In the June 2008 issue of this publication the idea of an Epic Recession was introduced to explain the historically unique and extraordinary character of the current economic crisis. The crisis that began emerging in the real economy last spring—set in motion by protracted financial instability over the preceding year, 2007-08—was described as ‘epic’ as a way of differentiating it from typical postwar recessions as well as from classic global depressions. Epic recession, it was noted, shared elements of both typical recession and classic depression. Epic recession was an unstable, hybrid condition that could not be sustained, but would inevitably revert back to a ‘normal’ recession, or else continue to evolve further toward global depression. Not least, typical fiscal and monetary policies designed to contain normal recessions prove largely ineffective in the case of Epic Recessions.
Events and conditions since June 2008 have increasingly confirmed the prediction the U.S. economy was headed toward a recession of ‘epic’ dimensions. All but one of the eight predictions made at the conclusion of the earlier June article have since been confirmed. Conditions since June 2008 have deteriorated significantly. Financial instability events continue to multiply and occur with ever-greater magnitude, despite the literal several trillions of dollars thrown at it in the last six months by Treasury Secretary, Henry Paulson, and Federal Reserve Bank chairman, Ben Bernanke, while the real, non-financial economy continues its descent toward a potentially deep and long downturn in the U.S. and globally as well.
Sometime in 2009 the US economy will reach a tipping point in terms of Epic Recession. By the end of 2009 it will be clear whether the economy’s path is toward containment and reversion back to a ‘normal’ recession, or whether the downturn will continue to accelerate toward a deeper contraction, financial and real, and a bona fide classic depression event.
A major factor determining the economic trajectory will be the fiscal policies adopted by the new Obama administration in 2009. Will fiscal policies—i.e. government spending, tax, and related industrial policies—be ‘too little too late’, as has been the case for both monetary policy and Bush-Congressional policies from mid-2007 through 2008?
Will the Obama and the Democratic Congress employ strategies best describable as ‘Clintonomics II’. That is, essentially the same policies as did Clinton and his Treasury Secretary, Robert Rubin, in the 1990s—albeit perhaps with a somewhat more vigorous approach to deficit spending. Or will Obama, his economic team of Clinton-era economic ‘retreads’, and the new Congress for the first time attempt to get ahead of the crisis curve by breaking new policy ground by fundamentally restructuring the economic system. To put it another way, will Obama and the Democrats see the current crisis as just a more intense repeat of 1993? Or as a potential 1933?
In a number of ways the current financial and economic crisis is similar to conditions and events circa 1930-31. That earlier period too might have been defined as ‘epic recession’, i.e. clearly not a typical recession and not yet inevitably a depression but nonetheless evolving from the former to the latter.
A Short History of the Banking Panic of 2008
In acts of increasing desperation, in the course of just three months, since early September 2008, Treasury Secretary Paulson and Federal Reserve Chairman, Ben Bernanke, have thrown more than $3 trillion of bailout money at banks and financial institutions—with virtually no effect. Credit markets still remain largely frozen. Long term interest and mortgage rates have declined less than a half percent. Housing, stock, and other asset prices continue to plummet, producing deepening losses, requiring further write downs on balance sheets, and provoking the likelihood of widespread business and consumer defaults in the months immediately ahead.
Despite having received historic amounts of cash injection from the Treasury and Federal Reserve, most banks still refuse to loan at reasonable rates, or even loan at all, in particular to homeowners, small businesses, consumers and increasingly to business in general. Credit not merely contracted, it crashed. Bankers have simply taken and pocketed the trillions, used the money to buy other competitors, or have simply just sat on it, i.e. hoarded it. This amazing response by banks and financial institutions to government efforts to provide liquidity, to refloat their technically bankrupt balance sheets, can only be described as nothing less than a ‘bankers strike’. Yet the response of Paulson-Bernanke has been to reward banks with literally trillions more taxpayer money.
During the initial year of the financial crisis, from July 2007 through June 2008, Paulson-Bernanke pumped more than $600 billion into the banks to get them to open up and loan once again to business and consumers—to no avail. But that paled compared to what was yet to come. By early September, another $200 billion was put up by the Treasury to bailout the quasi-government agencies, Fannie Mae and Freddie Mac; that was followed in turn by $150 billion for the investment giant, AIG, and thereafter in a matter of days by the $700 billion blank check written by Congress to Paulson, called the ‘Temporary Asset Relief Program’ (TARP) designed by the Treasury for the purpose of buying up toxic bank assets.
