posted September 8, 2010
An Economic Crisis Balance Sheet: 2007-2010

Every spring, for the past three years, government officials and business press pundits have offered a drumbeat of selective data and declarations that the recession has turned the corner. Light at the end of the economic crisis tunnel is at last growing brighter, we’ve been repeatedly told. And every year they’ve been wrong.

In April 2008, immediately following the collapse of the investment bank, Bear Stearns, CEOs of the major banks trotted out in coordinated press conferences proclaiming the worst was over. Many of them would be gone before the year’s end. Thereafter, in April 2009, proclamations by Obama administration chief economic advisor, Larry Summers, Treasury Secretary Tim Geithner, and President Obama himself, assured the public that the administration’s $787 billion fiscal stimulus bill, together with measures to bailout the banks , would ‘create millions of jobs’ and ‘get credit flowing again’. But neither jobs nor credit followed. Total jobless, measured by the Department of Labor’s ‘U-6’ unemployment rate, the most comprehensive indicator of joblessness, rose from 15.4% in April 2009 to 16.5% a year later. At the same time total bank lending in the U.S. declined by 10% throughout 2009 and another 3.25% in the first three months of 2010.

This past spring 2010 once again the hype of emerging recovery was fed to the public. According to Summers, the recovery was well underway and was “more vigorous than was common in such crises?. The U.S. economy was now “moving toward escape velocity? that would “result in increased job creation?. Evidence cited in support included a nascent rebound of manufacturing and exports, plus net new job creation since January 2010. A ‘V-shaped’ (i.e. a rapid bounceback) sustained recovery was finally underway. Yet no such sustained recovery has been evident, as the facts below will shortly reveal.

Such perennial premature proclamations have all proven wrong! To understand why, it is necessary understand the recent three year-long crisis within a broader general context—a crisis that has been morphing across sectors and geographically and is still very much continuing. In fact, most released economic data for May-June 2010 point to the U.S. and other global economies once again either slowing, or about to slow, while global financial instability is growing worse once more.

Over the past three years two broad trajectories within the current crisis have been apparent. The first from August 2007 to roughly June 2009 represents a period of accelerating economic contraction, marked by several major financial instability events and a concurrent, steep decline in the real economy. The second, from June 2009 to June 2010 is a period of leveling off after the sharp decline, characterized by a weak, partial, ‘recovery’ with little evidence of sustainability. The key question is whether the next period, commencing in late 2010 or early 2011 will more resemble the second, with continued relative stagnation, marked by brief, weak upturns, and relapses—i.e. a ‘W-shape’ (double dip recession) trajectory. Or whether the next period will resume a phase more like the first, with renewed financial instability events and subsequent deeper real economic declines.

As part of a ‘balance sheet’ general assessment of the past three years, what follows will first summarize the first two periods encompassing the past three years. Both periods are now part of the historical record. The balance sheet will then note the various negative forces today, mid-2010, contributing to continued economic stagnation and raising the potential for a possible economic relapse and renewed economic decline. The important question is whether, ‘on balance’, the economy will continue to drift over the next 24 months, with no sustained recovery emerging. Or whether it will turn much worse again, with renewed financial crises erupting and a resumption of a steep real economic contraction once again. Or, to use an alternative alphabet description, will the future economic trajectory resemble a ‘W-shape’, and double dip? Become a ‘U-shape’ characterizing class depressions? Or will it resemble, after three years of waiting, a ‘V-shape’ rapid recovery.

Initial Contraction and Accelerating Collapse: August 2007-April 2009

August 2010 marks the third year of the economic crisis since its initial eruption in early August 2007, precipitated by the collapse of housing and the subprime mortgage market. In a matter of weeks that financial implosion quickly spread to the unregulated ‘shadow’ banking system of unregulated and highly speculative hedge funds, investment banks, private equity firms, finance companies, etc. Within a few months it thereafter infected in turn the commercial banks (e.g. Chase, Citigroup, Bank of America, etc.), which after decades of deregulation from Reagan to George W. Bush had become tightly integrated with the unregulated shadow banking sector. By December 2007 Commercial banks had virtually stopped lending, even to each other. By year end 2008 the entire financial system was in effect freezing up. Nothing remotely close to that had happened before, at least not since the 1930s.

