Neither current or anticipated economic growth rates are likely to be sufficient to offset the high levels of household, government and corporate debt the nation has accumulated.

With years to go before sectors such as residential construction recover fully from the credit crisis and ensuing recession, households are saving rather than consuming, while the corporate sector remains cautious. At the same time, regulators – coming in late and, arguably, with an inappropriate response – are focused on clamping down on “risky” loans. Unfortunately, in today’s environment, most loans are viewed as risky.

Slow Growth Ahead

As a consequence, the US financial system is only slowly regaining strength and building capital. Further, we expect that years of residential mortgage defaults, restructuring and defaults on commercial real estate and other business loans will continue to be a significant drag on economic growth.

Just as the economy offers few signs of accelerating, the federal deficit shows no sign of reversing, prompting virtually all economists to forecast large deficits five and more years into the future. The good news is that things could be worse. If interest rates were higher, the interest component of the federal budget would be much higher as well – possibly even higher than the $671 billion for defense that President Obama has proposed for fiscal 2012.

The Federal Reserve can control the short end of the yield curve (representing very short-term interest rates) for a while longer, but rates are very likely to rise at the long end of the curve. As the economy recovers, private credit demand will rise, adding to federal demand – and making investors nervous about how the government is going to deal with even more debt. These rising rates could push the government into a debt spiral à la Greece, a situation in which debt service grows so fast that tax revenue cannot offset the deficit’s rise.

Change Is Possible

The United States is not Greece. Both the president’s deficit commission and the Republican “Ryan proposal” illustrate that the government’s tax and expenditure structure can be adjusted to avoid the debt trap. The problem, then, is political rather than economic. With a presidential election coming, no one is willing to press for the needed changes in spending, tax and fiscal policy.

Moreover, and of equal importance, huge amounts of federal money are still being used to protect various special interests, primarily through the use of tax concessions.

Some people expect inflation to be used to disarm the debt trap, as it has in many other countries (and, indeed, in the US between 1945 and 1960). However, high rates of inflation are unlikely in a world of unemployment, excess capacity and reluctant lenders.

Moreover, it is not clear that our leaders really believe that inflation will be able to bail them out.

If inflation should spiral higher, interest rates will rise as well, not only pushing the federal government closer to the debt trap but significantly slowing the economy and further cutting government revenue.

Next Steps

What should a prudent investor do? For the moment, holding a broadly diversified portfolio, mainly in US dollars (which we think are oversold), significantly in blue chip equities (they are the most resilient), and with short-to-moderate bond duration makes sense. However, watch for the crisis to come. Capital preservation will then require a move toward a globally rather than a domestically oriented set of investments.

George Feiger is chief executive officer of Contango Capital Advisors, the wealth management arm of Zions Bancorporation (www.contangoadvisors.com).

]]> http://think.zionsdirect.com/2011/06/02/defusing-the-debt-trap/feed/ 0 http://think.zionsdirect.com/2009/04/13/coping-emotionally-with-the-economic-meltdown/ http://think.zionsdirect.com/2009/04/13/coping-emotionally-with-the-economic-meltdown/#comments Tue, 14 Apr 2009 03:59:04 +0000 Dawn Corrigan http://think.zionsdirect.com/?p=1014 Read More]]>

If you have a 401(k) account, a mortgage, job, car, or if you eat food — or if you have a loved one who does — then chances are you’ve experienced additional stress this year. The economic downturn, experts assure us, has affected just about everyone: rich and poor, young and old, white collar and blue collar, blue states and red. We’re all in this together. But when we’re watching our investments shrink, or looking at a bill we can’t afford to pay, it’s easy to feel very alone.

Insomnia, anger, depression, self-medicating with drugs or food, and panic attacks are just some of the symptoms that have been reported because of “credit-crisis stress.” Here are some tips for coping when it feels like the sky is falling.

Count Your Blessings
Taking a quick appraisal of one’s life and dwelling on the positive can keep that sense of panic at bay. Even with smaller savings accounts, many of us are better off materially than those who came before us. Do you still have shelter, hot running water, food on the table for yourself and your family? Then you’re blessed. Don’t just pay lip service to this idea; use your imagination to experience what life would feel like without the material comforts you may sometimes take for granted. Then open your eyes and step back into your own life.

Remember History
Many of us admire the “Greatest Generation,” but few wish to walk in its shoes. We’ve had it easier than our parents and grandparents who survived the Depression and World War II and went on to flourish. Now it’s our turn to have our mettle tested. Can we work together to find solutions to this crisis as they did?

Have Faith
Times of trouble serve as reminders to have faith in the things we believe in, whether that’s God, community, family or self.

Control What You Can
Part of what makes an economic downturn so frightening is the feeling that it’s out of our control. But in reality, it never was in our control. Try focusing on another source of stress. Choose something over which you do have control, and then tackle it head on. Been putting off visiting a loved one in need, or some other task? Do it now. Asserting control and eliminating a stressor is a great way to combat negative feelings.

Turn Off the TV
Human beings are empathetic. When we hear the voice of someone in distress, many of us will feel distress as well. For this reason, staying glued to the television, radio or Internet for constant updates can be counterproductive. Turn the electronics off and go for a long walk instead. Chances are you’ll feel much better.