Paulson panicked Congress with warnings the economic sky would fall in without the $700 billion, an amount that, he declared, would also resolve the financial crisis once and for all. But neither happened: the sky didn’t fall; the financial crisis didn’t end. What did happen is that banks continued to refuse to lend despite the more than trillion dollar infusion. The ink was hardly dry on the $700 billion TARP check, when the following Monday research departments of the JP Morgan Chase bank and Bank of America estimated that $1.7 and $1.83 trillion, respectively, would be needed by banks in bailout funding.
Meanwhile, while Paulson at Treasury was acquiring his trillion for bailouts, Fed Chairman, Bernanke, was simultaneously busy in September-October disbursing his own trillion of still additional taxpayer dollars to foreign banks; to non-banks to buy up their commercial paper; to money market mutual funds to offset their outflows; and in November allotting another $320 billion to Citigroup—a company with $1.2 trillion in off balance sheet liabilities and thus technically bankrupt by any reasonable financial measure.
To top it off, to make doubly certain bankers and friends had more than sufficient funding, Bernanke committed yet another $800 billion at the end of November. In short, in a 90 day period just about $3 trillion was allotted or committed, about $1 trillion a month! In exchange for all that, 30 year fixed mortgage rates at the end of November had fallen to 5.97% compared to 6.1% a year earlier. The bankers strike continued.
The $3 trillion handout thus hardly budged bankers and buddies to loosen up and lend to homeowners or housing markets. Already progressively contracting for months prior to September-October, a similar drying up and tightening of credit deepened for businesses across the board after September. Mass layoffs doubled over the year previous. Consumer spending literally fell off a cliff. Business spending on new plant and equipment froze. The U.S. economy shifted gear, passed a point of no return, and began to descend even more rapidly toward the unique condition called Epic Recession.
To better understand the nature and characteristics of Epic Recession, and therefore what lies ahead most likely for the U.S. economy in 2009 and beyond, the following ten points provide a brief outline and description.
Ten Characteristics of Epic Recession
1. Duration: Each of the nine post-1945 recessions did not extend for more than three consecutive quarters. At the other extreme of the spectrum, depressions that occurred in the 1929-33, 1890s, 1870s and 1830s in the U.S. all lasted 36 months or more. The organization currently responsible for identifying recessions—the National Bureau of Economic Research (NBER)—this past December 1, 2008 officially declared the present recession began in the fourth quarter of 2007. That means the current recession is already longer than 12 months. The fourth quarter 2008 will undoubtedly record further economic decline, and most predictions are the economic slide will continue at least through the first half of 2009 at minimum, and quite possibly longer. That means the current downturn will last 21 months at a minimum. That’s already twice that of all prior postwar recessions—clearly qualifying as an ‘epic’ event in the ‘duration’ category.
2. Depth: There are two fundamental ways to measure ‘depth’: the decline in gross domestic product (GDP) and the rise in the level of unemployment. A number of problems exist with GDP as a measure of economic decline, in particular the way it is calculated today after decades of revisions from Reagan through GW Bush which have served to minimize GDP fluctuations. However, typical postwar recessions have been associated with drops in GDP of typically no more than 5%-6% in any of the quarters. In contrast, depressions are associated with declines in GDP equivalent statistics of more than 20%, and much more in most cases. An ‘epic’ recession would thus be accompanied by GDP declines from peak to trough between 10%-20%.
But a better measure of depth is the level of unemployment. And here the current recession is clearly now entering epic territory. In the four recessions since the mid-1970s (1974-75, 1981-82, 1990-91, 2001) the number of unemployed increased by about 3 million. But that growth in unemployed in each recession took three years to reach the 3 million additional unemployed level. The current downturn has already passed the 3 million additional unemployed mark in half the time. And at least another half million will be added to the unemployed when results for November and December 2008 are calculated.
Moreover, today’s 3 million is really 4.2 million more unemployed, if the huge increases in involuntary part time employed are counted. One of the hallmarks of the past year has been the hiring by business of more than 2.5 million involuntary part time workers, while simultaneously laying off more than two million full time employees. That means millions more full time employees are actually being ‘laid off’ and rehired as part time. Two part-time conversions should be counted as one full time layoff, but the government considers anyone working part time fully employed no matter how few hours they actually work. Thus the massive shift to part time now underway is masking and underestimating the true unemployment level by millions.
Given the rapid rise in mass layoffs and announcements in the fourth quarter of 2008, it is likely that an additional 3-4 million will lose jobs in 2009. Never before in the course of a two year period has the level of unemployed risen by 8 to 10 million, which is not only possible but likely. The true, effective unemployment rate by year end 2009 will very likely exceed 10% even according to official estimations (which would be the equivalent of 13-15% if accurately calculated). Epic recession is associated with unemployment levels of 5 million plus net increases, and double digit unemployment rates. The current downturn is well on track to attain those levels.
