2008 Review Part 1

GLOBAL CREDIT CRISIS: SYNOPSIS |

The month of September marked a stunning collapse in global credit and financial markets. Unlike the financial turmoil of 1987 and 1998 when economic activity was relatively unaffected, incoming data reports indicate unambiguously that global economic activity is weakening sharply and rapidly in every country of consequence in tandem with the deterioration in global credit and financial markets.

The triggering event was the decision by U.S. authorities to let Lehman Brothers fail, which with the benefit of hindsight was a grievous error. However, I do not wish to leave the impression that the crisis we are now deeply enmeshed in could have been averted had the authorities bailed out Lehman Brothers as they did with Bear Stearns earlier in the year. It still would have occurred, perhaps a little later, and perhaps a little less violently, but it still would have occurred. Why? … because it is now abundantly apparent that we are at the end of a decades-long debt leveraging super-cycle.

While it is indisputable fact that increases in debt leverage increase risk, we deluded ourselves into believing that financial innovations and greatly increased financial modeling and policy sophistication enabled us to manage the increased risk brought about by ever increasing leverage and made it possible to tame the business cycle. We shall see in due course what the economics profession has to say about the much-lauded “Great Moderation” in the economy we experienced over the last 30 years. It now appears that the “Great Moderation” might have been artificially induced by steadily escalating amounts of debt leverage and that reduced volatility was simply an artifact of financial engineering at the transactional level and aggressive use of monetary and fiscal policies at the macro-economic level. What is abundantly clear is that imbalances built in every country and in every economic sector to the point where the systemic aggregate risks had become so great that in the end the system’s collapse became inevitable.

I have remarked in past commentaries about the risk of ever increasing leverage and how aggressive policy intervention to limit the consequences of recession was preventing a full cleansing of the previous cycle’s excesses so that the level of risk built progressively from cycle to cycle. I also commented that ultimately the extent of leverage would become so great that policy would no longer be able to limit or control the adjustment process.

Two things are now clear. First, there is no longer any doubt that the spectacular collapse in global financial and credit markets, the inevitable consequence of an overextended system that permitted aggregate risk to accumulate way beyond institutions’ and governments’ ability to manage and contain it, has been followed by a precipitous and massive collapse in aggregate demand globally. Prior to the events of September the unraveling process was already underway, but the slow pace fortified the optimists’ belief in the efficacy of aggressive policy intervention to foster the healing process, both in financial markets and in macro economic activity. Policy failed, not so much because of specific mistaken actions but because the problems that had built up over decades were so much greater than traditional policy was capable of handling. That is not to say, however, that policy does not matter, which leads me to my second point.

Second, the power of negative feedbacks stemming from the burst housing bubble, balance sheet deleveraging and the unwinding of other unprecedented global economic imbalances, such as the huge U.S. trade deficit and the rapid and unbalanced growth in China, continue to be underestimated. In my opinion, the ability of policy intervention to contain negative feedbacks continues to be overestimated. For policy intervention to be effective, it must be structured in ways that permit excesses to be purged and reasonable balances to be reestablished. But, it also must be structured to avert the very real potential for violent negative feedbacks to become perpetuating in ways that fuel the negative global aggregate demand shock and drive global economic activity down to levels that foster intense human suffering and create unwelcome social and political upheaval. Thus, policy needs to focus on interdicting the negative feedbacks and in restoring enough confidence and optimism that dilutes the excessive risk-averse behaviors that are currently compounding the downward spiral.

The current situation with the three U.S. automakers – General Motors, Ford and Chrysler – is illustrative. Nominal retail auto sales have fallen 26% over the last year. The impact has been far greater on the U.S. manufacturers than foreign manufacturers domiciled in the United States. Now these three manufacturers are in desperate straits with only enough cash to survive a few more months. We know that if we let these companies fail there will be enormous negative consequences for the U.S. economy. Yet, we also know that a return to business as usual, once the crisis passes, will leave us with weak companies ill-equipped to be successful in a restructured economy that will focus increasingly on energy efficiency and environmental issues.

The tough love of bankruptcy will surely reinforce the downward spiral in aggregate demand and greatly compound our economic troubles. But based on the experiences of other countries that shored up and protected broken companies, such as Japan during the 1990’s, we know that such responses not only delay essential rejuvenation but also weaken the economic strength of the nation as a whole.