Get Help if You Need It
If you’re having trouble paying your bills, you’ll want to act right away. The National Foundation for Credit Counseling can recommend a trustworthy credit counselor in your area.

Don’t Stop Saving
As long as you’re paying your bills, keep saving, even if it’s only a little each month. You can ride out the current uncertainty by putting savings in CDs until the market improves.

Featured in the March/April 2009 issue of Zions Bank’s Community magazine.

*Artwork from arimoore under Creative Commons license at Flickr.com.

Jonathan Jarvis is a Masters of Fine Arts Candidate in the Media Design Program at the Art Center College of Design in Pasadena, California. Jarvis is well versed in interactive design, such as in this effort of “giving form to a complex situation like the credit crisis”. His website is jonathanjarvis.com.

These videos are used by his permission.

PART ONE

ZIONS BANCORPORATION AND AFFILIATES IN THE NEWS |

Regional and national publications and community leaders have once again turned to Zions Bancorporation and affiliate executives to help give understanding and perspective about our current economic environment. See the links below for more information.

Les Roka of Utah CEO Magazine writes in “Clear the Fog from Annual Reports” of CEO Harris Simmons’ “straightforward approach” when speaking with shareholders.

February 27, 2009
“With a sputtering economy and soaring unemployment numbers, some may question whether now is a good time to be starting a new business. Scott Anderson, President and CEO of Zions Bank, wants to ensure that it is.”

February 12, 2009
George Feiger tells SNL Financial that while funds of funds have been outperforming the market, “they have broken the promise that they won’t go down.”

February 7, 2009
Mike Freeman at The San Diego Union-Tribune reports that “California Bank & Trust will acquire the branches, deposits and loan pool of Alliance Bank.”

January 23, 2009
George Feiger expects economic losses to continue through 2009, the Daily Camera reported.

December 2008
Vectra Bank President and CEO Bruce Alexander tells Jeff Rundles that Vectra is continuing to “make loans” while “being careful and prudent.”

December 5, 2008
Brice Wallace of the Deseret News quotes Contango CEO George Feiger when writing that “the longterm ramifications of the downturn will ‘reshape the topography’ of American retail.”

December 18, 2008
Bruce Alexander, President/CEO, Vectra Bank Colorado, has been picked to take part in a leadership team to “help draft an economic stimulus plan for Denver.”

November 14, 2008
Katie Kuehner-Hebert of American Banker quotes from CFO Doyle Arnold’s presentation at a Merrill Lynch & Co. conference, during which he discussed Zions participation in the Treasury Department’s Capital Purchase Program (article: “Treasury Funds Secured, Zions Looks Outward”)

*Artwork created by City On Fire at Flickr.com.

U.S. ECONOMIC OUTLOOK |

THE AMERICAN ECONOMY…the recession continues
Domestic and global financial sector paranoia has contributed to major weakness within the U.S. economy. Enormous investment and lending losses have sharply curtailed the availability of credit.

Such financial sector weakness has led to creative and extremely costly government proposals to stabilize financial markets. These factors, combined with prior excesses in new home construction and existing home price appreciation, led to the current period of serious recession, which officially began in December 2007.

BUDGET DEFICITS
…off the charts
The combination of serious U.S. recession, enormous war spending, one financial stabilization program after another, and Congressional economic stimulus spending could see the fiscal year (FY) 2009 deficit, which began on October 1, 2008, easily exceed $1 trillion. The budget deficit for FY 2008 was $455 billion, also a record. Note, however, that much of the Government’s investment into major financial institutions will be returned to taxpayers in coming years as financial markets (hopefully) return to some level of normalcy.

UNEMPLOYMENT
…to move higher
The nation’s jobless rate reached 6.7% in November, a 15-year high. It could reach, and possibly exceed, 7.5% to 8.5% during 2009. By comparison, the jobless rate averaged 4.6% in both 2006 and 2007.

U.S. employment has declined for 11 consecutive months, with nearly two million fewer jobs today than a year ago. However, longer-term labor shortages, especially for skilled workers, will remain center stage for years to come.

INFLATION
…to move lower
The sharp decline in oil and other commodity prices of recent months, should it continue or simply stabilize, will help unwind much of the inflation pressures that pushed inflation (the CPI) to a 16-year high of 4.1% in 2007. Most forecasters expect a 2008 CPI rise of roughly 2.0%, with a slightly smaller increase expected in 2009. Note that there are as many concerns about deflation during the next few years as about inflation.

THE FEDERAL RESERVE
…just plain aggressive
The Fed has been a major player in numerous financial stabilization programs announced during the past 16 months. The sharp decline in inflation pressures provides the Fed “cover” to aggressively use its balance sheet to improve financial flows. Its critical federal funds rate was recently at a 50-year low of 1.00%, with the prospect of going still lower.

Solid evidence of U.S. financial stabilization and a resumption of modest economic growth in 2009’s second half—the current view of most economists—will lead financial markets to expect a minimal reversal of Fed policy late in the year or early in 2010.