3. Debt: A particular characteristic of depressions is the buildup of massive levels of speculative debt just prior to the economic collapse. All the great depressions in the U.S. in the 19th century and the 1930s were associated with speculative debt excess, in particular speculation and unsustainable debt in land and housing. When the speculative bubbles burst, the economic decline occurs more rapidly and deeply than normal recessions. Typical recessions are associated with causes largely unrelated to financial and banking instability. In contrast, depressions are almost always associated with financial crises, brought on by (speculative) asset price booms and busts, especially when system wide in nature. The current recession has been associated clearly with speculative debt buildup. In that sense, the current recession looks much more like a depression event than a normal postwar recession.
For example, more than $22 trillion of the current total US $49 trillion debt (i.e. government, consumer, financial institution, and non-financial corporate combined) has been added just since 2001. The current financial crisis is due to the ‘unwinding’ of that excess debt, $18 trillion of the $22 of which is corporate (financial and non-financial) debt. The financial crisis has been particularly intractable due to the huge volume of debt unwinding that has yet to be contained despite the Treasury-Fed throwing $4 trillion to date at it. The $4 trillion is likely just half that which will eventually be required.
4. Deflation: Closely associated with the speculative driven debt, now unwinding, is deflation. That is, falling prices. In order to rid themselves of the excess debt on their balance sheets, financial, bank and non-financial corporations alike begin dumping their various debt-accumulated assets at firesale prices just to get them off their books. Or, if they are banks and have banker friends at the Treasury and Fed, they get the government to buy up their bad assets, or buy their bank preferred stock to offset the bad assets, or insure them for losses as their bad assets decline in value (the Citigroup formula). But not all asset price deflation can be contained thus. Asset prices begin to collapse, as in the housing asset market, then spread to commercial property asset markets, then to various other forms of financial assets like commercial paper, money market funds, and so on.
The great danger of deflation is that it eventually spills over from asset prices to other prices in the mainstream economy. Product or goods prices then begin to decline across the board, and as non-financial businesses face an economic crisis and start to layoff employees in mass numbers (now happening), wages begin to decline as well (wages are just prices for labor services). So deflation begins to generalize, and deflationary expectations take hold, driving down prices further.
The above scenario always occurs in depressions and never in typical recessions. During the depression of the 1930s asset prices collapse more than 50% on average, and product and wage prices by nearly as much. Deflation is not an issue in normal recessions. However, the current recession is now beginning to experience the early phases of deflation. It is already rampant in asset price markets from housing to bonds to stocks to other financial instruments, and is rapidly spilling over to product prices. Autos, consumer durable goods, home repair, commodities, ‘big box’ retail, restaurant, entertainment and personal services, are all beginning to experience deflation. On the labor markets side, wage deflation is showing up in conversion to part time employment, elimination of overtime pay, non-paid vacation plant shut downs, cuts in company contributions to 401k pensions and benefits, and even outright direct wage cuts as in the auto industry, construction, and elsewhere. In other words, the current recession shares not only the excess debt characteristic with depressions, but the consequent deflationary characteristic as well. The current epic recession will experience further deflationary pressures, but not likely as severe as that experienced during a classic depression.
5: Defaults: A consequence of the debt-deflation dynamic characteristic of depressions and epic recessions is a significant rise in corporate and consumer-homeowner defaults. Defaults occur when a company or consumer cannot ‘service’ debt payments. That is, cannot make interest payments on the debt and thereby ‘default’ due to inability to pay. Defaults result in turn in two things. First, the bank or whoever provided the loan or bond financing is forced to ‘write-down’ the value of the loan or bond, which means a loss on their own books. The asset is thereafter then sold off, at well below market prices. Consumers in default lose their home or autos. Companies in default go out of business or reorganize. All or a large part of their workforce is typically laid off, adding to the economic downturn. (Or they may then default on homes and autos in turn without jobs or income to make payments). It is estimated that 5 to 7 million homeowners will default in the current downturn—not your typical recession!. Corporate rating agencies like Standard & Poors estimate a minimum tenfold increase in corporate defaults and bankruptcies as well. Debt-deflation thus drives the defaults and the latter in turn further drive deflation and still additional losses by banks and other financial institutions. (Paulson and Bernanke then throw additional money into the growing hole in bank balance sheets, temporarily offsetting the losses but never closing the hole that continues to grow larger as housing and other asset prices continue to fall, driving further bank losses and write-downs). Like debt-deflation this third triad of defaults is also associated with depressions but not at all with typical or normal recessions. It is associated as well with the current downturn, thus characterizing the current downturn as ‘epic’ rather than a normal recession.
