Still way too much money sloshing around for a depression

Despite the fact that many banks, some businesses, and some consumers have had liquidity problems over the past year, the simple fact is that overall there is still way too much money sloshing around in the economy for a depression to take root in the near term. Sure, some people are short, but others have more than enough to spare. There are several trillion dollars in money market funds alone. For a depression to take root we would need to see a substantial chunk of the current money supply simply evaporate. Sure, that could happen, but it has not happened to date. As long as the Federal Reserve and Congress succeed with the various stimulus programs already underway and currently anticipated, we will be unlikely to see the kind of evaporation of liquidity in the overall economy that would be needed for a true depression to take root and thrive.

Sure, the Federal Reserve and Congress still could manage to stumble and make enough policy mistakes that could lead to a depression, but we are not seeing any evidence of such mistakes, yet. In fact, some people are arguing that the Fed is pumping too much liquidity into the economy.

-- Jack Krupansky

Weaker companies may be in real trouble

Even in the best of economies there are a lot of weaker companies that manage to survive and get funded by so-called junk bonds. But, when times get tough, these companies run into trouble real quick since people are reluctant to buy lots of junk debt when these weak companies are at much higher risk of failure. It may make sense that weak companies should perish in a darwinian world, but there are a lot of people employed by these companies and the companies spend a lot of money buying goods and services, so failures can cause a lot of harm to the economy. Until now, we have been hearing about data that is the worst since the Great Depression, but now we have a data point that is worse than the Great Depression. Gary Shilling says that "Junk bond spreads vs. Treasurys now imply a 21% default rate, higher than in 1933 at the bottom of the Depression." That could mean trouble. Not just worse than the depression, but worse than the worst point of the depression.

The open issue is whether the mad rush to quality by investors has simply caused investors to dump junk bonds regardless of their likelihood of default or whether the fundamentals of these weak companies are really so bad that more that one out of five are in fact likely to fail. I simply do not have any data to answer that question.

Ultimately, we will be able to infer the answer from whether payroll employment continues to fall by 500,000 or more for more than a few more months.

I would also note that although the Federal Reserve is currently supporting the commercial paper market, that is only for high quality commercial paper, not the comercial paper issues by companies whose debt is considered junk. So, weaker companies could be in a lot of trouble.

Quite a few of these companies can probably squeak by for a few months, but going more than a few months may break the camel's back for junk-funded companies.

Sure, massive fiscal stimulus will help the overall economy, but it may mean that the government has to pump in even more massive doses of money to compensate for a significant failure rate for junk-funded companies, since fiscal stimulus is unlikely to flow directly into very many junk-funded companies.

I have not heard anybody make an estimate of what fraction of the conomy is composed of junk-funded companies.

-- Jack Krupansky

Size of stimulus plan growing

It is a measure of the magnitude of the current "recession with adjectives" that the projected and rumored size of the fiscal stimulus plan continues to grow. The latest rumor is that the goal will be to "create or save" 3 million rather than merely 2.5 million jobs over the next two years and that the price tag over two years is now projected at $775 billion in contrast to the original $500 to $700 billion. And, the plan is still evolving as the economy continues to deteriorate.

An open question is how much of that money will be front-loaded for the first year and even the first six months.

Another open question is what a follow-on revision might look like if after six months the result is too weak or the underlying economic problems turn out to be significantly worse than currently anticipated.

Not to mention the fact that the net job loss might be more jobs than the stimulus will supposedly create.

Not to mention the fact that there are millions of people who are underemployed or have given up hope of finding jobs as a result of the quirky economy of the past eight years and are not counted in the official unemployment number even though they are not working at anything near their peak of productivity.

The big question is how much money will be deployed in the first three or four months and how quickly that money results in an increase in economic activity by the time we hit the six-month milestone and need to judge whether to adjust the course of the stimulus plan.

Still, this is a good first step. There really is nothing better to do than to give the economy a good swift kick, the stronger the kick the better. And if the first kick is not enough, keep on kicking.

