolonged downturn, but no Great Depression (The US Economy: How bad will it get?).

In the short run things will undoubtedly get worse. Despite their recent fall, real estate prices remain well above historical norms and will have to fall in real terms either through further falls in nominal prices or through many years of stable prices given the current inflation rate. Financial firms still have a lot to worry about. Hundreds of billions of dollars of variable rate mortgages will reset in 2009 causing further foreclosures. Credit card loan books are headed for trouble as consumers have seemingly tapped out their credit cards (the most expensive form of credit available) instead of decreasing spending to maintain their standards of living. Economic headwinds will lead to higher unemployment and cause delinquencies to rise on both credit card and car loans. Given the economic uncertainty, companies will undoubtedly be more careful, which makes sense on a micro level, but slows down economic activity. The unemployment rate will rise and way well exceed 10% at some point in the next few years. The personal savings rate will rise to a more sustainable rate both as households repair their balance sheets and baby boomers prepare for retirement. Again, this makes sense on a micro level, but will lead to further macroeconomic slowdown. Exports which had been the saving grace of the US economy for the past few months are unlikely to be able to hold up given that the crisis has spread to Europe where Italy and Spain are already in recession with Germany on the brink of one. Japan’s export led economy may have already faltered and may be heading back into deflation.

In other words the crisis will spread from Wall Street to Main Street and the US economy and that of the world will slow down significantly for the next few years. However, this is not a Great Depression. Between 1929 and 1933, the US economy shrank by a quarter. Real estate prices fell by 50% in 2 years. Retail banks failed. Unemployment reached 25%. Many queued around the block for soup and bread. In New York many who lost their residence found refuge in Central Park.

The unemployment rate is currently 6.1% and the banks that have mostly been affected by the crisis are the commercial banks rather than the retail banks. Most importantly, the Fed has learned from past mistakes. Overly tight monetary policy turned the downturn into the Great Depression during the 1930s. Ben Bernanke is a scholar of the period and will not let it happen again. The global rate cute that was orchestrated by the major global central banks yesterday shows they understand the gravity of the situation and are trying to provide appropriate liquidity. I am confident the combined might of all the world’s central banks will prevent the crisis from becoming catastrophic.

After a few lean years, having avoided a Depression, I am sure we will bounce back and a new boom will start in green technologies with support from the continued growth for Internet and biotechnology companies.

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  • Many Thanks Fabrice for your post. I was waiting for it since a couple of days 🙂 … and anxious to read your comments and recommendations.

    May I add one positive consequence of the current financial crisis: from my point of view it could help moving the talents from the financial community to the industry/services.

    Tough periods are great times for entrepreneurs 🙂

    Congratulations for your blog and your life! Tu me fais envie bien des fois 🙂

  • So THIS is what you do when you can’t sleep on a plane?? 😉

    Nice work….good read, and you’ve once again made what could be a confusing topic understandable for the non-economist, which I think is generally lacking in the press these days.

    Enjoy China and catch ya when you’re back!
    xo

  • FYI: I am 47 and was economically aware from an early age. I can tell you this downturn does not feel the same as any in my lifetime. I hope you are correct about not being Great Depression II. However there is a finite probability that will be the result. Our politicians are not satisfied to only sow a high level of distrust caused their easy money policies, Fannie / Freddie and forcing bad loans to people who were bad credit risks. Now with their mammouth bailout is further eroding trust.

    Who among us with any reason can not see they plan on inflating us out of this situation???

    I think had the politicians not meddled the economy would have cleared on its own in reaonable time. Now with one bailout at the first sign of failure I fully expect them to meddle further. One has to wonder if this will be our ultimate undoing. They resist all practical measures to shore up our economy including oil drilling on the outer continental shelf.

    BTW: Green tech won’t be the next wave. Biotech / nanotech / robotics will be. They may be green by a side effect. But I must protest the use of the word “green” … It is way overused these days and I fully expect “green” and “environmentalist” to be a dirty word in the not too distant future for it is just another word for luddite.

  • Thanks for your post. It is nice to read something that isn’t all doom and gloom we’re all going to die type stuff. Between your post, and the book I just read, “Plunder,” by Danny Schechter I now have a little hope- everything else I have read is pretty depressing.