Some companies at present high on a list of potential defaults, and consequent bankruptcy and reorganization, include one or more of the big three auto companies, GM-Ford-Chrsyler. The latter will almost certainly default, as may GM itself failing a US direct bailout. Within 18 months there will be only one large US auto company in the US, and possibly one less Japanese company as well. Commercial building companies (malls, office buildings, hotel, builders) will experience several defaults, as will hotel chains, restaurant chains, resorts, and one or more name retail companies like a Sears or JCPenneys. Many smaller retail chains will go under, and countless small businesses. Many more will avoid default by merging with competitors (de facto default). Scores, and perhaps even hundreds, of smaller community and regional banks will go under, as may several large service companies like Sprint. These are not recession events. They are depression or depression-like ‘epic’ recession events.
6. Financial-Credit Instability: Depressions are the consequence of increasingly severe and protracted banking crises and the widespread disfunctioning of credit markets. Banking or other financial institution collapse are rarely the cause or consequence of recessions in the normal sense. Occasionally a particular bank may go bust, as was the case of Continental Illinois bank in the early 1980s. Even a credit market or two might experience severe stress, as did the Savings & Loan industry in the late 1980s, which no doubt contributed to the 1990-91 recession. But a generalized, systemic bank crisis is not a characteristic of normal recessions. In contrast, the great depression of the 1930s was directly related to a series of banking crises and panics, which followed the stock market crash of October 1929. The first bank crisis occurred in late 1930, a full year after the stock market crash. The second a year after that, in late 1931, and was more severe. Still more severe bank crises occurred in mid-1932 and then in the spring of 1933, resulting in a banking industry shutdown by the new president, Franklin Roosevelt. Each crisis was more severe. In between each, the drivers of debt-deflation and non-bank business and consumer defaults created the conditions for feedback and subsequent more serious banking losses, write-downs and financial defaults.
The U.S. economy has just experienced its first banking panic and crisis, set off by the chain of events precipitating by the near collapse of the housing giants, Fannie Mae and Freddie Mac. The forced bailout of Fannie/Freddie by the Treasury in turn set in motion the collapse of the investment bank, Lehman Brothers, and thereafter in sequence AIG, Merrill Lynch, Wachovia, Washington Mutual—the latter of which were forced into acquisition by the remaining large banks in order to prevent further defaults. The current banking panic, still running its course, is on track to precipitate spreading business and consumer defaults in 2009. Should the latter occur in sufficient number, it will lead in turn to a subsequent, more serious banking panic in late 2009 or early 2010. In short, the current ‘epic’ recession appears to be following a trajectory in some ways not unlike events of the early 1930s.
The nexus between the current banking crisis and subsequent non-bank business and consumer defaults is the sharp contraction of the credit system. During normal recessions credit contracts, causing businesses and consumers to reduce borrowing and thus spending. But the credit contraction is never so severe that businesses must dump assets at firesale prices or sell products below market prices to raise operational cash or service debt, whereas in both epic recessions and depressions that is precisely what happens. In the latter, credit does not merely contract, but may actually crash. That is, credit markets virtually shut down across the board for a period of time. Thereafter, even if resurrected, credit remains severely restricted and a vestige of what it once was. The difference between epic recession and depression in terms of financial instability, banking panics and crises, and degree of credit contraction is thus largely a matter of magnitude and degree. Banking crises occur in both, but are more frequent and severe in the case of depressions. Credit may shut down for several years in the case of depression, while weeks or months during epic recession. In normal recessions, in contrast, credit is tight and more expensive but still largely available, while multiple or systemic wide financial crises do not occur.
7: Monetary Policy: Yet another key characteristic differentiating recessions from epic recessions and depressions is the relative effectiveness of government monetary policies in containing the economic downturn. In a typical recession, traditional monetary policies by the Federal Reserve are able, with a lag, to slow and halt the contraction and re-stimulate the economy—particularly when combined with counter-cyclical fiscal policies. Monetary measures reduce short term interest rates, which eventually bring down longer term rates, that in turn stimulate investment in housing and capital equipment, generate hiring, more consumption and recovery.
In contrast, in depressions the severity of banking losses, deflation and defaults result in traditional Federal Reserve monetary measures becoming ineffective. The Fed finds itself lowering short term rates to near zero with no resulting stimulation of bank lending to businesses and consumers. Banks end up ‘hoarding’ cash. While short term rates drop to zero, long term rates (mortgages, bonds, etc.) remain at high levels—which is another way of describing credit contraction. In fact, as price deflation occurs real levels of debt actually rise, worsening the debt-deflation dynamic. Businesses are forced to pay off pre-existing debt with money that is worth less, thus creating a greater debt service stress. Monetary policy becomes essentially neutralized and ineffective. It may even become counter productive, exacerbating the situation.