GASOLINE PRICES
…like cutting taxes
Need a bit of “good” economic news? The plunge in gasoline prices from a high of roughly $4.25 per gallon in early July to around $1.50-$1.80 now is the equivalent of a $250 billion tax cut for American consumers. One concern is that prices could go too low … and put prior initiatives regarding developing alternative sources of energy on the “back burner.”

THE GLOBAL ECONOMY
…more slowing expected
Five years of powerful global economic performance gave way to major slowing during 2008. A global recession during 2009 is likely.

As in the U.S., global financial markets and major financial market players have been decimated by a loss of confidence…the most crucial component of the lending and investing process. If you don’t have confidence in the firms you lend money to, you simply don’t do it…just ask Bear Stearns and Lehman Brothers, now deceased.

Better news? Recent declines in energy, commodity, and many food costs have been good news for hundreds of millions of the global poor.

Asian economies are dealing with their own exposure to global financial market distress and slowing global exports, with various nations enacting their own stimulus packages. China’s recently announced $586 billion stimulus program comes to mind. A series of Chinese interest rate cuts have also taken place as this nation faces economic growth that may soon be half its prior blistering pace.

Japan’s economy continues to struggle to regain its 1980s economic magic. Today? Japan is again in recession. As before, the Japanese fear the rising Asian clout of the Chinese.

I have no doubt that European business leaders and politicians were laughing at the U.S. earlier in 2008 for the enormous financial mess we got ourselves into. The laughter ceased when the Europeans soon realized their challenges might surpass our own.

Europe is now dealing with its own recession, with limited prospects for emergence anytime soon. The weakness in home prices in many European nations exceeds that in the U.S., as many communities saw home prices skyrocket earlier in this decade. More interest rate cuts are coming from the European Central Bank.

Russia’s critics have had a field day in response to its aggression into Georgia. The Russians have experienced some of the global community’s most volatile stock market performance, in part tied to the collapse of energy prices.

Oil wealth continues to accumulate across the Persian Gulf. However, many investors are losing sleep because of massive commercial development commitments that were predicated upon oil remaining north of $100 per barrel … whoops.

Major South American nations struggle with much lower energy and commodity prices than their respective budgets assumed. Other nations in the region struggle with high taxes, enormous business red tape, and highly anxious credit markets.

Canada is facing its own likely recession as its major export market—the U.S.—struggles with recession. Growth in Mexico is modest, but must improve to provide greater opportunities for its citizens.

THE BOTTOM LINE?
U.S. economic recession will hopefully give way to modest growth by mid-year 2009. We also expect: a much larger budget deficit … rising unemployment … declining inflation pressures … record low short-term interest rates … stable energy prices … and a very weak global economy.

Jeff Thredgold is an economic consultant to Zions Bank

Featured in the Winter 2009 Issue of Zions Bank’s Insight newsletter within the January/February 2009 issue of the Community magazine.

*Artwork from luccawithcheese under Creative Commons license at Flickr.com.

IMPACT ON CONSUMER SPENDING AND GDP |

Housing, poses enormous risk to the U.S. economy through its impact on financial markets, financial institution solvency and consumer confidence and spending. Key will be what happens to housing prices and the extent to which falling prices affect expected losses on mortgages and other linked financial instruments and the extent to which declining wealth affects consumer spending. Prospects are decidedly negative on all fronts as housing price declines continue unabated.

The linkages between housing wealth, price changes and consumer spending are imprecise and have been hotly debated. As the evidence comes in the debate is being resolved. Unfortunately, it appears increasingly that the resolution is in the direction of those who believe that housing had a substantial impact in stimulating consumer spending during the bubble phase and will have a commensurate negative impact now that the bubble is unwinding.

Part of the difficulty in tracing cause and effect is tied to transmission lags between changes in household wealth and consumer spending. These lags are long. My modeling indicates that falling housing prices will place considerable downward pressure on GDP growth during 2009 and 2010. Table 2 shows the timing and size of impacts of housing on GDP growth, which captures consumer spending, residential construction and other linked effects. Note that my Severe Recession scenario projects a -12.1% additional cumulative decline in nominal housing prices over the next two years (from 2008 Q3 through 2010 Q3), while the S&P Case-Shiller CME 10-city futures project a -14.7% decline over the same time period.

The Severe Recession GDP scenario indicates that non-housing GDP growth has been weak for several quarters. It turns negative during the fourth quarter of 2008 as recession deepens.

During 2009, the lagged impacts of cumulative declines in home prices have a very negative effect on GDP, which is offset by recovery in the rest of the economy beginning in 2010. The risk is that the recovery in the rest of the economy will be less than forecast because of negative feedbacks from housing (see Chart 1).

Table 3 includes the effect of $700 billion in additional stimulus in 2009 and 2010 on quarterly GDP forecasts. While stimulus has no effect on the housing component of GDP, it has a very favorable effect on non-housing GDP, beginning in late 2009 and gaining momentum during 2010. But, what is also clear from Table 3 is that it will take a very long time to overcome the drag on GDP of negative housing wealth effects and this will keep GDP on a slower growth trajectory for years to come.

