Last Monday the Stock Markets around the world suddenly panicked. The collective bad economic news that has been appearing for nearly a year now in a drip - drip - drip process has allowed both Wall Street traders and government economic leaders to continually say that, while there are some difficulties in the economy (sub prime mortgage crisis, sharply increasing home foreclosures, general credit crisis world wide, increase in the unemployment rate in December, etc.) the American economy is both resilient and powerful, and all this bad news will soon go away. Finally a few stockholders decided that it wasn't going away, so they sold stocks, and the rest of the markets took notice. A lot of wealth disappeared in the stock market sell off.
The growing evidence that the economy isn't doing well for an awful lot of average people did not get the attention of either the federal reserve or the Bush administration, but the disappearance of a lot of wealth on the stock market got their attention. That's why the Fed took the unusual action of dropping the interest rate a large three quarters of one percent in an unscheduled meeting. Then Wednesday the New York Times published an article that questioned whether the economy has really been working well at all.
The recent financial turmoil has many causes, but they are tied to a basic fear that some of the economic successes of the last generation may yet turn out to be a mirage. That helps explain why problems in the American subprime mortgage market could have spread so quickly through the world’s financial system. On Tuesday, Mr. Bernanke, who is now the Fed chairman, presided over the steepest one-day interest rate cut in the central bank’s history.So the short story version is that the last two bubbles have made the economy seem to be protected from Recession, but both of those bubbles were created by excessively low interest rates as the federal Reserve under Alan Greenspan tried to manipulate the economy for largely political reasons. Those artificial manipulations have reached an end, so that the consumers can no longer support continued economic growth the way they have been for nearly two decades.
The great moderation now seems to have depended — in part — on a huge speculative bubble, first in stocks and then real estate, that hid the economy’s rough edges. Everyone from first-time home buyers to Wall Street chief executives made bets they did not fully understand, and then spent money as if those bets couldn’t go bad. For the past 16 years, American consumers have increased their overall spending every single quarter, which is almost twice as long as any previous streak.
Now, some worry, comes the payback. Martin Feldstein, the éminence grise of Republican economists, says he is concerned that the economy “could slip into a recession and that the recession could be a long, deep, severe one.” In Monday’s Democratic presidential debate, Barack Obama made the same argument: “We could be sliding into an extraordinary recession,” he said. [Snip]
But a recession is now more likely than not. It may well have started already. The Philadelphia Fed reported Tuesday that the economy shrank in 23 states last month, including Ohio, Missouri and Arizona, and was stagnant in seven others. California and Florida, with their plunging home values, may soon join the recession list.
The bigger question is how severe the recession will be if it does come to pass. The last two, in 1990-1 and 2001, have been rather mild, which is a crucial part of the great moderation mystique. There are three reasons, though, to think the next recession may not be.
First, Wall Street hasn’t yet come clean. Even after last week, when JPMorgan Chase and Wells Fargo announced big losses in their consumer credit businesses, financial service firms have still probably gone public with less than half of their mortgage-related losses, according to Moody’s Economy.com. They’re not being dishonest; they just haven’t untangled all of their complex investments.
“Part of the big uncertainty,” Raghuram G. Rajan, former chief economist at the International Monetary Fund, said, “is where the bodies are buried.” [Snip]
The second problem is that real estate and stocks remain fairly expensive. This shows just how big the bubbles were: despite the recent declines, stock prices and home values have still not returned to historical norms.
David Rosenberg, a Merrill Lynch economist, says that the stock market is overvalued by 10 percent relative to corporate earnings and interest rates. And remember that stocks usually fall more than they should during a bear market, much as they rise more than they should during a bull market.
The situation with house prices looks worse. Until 2000, the relationship between house prices and rents remained fairly steady. The same could be said about house prices relative to household incomes and mortgage rates. But the boom of the last decade changed this entirely.
For prices to return to the old norm, they would still need to fall 30 percent across much of Florida, California and the Southwest and about 20 percent in the Northeast. This could happen quickly, or prices could remain stagnant for years while incomes and rents caught up.
Cheaper stocks and houses will benefit many people — namely those who don’t yet own a home and still have most of their 401(k) investing in front of them. But the price declines will also lead directly to the third big economic problem.
Consumer spending kept on rising for the last 16 years largely because families tapped into their newfound wealth, often taking out loans to supplement their income. This increase in debt — as a recent study co-written by the vice chairman of the Fed dryly put it — “is not likely to be repeated.” So just as rising asset values cushioned the last two downturns, falling values could aggravate the next one. [Snip]
But it’s hard not to believe that the economy will pay a price for the speculative binge of the last two decades, either by going through a tough recession or an extended period of disappointing growth. As is already happening, banks will become less willing to lend money, households will become less willing to spend money they don’t have and investors will become more alert to risk.