This kind of approach is very likely to assure that the economy does not slip into a depression.

-- Jack Krupansky

Deleveraging

One of the factors that makes this "recession with adjectives" so different is the extreme degree of financial leveraging that is pervasive in the economy. Businesses with excessive debt loads. Consumers with huge mortgages and tons of credit card debt. Banks with insufficient and illiquid capital. Heavily leveraged hedge funds. Investors heavily into commodities (which are typically leveraged). Not to mention government debt. Part of the reason for the sharp pullback in economic activity is that there was an excess of activity due to the extra capital "created" by all of the leveraging and now that leveraging is being removed in a rather disorderly manner. This painful deleveraging process will continue for some indeterminate period. Bankruptcy hastens the process. Renegotiation of interest and maybe even principle moves the process along, but at only a slightly faster than a natural paydown of debt. Bailouts and "stimulus" helps as well. And, unfortunately, even as deleveraging proceeds, some businesses and consumers are going even deeper into debt due to lost income, revenue and jobs.

The big question is whether the necessary deleveraging of the excess leveraging of the past five years will be completed promptly and reasonably orderly to end the recession within the next year or so, or whether the process stalls out and we slip into Japan-style "lost decade" or even a true depression.

It looks as if the likely scenario will be a partial deleveraging over the next two years, sufficient to enable the economy to be semi-healthy again. This being America, a disturbing degree of leveraging will persist, but not sufficient to push the economy into a "lost decade" or depression.

The most important factor is getting the banking and the rest of the financial system solvent again. The Federal Reserve has been stepping in to substitute its own solvency and liquidity, and that will continue and be sufficient to hold the financial system together over the next two years, but eventually we need to see the private sector once again be able to pick up the slack.

In short, leveraging made the economy look stronger than it was over the past five years and now the deleveraging is making the economy look a lot worse. Fed action, fiscal stimulus, bailouts, bankruptcies, and restructuring will gradually repair the economy and most likely assure that the economy does not slip into a lost decade or outright depression.

Still, deleveraging is one of the key factors to keep an eye on. For example, in the case of GM, they must figure out how to reduce their debt load by at least a factor of three if not four or even five to assure not just that they can survive, but to enable them to thrive as well. Bankruptcy can do that, but they may be able to convince bondholders that they would get an even worse deal in an outright bankruptcy. That is just one example.

-- Jack Krupansky

Worst since the Great Depression

Over the past few months there has been quite a stream of media articles that basically say "This is the worst <whatever> since the Great Depression." For almost any <whatever> that you want to fill in. For example, a Bloomberg article by Whitney Kisling entitled "U.S. Stocks Rally, Led by Banks, as Fed Cuts Rate to Record Low" says "The S&P 500 has fallen 38 percent in 2008, poised for its worst year since the Great Depression, after losses and writedowns at the biggest global financial companies reached almost $1 trillion and earnings at U.S. companies dropped for five straight quarters, matching the longest streak on record."

Now just because anything is the worst since the last depression does not mean that we are in a depression, but it does suggest that we may not be very far away.

The talk is now that the U.S. economy may need a full $1 trillion in stimulus over the next two years and that $700 billion would merely be a starting point highlights that the U.S. economy is still in a fragile state that could very easily and quickly slide into a depression-like slump if that stimulus were not in the offing.

-- Jack Krupansky

Even the best and the brightest of college endowment funds are getting slammed

Sure, there has been a bear market over the past year, but with all of their resources and sophistication you would have thought that the top university endowment funds would have repositioned themselves to avoid the brunt of the bear market and financial crisis. But, no, they in fact managed to pre-position themselves in a variety of "alternative" investments which in fact became very illiquid and resulted in dramatic paper losses which would be much worse if they actually tried to liquidate many of these positions in such assets as mortgage-backed securities, real estate, commodities and natural resources, and hedge funds. Harvard, Yale, Michigan, Columbia, you name them, they all have whopping paper losses, upwards of 25% to 30% and potentially more. What all of this illustrates is that the financial system and investment landscape has broken down to an unprecedented degree that is normally only associated with a depression.