However, at year end the system had not yet entered a panic phase. Banks were becoming increasingly insolvent (i.e. technically bankrupt), but had not yet begun to collapse. Bank insolvency deepened throughout the first half of 2008, as financial institutions became increasingly ‘fragile’—as their assets plunged in value, bad debts mounted, losses grew, and income and inflows of capital contracted. In other words, financial fragility deteriorated, as the bank losses and debt rose and revenue and capital inflows necessary to cover that rising debt fell. Eventually that growing fragility would ‘fracture’ at some point, precipitating a broad based financial collapse and panic. By mid-year 2008 that is exactly what began to happen.

Unlike prior post-1945 ‘normal’ recessions, the current crisis has been clearly precipitated by financial instability worsening in several stages. First the mortgage markets imploded. Then the instability spread to other financial sectors. Eventually, after a period of gestation behind the scenes (first half 2008) the crisis erupted once again in a broader, deeper and more generalized form. In other words, financial crises occur in stages or phases, with periods in between in which it may not be apparent the instability and fragility is actually deteriorating further. Thus far there have been two clear such instability events: the initial mortgage bust and the banking panic of 2008. The important question for the present is how much the Euro ‘sovereign debt’ crisis now unfolding will eventually impact the Euro banks, and in turn US banks, thus precipitating a third global financial instability event followed by a new round of real economic contraction.

The initial financial instability eruption that occurred in the form of the subprime mortgage bust and its spread to other financial sectors in 2007 soon precipitated a corresponding decline of the ‘real’ (non-financial sectors) economy. By December 2007 the real economy in the U.S. rapidly slid into recession, followed soon after by most of the advanced economies of Europe, Japan, and elsewhere. Thus, unlike ‘normal’ recessions, the crisis was synchronizing globally by 2008. Moreover, financial instability the real economy were also becoming more interdependent, with each feeding off the other. That too was unique compared to prior ‘normal’ recessions. Both the financial and the non-financial, real economy were becoming increasingly fragile—with fragility on the real side of the economy expressed in terms of consumption as two-thirds of consumers’ incomes stagnated while their debt levels rose.

By the late summer 2008 the crisis shifted to a new, even more serious phase, leading to the well-known collapse of major financial institutions like Lehman Brothers, AIG, Merrill Lynch, and the effective insolvency of banking giants like Citigroup and Bank of America. With the ‘banking panic of September-October 2008’ financial fragility had clearly ‘fractured’. That deeper financial decline provoked an accelerated decline of the real economy within just a few weeks. Industrial production and business spending nearly shut down in the closing months of 2008. Lending by virtually all sectors of financial institutions dried up. Non-financial businesses rushed to cancel new investment plans, suspend investment projects in progress, and dramatically cut back even current production. Mass layoffs of a dimension not seen since the 1930s immediately followed in October-November 2008, at a rate of one million a month or more from November through April 2009—a rate of job loss that exactly tracked the collapse of jobs between 1929 and 1931. Six million were laid off in a matter of six months. To the six million were added an additional 7 million reduced from full time to part time employment. Millions more thrust into ‘discouraged’ status and forced to leave the labor force. Millions more of the employed were experiencing foreclosure on their homes. And tens of millions were experiencing collapse of retirement funds and housing values. After a quarter century of virtual stagnation of real weekly earnings for a hundred million workers in the U.S., and thus growing long term consumption fragility, after November 2008 consumption fragility also ‘fractured’ concurrently with financial fragility in the banking system. Never before had both occurred more or less concurrently—at least not sense 1929-30, or before that in 1907-08.

Throughout 2008 the Federal Reserve under its chairman, Ben Bernanke, was late to respond and fell consistently behind the crisis curve. Treasury Secretary, Henry Paulson, performed even worse. He sat on the sidelines until the summer of 2008, allowing the Federal Reserve to expend nearly its entire available $900 billion of funds on hand bailing out the investment bank, Bear Stearns, rescuing foreign bond holders and banks, and pumping free, no interest, dollars into financial institutions that increasingly were becoming technically insolvent—i.e. their losses were exceeding their assets. And the losses were growing faster than even the Fed could offset with money injections.

