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The Recession & More Government Bailouts |
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FORECASTS & TRENDS E-LETTER IN THIS ISSUE: 1. Latest Grim Numbers On The US Economy 2. The Latest On The Government Bailouts 3. Fed Announces The Mother Of All Bailouts 4. Troubling Aspects Of The Fed’s Latest Bailout 5. Fighting A “Debt-Deflation” At Any Cost Introduction The economy, the financial crisis and government bailouts were certainly hot topics for discussion among the large group of family and friends that we entertained over the Thanksgiving holiday and the weekend following. These sorts of issues would not normally come up at this annual gathering, but it is just more evidence that the current sinking state of the economy and the credit crisis is on the minds of virtually all adult Americans, no matter their financial strata. Most of my Thanksgiving guests have been dizzied by all the different government bailouts that have been announced recently (haven’t we all!), and most were very much against them, as is a majority of Americans according to several surveys. What most people don’t understand is that the government and the Fed will do anything they possibly can to prevent the economy from falling into a full-fledged debt deflation. Debt deflation is a cycle in which prices fall broadly, in some cases across the spectrum of assets. Most historians attribute the Great Depression to a debt deflation between 1930 and 1934. Likewise, Japan’s decade of deflation and severe recession in the 1990s is the model everyone wants to avoid. For obvious reasons our monetary authorities do not want to see either happen again. I will be writing about deflation more in upcoming issues. This week we will discuss the recent government and Fed bailouts as we go along, including some recent analysis by Stratfor.com and a nice chronicle of how the financial crisis has unfolded thus far. But first we want to take a look at the latest economic data, most all of which are bleak. While 3Q GDP was down only 0.5% according to the latest report, most analysts expect that the economy will plunge by at least 2-3% in the 4Q. That’s a lot to cover, so let’s get started. Latest Grim Numbers On The US Economy I trust that everyone reading this is well aware that we are in a serious recession brought on almost entirely by the housing slump and the credit crisis which followed. The government and the Fed have proposed massive bailouts in an effort to get the credit markets moving, banks lending, and consumers spending once again. But is it working? The answer is, not yet. Here are the latest economic reports. Last Tuesday, the Commerce Department revised its estimate of 3Q Gross Domestic Product from –0.3% to –0.5%, annual rate. In the 2Q, real GDP increased 2.8%. The decrease in real GDP in the 3Q primarily reflected negative contributions from personal consumption expenditures, residential fixed investment (housing), and equipment and software that were partly offset by positive contributions from federal, state and local government spending, private inventory investment and exports. Most economists and analysts are expecting a much greater decrease in GDP for the 4Q. While we won’t get the first estimate of 4Q GDP from the Commerce Department until late January, a recent survey conducted by the Philadelphia Fed suggests that real GDP will decline at a 2.9% annual rate in the 4Q. Likewise, the consensus now is that at least the first two quarters of 2009 will see similar decreases in GDP if not worse. There are plenty of analysts that now expect all of 2009 to hold negative growth for the economy. At this point, I cannot disagree. Things are indeed quite bleak. The Index of Leading Economic Indicators (LEI) fell sharply in October, down –0.8%, marking the fourth decline in the last five months. The LEI declined sharply in October as stock prices, building permits, consumer expectations and the index of supplier deliveries made large negative contributions to the index. Without the very large positive contributions from inflation-adjusted money supply (the largest in seven years), the leading index would have been substantially weaker. Between April and October 2008, the LEI declined 2.4% (a -4.7% annual rate), falling considerably faster than the 1.2% decrease (a -2.3% annual rate) over the previous six months. Durable goods orders (large ticket items) plunged 6.2% in October, more than double the 3% decline economists expected. The report showed widespread declines throughout manufacturing led by decreases in autos and airplanes. Factory orders plunged 5.1% in October. The manufacturing sector is being hit by the slowdown that is occurring in the rest of the economy. The prospect that the US, the world’s largest economy, has entered what could be a severe recession is dragging down growth in other areas and dampening demand for US exports, which had been the one bright spot for the economy this year. The unemployment rate surged to 6.7% in November as more than 500,000 jobs were lost in that one month alone. Most forecasters now expect the US unemployment rate to soar to 7% or above by the middle of next year. It will not surprise me if unemployment reaches 7% in the 1Q of next year. As we all know, consumer spending accounts for apprx. 70% of GDP. In October, retail sales dropped 2.8% following a decline of 1.3% in September. It is unusual to see large drops in consumer spending in October with the holiday season approaching, but this is no usual year. Most retailers expect 4Q sales to fall below yearago levels this year. It is encouraging to note, however, the latest media reports which indicate that on Black Friday (the day after Thanksgiving) retail sales were up 3% over last year. That increase was largely attributed to the fact that retailers had already discounted merchandise to levels not normally seen until later in the season. The Conference Board’s Consumer Confidence Index, which fell to an all-time low of 39.5 in October, rebounded modestly in November to 44.9 largely due to the sharp drop in oil and gasoline prices. However, the University of Michigan’s Consumer Sentiment Index, which asks different questions, was basically unchanged in November at 57.9 versus 57.6 in September. Both