Why did this happen? It happened simply because traditional common stocks were no longer attractive to so-called "institutional" investors, resulting in an excessive level of over-investment in so-called "alternative" investments, which help to fuel the real estate, commodities, and asset-backed securities "booms". Unfortunately, a lot of those alternative investments have proven to be one-way or dead-end streets with bursting bubbles at their ends.

What all of this means is that our financial system and investment landscape is seriously out of whack and in serious need of restructuring. A simply bailout will not do the trick, even $1 trillion would not be enough, but we may need to get the economy basically limping again before it will be strong enough for serious restructuring.

A failure to perform all of the needed restructuring would be a sure recipe for a depression, but I feel confident that we have enough smart people on the job now to be reasonably confident that we will have a much more sound financial system and investment landscape a few years from now. Still, there is plenty of room for Congress and others to make things even worse than they already are.

-- Jack Krupansky

Is deflation becoming a big problem?

I see increasing references in the media to deflation, but the simple truth is that we are a long way from true deflation. Sure, headline consumer prices declined by -1.0% in October and now -1.7% in November and that seems awfully deflationary, but we need to look to core prices to determine the underlying trend. Just as the Federal Reserve "ignored" high inflation when energy and commodities prices were soaring, we now need to "ignore" large price declines as energy and commodities prices revert back to their normal range before the commodities speculation took off a couple of years ago. In fact, ex of food and energy price changes, the inflation rate was flat in November after being down very slightly in October and year-over-year prices are up 2.0% and up 0.4% if the past three months are annualized.

In short, we are in fact seeing some welcome disinflation but are we are not yet seeing true deflation. Core consumer prices would have to come down substantially to indicate true deflation. Even if core prices decline for several months, that would not be enough to unwind much of the increase over the past three years with the commodities boom.

-- Jack Krupansky

Will the Republicans lead us into a depression out of good intentions?

Most sensible people have little trouble seeing the wisdom of bailing out the Detroit car companies, as distasteful as that seems, but there are quite a number of Republicans who simply do not get it and seem determined to pursue ideology over pragmatism. Such a bias in favor of ideology is in fact one of the ways that a recession can get turned into a depression. In 1930 the Federal Reserve was determined that "strong money" was the way to go. The so-called liquidationists were determined to take a hands-off, darwinian approach to letting the markets fix themselves. We know how that movie ended. So, a big question is the extent to which these Republican neo-liquidationists will seek to block efforts to stimulate the economy. If they are successful, the current "recession with adjectives" will have the prospect of turning into an outright depression.

Make no mistake, the Republicans have the best of intentions, but that does not make them right. They are simply grossly overly-optimistic about the pace at which a liquidationist approach can succeed. Japan had its "Lost Decade" in the 1990's. I do not think that the average American is ready to sign up for such a cold-turkey approach to economic recovery, even if it is in theory possible.

The real threat here is not the Republican liquidationists ("Let them file for bankruptcy!") per se, but a lack of bipartisanship in Congress. Barney Frank did work with the Bush administration on the Detroit bailout bill, leading House Speaker Nancy Pelosi to claim that it was a bipartisan effort, but they failed to work with enough moderate Republicans to assure that they had a bill that moderate Republicans (non-liquidationists) could support.

So, come January 20, 2009, the test will be to see how committed Barack Obama is to true bipartisanship. I think he is and that he is very good at reading the writing on the wall, but the open question is the degree to which he can "persuade" the more liberal Democrats to comproimise sufficiently to appeal to enough moderate Republicans to garner the 60 votes needed to get anything done in the Senate. I have high confidence that he can do it, but he is going to have to prove that I am right.