Even more behind the crisis curve, trying to catch up with events, was the U.S. Congress under Bush. It passed a paltry $168 ‘stimulus’ bill that was mostly composed of business tax cuts. That stimulus had virtually no effect on the deepening decline of the U.S. economy.

Paulson was finally forced to act in mid-summer 2008 with the imminent collapse of the quasi-government housing mortgage agencies, Fannie Mae and Freddie Mac, that were collapsing under the weight of having to take on the bad mortgage loans of the private sector lenders. Paulson bungled that as well, and was forced eventually to intervene with $200 billion in July to assure foreign bond holders in Fannie/Freddie the US government would not let them fail. If it hadn’t, the continued purchase of U.S. bonds by foreign investors and banks would likely have plummeted. Paulson allowed Fannie/Freddie common stockholders, however, to bear the brunt of losses, as Fannie-Freddie stock was also driven to near zero by short-sellers and other speculators.

Following the temporary bailout of Fannie/Freddie, Paulson then shot himself in the other foot by refusing to bail out either bond or stockholders at the investment bank, Lehman Brothers, the main competitor to Paulson’s own company, Goldman Sachs, where he was once CEO. Lehman collapsed, followed quickly by a string of others, precipitating the ‘banking panic of 2008’. At that point, the economy crossed the economic rubicon from ‘normal’ to Epic Recession, with mass layoffs, a collapse of production and investment, and a freefall in U.S. gross domestic product (GDP) not witnessed since the 1930s.

Most of the big 19 banks were technically insolvent by October 2008. Paulson’s answer was to browbeat Congress into giving him a $700 billion check called TARP (term asset relief program) to ‘buy the bad assets’ from the banks, thereby releasing reserves for them to lend to ‘get credit flowing again’. But the banks refused to sell except at inflated prices, not at the real collapsed market values of the bad assets. But Paulson couldn’t buy at inflated market values with funds provided by Congress. So nothing happened. The bad assets remained on bank balance sheets and lending continued to freefall. For cover, Paulson threw the money around to institutions that didn’t need it often forcing them to take it. Other uses were found for the funds, such as the auto companies and their finance arms. Or the buying of insurance giant, AIG, by the government, which amounted to merely a money pass through to AIG’s biggest debtor, Goldman Sachs, Paulson’s old company.

Much attention has been given to TARP and the $700 billion. But TARP was just a minor backstory. The real plot and real money spigot involved the Federal Reserve. Bernanke’s Federal Reserve didn’t need Congress’s appropriation and money. It could print its own if needed. Moreover, it didn’t have to tell Congress a thing about how it dispensed its bailout funds, to whom, on which terms, etc. The Fed threw more than $3 trillion at the banks, essentially giving them free money at near zero interest rates. In fact, it actually paid them to take the money by paying them interest on the money it gave them when the banks deposited the funds back with the Federal Reserve. Of course, the banks took the ‘free money’. Both the big 19 ‘name’ banks, as well as thousands of the remaining 8000 regional-community banks. So did many of the unregulated ‘shadow’ banks like market funds, finance companies, insurance companies. But they didn’t lend to businesses in the U.S., to create real products and jobs. Instead they lent to other hedge funds and shadow banks that speculated in foreign currency, offshore real estate, commodities, gold, emerging market funds, and the like. The business press calls it euphemistically ‘trading’. In fact it is ‘financial speculation’—practices that created much of the current financial instability in the first place. The arrangement did result in rising profits for banks, which in turn drew in more investors buying bank stocks. Those profits and bank stock appreciation were sufficient to just about offset half of the bad assets and debts remaining on bank balance sheets. By the end of 2009 banks would accumulate about $1 trillion in cash and sit on it, except for speculative investing forays offshore.

Key Conclusions First 18 Months

Key conclusions from the first eighteen months of the crisis are as follows:

First, normal fiscal and monetary policies designed to engineer a recovery from ‘normal’ recessions have little effect on ‘epic’ recessions characterized by multiple financial instability events, deep and long credit contractions, and where financial and consumption fragility have deteriorated severely.