  • This isn’t going to settle out until after the Credit Default Swap payoff auctions on Oct 23. Only then will everyone know just how exposed everyone else is. Many banks will fail no matter what the government does. But many will also survive and once shown to be sound their business will resume.
    .
    What is scary to me about this is the way governments are taking over ownership of private sector financial institutions and private industry. Just think of the banks being run like the IRS or the Post Office – and by the very same people with political mandates. While it would hurt, it would be better to just let many of these banks fail and be replaced with new ones. All this life support is going to do is lead to perpetually sick banks run by politicians for political purposes.

    .
    The $45.6 trillion Credit Default Swap Crash vs. the $700 bil Sub Prime Crash
    .
    All of this because 5% of U.S. mortgages are defaulting? This 5% isn’t that big a number compared to the world financial markets. After all, the other 95% are still paying and yielding a cash flow. So if sub primes didn’t cause this what is going on?
    .
    What is going on is a Credit Default Swap caused crash. A CDS is a form of insurance on loans that pays off if the loan defaults. CDS are totally unregulated and un-monitored by any government agency. CDS are not called insurance because insurance is regulated. If it was called insurance, and regulated, the issuers of the policies would be required to have assets enough to cover any claims. But it isn’t insurance. And it turns out the issuers of CDS never had the assets to cover any claims – even a small claim like the sub prime mortgage defaults. If they had paid off the sub prime defaults everyone would have their money and there would be no bailout.
    .
    The banks and financial institutions that issued unregulated CDS made billions collecting the premiums (but they are not called premiums because it isn’t insurance). But when the sub prime backed instruments started to default they couldn’t pay off because they had no assets to pay off with. AIG is one example. And everyone noticed and started to worry.
    .
    The real problem is that CDS were not sold to cover just mortgages loans. They were sold to cover almost every kind of lending instrument. Obviously, a bond that is insured against defaulting is more valuable and higher rated than one that is not insured. So once the CDS began defaulting on the subprime market it became obvious they were worthless insurance on everything else they insured, which is just about everything else out there. So the value of every bond, hedge fund and other investment instrument dropped on the books of every institution holding them. And they dropped fairly sharply.
    .
    And then there are the CDS themselves. They were on the books as an income producing investment instrument just like a bond from a legitimate insurance company. Now they are virtually worthless. How much were they worth before the truth about them was revealed? $42.6 TRILLION. For perspective, this is equal to the entire household wealth of the U.S.; the U.S. stock market is capitalized at $18.5 trillion. So what really has happened is that the global financial markets have just taken a $42.6 trillion dollar loss of assets.
    .
    Our recent bailout is only $700 billion, a tiny fraction of the outstanding CDS and not enough to make a tiny tiny dent in the debt the financial institutions are now holding. So what did our elected officials just do? They bailed out their campaign donors and gave them a chance to cash in their chips and leave the game with some cash in their pockets.
    .
    The sub prime defaults are just a minor diversion that takes your eyes off what has really happened. Huge companies, here and abroad, (CDS started in Europe) committed a fancy complicated form of fraud. They sold insurance that wasn’t really insurance, collected billions in “premiums” that pumped up their books and made billions for their executives and brokers. They often issued a CDS to a buyer to pump up the price of a bond or financial instrument they were selling and thus increased their profits two ways.
    .
    If a real regulated insurance company had done this the executives would all be indicted, prosecuted and put in jail for a long time. It was fraud and I hope our government will go after these weasels and put them in jail. But I doubt that will happen.
    .
    The problem right now is that no one knows who is holding what or even how to begin to value holdings. The value of holdings of all kinds have clearly dropped. But by how much? In the sub prime mortgage market, for example, the houses are still out there and clearly they have some considerable value. But how much? The same holds across all the markets. The tangible assets securing most of the loans are still out there. But what are they worth now? We are about to see a huge 100 year shake out on the value of everything and everyone is going to take a hit. The more leveraged any business or individual is the more they are going to devalue. And that is another new aspect of this crash.
    .
    Super low interest rates made borrowing possible – smart – at rates that would have been unthinkable 20 years ago. 20 years ago being leveraged at a 5 to 1 rate was the normal limit. Today 30 to 1 is normal. 4% interest rates simply could not be ignored and go unused. Hedge funds with 4% interest rates made extreme leveraging even more extreme for large investors and funds. It turns out some hedge funds had 100 to 1 leveraging. (Hedge funds are another unregulated market) So our entire economy, the businesses, the banks, individuals are credit extended like never before in history. So they are all going to be devalued like never before. This is going to be the perfect financial storm. And it isn’t going to end anytime soon.
    .
    A lot of companies are going to fail – unavoidably. There is going to be a lot of unemployment. A lot of retirement funds are going to fail – including government backed retirement funds like state funds. And the U.S. government cannot bail them all out. But it will try at first. And the government will have unemployment claims and welfare claims like never before. And all this will cause another problem that will cause more pain. Inflation.
    .
    Inflation like we haven’t seen in decades. Because the only way the government will have to pay off its debts – and they are going to be huge, even compared to our present huge debt – is to print money. Lots of money.
    .
    We are going to see something unthinkable in the past. High unemployment, bankruptcies, banks closing and a very slow economy, BUT with high inflation because every government in the world is going to print money to try and bail things out.
    .
    What to do? Getting out of debt would be a good idea. Cash is good – but vulnerable to inflation. Gold is better. Start minimizing your expenses in every way possible. If you are about to retire don’t. Keep the job if the job is still there. If your retirement fund doesn’t go bust, inflation will devalue the retirement payments. Things will settle out. The economy will restart. New companies will be started to replace the ones who go under. The sun will come out again. But not for a long time. – Jerome