A $500 billion stimulus bill may seem like a slam-dunk in the current economic climate, but the liquidationists and their allies won't agree with a lot of the more liberal components of such a bill if it is not carefully crafted to be palatable to center-right conservatives.

In summary, I do believe that Barack Obama will steer us on a course to avoid a depression or "lost decade", but he needs to rack up some time at the helm to convince people.

-- Jack Krupansky

Even the rich are getting slammed

Usually, in a garden-variety inventory adjustment recession it is the low-level workers who get hit the hardest and the wealthy seem to just get wealthier. But in the current "recession with adjectives" even the rich are getting hit and hit very hard. Many billions of dollars have been tied up in auction-rate securities. Hedge funds are getting slaughtered. Alternative investment strategies are failing left and right. The Bernie Madoff $50 billion Ponzi scheme is merely the latest in a long list of bad financial events for the so-called "rich."

Not that the rich need any sympathy, but their money usually helps to fund new business ventures and charities, which in turn spend the money. Their financial setbacks of the past year have already made a significant dent in venture investment and funding of charities. Unless their plight turns around soon, the accumulated loss of a source of funding will be an ongoing drain on the economy.

This loss of economic "juice" will not cause a depression on its own, but it adds a few more negative adjectives to the "recession with adjectives" and means that there is yet another economic niche that will need to be filled with government stimulus in order to bring the economy back to even minimal health.

The bottom line is that this decline in investable wealth of the rich is yet another sign that a depression is a distinct possibility unless the government acts very boldly and promptly and in a sustained manner.

Barack Obama is about to embark on the adventure of a lifetime.

-- Jack Krupansky

More stimulus needed

I do appreciate the desire of the incoming administration to put a lot of resources into infrastructure improvements, but the accelerated pace of job loss strongly suggests that even $350 billion over the next year focused on infrastructure will simply not be enough to "trickle" around to the full economy fast enough to recover from current job loss or job loss to be expected next year before the stimulus kicks in strongly enough to induce employers to stop cutting jobs, let alone start hiring again in a dramatic fashion. Besides infrastructure investment that will directly create certain kinds of jobs and boost certain sectors of the economy, there needs to be direct stimulus to consumers on an ongoing monthly basis until we see at least a hint of health returning to the jobs market. Something on the order of $50 billion per month is needed, like, now, or starting ASAP in February. That number could decline as employment picks up, but it actually could take two full years or more to recover from the business confidence destruction we have seen to date. That would be $600 billion per year. And that would be on top of the $250 to $350 billion per year for infrastructure investment.

So, we are potentially looking at close $850 to $950 billion per year, close to $1 trillion per year, for at least two years.

Seriously, that is the magnitude on the destruction that has been done to our economy.

Absent any significant stimulus to support and resurrect the economy, it could take five to ten years to gradually rebuild the economy. Such an extended period of contraction and very slow growth would certainly qualify as at least a low-grade depression.

The open question is what will happen to employment and income and economic activity if the stimulus falls far short of that number and amounts to only $250 billion for instructure investment. The result would probably be something on the order of half a million jobs lost every month for upwards of a year and a half, spiking unemployment to 15% or above, and for a number of years. That may not qualify for a true depression, but try convincing anybody who is experiencing the loss of job and income.

The $500 to $700 billion number from earlier in the fall was before we knew that Detroit was in such deep trouble and before many of the current job cut announcements.

And if Congress botches the Detroit bailout and car sales continue to plunge, the outlook will only get worse and the required stimulus will only grow larger. But the prospect of Detroit imploding may have the advantage of convincing people that more stimulus is needed.

-- Jack Krupansky

The Great Depression included two distinct recessions

The Great Depression in the U.S. began roughly with the stock market crash in October 1929 and lasted until the onset of World War II, roughly somewhere between 1939 or the early 1940's. That was all considered one depression. But, that period in fact encompassed two distinct business cycles or recessions, making it somewhat problematic to contrast a recession with a depression.