Second, leaving bank bad assets on bank balance sheets, and offsetting the values of those assets by temporary massive, trillion dollar money injections by the Fed and Treasury, only partially stabilizes the banking system. The trillions of bad assets remain, representing a potential serious future source of financial instability.

Bailing out the banking system cannot generate a sustained recovery of the real economy. It may prevent a further immediate collapse, but cannot generate real recovery. Only massive fiscal spending on job producing investment can produce sustained recovery.

Fourth, not only was the level of financial fragility high on the eve of August 2007, it grew worse over the downturn, and it still has not fully recovered. Consumption fragility was similarly severe by August 2007 after decades of real income stagnation. It has further deteriorated since 2007 as a consequence of mass layoffs, chronic high and long unemployment, high rates of home foreclosures and delinquencies, and multiple other factors.

The fiscal stimulus of 2008 represented a token attempt, with virtually no prospect of success, at generating economic recovery at any time during 2008. It was mostly free tax cut handouts to business and a one time consumer tax rebate, little of which was actually spent. For fiscal stimulus to play an effective role in recovery its magnitude must be twenty times that which occurred in 2008. In addition, its composition must target immediate job creation and the alleviation of longer term consumption fragility.

From Collapse to Stagnation: April 2009-June 2010

During the first six months of Obama’s term the economy continued to decline. As late as June 2009 the economy was still losing 500,000 jobs a month. The two key measures proposed by the early Obama administration to engineer recovery was the $787 billion stimulus package of spending and tax cuts, roughly half each. And a series of three banking stabilization measures mentioned previously: the PIPP, TALF and HAMP. The PIPP was merely TARP warmed over. It too, like TARP, proposed the government assist the removal of bad assets clogging bank balance sheets. Unlike TARP, the government would not buy the assets directly, but subsidize buyers and sellers market prices for the assets. But neither banks nor investors rose to the occasion. Banks still did not want to sell at below inflated prices; and investors didn’t want to buy risky assets, often worth a tenth of their original value, above the deflated true market price. PIPP was dead on arrival and dismantled within months. Similarly, TALF was designed to subsidize investors to buy up the bad ‘securitized’ mortgage, consumer credit, auto and student loans. But again few takers. It was largely dismantled by the FED within months. Finally, HAMP was designed to subsidize mortgage lenders and servicers to entice them to offer lower mortgage rates for new home buyers. The idea was to get them to buy up the large volume of new housing inventory (thus aiding home builder companies) still on the market that couldn’t be sold due to accelerating foreclosures and excess housing supply. At merely $75 billion allocated, HAMP had little effect as well. It was given a second boost, however, with the supplemental ‘first time homebuyers’ subsidy program enacted by Congress after the passage of the original $787 stimulus..

In short, the official bank bailout programs of the Obama administration were largely programmatic cover for the real bank bailout strategy. That real strategy included Congress lifting the requirement that banks report their losses at true market value, or suspending what was called ‘mark to market’ accounting. Banks could now legally lie and misrepresent their actual losses and bad assets, making them appear more profitable. A second measure was the administration’s launching of phony bank ‘stress tests’ to make it appear the big 19 banks were in fact not insolvent. The third was the administration’s encouragement of the banks to engage once again in ‘trading’—i.e. speculative investing in offshore financial markets in order to quickly raise profits. And bank profits did rise as a result. The combination of false accounting, phony stress tests, and renewed speculation did the trick. Stockholders re-entered the market buying bank common stocks, further capitalizing bank losses. All these measures originated circa April 2009, once it became clear PIPP and TALF were essentially dead on arrival. Almost immediately bank stock prices surged. Speculative profits flowed in, enabling bank stock prices to continue to grow. This continued throughout 2009 into early 2010, when a host of events slowed bank profits accumulation and stock price gains. In the interim, however, the big 19 banks did accumulate a hoard of about $1 trillion in cash—although their bad assets, according to the International Monetary Fund, still amounted to about twice that amount. Further banking collapse had been avoided, but at the cost of more than $3 trillions in loans and spending by the Fed, the FDIC, and other government bank bailout agencies. The ‘bad assets’ had been offset, at least temporarily. But at the cost of a corresponding increase in ‘bad assets’ on the public balance sheet of the U.S. government.