GDP Growth Prospects Post Recession

You should note in Chart 1 that GDP growth post recession does not recover to the pre-recession level. Both of the last two recessions have been followed by prolonged periods of sub-potential GDP growth. Not only is this likely to be repeated in 2010 and 2011 but there is cause to expect sub-potential growth to be worse and extend for a longer period of time. Even the massive $700 billion in fiscal stimulus assumed in the Fiscal Stimulus scenario only manages to boost GDP growth to about 2%. I calculate that real GDP non-inflationary growth potential is currently between 2.50% and 2.75%. This is lower than in recent years due to slowing labor force growth and lower productivity gains. GDP growth is likely to remain below potential and that will add to an output gap that is already headed toward -6% to -8% by 2010 according to various estimates. Large output gaps are highly deflationary.

In past cycles aggressive monetary and fiscal policy eventually stimulated recovery, primarily through consumer spending. But there was a consequence. The saving rate resumed its secular decline and consumer debt to income ratios eventually climbed to new highs. Recovery was also assisted by expansion in household wealth.

The era of steadily rising household leverage is over. We have entered a new trend toward greater saving and less reliance on debt. By definition, a higher saving rate means that consumers will spend less out of current income. This will translate into slower GDP growth until the saving rate stabilizes. Moreover, housing wealth will not be an engine of consumer spending for a very long time. Once the housing price correction has run its course, a return to real rates of growth in housing prices of about 1.2% annually seems likely. How much this eventual return to rising real housing prices translates into consumer spending will depend importantly on the rate of inflation, which I expect to be near zero or negative (deflation) for a considerable period of time.

This is part 4 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.

OUTLOOK FOR GDP |

The outlook is extremely bleak. The current recession is in its 13th month. Most recessions over the last 60 years have ended by this time. This one not only has not ended, downward momentum is intensifying.

Q3 GDP

The revised estimate of Q3 GDP growth was -0.5%. This figure will be revised once more. The final number will be reported in the coming week and is expected to be revised down to between -0.6% and -0.9%.

Real consumer spending declined at an annual rate of 3.7% in the third quarter(likely to be revised down to -4.0%), the first negative quarter since 1991 and the worst negative quarter since the second quarter of 1980. Unfortunately, based on the severe decline of 4.7% in nominal retail sales from September through November, consumer spending is likely to fall further in the fourth quarter, which would make the current recession comparable in ugliness to the 1973-75 recession.

Capital spending, which was supposed to be the bright spot because of export strength earlier in the year, fell at a 5.7% annual rate in the third quarter. This was the weakest quarterly performance since 2002 when the tech wreck was still unfolding. The decline was concentrated in old economy industrials and transportation equipment. But even technology capital spending growth shrank from 7.9% in Q2 to 2.5% in Q3.

Residential construction fell at a 17.6% annual rate – the 11th consecutive quarterly decline. Not since the Great Depression has housing been so weak for so long. Growth was positive in nonresidential construction but slowed to 6.6% from 18.5% in the second quarter. Based on anecdotal reports, increased credit stringency and collapsing consumer spending, substantial negative growth in nonresidential construction is now underway and will prove to be very troublesome for lenders who have specialized in this sector.

Net exports, still benefiting from the surge in exports triggered by a weak dollar prior to September, added 1.1% to GDP growth in the third quarter. Government added 1.2% (primarily defense related) and inventory accumulation added 0.6%. Without these favorable factors, GDP would have been reported as -3.2%. With the dollar’s value now rising sharply and global recession in full sway, the addition to GDP from net exports will reverse in the fourth quarter. The same can be said about inventory accumulation, which almost certainly is involuntary right now as sales fall faster than businesses can cut back on production.

GDP Forecast

GDP growth over the next two quarters will be very negative. The two GDP forecast scenarios shown in Chart 1 – severe recession (base case) and depression (what do you call a recession that is worse than severe?) – both indicate that 2009 will be a very difficult year.

In the severe recession scenario – base case – the unemployment rate peaks at 9.6% in the first quarter of 2010 and 2009 real GDP growth is -0.8% fourth quarter to fourth quarter and -1.2% year over year; the worst quarter is the second quarter of 2009 at -1.7% over the previous 12 months. In the depression scenario unemployment peaks at 10.6% in the fourth quarter of 2010 and 2009 GDP growth is -1.1%; the worst quarter is the second quarter of 2009 at -2.0%. Based on forecasts from others, it appears that my unemployment estimates are high and my forecast decline in real GDP is too low.

To put these scenarios into historical perspective, the 12-month rate of real GDP growth fell to 0.3% at the bottom of the 2001 recession, but growth did not contract. In earlier recessions GDP growth bottomed at -1.1% in the first quarter of 1991, -2.7% in the third quarter of 1982, -2.3% in the first quarter of 1975.

Economists have busy revising down 2009 real GDP growth estimates. My econometric model’s estimate is -1.2%, which I believe greatly understates the downside risk. Merrill Lynch expects -2.9%; Goldman Sachs expects -1.6%; and Global Insight expects -1.8%.