According to the Business Cycle Dating Committee of the National Bureau of Economic Research, the first recession lasted from August 1929 until March 1933. That was the worst of the depression. Then the economy actually rebounded strongly, hitting a new peak of industrial production in early 1937, higher than 1929. But then the economy fell apart again, with a second recession from May 1937 until June 1938. To be sure, the trough in 1938 was well above the depression bottom in 1933, but still deep by traditional recessionary standards.

One of the lessons here is that even if $500 billion of fiscal stimulus enables a recovery from the current recession, it is very possible that we could see a second recession within a few years unless the fiscal stimulus actually results in sufficient structural change and the creation of sufficient sustainable jobs to sustain the economy as that fiscal stimulus peters out. Sure, it is easy to "create" construction jobs with government spending, but many of those jobs will promptly evaporate once the government spending ceases.

So, maybe the key takeway is that the fiscal stimulus may need to last for five or even ten years, until the underlying structure of the U.S. economy is actually truly "sound" again, and not based on mountains of debt and complex financial instruments -- or dependent on government spending. I suspect that we actually will need to permanently include about $250 billion or more of that fiscal stimulus in the federal budget, if for no other purpose than to enable the private sector to withstand future financial, economic, and political shocks.

-- Jack Krupansky

Recession with adjectives

Further illustrating the point that this is not a garden-variety recession, economist Martin Feldstein refers to it as "a recession with adjectives... A deep recession, a long recession, a damaging recession." Still, maybe it will need a second or even third level of adjectives before it even begins to register as a depression.

-- Jack Krupansky

Confidence in institutions

One of the ways that a depression is different from a garden-variety recession is that confidence in formerly rock-solid institutions gets so badly shaken that they crumble and need to be replaced with wholly new institutions. In a recession, most of the institutions remain at least relatively solid and it is merely the overall level of economic activity that is the major concern.

So, where are we now?

Well, we have certainly seen a hefty amount of shaken confidence in our banks, Wall Street, the value of housing, and a President-elect being chosen after running on a platform of radical "change" in how Washington does business.

Still, despite the hits to confidence, there is still a strong level of confidence in many of our public institutions.

Sure, we had a couple of bank runs and even runs on money market funds, and sure, the Federal Reserve, Treasury, and FDIC, were forced to dramatically shore up the financial system, but the original institutional structure does still stand, and it stands with a renewed level of confidence. Sure, the sytem could have collapsed, but the point is that a collapse was averted.

Sure, people do really want to see "change" in Washington, but they want some change and they want "smart" change, but not an outright revolution.

With all that has happened, the net effect is that we are seeing incremental, evolutionary changes, but not a wholesale, clean-slate revolution. The Great Depression ushered in the New Deal, but we are merely enhancing a lot of those same institutions.

Sure, Wall Street investment banks have vanished as a breed, technically, but in reality they have simply moved under the umbrella of the banking system overseen by the Federal Reserve. Yes, this says that the current episode is much worse than a garden-variety recession, but still not quite to the level of a depression.

There is still plenty of time for further financial and economic problems to develop, but the question will remain whether we see the kind of undermining of confidence in institutions that would be expected in a true depression where institutions completely fail on a widespread scale.

In short, we are not yet "there", but it remains technically possible that we could still stumble into a depression.

-- Jack Krupansky

Why a depression is very unlikely

Although it does appear that a depression is technically possible, I believe that it is very unlikely for the simple reason that there are still too many people around (including Bernanke) who know a lot about the last depression and its causes and they are committed to pumping enough stimulus into the financial system and the economy to avoid a recurrence.

It is still possible that a divided Congress could produce a flawed sequence of stimulus packages, but it is much more likely that they will make enough of the right moves to avert a depression, especially since the Democrats have already indicated a propensity to ramp up spending.