On the fiscal side, the Obama $787 official package of spending and tax cuts was even less successful. Half of it was comprised of tax cuts, mostly targeting business, and nearly all of which had little immediate impact over the next eighteen months. On the spending side, the remaining $400 billion or so was not designed to create jobs. The stimulus was primarily designed to offset the growing consumption collapse by spending on extended unemployment insurance, subsidizing medical insurance premiums for the millions more newly unemployed, plugging up state and local governments massive loss of tax revenues due to the deep recession, providing aid to schools, and a one time $250 check to social security recipients.

While useful measures in the very short run, these programs did not generate jobs and more than did the business tax cuts. They were very short run and in effect represent another important aspect of the Obama general recovery strategy: namely, just as that strategy focused on ‘putting a floor’ under the banking collapse by providing trillion dollar free money injections to banks, the Obama fiscal strategy focused on ‘putting a floor’ under the consumption collapse. The fundamental, and faulty, logic behind the Obama recovery strategy in both its monetary and fiscal dimensions was that putting a floor under the banking collapse would result within months in banks lending again. Business would then start investing and adding jobs. In other words, it was a completely ‘free market’ approach to ending the crisis. The Obama strategy was never to create jobs directly, but to buy time for the markets to recover to do the task. But as noted previously, the banks did not lend. Business did not invest—at least not in the U.S. And giving money to unemployed, local government, schools and retirees did not create jobs.

The modest economic growth that has occurred after mid-year 2009 has been due to three factors unrelated to either the Obama bank bailout or the $787 billion stimulus. As analyses now show, growth has been largely the result of one time ‘shot in the arm’ programs like ‘cash for clunkers’ and ‘first time homebuyers’ subsidy’ passed by Congress after stimulus and bank bailout. It has been due to technical factors involving business inventory adjustments. And to a surge in exports and manufacturing driven by the rapid recovery of economies and markets offshore, notably in China, Brazil, and elsewhere in Asia, and by a relative fall in the value of the U.S. dollar making US exports temporarily more competitive.

Dissecting GDP and Faltering Economic Recovery

For example, in the third quarter of 2009 the first positive growth of Gross Domestic Product (GDP) occurred, at a 3.5% rate. However, almost all of that growth was the consequence of the two programs, ‘cash for and ‘first time homebuyers’ mentioned previously plus a slowdown in the rate of inventory depletion compared to the previous quarter, which gets recorded as a technical ‘growth’ in GDP. The first two programs accounted for nearly two-thirds of the 3.5% and inventory technicalities just under another third. In other words, the $787 stimulus accounted for less than .5% of the 3.5%.

In the fourth quarter, GDP surged even more, at 5.7%. But 3.5% of that was technical inventory adjustment. Another .5% due to manufactured export surge driven by Asia and Europe demand for US products now more competitive as the dollar declined. Another 1% due to the twin supplemental programs. Leaving less than 1% due to the original stimulus.

In the first quarter of 2010, GDP began to falter after only two quarters, to 3.0%. This abruptly reversal was significant. In normal recessions, for example, GDP growth continues to accelerate beyond two quarters and at levels far higher than what has been occurring this time. Typically, GDP growth surges at quarterly rates of 8%-9% for at least four quarters. Moreover, 1.6% or more than half of the 3.0% gain was again due to inventory change. Another .75% due to ‘cash for clunkers’ boosted by its announced discontinuation at quarter’s end. And a similar surge in ‘first time homebuyers’ also anticipated for ending at the time. The remainder first quarter growth was due to exports-manufacturing, driven by foreign factors once again. Data for the second quarter of 2010 is not yet available but may well show a further slowing in GDP growth rates.