  • This isn’t going to settle out until after the Credit Default Swap payoff auctions on Oct 23. Only then will everyone know just how exposed everyone else is. Many banks will fail no matter what the government does. But many will also survive and once shown to be sound their business will resume.
    .
    What is scary to me about this is the way governments are taking over ownership of private sector financial institutions and private industry. Just think of the banks being run like the IRS or the Post Office – and by the very same people with political mandates. While it would hurt, it would be better to just let many of these banks fail and be replaced with new ones. All this life support is going to do is lead to perpetually sick banks run by politicians for political purposes.
    .
    .
    .
    Guess I will repost this for those who didn’t see it the first time. Skip it if you have seen it already.
    .
    The $45.6 trillion Credit Default Swap Crash vs. the $700 bil Sub Prime Crash
    .
    All of this because 5% of U.S. mortgages are defaulting? This 5% isn’t that big a number compared to the world financial markets. After all, the other 95% are still paying and yielding a cash flow. So if sub primes didn’t cause this what is going on?
    .
    What is going on is a Credit Default Swap caused crash. A CDS is a form of insurance on loans that pays off if the loan defaults. CDS are totally unregulated and un-monitored by any government agency. CDS are not called insurance because insurance is regulated. If it was called insurance, and regulated, the issuers of the policies would be required to have assets enough to cover any claims. But it isn’t insurance. And it turns out the issuers of CDS never had the assets to cover any claims – even a small claim like the sub prime mortgage defaults. If they had paid off the sub prime defaults everyone would have their money and there would be no bailout.
    .
    The banks and financial institutions that issued unregulated CDS made billions collecting the premiums (but they are not called premiums because it isn’t insurance). But when the sub prime backed instruments started to default they couldn’t pay off because they had no assets to pay off with. AIG is one example. And everyone noticed and started to worry.
    .
    The real problem is that CDS were not sold to cover just mortgages loans. They were sold to cover almost every kind of lending instrument. Obviously, a bond that is insured against defaulting is more valuable and higher rated than one that is not insured. So once the CDS began defaulting on the subprime market it became obvious they were worthless insurance on everything else they insured, which is just about everything else out there. So the value of every bond, hedge fund and other investment instrument dropped on the books of every institution holding them. And they dropped fairly sharply.
    .
    And then there are the CDS themselves. They were on the books as an income producing investment instrument just like a bond from a legitimate insurance company. Now they are virtually worthless. How much were they worth before the truth about them was revealed? $42.6 TRILLION. For perspective, this is equal to the entire household wealth of the U.S.; the U.S. stock market is capitalized at $18.5 trillion. So what really has happened is that the global financial markets have just taken a $42.6 trillion dollar loss of assets.
    .
    Our recent bailout is only $700 billion, a tiny fraction of the outstanding CDS and not enough to make a tiny tiny dent in the debt the financial institutions are now holding. So what did our elected officials just do? They bailed out their campaign donors and gave them a chance to cash in their chips and leave the game with some cash in their pockets.
    .
    The sub prime defaults are just a minor diversion that takes your eyes off what has really happened. Huge companies, here and abroad, (CDS started in Europe) committed a fancy complicated form of fraud. They sold insurance that wasn’t really insurance, collected billions in “premiums” that pumped up their books and made billions for their executives and brokers. They often issued a CDS to a buyer to pump up the price of a bond or financial instrument they were selling and thus increased their profits two ways.
    .
