Since the current recession is caused by a combination of the garbage mortgage loans bankers have been selling at exorbitant prices to investors for years and the fact that the American consumer has run out of both disposable income and savings to spend in consumption and the government is not going to do anything beyond playing with interest rates and the money supply (both financial economy measures to deal with what is now a real economy problem of lack of consumption), there has been no obvious source of recovery any time soon.
Lack of demand means lack of investment and declining sales. The absence of increased consumer income together with the inability of banks to lend even at previous levels shuts off any likelihood of an economic recovery anytime soon. The negative feedback loop here is that the declining economy is leading to increased unemployment and even less money for consumers to spend.
Financial fixes that the Federal Reserve can conduct involve either lowering interest rates or increasing the money supply. Increasing the money supply directly creates inflation. The bond market will react to anticipated increased inflation by increasing interest rates - anticipation of inflation is the reason why long-term mortgages have not dropped in price, for example. In the meantime, the fed lowering short term interest rates (the only rates the fed has much control of are short term) will continue to cause a drop in the price of the dollar and thus increase inflation.
This view has gone mainstream. Read Jon Markham at MSN Money. He reports on the highly respected money manager Mohamed El-Erian's recent report that we face "...a painfully stretched-out global recession over the next couple of years."
El-Erian believes that the solvency issues now challenging big U.S. banks are destined to spread out into a full-blown economic dislocation that engulfs and endangers innocent bystanders the world over.Here is El-Erian's view of how the recession is spreading. Bullet points are added.
In an interview this week, he insisted that regional banks and local governments can no longer stomp their feet and claim they are immune from danger because they did not speculate on high-risk real-estate loans or structured finance: Collateral effects are going to crash into every institution that has ever lent a dime as excessive levels of debt are violently wrung out of the global financial system.
"I live in a world where crisis management is the norm, not the exception, and you learn a few things" El-Erian said. "You learn never to underestimate the destructive power of negative feedback loops."
The insidious loop now has spun its way from Wall Street to the everyday lives of Americans as a financial crisis has become an economic crisis.So according to El-Erian, there is still a stock and bond bubble, with both still greatly overprices. Working those prices out will involve a set of negative feedback loops that are all operating to deepen and extend the recession now. There are no free market possibilities which can stop those feedback loops or even shorten the time they go on.What makes El-Erian stand out among so many skeptics today is his view of the length of time these loops will need to play out. He argues that current stock and bond valuations are still so lofty, even after recent declines, that they suggest most investors believe solutions will come quickly -- creating a V-shaped recovery.
- Damaged money-center banks are lending less, leading to lower levels of production and curtailed expansion at companies.
- That has led to job cuts,
- which in turn have led to cutbacks in consumer cash flow and spending,
- which are feeding back into creating problems for credit card, auto and home loans made by smaller banks.
- Those troubles will in turn lead back to a diminished appetite to lend locally for projects with the slightest whiff of risk.
Clearly the only hope that the recession can be shortened lies in government actions. Here's El-Erian's view of that.
El-Erian thinks U.S. government action has been so slow and timid that the recovery will instead drag out into the shape of an L and that it will curve upward into a U only when regulators and lawmakers worldwide are bludgeoned by losses to coordinate their approach despite dramatic regional differences in growth and indebtedness.A lot of this, El-Erian believes, is because the western bankers and financial experts do not realize that the world economy is very suddenly shifting.
"Policy change in Washington, D.C., has been too little, too late," he said. "In a crisis like this, leaders have to be much bolder." [Snip]
A big part of the problem, he says, is that U.S. financial leaders have failed to communicate the extent of the problem, insisting that everything is fine and thereby creating false expectations. He also believes that the Federal Reserve has erred badly both by taking on too many responsibilities and by not prioritizing them effectively. The Fed, he says, started with this mandate: to guide short-term interest rates in a way that supports U.S. economic growth without causing inflation. In March, it appeared to add another mandate: to promote financial stability by mediating deals to keep faltering broker-dealers from collapsing, as it did by assisting the takeover of Bear Stearns by JP Morgan (JPM, news, msgs). And the Fed then appeared to add one more mandate when Bernanke began to talk up the value of the dollar, which is something no predecessor had done.
These mandates conflict with each other, particularly in an economy in need of radical deleveraging, or the shedding of debt. Unless Bernanke can pare back his obligations and clearly articulate that he will help promote growth as a top priority, it will be difficult to assure investors that the central bank is being guided by policy focused on restoring profitability to banks and companies.
...the United States and Europe have lost their role at the center of the investment universe. He observes that we are currently at a unique moment in world history when the richest countries on Earth are borrowing heavily from the poorest countries... [Snip]So if El-Erian is correct, the global financial world is rapidly shifting away from the current wealthiest countries and towards the less-developed world.
El-Erian says, the world is "upside down" when you consider the strange turn of events that have led irresponsible New York banks to go hat in hand to Abu Dhabi, Singapore and China's sovereign wealth managers in search of new capital. "Poor countries are recapitalizing the rich countries. It's a complete change," he said.
As a result of this transformation in world finance, emerging economies are buying developed countries' assets on the cheap and thus will be first to benefit when global deleveraging is complete. And even at present, while heavily indebted consumers in the United States, United Kingdom and Australia are cutting back on their purchases, dampening their countries' economic growth, consumers in Eastern Europe, China and India who have never had credit cards or subprime mortgages are actually accelerating their purchasing, helping their local economies power ahead.
Going forward, El-Erian believes we should anticipate a widespread realignment of the U.S. banking system, with dozens of medium-sized and large banks disappearing and a few supersized entities, such as, potentially, JP Morgan, emerging.
The current economic problems, then, reflect major changes in global finance and economics and massive shifts in control of the world's assets. This rather sounds like the abrupt shift that occurred in global finance as a result of WW I, in which Great Britain, France and Germany entered the war effectively owning or controlling over half the world, and four years later came out of the war as essentially destroyed debtor nations with the U.S. owning most of the debt.
But the global shifts are less clear than the fact that the current recession is gong to get deeper rather they recovering by early 2009. That is no longer insider-information known only by the big money banks and traders. MSN Money has reported it, which means that it is already old news that has gone mainstream.
Discussing the political problems of the Whigs as the severe recession of 1837 to 1846 ran on, Historian Daniel Feller stated "It was one thing to invite people to thrive on their own, another to tell them to suffer on their own." [From p. 505, "What Hath God Wrought[*]" by Daniel Walker Howe.] It has surprised me to find that American political rhetoric from the period of Andrew Jackson and Thomas Jefferson seems to be recycled by modern politicians.
Today's Republicans have a strong interest is denying that the economic conditions are bad and getting worse with little likelihood of recovery soon, particularly since they base a lot of their appeal to voters keeping government intervention out of both the real and the financial economy. Ex-Senator Phil Gramm's recent statement that the American public is a bunch of whiners is exactly that. He is expressing the conservative view that Americans need to suffer alone.
If El-Erian and I are correct about the depth and length of the current economic problems, the conservative economic message and the Reagan Revolution are dead in the water and will be for a long time.
[*] Addendum 8/11/2008 11:52 pm CDT Misspelling of "wrought" corrected. I blame my fingers liberated by touch-typing for that error. My typing fingers are convinced I meant "wrote."
Which, if you think about it, is a very interesting piece of psychology. How much conscious control do we really retain over those functions we have learned sufficiently well to relegate to unconscious processes - like driving a car or shifting a manual gearshift, for instance.
Think of a soldier trained to fire at any possible threat before thinking about it. It's the same psychological process.
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