The point of the above data is twofold. First, what growth and economic recovery has occurred since mid-2009 has been driven by temporary programs, temporary adjustment factors, and exports. The $787 billion has had little effect due to its poor composition of spending, excessive business tax focus, and insufficient magnitude. Second, the temporary factors driving the last twelve months of tepid growth have come or are about to come to an end. As of June 2010, both the ‘cash for clunkers’ and ‘first time homebuyers’ programs have been suspended. Both the auto sales and housing construction blip likely only pulled future sales into the present, rather than generated net additional long term output. The technicalities of inventory adjustment have all taken place. And the export-manufacturing mini-surge is about to end, as China, Brazil and other countries have recently moved to cool off their economies and as the dollar rises against the Euro and export sales to Europe consequently fade. In addition to all that, what minor contribution the Obama stimulus package provide to growth is fading as the economy enters the second half of 2010. Finally, the Federal Reserve is additionally preparing to raise interest rates once the November elections are over, and will no longer buy back trillions in bad mortgages.

Given the obvious dissipation of the various factors responsible for the past year’s weak economic growth, it is reasonable to ask where then is the continued growth to come from after the November 2010 elections? It is growing increasingly clear that the ‘deficit cutting hawks’ are gaining momentum in Congress. So little in the way of further federal stimulus spending will thus likely occur in what remains of election year 2010. States, cities and school districts will turn to massive layoffs, wage cutting, and local tax hikes as a consequence—all of which will impose further pressure on an already slowing economy. Should Democrats lose further seats in the House and Senate, a highly likely event, federal spending will be almost certainly further reduced in 2011. Even extending unemployment benefits has run into trouble at mid-2010, and both parties in Congress have already agreed that the unemployed will no longer have their medical insurance premiums subsidized by government spending.

The Truth About Jobs

Perhaps the best indicator of the faltering ‘recovery’ is the jobs numbers since January 2010. Much has been said about the economy having ‘turned the corner’ based on an alleged positive upturn in job creation. But a closer look behind the numbers reveals a quite different picture. For example, since January a total of 575,000 federal jobs have been created. But 574,000 of these have been temporary federal census workers, who will be rapidly laid off in the fourth quarter of 2010. In addition, state and local governments have shed 81,000 jobs through May 2010. In the private sector of the economy, of the 495,000 jobs added, a total of 468,000 were involuntary part time workers. At the same time hundreds of thousands of full time permanent jobs have been eliminated. The picture is one of a heavy ‘churning’ of jobs, from regular full time to temporary and part time, the latter of which are paid far less and with few benefits, thus adding to downward pressure on consumption already increasingly fragile.

Today’s duration of unemployment has continued to rise, on a base already that is the worst since records were first kept of the statistic. There are reportedly six workers for every job opening. One in four workers in the US labor force has experienced some period of unemployment since the crisis began, also an unprecedented figure. The true total jobless, when properly calculated are between 23-25 million, not the official 15 million. And these don’t account for the tens of millions of inner city youth, undocumented, and itinerant workers who are never interviewed by the Labor Dept. in its estimating of unemployment rates. These groups no doubt suffer from an even higher jobless rate. The true level of jobless workers is thus likely in excess of 25 million and the true, effective unemployment rate between 18%-19%. To recover the jobs lost since the current recession began in December 2007 would require hiring more than 300,000 workers every month from now until 2017.

These broad data for GDP and jobs do not point toward a sustained ‘V-shape’ recovery and in fact strongly suggest a ‘W-shape’, double dip recession may be on the horizon following the November 2010 elections. This likely outcome has been corroborated in recent months by a host of additional economic indicators, apart from GDP and Jobs, that point to a continued slowing of growth and a faltering recovery once again—i.e. a trajectory typical of a ‘Type I’ epic recession this writer has described elsewhere. for example, housing construction has once again fallen back with the ending of ‘first time homebuyers’ and housing prices are predicted to fall by even mainstream economists as foreclosures and mortgage delinquencies rise. Retail sales fell in May 2010 for the first time since September 2009. Auto sales have peaked. And even manufacturing has begun slowing in various parts of the country. A further general indicator of a weakening economy is prices.