Obama Administration Likely To Enact Substantial Fiscal Stimulus

Greatest Negative Demand Shock Since the Great Depression. The economy is currently experiencing the worst negative demand shock since the Great Depression. A massive demand shock causes a precipitous decline in spending in all sectors of the economy – consumer, business, state and local government and net exports. The collapse in spending causes revenues and incomes to fall and reinforces the downward momentum of the demand shock on spending.

Liquidity Trap – Monetary Policy Becomes Ineffective. Traditional policy measures include monetary and fiscal policy. Monetary policy focuses on reducing the cost of credit by lowering interest rates and providing ample liquidity. The intent is to strengthen demand by making credit cheaper and easier to

access. However, in the current cycle monetary stimulus has become ineffective because credit markets, which are the conduits through which monetary policy works, have either disappeared altogether or are barely functioning. The financial sector has fallen into a classic liquidity trap in which risk aversion is so intense that zero interest rates and unlimited liquidity have no effect on spending activity.

Fiscal Policy. The other traditional policy tool to stimulate demand is fiscal policy. This can come either in the form of tax cuts (rebates) or spending. Each dollar of fiscal stimulus can have a decidedly different impact in treating and moderating the current demand shock depending on how it is disbursed. Timing is also an issue. For example, infrastructure spending has a high effective spending multiplier and produces substantial improvements in productivity over time but infrastructure projects take a long time to get up and running and therefore have very limited short-term benefits in offsetting a massive decline in spending.  Tax rebates are relatively immediately but they may go into debt reduction and saving rather than offset lost spending.

TARP (Troubled Assets Relief Program) Is Defensive, Not Stimulative. For example, the $335 billion in TARP out of $700 billion that has been earmarked to date will have almost no immediate impact on stimulating demand. Almost all of this money will be invested in financial institutions and simply replace private sources of capital that have disappeared because of the seize-up in credit markets. That is not to say these investments are unimportant. They are very important because they are preventing the potential total collapse of the private financial system. Such a collapse, were it to occur, would greatly exacerbate the

negative demand shock. Preventing a financial system collapse avoids this outcome but it does not induce financial institutions to extend new credit in the face of greater risks. Once financial markets stabilize and private capital flows loosen up, TARP funds will be returned quickly to the federal government. So,

TARP should be viewed as a preventive and defensive policy measure, not as a stimulus measure.

Tax Rebates. To arrest and reverse the downward momentum of the demand shock fiscal policy must focus on stimulating spending that creates jobs and incomes and that restores sufficient confidence in the future so that risk aversion moderates and businesses and consumers begin spending again. In early 2008 Congress enacted a tax rebate program that returned about $100 billion to consumers, equal to about 1% of disposable income. While there is no definitive study available that explains exactly what happened to these dollars, the subsequent massive deterioration in the economy and flow of funds data, which show that consumers reduced debt during the third quarter, imply that a vast amount of the money went into debt liquidation and saving. That helps consumers repair balance sheets, just as TARP funds have a similar effect for financial institutions, but the dollars don’t get spent and so they don’t help much in arresting the demand shock and they certainly didn’t reverse the shock. Indeed, the shock gained considerable momentum after the tax rebates had run their course.

Transfer Payments – Unemployment Benefits and Food Stamps. There are other kinds of spending, such as extending unemployment benefits and food stamps, that unquestionably lead almost immediately to higher consumer spending, particularly in times of rapidly rising unemployment such as now. So, some of the pending fiscal stimulus will go to such programs.

Reduce Tax Withholding and Payroll Tax Schedules. This would be easy to implement quickly but is not likely to have an impact much different from tax rebates. Also, reducing payroll taxes for social security and medicare would further exacerbate the long-term solvency of those programs.

Targeted Grants to State and Local Governments. Unlike the federal government state and local governments are required to balance spending with revenues. When the economy contracts state and local tax revenues also contract leaving states with little option but to cut spending or raise taxes. Both actions reinforce the negative demand shock.

The National Conference of State Legislatures reported that 30 states face a combined deficit of $30 billion in fiscal 2009 and 25 expect a deficit of $60 billion in 2010. Like the initial estimates of subprime lending losses, these numbers are bound to grow by leaps and bounds as the economy continues its relentless deterioration. California alone faces a 2009 budget deficit of $15 billion.

Federal stimulus can ease the impact at the state and local level by allocating stimulus dollars. Some dollars can be immediately deployed, such as Medicaid benefits. But stimulus dollars for other programs, particularly infrastructure projects. will be dispersed over time.

Federal Spending Programs. There has been much talk about systematic underinvestment in infrastructure over the last several years and the need to reverse that neglect. There is little doubt that investment in infrastructure will benefit long-term growth, but it is difficult to deploy infrastructure investments quickly and thus this kind of stimulus will have limited short-run benefits.

President-elect Obama has already emphasized the importance of infrastructure in the following areas: energy-efficient public buildings, modernize and upgrade school buildings, increase broadband adoption, modernize health care system through technology, light rail and other national infrastructure projects.

Possible Composition of Stimulus Package. The Center for American Progress has suggested $350 billion in one-time programs:

Or, grouped somewhat differently:

About 50% of this proposed list is for infrastructure projects but perhaps as little as 10% of that is ready to go.