-- Jack Krupansky

Depression vs. recession

I have not yet run across any really good definitions for an economic depression. In fact, ten years ago when I was reading about The Great Depression, I saw references to the fact that "depression" was once the standard term for what today we call a "recession." The question is whether there is a qualitative difference, or whether the distinction is simply quantitative and whether a depression is simply a recession that is much worse and much longer than a "typical" recession. A recession is usually considered "temporary", which a depression tends to be "prolonged."

I will start working on my own definition.

One important quality is that the economy usually bounces back to a new high level of activity fairly quickly (a few months to a year or two), while a depression "destroys" enough economic capacity so that it may take more than a few years to restore the level of output, employment, and income to its previous peak, and that recovery is only after a prolonged decline to the "bottom", maybe two years or more.

A typical recession results in temporary job loss, such as factories firing workers due to excess inventory and then rehiring those same workers once inventory levels have declined to a level requiring significant replenishment. A depression would tend to involve widespread permanent destruction of jobs such that people are forced to seek employment at new positions that did not exist before the decline, and obviously that process will not tend to be rapid, especially if reduced credit and capital result in slower formation of new firms and new positions.

Note that Obama is talking about creating new "green" jobs, rather than bringing back more jobs to Detroit or residential housing construction.

In short, a typical recession tends to be "cyclical" (inventory fluctuations) while a depression tends to be disruptive and "structural."

Another question is whether a depression could be relatively brief, such that it could actually be shorter than a "bad" recession. For example, could the destruction of many "old economy" jobs in favor of gradual creation of "new economy" and "green" jobs qualify the current episode as a depression, even if massive fiscal stimulus permits the economy to bounce back within a year.

That begs the question of whether the economy would be headed for a depression if massive fiscal stimulus (coupled with massive Federal Reserve support) was not in the offing. So, even if we do not see the kind of declines in output, employment, and income usaully associated with a depression, would the level of stimulus indicate that an "imminent depression" was in fact a plausible possibility.

-- Jack Krupansky

Even Google is getting cautious

You do have to wonder what the state of the economy really is if even Google feels the need to tighten its belt. From an article in The Wall Street Journal by Jessica Vascellaro and Scott Morrison entitled "Google Gears Down for Tougher Times":

So with the U.S. economy in a recession, Google is ratcheting back spending and cutting new projects. "We have to behave as though we don't know" what's going to happen, says Google Chief Executive Eric Schmidt. The company will curtail the "dark matter," he says, projects that "haven't really caught on" and "aren't really that exciting." He says the company is "not going to give" an engineer 20 people to work with on certain experimental projects anymore. "When the cycle comes back," he says, "we will be able to fund his brilliant vision."

I have to cringe when I read the words "When the cycle comes back" since they make it sound as if something extremely precious has just evaporated in front of our eyes and that maybe even Google is filled more with "hope" than a hard-core plan.

For some reason, this made me think of IBM, which thrived in The Great Depression since the New Deal government programs fostered a true renaissance for data processing equipment with all of those new social programs that needed to track people.

This leaves me wondering what "digital" technologies may blossom over Obama's first term. We do know that he intends to spend a lot on green power, alternative energies, and the Smart Grid. It will be interesting to see what happens with government spending on other, non-power "digital" technologies.

-- Jack Krupansky

Economic depression vs. mental health

I revised the name of this blog to "Economic Depression Watch" since "depression" is also or more commonly a reference to a mental health problem. For example, do a Google search on "depression" or "depression watch" and you will find mostly mental health results.

Another reason for the change is that the www.DepressionWatch.com domain name was already taken.

I have also registered www.EconomicDepressionWatch.com with stealth redirection to this blog, but it may take some time for domain name to become functional.

Now, none of this is to say that an economic depression cannot interact with mental health, but that is another story.

-- Jack Krupansky

Could the U.S. economy slip into a depression in the near future?

This new blog will focus exclusively on examining the many factors which could determine whether the U.S. economy could possibly slip into a depression in the near future.

My personal opinion is that it will not happen, but it is technically possible even if it is very unlikely.

Stay tuned.

-- Jack Krupansky