measures of consumer confidence remain at very discouraging levels. On the housing front, the numbers continue to worsen with no end in sight. New home sales in October fell to their lowest level in 17 years, according to data released last Wednesday. The US Census Bureau said the sale of new houses tumbled 5.3% in October to an annualized rate of 433,000. That compared to 457,000 one month earlier and was the weakest showing since 1991. The number of existing homes in the US that were sold in October fell 3.1% compared to September and was 1.6% below the annualized rate in October 2007. Housing starts also fell sharply once again in October to a 17-year low. Building permits also continued to decline significantly in October. Even though home sales are now down 69% from the July 2005 bubble peak of 1.39 million units, builders have not been aggressive enough in curbing production because the most critical variable of all, the unsold inventory backlog, rose to an 11.1 month supply in October from 10.9 in September. Thus, we may not have seen the worst of the housing slump yet. The National Bureau of Economic Research (NBER) recently announced that the US economy is officially in a recession that began in December of 2007. This marks one of only a very few times that NBER has made such a determination without two consecutive quarters of decline in real GDP, which is the traditional definition of a recession. To round out the latest economic reports, the Consumer Price Index fell 1.0% in October, the largest monthly decline in the index since its creation in 1947. The Producer Price Index (wholesale prices) plunged 2.8% in October. These drops in prices reflect the fact that we are in a severe recession, consumer demand is plunging, and producers are dropping prices in reaction. The data above paint a troubling picture for the US economy and thus those around the world. The trouble is that the US economy is the world’s engine of growth, and US consumers are the fuel of that engine of growth. Now, US consumers are being forced to cut back and save more. The Latest On The Government Bailouts As noted above, the government’s efforts to head-off the US financial crisis have already gone beyond what many of us could have imagined just a year ago. This financial crisis has resulted in so many different rescue operations, involving trillions of dollars. The initial $700 billion rescue package that was finally approved by Congress in October boggled our collective minds. This financial crisis has evolved so fast that it is hard for most Americans to keep track of what has happened, much less understand it. Here is a good, concise chronology published by the Houston Chronicle (Chron.com) on November 25th:
Fed Announces The Mother Of All Bailouts As noted above, on November 25th, the Federal Reserve announced yet another huge bailout – up to $800 billion - aimed at freeing up seized credit markets. You would expect that this new, unprecedented bailout would be still making news and have been completely and utterly analyzed. I don’t find that to be the case. Actually, it’s somewhat troubling that the Fed, acting under its own initiative and without any congressional approval, can uncork a bailout $100 billion bigger than the $700 billion TARP rescue package Treasury Secretary Paulson had to peddle on Capitol Hill. Even more surprising is that this newest bill aims to do the very things that Secretary Paulson initially planned for the $700 billion – buy up troubled mortgage securities – before he changed his mind on how best to use the TARP money. I’ll provide some analysis below, but first let’s see exactly what the new Fed bailout has been designed to do. Much of the buzz on the street about this new Fed program has been that this is “Main Street’s Bailout,” meaning that the relief from this $800 billion of pocket change is designed to get to the ultimate consumer rather than going into bank stocks. Is Bernanke playing a little political football here? Maybe. Stratfor.com had one of the better descriptions of the Fed’s new plan to restore liquidity to the housing and consumer credit markets. I have reprinted an excerpt of Stratfor’s November 25 article below, and will follow up with my own analysis:
The key is the last sentence and the last phrase – “if all goes according to plan.” So far, I would say, not much has gone according to plan, assuming there ever was one. A year ago, most analysts believed that the subprime problems would be contained in the US mortgage/banking sectors and would not affect the overall investment markets. Now we know that these endemic problems have spread to all credit markets, virtually around the world. Troubling Aspects Of The Fed’s Latest Bailout Reading through Stratfor’s excellent analysis of the Fed’s recent announcement, you may have picked up on some potentially troubling words. First, Stratfor talks about how the Fed can simply “print currency” necessary to pay for this bailout. Remember the controversy surrounding a 2002 speech by Ben Bernanke that alluded to printing money and distributing it from helicopters? Well, the printing press has evidently been placed on board the chopper at Gate One. As a general rule, printing money is de-facto inflationary. History is filled with examples of countries that experienced hyper-inflation due to cranking up the printing presses. However, not as evident in Bernanke’s “helicopter” speech was a footnote that addressed the fact that some inflation is actually a good thing, since it erodes the real value of outstanding government debt. As I will discuss below, it can be argued that the Fed had to print money to fund bailouts or risk a severe economic depression. However, we need to be aware that the side effects from this “cure” may include increased inflation in the future. Even Fed Chairman Bernanke acknowledges the risk. In a speech last week here in Austin, he said that the Fed’s balance sheet “…will eventually have to be brought back to a more sustainable level. However, that is an issue for the future; for now, the goal of policy must be to support financial markets and the economy.” Next, the Stratfor analysis discusses how the “sticky” parts of the process have now been handled. It is generally believed that Paulson backpedaled on buying up