The U.S. automakers are victims of two things – one based on longstanding U.S. policies and the other of their own making. The policy failure is a decades-long commitment to cheap energy. This policy has been intertwined with other policies such as those promoting ownership of single family detached dwellings. As any land use economist would tell you, this has led to inefficient and extremely costly development and provision of social services. We are now at a point where energy is no longer abundant in the traditional forms and certainly isn’t cheap.

The question now is whether we will have the determination and willingness to fundamentally alter these policies or whether we will band aide them and continue to stagger from crisis to crisis. The automakers are already authorized to borrow from the federal government to retool their factories and design cars that are more energy efficient and environmentally compatible. However, the collapse in auto demand has presented an immediate operating crisis.

The second failure is that American automakers do not seem to know how to make cars that Americans will buy. When wages are reduced and health and pension plans are right-sized to meet intense global competition, the automakers will still not be able to compete effectively until they make the right kinds of cars. This is a matter of corporate culture that appears unique to the American manufacturers. The task of saving the companies and simultaneously guiding them in directions that will result in long-term successful viability without enormous and on-going subsidization seems daunting. But, it is a task that must be accomplished both to avert worsening the economic downturn in the near term but also to ensure that the companies emerge as a vibrant part of a revitalized and balanced economy.

While the automakers are a graphic and perhaps extreme example of what has gone wrong in the U.S. economy, they are illustrative of the need to revamp policies across the board in ways that deemphasize Americans’ obsession with consumption and overreliance on debt and in ways that recognize that systemic risks can grow to unmanageable levels without appropriate and effective governance and regulatory processes.

In the commentary that follow I discuss eleven key economic variables and comment on what has happened since various 2008 forecasts, including my own, were made at the beginning of the year.

In the remainder of this economic commentary I focus on U.S. GDP, which is poised to fall at a rate not experienced since the ill-conceived Carter Administration’s experiment with credit controls decimated the U.S. economy in the second quarter of 1980. Most unfortunately, the current crisis and collapse in aggregate demand is much more fundamental. In 1980 we were faced with runaway double-digit inflation and high interest rates, but we did not have excessive levels of debt, we did not have a trade deficit with the rest of the world equal to 5% of GDP and we did not have the plethora of financial risks that have now reached systemic proportions courtesy of financial engineering and ineffective governance. What this means is that it will not be easy to slow the negative momentum of falling demand, let alone reverse it.

The U.S. and global economies are on the razor’s edge. This is no ordinary recession. All of the global excesses brought about by unprecedented use of leverage and misunderstanding of systemic risks are unwinding furiously and simultaneously.

We have been living in a world fraught with excess supply, which in and of itself is highly deflationary. That fact was hidden from view by the powerful global economic cycle, now ended, that produced a series of bubbles in real assets, such as houses and commodities, which made it appear for a time that inflation was the problem. Inflation can never be a problem in a world of excess supply and reasonably disciplined monetary policies. But deflation can be an enormous and potentially deadly problem leading to extreme financial system distress and even to social and political upheavals. We are now on the razor’s edge of falling into a pernicious deflation which surely will occur if aggregate demand continues to collapse.

Policy must focus on shoring up and eventually restoring aggregate demand. In this regard, I am hopeful and optimistic that the incoming Obama Administration understands the gravity of the situation and the risks and understands the urgent need to respond quickly, decisively and in size. Let us all hope that the new administration will be successful and also that longer run it addresses and revamps the policies that led us into this quagmire.

This is part 1 of our four part series of Bill Longbrake’s review of 2008 and the ongoing credit crisis. Bill Longbrake is the former Deputy to the Chairman and CFO of the Federal Deposit Insurance Corporation and Vice Chairman of Washington Mutual. He is currently on the Board of Directors for First Financial Northwest.

Originally published as Bill Longbrake MEMORANDUM, December 15, 2008, RE: Economic Commentary – Massive Negative Demand Shock Threatens Worst GDP Performance Since the Great Depression; Specter of Pernicious Deflation Lurks.

*Artwork created by Iron Man Records under a Creative Commons license at Flickr.com.