Economic Outlook: The Depression in the Rearview Mirror

By Richard Hylton
Thursday October 09, 2008 - 09:29:00 AM

Every day now a new blow seems to send the world’s financial system staggering as it desperately seeks a chance to right itself. Congress passed the $700 billion bailout and things have gotten worse, not better. Now several states, notably California, can’t even raise the money they need to meet payroll because the bond markets are nearly shut down.  

Short-term borrowing rates continue to rise as banks look warily at lending even to each other; banks across northern Europe that are teetering on the brink of collapse have been nationalized or rescued by central governments; central banks are pushing interest rates down in a desperate effort to avoid an economic depression; and, oh yeah, for the first time since the Great Depression the federal government is lending money directly to industrial corporations because the credit markets are paralyzed and without short-term borrowing these companies will not be able to pay their bills and then our entire economy will be in free fall. What gives?  

Well, first of all, that $700 billion that is supposed to buy up all the junk securities that are on the balance sheets of banks and investment houses will not get us out of the woods. It might help stabilize some of the financial institutions so that they will begin to lend again (that’s the hope, anyway) but it isn’t enough to restore faith in the underlying solvency of the world’s banks, big property companies, and investment houses.  

Once the Secretary of the Treasury and the Chairman of the Federal Reserve Bank declared to the world that our entire financial system would melt down without their hastily put together rescue plan, it became necessary to approve some version of the plan if only to avoid the immediate realization of their apocalyptic prophecies. But it’s clear from the series of desperate moves that have come out of the Federal Reserve since last week that the problems dwarf the so-called “bailout.”  

The U.S. stock markets have lost one-third of their value since the start of the year and much of that drubbing has come over the past month. Americans have not spent so much time thinking about the 1930’s since the gasoline lines of the early ‘70s reminded them of the bread lines of the Depression. And now that the crisis has become a bona fide international mess, everyone is wondering how the drama will end.  

A few things seem clear:  

1. The cost to the Treasury at the end of this mess will certainly exceed $700 billion and will likely run into the trillions of dollars. The Federal Reserve has turned itself into the world’s biggest pawn shop, the world’s biggest industrial bank, and generally the world’s biggest money hydrant. In a desperate attempt to jumpstart the world’s credit markets the central bank is providing hundreds of billions of dollars in liquidity to every sector of the economy and accepting almost anything as collateral. Banks and merchant banks can go directly to the Fed for loans and now so can industrial companies like General Electric and FedEx. If any of those companies end up insolvent the taxpayers will have to take the losses.  

2. Inflation worries are on the back burner for now as Federal Reserve chairman Ben Bernanke tries to avert a multi-year recession or even a depression in the real economy. The more afraid the central bankers around the world get the more they are willing to abandon their commitments to keeping inflation under control and so they start cutting interest rates in hopes that cheaper money will jump start lending and more economic activity. That opens our economy to the risk of stagflation, rising prices and no economic growth. Japan has only recently emerged from a long brutal period of stagflation after their bubble economy burst.  

3. Little has been done to address the underlying problem of sinking house prices. The latest study shows that about one in every six homeowners in the United States has a mortgage that is higher than the current value of their house. As house prices continue to fall, those numbers will worsen and the default rate will continue to climb. Until the government establishes a systematic way of organizing workouts between lenders and borrowers, the securities backed by these mortgages will continue to undermine balance sheets around the world.  

4. Many of the banks in the United States will have to be closed or acquired by other healthier banking companies. This is likely to go on for years as their balance sheets deteriorate and the government steps in. Or a more systematic approach can be taken by the regulators who push the weak lenders to sell themselves to the strong ones or face collapse. Here again the government will likely have to backstop the losses and those numbers might be huge.  

5. The Securities and Exchange Commission and the Financial Accounting Standards Board move last week to allow companies to dream up a value for the securities on their books instead of using the “mark to market” rule for valuing their securities will only delay the painful day of reckoning for all those companies with lots of mortgage-backed securities. Essentially, the old rule said you must establish a fair value for your securities by using the price you would get in an active market or the prices similar securities are fetching. That value is what goes on your balance sheet. Of course, currently the market value for a lot of these kinds of securities falls somewhere between fire-sale prices or zero. Mostly it’s not even possible to establish a value because there are no buyers. So the SEC and FASB are saying that banks should pick the value they think these things would be worth if the world’s markets were not collapsing. In other words, “Let’s say its worth what you think it should be worth and later on when things get back to normal we will change that to what it’s really worth.” How this will restore confidence among lenders in the solvency of borrowers is not clear to me.  

6. Hank Paulson and his team at the Treasury Department blew it big time in not developing a Plan B (“What If Things Start Melting Down”) approach to this crisis. Let’s not forget, the credit crisis started in August 2007. Paulson’s 2007 plan to ease the problem went nowhere and it looked for a while as if the markets could settle things themselves. But aren’t the big boys at the top of the world’s largest economy supposed to have a back-up plan in case the markets can’t settle themselves? That seems prudent. But earlier this year officials from the Treasury Department were assuring folks in the California governor’s office that they did not need to worry about Treasury’s plan because things were going to be fine. That would explain why Congress got a slapdash three-page non-plan in September that basically said give me $700 billion now with no questions asked or everything will collapse. Don’t be surprised if the guys at Treasury and the Fed come up with another plan to fix things. Perhaps they will spend more time crafting the next one.