Wednesday, April 15, 2009

The Future of the Economy: Three Scenarios

From the look of things, it seems like we're nowhere near the end of the recession. The consensus economists have become more optimistic in the past few weeks, however. They point to the recent signs in consumer spending and home sales that might be pointing to a turnaround for the economy, or at the very least, a decrease in the rate of decline. The stock market likes the optimism and has been (irrationally) rising very strongly in the past few weeks. I don't see anything to change my mind, though. Things still look bad, and I think things have a good chance of becoming even worse. Looking at the Great Depression, people are thinking we are in 1933 after Roosevelt's bank holiday. I, on the other hand, worry we're in 1930. Things were becoming bad after the stock market crash in 1929, but what started the Great Depression was not the crash; it was the bank panics that started in 1931 and lasted until 1933. That was what made the Great Depression so Great. With that in mind, here are three ways the economy could play out in the next year or two.

1. Consensus: The bottom is a few months away
Frankly, this is the most unrealistic scenario, but it is something we should consider, however unlikely it is. Suppose that Geithner and Bernanke can pull off their trick and actually instill some sort of confidence in the banking sector. A stabilization of the banks might cause housing prices to at least slow their rate of decline. With banks able to lend again, companies can get the credit they need to expand their business. Consumers slowly begin spending again, and the economy gradually recovers. We might have many quarters of anemic growth, but at least we'll be out of the woods.

This seems to be the consensus picture. Most economists have been moving the time they predict the bottom will occur forward to somewhere around the fourth quarter of 2009 or so. If this actually is the case, then it makes sense for the stock market to be rallying right now, since the stock market is a leading indicator of the economy.

What's wrong with this picture? Well, everything. Obviously, Geithner and Bernanke truly, truly hope that things will play out this way, but let's be realistic. The biggest linchpin is the stabilization of the banking sector. But the banks are suffering not from a liquidity problem, as the Treasury and Fed would have us believe, but from a solvency problem. Given that the banks are technically bankrupt (haha, sorry), making it easier to trade won't actually do anything. The government's new PPIP plan implicitly assumes that the market for toxic assets is frozen (hence, a liquidity problem), and that because the market is frozen, the bid-ask spread between the banks and investors is too large, and that is what is keeping the banks from recovering. This is also the reasoning behind the suspension of mark-to-market accounting. By adding money to the market, the government hopes that the price for toxic assets will reach its so-called "true" value.

But investors are asking for 30 cents on the dollar for these toxic assets because these assets are actually only worth 30 cents. The PPIP might actually succeed, though, in inflating the value of these toxic assets... at least until housing prices fall enough that banks have to take yet more writedowns. The PPIP is simply a way to obscure the fact that the government will be bailing out the banks... again.

If banks truly were facing a liquidity crisis, then loaning money would work because banks could rely on their future profits to pay back the loans. But if the banks are insolvent -- which they clearly are -- then loaning money simply delays the inevitable. More money does not make a company turn a profit. The issue is profitability, and the banks are not profitable.

2. The bottom will be in the second half of 2010 or the beginning of 2011
This is the most likely scenario in my mind. The economy cannot recover until the banks get through their solvency crisis. I think several months from now, the government will finally realize that the only realistic scenario is for some sort of "reorganization" (i.e., structured bankruptcy through a nationalization) of the banks, which will involve the culling of the weakest ones. Citigroup will certainly not survive. Neither will AIG, or Bank of America, at least as a public company. Wells Fargo has been substantially weakened by its acquisition of WaMu. JP Morgan will be facing a lot of pain, but it will probably survive. Goldman Sachs will likely survive as well, though it has yet to face any significant test.

Housing prices will continue to fall. But the bigger thing will be mortgage resets. What caused all of this was the default on subprime mortgages. The next wave of resets will be hitting homeowners sometime next year. This time it will be option ARMs. The defaults on option ARMs will make subprime look like prime. When homeowners see their mortgage payments tripling, there's no chance in hell they're going to continue paying it -- even assuming they had the ability in the first place to make those payments. This will cause massive losses for the banks, and could in fact be the 1931 event that we're looking for. Allow me to be optimistic(!) , but there is a silver lining here. The banking panic redux will quite possibly provide the impetus necessary to finally deal with the banking problem properly. The government will realize that it simply cannot continue pouring money down a bottomless pit. The losses will continue, but at last we'll be able to start anew. As I have said, once we solve the banking problem, we can finally start getting through this recession.

Meanwhile, unemployment will continue rising and could possibly reach a peak of around 15%. We'll continue having a massive asset deflation. The stock market will certainly fall from its current price. If the recession ends in the beginning of 2011, it will have lasted for three years. To put this in perspective, that is about as long as the 1980-82 double recession (though technically there was a year of growth in between) and a bit shorter than the 1929-33 recession. So things will be bad, but probably not worse than the Great Depression.

3. The Greater Depression
I have to admit that the second scenario might actually be a bit optimistic. I assume that the government will finally get its act together and do what's necessary for the banks, but as we all know too well, government has a pretty poor track record of doing things right. That was part of the problem of the Great Depression. The government, through its action and inaction, turned what was a bad recession into an entire decade of misery. For all the talk about how we have learned the lessons of Japan and the Lost Decade of the 1990s, what amazes me is how much we're copying Japan. Though we may know what to avoid, will we actually do things differently? That remains to be seen.

In considering the Greater Depression, there are actually two ways this could pan out. The first is a Great Depression but on a greater scale. We end up with massive unemployment (well over 15%, maybe even over 20%), and the stock market completely crashes. The stock market in the 1929-33 recession lost 90% of its value. If the same thing happens to the market today, then we'll be looking at a Dow of around 1400 and S&P of 150! The recession will last for years, until early 2012 at the earliest, possibly until 2014. The government will be powerless like Japan was to stop it. It will be a slow and painful bleeding of wealth and energy, but eventually all the bad blood is removed from the body, and the economy can start to rebuild itself.

Alternatively, the government could go with the nuclear option. That is, the problem we have right now is deflation. What the government might end up doing is pulling a Zimbabwe and going for hyperinflation. Through the printing of huge amounts of money (or rather, adding more zeros to an account in a database), the Fed can get the housing market, the credit market, and the banking sector all moving again. Of course, the only problem is that they'll be moving at incredible speeds as everyone tries to dump their dollars before they become worthless. The currency collapses, but we destroy all debt in the process, and we finally have the chance to start all over.

In both scenarios people lose. The difference is who loses the most. In the Greater Depression, those who don't have a job will be having a miserable and painful experience. Those who do have a job, on the other hand, might actually finds things to be not so bad. As they say, the Great Depression was great if you had a job. Prices were constantly falling, meaning that you could buy more and more for less and less. By forcing everyone, including the government, to pay down their debts, the foreigners get to keep their money at the expense of the Americans. In the Weimar Republic/Zimbabwe scenario, the middle class will be totally wiped out, though they will get to start with a clean slate, as all their debts will be cancelled in the process. The foreigners, too, will be wiped out when we repudiate our debt. The poor actually might not do so badly because they have no assets to lose, while those who own tangible assets like gold, commodities, and real estate will be able to preserve their purchasing power. They will probably even end up ahead after the hyperinflation ends, as they will be the ones with all the remaining wealth.

No matter how it plays out, somebody has to lose. The Devil demands his due.


I talked about monetary policy a little bit in this last scenario, but I haven't talked too much about it when I should be, because how the Fed acts will have a big effect on what will happen in the coming years. I'll talk about inflation and deflation in more detail in the next post or two. I'll also talk about some investment ideas for the future.

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