[Highlighting mine - Editor WTF-o]
The interest rate manipulations have created an economy that is out of balance, which is why both stock and real estate remain too expensive. Both have to come down in price a great deal before the economy is back in reasonable balance. But the long period of artificially maintained growth had a negative effect on the financial markets. Lenders began to feel that the only way they could lose money was by not lending, so they threw out the rule book on reasonable standards for lending. Now no one knows which loans on the books are good and which ones are bad. This is complicated by the way banks have been packaging similar loans and selling the packages. This means that as bad loans go into default they also take down what might be good loans as they go bad, and no one knows which loans are bad and which ones might be repaid. It also means that there is little connection between the final purchasers of the loan packages, and in particular the people who own a loan have no mechanism for working out modified terms of repayment that could prevent default.
This is true for a great deal more than just mortgages, since lenders have sold mortgage loans to obtain more money to lend in other ways, but the mortgages they sold went with the right of the buyer to sell them back if they go into default. That means that taking back defaulted mortgages reduces bank capital to support other types of loans. There are at least two more big blocks of adjustable rate mortgages that are going to have payments sharply increased this year, and no one knows how many more mortgages will be driven into default as a result. So banks don't have funds to lend for other reasons besides home purchases because they literally have no idea how much they have in lendable funds.
That means that lending for any reason is going to be limited for at least a year, and there is uncertainty about how much longer. Uncertainty itself restricts lending. This is going to be particularly hard on mortgage lending since lenders are aware that much of the housing in Florida, California, the Southwest and the Northeast is still overpriced. Since increased activity in the housing industry is usually the first industry to lead the way out of a recession, that is going to make it even more difficult to end the recession.
The current economic downturn will be a Recession, and all indicators suggest that it will last until the bad loans are finally all identified and dealt with, until lending standards are cleaned up so that purchasers can trust the loans sellers sell them, and until housing prices come back to a level in line with what rental rates can pay for. That means that the American economy is very unlikely to recover in less than at least two years.
The cause of this Recession is primarily mismanagement of the macro economy by the federal government and the Federal Reserve. This is the easily predictable result of implementing the Reagan Revolution demands for deregulation of the financial industry along with Alan Greenspan's continued efforts to use the Federal Reserve to artificially prop up the economy. Without the Reagan Revolution prescriptions, the federal reserve mismanagement to try to cover up the problems caused by deregulations, and without Bush's economically irrational tax cuts for the wealthy and Bush's War in Iraq with the excessive borrowing and uncontrolled spending spending that has accompanied that war, America would currently have an economy that provided prosperity and stability. as it is, we have a perpetual war in Iraq together with at least a two year Recession that will probably be one of the most severe since the Great Depression.
Addendum 11:53 PM CST
Glad I didn't read this article by Robert Reich before I wrote the material above. He says much the same thing, but he says it a great deal better than I do. Here is his conclusion:
How much worse can it get? The housing bubble drove home prices up 20 to 40 percent above historic averages relative to earnings and rents. So now that the bubble is bursting, you can expect prices to drop by roughly the same amount, and new home construction to contract. The latter plunged last month to its lowest point in more than 16 years. A managing partner of a large Wall Street financial house told me a few days ago the scenario could get much worse. He gave a 20 percent chance of a depression.[Editor's Note: The above paragraph was written before the Congressional agreement that removed $70 billion of the $150 billion and gave it to investors and Bush refused to permit an extension of unemployment benefits and expansion of food stamps. Don't forget that that the purpose of food stamps is to provide customers for grocery stores and agricultural distributors when unemployed customers can't get enough money to buy the product. So half the stimulus was removed from effective stimulus methods and tow of the most effective channels for stimulus were vetoed in negotiations with the white House because Bush doesn't believe the government should help people, just businesses, bankers and investors. This makes it much more likely that the stimulus effort will be overwhelmed by the housing slump. Now back to Reich's article.]
Even if a stimulus package were precisely targeted to consumers most likely to spend any money they received, the housing slump could overwhelm it. According to a recent estimate by Merrill-Lynch, the slump will hit consumer spending to the tune of $360 billion this year and next. That’s more than double the size of the stimulus package President Bush or any leading Democrat is now talking about. And the Merrill-Lynch estimate is conservative.
In reality, the crisis is both a credit crunch and the bursting of the housing bubble. Wall Street is in terrible shape and Main Street is about to be in terrible shape. And there’s not a whole lot that can be done about either of these problems — because they are the results of years of lax credit standards, get-rich-quick schemes, wild speculation on Wall Street and in the housing market, and gross irresponsibility by the Fed, the Treasury and the Comptroller of the Currency.Essentially our economy has been running on life-support since at least 2000 and probably even earlier, and the chicanery that was conducted to keep it from going into recession in the past has done a great deal of institutional damage to the economy.
Now we are going to pay the price for the unrestrained lies, politics and greed.
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