Goldman Sachs has suggested a more expansive two-year stimulus package:

Size of Stimulus Package. While the programs suggested above total $350billion, as the economic crisis has deepened, policy discussions increasingly have focused on larger numbers in a range of $500 to $700 billion over two years. Knowledgeable observers suggest that a large stimulus size would have to come from additional tax reductions rather than spending increases, if it is to have much additional impact in the near term.

Merrill Lynch asserts that stopping the recession dead in its tracks and holding the unemployment level at 6.7% would require a budget deficit of 14% of GDP in 2009. This would amount to a deficit of $2.0 trillion, about $1.0 to $1.1 trillion above the projected 2009 fiscal deficit without any further stimulus. Merrill suggests further that a $600 billion stimulus program would be required to merely offset the income projected to be lost by the private sector during 2009.

It will be increasingly difficult to gauge the impact of the reported federal budget deficit on the economy because some of the dollars, like most TARP funds, will be included in the reported deficit, but will have little if any direct impact on spending. For example, the budget deficit for September and October 2008 was nearly $250 billion above the deficit for the same months in 2007. However, this increase included $191 billion in TARP outlays and $14 billion in funds obligated in the Fannie Mae and Freddie Mac conservatorships. Most of this $205 billion increase will have little stimulative impact.

Economic Impacts of Stimulus. All GDP forecasts will be revised once the outlines of the Obama Administration’s fiscal stimulus package become public. I have attempted to show the potential impact of stimulus on GDP growth over the next three years in the Fiscal Stimulus scenario in Chart 1. I assume approximately $700 billion in additional spending split $400 billion between fiscal 2009 and $300 billion in fiscal 2010. This is slightly more aggressive than the Goldman Sachs estimate. This stimulus is added to the Severe Recession scenario.

Stimulus improves real GDP growth from -0.8% in 2009 to -0.3%; from 1.4% in 2010 to 2.0%; and from 1.1% in 2011 to 1.6%. Core PCE inflation, which is falling rapidly and is forecast to turn into -2.2% deflation during 2010, falls a smaller -1.4% and then returns to zero by the end of 2011. The inflationary impact of stimulus in a deflationary environment is an extremely important and positive policy outcome.

Threat of Pernicious Deflation and a Perpetuating Negative Feedback Loop. Falling aggregate demand and price deflation are a deadly combination for the financial system. Debts are denominated in nominal dollars but in a deflationary episode incomes decline not only because unemployment rises but because wage and salary rates are first frozen and then cut outright. This means that in a deflationary environment it becomes increasingly difficult for employed people to service their debts. This will inevitably result in increases in defaults and bankruptcies. Such an outcome must be avoided at all costs because if it takes hold, the current collapse in aggregate demand will extend, deepen and lock into a perpetuating negative feedback loop. This is what economists refer to as pernicious deflation – or as Irving Fisher called it, “the debt-deflation cycle”. It is a very real and serious threat. It is one that precious little attention has been paid to as many economists continue to obsess about the risks of inflation. This is hardly the time to worry about future inflation. The consequences of pernicious deflation to our economy and social stability are much greater and the threat is much more imminent than the possibility and consequences of runaway inflation.

This is part 3 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 from Iron Man Records under a Creative Commons license at Flickr.com.

2008 FORECASTS –RESULTS YEAR TO DATE |

Overview

Table 1 shows the range of opinion that prevailed at the beginning of 2008 and the year-to-date results. Actual results through the October-November timeframe reflect a severe and troublesome deterioration in the performance of the U.S. and global economies coincident with the violent upheaval that swept over global financial markets beginning in mid-September. Indeed, virtually all optimism has evaporated and fears of the potential consequences of the rapidly escalating global recession abound.

The pessimistic view presented in Table 1 at the beginning of 2008 was actually not the worst view at the beginning of the year but one that reflected a mild recession scenario.

At the outset of the year I mentioned that the risks of a more severe recession developing during the year were higher than normal. I stated that factors that could lead to that outcome included a progressively worsening credit crunch, a more rapid decline in housing prices and further erosion in consumer confidence which collectively would lead to substantial pull back in consumer spending. Unfortunately, not only have all of these risks now become reality, the situation appears to be worsening by the day. Evidence is emerging that the U.S. and global economies may have fallen into a “Liquidity Trap”, an economic condition in which credit markets break down and monetary policy becomes ineffective. The last time this occurred was during the Great Depression of the 1930’s.

As I have expected since the beginning of the year, the National Bureau of Economic Research finally dated the onset of recession in the U.S. as December 2007. Initially, deterioration was gradual during the spring and early summer which emboldened the optimists.