subprime debt from banks because the negotiations would have taken too much time to do the banks any good. Now, however, the Treasury and Fed will be able to negotiate directly on the price of any debt purchased, making these purchase transactions potentially much faster. However, at what cost do we gain this additional transactional efficiency? We have an admittedly “unfettered” Fed dealing directly with the Treasury Dept. regarding the purchase and sale of hard-to-value debt. Does this bother anyone else out there, or have we come to the point where we have to believe the old line, “I’m from the government and I’m here to help you?” Finally, Stratfor notes that the Fed’s dealing with the bad subprime debt will produce almost certain losses, but that these can be handled “off the books,” again by printing money if necessary. The resulting inflation would be a consequence, but would be a less direct way of spreading the cost around to the public. Note that Stratfor doesn’t say that it won’t impact taxpayers, just that inflation will be a less direct way of paying the piper than other possible methods. Fighting “Debt-Deflation” At Any Cost As noted in the Introduction above, discussions about the recent massive government bailouts, and especially the latest from the Fed, are going on everywhere in America. Surveys consistently show that most Americans do not agree with the huge government bailouts. Choruses such as “Just let ‘em fail!” and “Where’s my bailout?” are common. What most people don’t understand is that the government and the Fed will do anything they possibly can to prevent the economy from falling into a full-fledged debt deflation. Whether we agree or disagree with the bailouts, it is clear that our monetary authorities, namely Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke, believe that if large financial institutions are allowed to fail on a large scale, it would send the economy into a depression. It appears quite clear to me that Paulson, Bernanke and company now believe that it was a serious bad decision to let Lehman Brothers go bankrupt. Now, they are doing everything in their power to make sure that no other large financial institution goes under, apparently no matter how much taxpayer money they have to commit, even to the point of firing up the Fed’s printing presses as a last resort. Deflation is typically defined as a persistent decline in the general prices of goods and services, or put differently, a negative inflation rate. A debt deflation is generally regarded as a persistent decline in the prices of goods and services, along with widespread loan defaults and bank failures. The last time the US experienced a serious debt deflation was in 1930-1934, the so-called Great Depression. In the Great Depression, America saw Gross Domestic Product plunge by 10% annually on average, and the unemployment rate skyrocketed to 25%. Clearly, no one wants to see that happen again, especially Paulson and Bernanke, not to mention President Bush and President-elect Obama. While most Americans seem to oppose the government bailouts, most of the financial/analytical/forecasting groups that I have followed for years believe that the bailouts were/are absolutely necessary. In fact, some of my most trusted sources believe that the government was slow to react to the credit crisis and has not done enough to make bailout money available. Certainly, there is also agreement among my sources that the government has made some mistakes and did not have a clearly orchestrated plan for how and when the bailouts would happen or where the bailout money would be directed. Such evidence is clear in simply how many times the plans for the original $700 billion TARP bailout have changed. At the end of the day the question is: What would have happened if the government and the Fed had done nothing in reaction to the credit crisis? Let’s start with the easy ones. AIG would have clearly gone bankrupt sending shock waves through the banking and insurance markets worldwide. Merrill Lynch would have almost certainly gone under, perhaps taking Goldman Sachs, Morgan Stanley and several other large investment banks with it, along with Lehman Brothers. It is impossible to know what would have happened if these giant financial players had been allowed to fail. Yet most Americans don’t seem to care. Just let the chips fall. Would the failure of these instititions have triggered a financial collapse? I think the answer is yes. But would these financial failures have sent the US economy into a serious depression if the government did nothing? There is no definitive answer. Clearly, Paulson and Bernanke feared that without the bailouts, we would have been looking at a global financial crisis and a worldwide depression of epic proportions. Most Americans who oppose the bailouts have not, in my opinion, thought through the possible implications had the government done nothing to rescue the credit markets. While we can’t be certain that a global depression would have unfolded had nothing been done, we also cannot know that it wouldn’t. Think about that. Finally, I would be remiss not to add the obvious: there is no guarantee that the bailouts will work. Only time will tell. But it is clear that the bailouts are not over. I expect the government to give bailouts to the automakers, one way or the other; if not this year, then President Obama will do it as soon as he gets in office. Likewise, Obama is planning another giant stimulus package – reportedly in the $700 billion range – for early next year. The point is, the bailouts are not over. More are coming in the Obama administration, if needed. How much more we don’t know. What we do know is that we will have a new president that comes from a political persuation that has no problem with the government owning parts of the private sector, which is a little scary now that the government already owns equity stakes in our nation’s largest banks and AIG. But that is another discussion for another time. Time to close and hit the “send” button. Hope this has been helpful. Very best regards,
Gary D. Halbert SPECIAL ARTICLES:
Graphic NYT: Tracking The Bailout
Bernanke's Daring Experiment
Getting Out of the Credit Mess
Instead of Spending, Cut Taxes |
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