Key Conclusions Second 18 Months

Some key conclusions from the second eighteen months of the recent crisis are:

First, he Obama administration’s bank bailout strategy was in essence no different than Bush’s, with the exception even more money was thrown at the banks on even more generous terms. Trillions of dollars of bad assets still remain on bank balance sheets, threatening future instability.

Second, despite massive injections of money and liquidity by the Federal Reserve, banks have continued to reduce lending, and to small and medium sized businesses in particular. Obama’s primary focus on getting ‘credit flowing again’ has not produced its declared, intended results.

Third, once again under Obama, as under Bush, bailing out the banks and ‘putting a floor’ under the banking system collapse, is not sufficient to generate a sustained recovery from an epic recession. Massive fiscal spending is required.

Fourth, the Obama strategy in retrospect was to subsidize banks, subsidize state and local government, and the unemployed. A short term strategy of staving off further collapse, it looked to and relied upon market forces to generate sustained recovery. The markets have failed to do so.

Fifth, fiscal spending must target public investment and direct job creation by the government. The Obama stimulus package’s magnitude of spending was only around $400 billion, while the composition of that spending had little to do with job creation. . Between $1 to $2 trillion in job spending is necessary to break out from long term stagnation.

It appears the Obama focus on allowing banks to return to speculative activity to generate capital and profits to offset losses has gone as far as possible, with bank stock prices and profits now flattening once again and more than half of bad assets and losses still remaining on bank balance sheets. Similarly, it appears the strategy of relying ultimately on bank lending to generate sustained GDP and job creation has begun to dissipate as well. Prospects for continued, let alone accelerating, GDP growth appear increasingly limited for the remainder of 2010 and 2011.

Threats to Recovery in 2010 and Beyond

The longer run scenario for the U.S. economy is not particularly positive. Jobs and housing continue to represent a serious problem for the economy, and appear to be heading for further softening rather than recovery. 25 million jobless and 7 million foreclosures represent a serious deterioration of consumption fragility in the system.
And those two figures do not tell the full story of jobs and housing’s negative impact on consumption and the economy. The hiring that has occurred has been at lower pay and fewer benefits levels. Higher paid full time jobs continue to disappear at the rate of tens and hundreds of thousands a month. Mass layoffs will soon hit the public employee sector in 2011, adding still further to the job losses at a time when the 600,000 plus temporary government census workers will have also just been laid off in late 2010.

Wage cutting via furloughs, benefit cuts, shorter workweeks, and lower entry pay have also been reducing the consumption base still further. Housing construction and sales, already off 75% from pre-crisis highs in 2006, have begun to weaken once again and home prices are predicted to fall a further 10%-20% in the period ahead. Foreclosures are also forecast to rise further. One in five mortgages will foreclose or default in the current cycle, and between 30%-40% home values are already ‘under water’. This is not a scenario for positive consumption growth or sustainable economic recovery.

States and cities in the U.S. are simultaneously facing a growing fiscal crisis. It has already become a major problem restraining recovery over the preceding year. Over the past year reductions in state and local government spending more than offset the amount of the Obama fiscal stimulus. Little attention has been given to that fact or the full dimension of the local government fiscal crisis. And that crisis will further worsen in the year ahead, as it appears that federal subsidies to the states will not continue as deficit cutting becomes the mantra of politicians at the federal level. Local government will be forced to raise taxes still further, as it lays off hundreds of thousands at minimum and reduces pay and benefits for millions more. To complicate local government financial stress further, signs of trouble have begun to reappear anew in the municipal bond markets. Should a crisis re-emerge here, the fiscal crisis, layoffs and tax hikes by state and local government will intensify several fold.

The slowdown in government spending at all levels, within a context of further housing deterioration, job losses, and wage decline is not a scenario for robust recovery. It is impossible to imagine a ‘V-shape’ trajectory with just these three—jobs, housing, government spending—thus deteriorating further.

The private sector shows additional signs of growing weakness as well. Most notable, the U.S. manufacturing-export sector’s recent modest revival we predict will likely fade as well in the coming months. This is due to three factors: China and other Asian economies slowing as policy makers try to cool off growing bubbles in real estate and stocks, which will slow demand for U.S. exports. And the falling Euro against the U.S. dollar will make U.S. exports more expensive, leading to Germany and other economies displacing U.S. export sales.