We can now, with the benefit of knowing what has happened, say without doubt that this optimism was illusion, wishful thinking and based on precious limited critical thinking. This kind of herd mentality and bias for “feel-good” talk seems to be a natural collective human tendency. Because of this tendency we rarely attempt to study with any degree of rigor how today’s policies and decisions could lead to problems and consequences in the future. We want to believe that markets work … in recent years this belief has bordered on being religious dogma. Because we believe, we become lazy critical thinkers and collectively become blind to imbalances that are developing and may potentially induce negative outcomes. Also, because we believe, we don’t engage in any kind of contingency planning. Then, when the deluge comes, the tsunami engulfs us, we don’t have a clear understanding of why it is happening and therefore policy responses are late and often are only partially effective or ineffective because they do not target the right problems. When the history of the last few months is written there will be much to say about the failures of policy making leading up to the crisis and also how some of the ad hoc solutions in the early stages of the unraveling process were ineffective and may even have contributed, in some instances, to deepening and accelerating the process of collapse.

But, let me start, as I customarily do, with a recap of what has happened in the U.S. economy so far during 2008 by reviewing key economic indicators listed in Table 1. These data, since they are averages for all of 2008, no longer paint a very accurate picture of the severe recession we are now in. Third quarter GDP growth was revised to -0.5%, which brought the annual rate of growth over the first nine months of 2008 to 1.0%. Q4 is shaping up to be an extraordinarily negative growth quarter. Current estimates range between -4 and – 7%, which would be the worst quarterly contraction since the second quarter of 1980 when the Carter Administration’s ill-fated experiment with credit controls decimated the economy. This would reduce GDP growth to 1.0%, as conventionally measured, and to -0.8% when measured from the fourth quarter of 2007 through the fourth quarter of 2008. If that is what occurs, then my view at the beginning of 2008, while seemingly quite pessimistic, at the time will prove to optimistic. (Note: 2008 GDP forecasts in Table 1 are not measured in the conventional fashion of year over year but rather from the fourth quarter to fourth quarter, which is the method I use in my econometric model [see Table 2 below] to derive a 2008 GDP growth estimate of -0.3%., considerably worse than my forecast in Table 1 of 0.0 to 0.5% growth. On a year over year basis my model’s real GDP growth estimate converts to +1.0%. However, my model’s estimate for Q4 while pessimistic, as it projects -3.9% growth, now appears to be at the optimistic end of the emerging forecast range.)

Inflation

Core PCE inflation for 2008 should average about 1.8%, only slightly above my beginning of the year forecast. For a while it appeared that my forecast that core inflation would fall during the year was far too optimistic because I did not anticipate the short-lived but powerful commodity price bubble which totally overwhelmed gathering disinflationary forces during the first half of the year. Over the first nine months of 2008 core PCE inflation increased at an annual rate of 2.4%. However, the crash in commodity prices since mid-summer and the swoon in consumer spending since mid-September seem poised to drive core inflation to zero during the fourth quarter and annual inflation for all of 2008 to 1.8%.

Total PCE inflation peaked in July at 4.5% and declined to 3.2% in October. Because of the collapse in commodity prices and the dramatic decline in consumer spending, the descent in total PCE inflation will accelerate over the remainder of 2008 and could end the year as low as 0.0%.

Employment

Payroll employment during the first eleven months of 2008 declined an average of 178,000 per month. This far exceeds the pessimistic view, and is worse than my even more negative view of -100,000 per month. November’s payroll loss was a staggering 533,000 on top of revised losses of 403,000 to September and 320,000 in October, bringing total job losses since the onset of recession in December 2007 to 1.9 million. The continuing and enormous escalation in initial unemployment claims in recent weeks makes negative revisions to October’s and November’s payroll data highly likely and implies a loss of 300,000 or more jobs in December.

Real Consumer Income and Spending

Consumer income and spending data were distorted earlier in the year by the fiscal stimulus program. While hopes were high that the stimulus would serve to prevent recession or keep one very mild, based on subsequent events, the fiscal stimulus either had very little lasting impact or its benefits were entirely swamped by high energy and food prices followed by the stock market crash after Labor Day. Through October, real consumer income rose just 0.5% (annual rate of 0.6%) and real consumer spending actually fell 1.5% (annual rate of -1.8%). Both results are considerably worse than my forecast and the pessimistic forecast.

In November retail sales fell 1.8% from the October level and are down 6.7% from a year ago. Both of these data points are in nominal terms. This means that the collapse in retail sales is far worse when adjusted for inflation.

Given what is happening in labor markets and the extreme loss of real estate and financial asset wealth, growth in real consumer spending for all of 2008 will be extremely negative. Growth in real consumer income will be near zero and could even be slightly negative.

Saving

The saving rate averaged 1.4% during the first ten months of 2008. It averaged 0.6% during 2007. The saving rate always rises during recessions and it is following this traditional progression in the current recession. I expect the saving rate will average 1.5 to 1.6% for all of 2008, slightly lower than my forecast of 1.8%. The saving rate was 2.4% in October, so there is a reasonable chance that my end of year forecast of 2.3% could be close to the mark.

Housing prices

Based on January-September data from Case-Shiller’s 20-city housing price index, housing prices fell -12.7%, or at an annualized rate of -16.5%. The 12- month rate of decline has worsened steadily throughout the year from -10.7% in January to -17.4% in September. Prices are now down -21.8% from the July 2006 peak. The monthly Federal Housing Finance Agency (FHFA) housing purchaseonly price index has declined 7.0% over the 12 months through September 2008. The FHFA index covers only homes with prime mortgages less than $417,000. Regardless of index, the rate of housing price decline accelerated from October 2007 through September 2008. For the second year running, all forecasts of home price declines are likely to end up being too optimistic. Most analysts expect prices to fall an additional 10 to 15%.