    If a real regulated insurance company had done this the executives would all be indicted, prosecuted and put in jail for a long time. It was fraud and I hope our government will go after these weasels and put them in jail. But I doubt that will happen.
    .
    The problem right now is that no one knows who is holding what or even how to begin to value holdings. The value of holdings of all kinds have clearly dropped. But by how much? In the sub prime mortgage market, for example, the houses are still out there and clearly they have some considerable value. But how much? The same holds across all the markets. The tangible assets securing most of the loans are still out there. But what are they worth now? We are about to see a huge 100 year shake out on the value of everything and everyone is going to take a hit. The more leveraged any business or individual is the more they are going to devalue. And that is another new aspect of this crash.
    .
    Super low interest rates made borrowing possible – smart – at rates that would have been unthinkable 20 years ago. 20 years ago being leveraged at a 5 to 1 rate was the normal limit. Today 30 to 1 is normal. 4% interest rates simply could not be ignored and go unused. Hedge funds with 4% interest rates made extreme leveraging even more extreme for large investors and funds. It turns out some hedge funds had 100 to 1 leveraging. (Hedge funds are another unregulated market) So our entire economy, the businesses, the banks, individuals are credit extended like never before in history. So they are all going to be devalued like never before. This is going to be the perfect financial storm. And it isn’t going to end anytime soon.
    .
    A lot of companies are going to fail – unavoidably. There is going to be a lot of unemployment. A lot of retirement funds are going to fail – including government backed retirement funds like state funds. And the U.S. government cannot bail them all out. But it will try at first. And the government will have unemployment claims and welfare claims like never before. And all this will cause another problem that will cause more pain. Inflation.
    .
    Inflation like we haven’t seen in decades. Because the only way the government will have to pay off its debts – and they are going to be huge, even compared to our present huge debt – is to print money. Lots of money.
    .
    We are going to see something unthinkable in the past. High unemployment, bankruptcies, banks closing and a very slow economy, BUT with high inflation because every government in the world is going to print money to try and bail things out.
    .
    What to do? Getting out of debt would be a good idea. Cash is good – but vulnerable to inflation. Gold is better. Start minimizing your expenses in every way possible. If you are about to retire don’t. Keep the job if the job is still there. If your retirement fund doesn’t go bust, inflation will devalue the retirement payments. Things will settle out. The economy will restart. New companies will be started to replace the ones who go under. The sun will come out again. But not for a long time.

  • Actually, the number one thing that’s given me hope is the fact that so many middle-class Americans are against the bailout. I even saw protests in the streets of Nyack (a suburb of NYC) the night before it passed. It means that, though there may be consequences down the line, people think that this is all about Wall Street getting in trouble and the rich getting bailed out. Which means that: 1. It hasn’t directly affected them yet and 2. They’re not likely to slow down spending. While this may not (and probably will not) hold forever, the price of fuel continues to decline which is always a boon for spending, and there is some hope that the financial sector can begin to straighten itself out on the back of the consumer spending before things decline further.

    PS – Jennie: You know how sports commentators always dumb it down during the playoffs because so many non-experts are watching? (explaining the exact rules for shooting free throws, letting everyone know how many quarters there are, etc.)? Well, I was watching CNN today at the gym and noticed that they were doing the Finance 101 Equity = Assets – Liabilities bar chart in the exact same green screenwriting marker sports commentators use (making it understandable for the non-economist). Too funny!