Despite the multi-trillion dollar bailout of the banks and the apparent checking of further financial fragility, there remain serious points of stress on the financial side as well as a growing risk of further financial instability in the future.

As noted above, the big 19 banks have raised profits and capitalization offsetting approximately half of their losses. This has been done by a combination of accounting changes, stock price appreciation, and speculation-driven profit gains. But all these factors are in retreat as of mid-2010. Bank stocks are falling, profits leveling off, and should financial regulation legislation in Congress prohibit banks from ‘trading’ with hedge funds and other conduits to speculative markets, then bank profits and stock prices will decline sharply in the year ahead.

Bank lending thus far shows no sign of a major pickup for small-medium US-based businesses, despite direct pleas by Obama and Fed chairman, Bernanke. Banks are hoarding what store of cash they have on hand, uncertain about future bank regulation, bank taxes, US and global mandated increased reserve requirements, and other developments—all of which will impact profits and lending. The outlook therefore for bank lending to turn around is low.

The second tier of 7800 regional-community banks is in even worse shape. Close to 300 have already failed or been merged by the FDIC, whose funds for future consolidation of local banks will require hundreds of billions $ more. The commercial property market, on which these banks depend heavily, shows few signs of recovery. Like residential housing, it too remains in a bona fide depression state. 795 tier two banks remain on the FDIC’s trouble list and at risk of collapse or merger.

The Fed has been completely unable to revive the securitized markets for commercial and residential mortgages, which only a few years ago amounted to nearly $2 trillion and today account for less than $100 billion in loans. To complicate the mortgage picture further, the quasi-government agencies, Fannie Mae and Freddie Mac, which are required to buy up bad mortgages by law, are themselves moving toward a further financial crisis. Already having been subsidized by $200 billion by the U.S. government, they will soon need another $200 billion to keep going.

Even Hedge Funds and other shadow banks, that had enjoyed a significant recovery in 2009, are now showing signs of difficulty. Having lost $700 billion during the 2008-09 financial implosion, the funds had recovered more than half of that loss last year. In 2010 however losses have once again returned.

But the biggest risk to financial fragility and instability is the potential impact of government debt crises beginning to appear in Europe at mid-year, and the likely impact on Euro bank losses and, in turn further, on U.S. banks in the months ahead. Globally bank exposures to potential losses in the European periphery countries of Greece, Spain, Portugal, and Ireland at mid-year amount to $2.6 trillion, according to data released in June by the Bank for International Settlements—i.e. the bank for central banks—located in Switzerland. European banks are exposed to $1.7 of the $2.6 trillion. It is likely that U.S. banks account for at least $500 billion of the remaining amount. French and German banks alone are exposed to more than $950 billion of the debt of those four countries. And that does not include other countries in trouble, like Italy, Hungary, and elsewhere in Europe. The potential and risk is likely even much higher than reported. Spain alone may have $1.5 trillion in debt, much of which is at risk. Given this major scenario of financial fragility and pending financial instability, in a repeat of the U.S. in 2007-08 European banks have begun to stop lending to each other. Should a chain reaction implosion occur in Europe, sovereign debt losses promise to cascade to Euro bank losses and to U.S. banks as well. The third global financial implosion will consequently follow. The effects of that on the real economy globally, and in the U.S., will be significant.

In conclusion, it is clear that finance and consumption in the U.S. is still quite fragile and could ‘fracture’ once again in the months immediately ahead. That would precipitate a still further contraction of the real economy. The real data behind the alleged economic ‘recovery’ of 2009-10 reveal an economy not in any way on the road to a ‘V-shape’ trajectory. On the contrary, the risks of a ‘W-shape’ and typical Type I ‘epic’ recession characterized by relative stagnation for years is more likely. And should another global financial implosion occur, whether in or outside the U.S., then that trajectory could very well deteriorate further to a ‘U-shape’ and bona fide global depression condition.

Jack Rasmus
June 2010

Jack is the author of the May 2010 released book, Epic Recession: Prelude to Global Depression, Palgrave-Macmillan and Pluto Press.

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