Housing Starts

Starts fell to 791,000 in October, bringing the year-to-date average to .97 million. Starts are now down 65.2% from the January 2006 peak and are near levels that marked bottoms in previous housing recessions. However, a variety of housing data implies that starts will need to fall further before the housing market can stabilize.

Dollar

The trade-weighted value of the dollar rose 12.3% over the first ten months of 2008, or 13.4% at an annual rate. None of the beginning of the year forecasts is on the mark. The optimistic scenario with a forecast for no change in the value of the dollar is closest, but for the wrong reasons. Through the first seven months of the year the value of the dollar declined, as forecast. The reversal over the last three months has been a direct consequence of the global financial markets crisis. Until the enormous U.S. trade deficit shrinks substantially the value of the U.S. dollar will be under relentless downward pressure. This fundamental force is still very much in play but has been overwhelmed temporarily by the global financial crisis. As global deleveraging has accelerated there are only two currencies investors wish to hold – the dollar and the yen. Both currencies have appreciated against all other currencies over the last three months. Given the severity of the crisis and the fact that deleveraging still has a long way to go, it seems likely that the U.S. dollar will remain a preferred currency for the foreseeable future. This is a very unhealthy development for U.S. businesses and for U.S. exports. Since peaking in July, through October U.S. exports of goods were down 13.3%. During the same timeframe, imports of goods were down 11.3%.

Interest Rates – Short-Term Rates – Federal Funds Rate

After much talk during the middle of the year that the Fed was done cutting interest rates and would soon need to raise them to stanch the threat of inflation, the meltdown in financial markets in September forced the Fed to lower the Fed Funds rate target to 1.0%. This is the level I forecast at the beginning of the year. Increasingly, it appears that the Fed will cut this rate to 0.50% or even 0.25% at the FOMC meeting on December 17th. Already the evidence indicates that the Fed has shifted to quantitative easing. The effective Fed Funds rate has considerably below the target of 1.0% for weeks.

Interest Rates – Long-Term Rates – 10-Year Treasury Rate

Long-term Treasury rates finally dropped precipitously in the last month in one of the greatest rallies of all time. I expected the rate to average 3.4% for the year and then end the month of December at approximately 3.0%. Through November this rate averaged 3.78% and looks likely to average about 3.7% for the year. However, the December average rate should be close to 2.7%.

The commodity price bubble and inflation scare during the first half of the year delayed the decline I and others expected in long-term rates that usually occurs in the early stages of a recession. After falling below 3.5% in March during the Bear Stearn’s crisis, long-term rates rose above 4.0% during the inflation scare. Now that the inflation scare is history and the severity of the global economic downturn has been recognized, the 10-year Treasury rate has fallen precipitously. As of December 12th, the rate was 2.57%, which is 95 basis points below the November average and 125 basis points below the October average of 3.82%.

This is part 2 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.

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.

THE WAY I SEE IT |

As the nation’s credit crisis has continued to make headlines, the United States Department of Treasury has continued to develop new tools to engender confidence and strengthen liquidity in the financial system. A major new element of the government’s response is the Capital Purchase Plan, an element of the Emergency Economic Stabilization Act recently passed by Congress, by which up to $250 billion is being invested in healthy banks that form the backbone of our economy. This new capital is being provided in the form of senior preferred stock, with a coupon rate of 5 percent for the first five years, after which the rate increases to 9 percent. Warrants to purchase common stock at current prices, in an amount equal to 15 percent of the total investment, are also provided to the government. The structure of the program virtually ensures that these taxpayer funds will not constitute a “bailout,” but rather an investment that will be fully repaid by the many banks receiving this investment.

Zions Bancorporation has received a $1.4 billion allocation of this capital, providing us with an exceptionally strong capital base during a period that is shaping up to be one of the most challenging in the nation’s economic history. When combined with the nearly $300 million in new capital we raised in the third quarter, these new funds will raise our Tier 1 Capital Ratio to approximately 10.9 percent—more than 80 percent greater than the regulatory “well-capitalized” threshold.

Our participation in the Capital Purchase Plan will ensure that our balance sheet remains very strong relative to our peers, and will enable us to continue to effectively serve our customers. We expect to use the capital to support our ability to provide credit in the communities we serve. Our ability to leverage this capital and further expand our loan production will depend as well on continuing to build our deposit base and prudently underwriting and pricing credit risk. But this is a very important step forward by the government in enabling the banking industry to begin unthawing the frozen plumbing of the nation’s credit markets.

When combined with the increase through the end of 2009 in FDIC deposit insurance coverage to $250,000—with unlimited insurance coverage on noninterest bearing demand deposit accounts—the Capital Purchase Plan provides us with tremendous resources to help serve customers and increase their confidence in our banks, and in the financial system.

Harris H. Simmons is chairman, president and chief executive officer of Zions Bancorporation.

Originally published in November 2008 Zions Bancorporation News Volume 2 issue 9.