In the current epic recession, the Federal Reserve, the US monetary policy authority, is approaching the threshold of ineffectiveness. Short term rates are near zero and provide no further stimulus to economic recovery. Long term rates have been largely unresponsive to the Fed’s cutting of short term rates from 5.25% to less than 1%. As of December 1, 2008, for example, 30 year mortgage rates (long term) have declined less than 0.25% compared to levels a year previous, despite the drop in the Fed’s rate and the more than $2 trillion direct injection of funds by the Fed into the banking system. The Fed’s monetary policy can only be described as a total, utter failure so far as stimulating the economic recovery is concerned. This is quite unlike past Fed and monetary policies relative success in prior recessions and economic stimulus.
8: Fiscal Policy: Defined as tax cuts and government spending, fiscal policy in past postwar recessions has often been combined with monetary policy to help restimulate recoveries. Whereas Fed policy aims at interest rate reductions as a path to stimulus, fiscal policy might supplement that with tax cuts and/or government spending programs. In all instances since 1947-49 some combination of monetary with fiscal stimulus has proved successful in generating economic recovery, although the long term trend over the postwar period has been the need for ever-increasing amounts of fiscal and monetary stimulus to generate a given recovery.
The current epic recession may prove far more intractable to fiscal stimulus than any since the 1940s. It still remains to be seen how effective fiscal policy might be in 2009, depending on the eventual Obama economic program still in development. But never before has the government had to undertake fiscal stimulus with such a large pending budget deficit. Nearly $500 billion in deficit was anticipated for 2009 and more for 2010—and that was prior to the $3 trillion handouts to banks and financial and non-financial institutions in 2008. And, of course, the fiscal stimulus plan will add further to the deficit in 2009-2010. It is largely an unknown what the consequences will be for a massive $500 billion to $1 trillion fiscal stimulus bill in early 2009, given the already anticipated $trillion dollar deficits.
In the 1930s the US government embarked upon fiscal deficit spending in the form of the Roosevelt New Deal programs. But that did not come until 1935, was not all that large in terms of government spending, and occurred when the government had no where near the deficits prior to 1935, compared to the deficit overhang it now has. Multi-trillion dollar deficits in 2009-10 may in effect result in the federal government being unable to borrow the money to finance the deficits from foreign banks, central banks, and investors—as it inevitably must—in order to finance the deficit. The US government may have to raise interest rates to do so. That will slow the economic recovery, not hasten it. It may also result in a collapse of the dollar as currency in world markets. Which brings us to yet another characteristic of epic recessions.
9. Currency Instability: Volatility and instability of exchange rates in the key currencies in world markets is another characteristic of depressions as well as epic recessions, while not a factor in normal recessions. The Great Depression of the 1930s was marked by a dramatic drop off in world trade between nations. As domestic economies declined, each responded by trying to offset domestic decline with stimulating export sales. Tariffs and quotas were used to gain an export advantage at the expense of competitors. But all could play that game and did. Competitive tariffs led not only to declining world trade but set off corresponding currency fluctuations. In normal postwar recessions current value volatility is not a factor. However, in today’s epic recession there are indications of growing currency instability among the leading global currencies: the U.S. dollar, the british pound, and the Euro. The mechanism driving the instability, however, is not competitive tariffs but rather rolling, competitive interest rate reductions. In addition, the role of interest rate derivatives and speculators appear to be exacerbating the currency fluctuations. This is very unlike a typical recession, while not as severe in its impact as currency fluctuations in response to competitive tariffs, as during the Depression.
10. Synchronized Global Downturn: Typical postwar recessions have occurred in one or a few economies at a given point in time, while other economies have continued to grow. Thus, while the US may experience a downturn, Europe or Asia may have actually been expanding. The expansion in the latter served to softened the downturn in the former, and hastened economic recovery. No such thing for a Depression event. Depressions are always global and increasingly synchronized across economies. As such, an economic slowdown in one country not only fails to dampen the downturn in another, but actually serves to exacerbate it. The economic contractions feed back on each other and accelerate and deepen.
The current recession shows signs of becoming increasingly synchronized. The US recession has clearly been followed within a matter of a few months by recession in the U.K., Germany, elsewhere in the European Union’s smaller economies, in Japan, and elsewhere. For a time, economists argued that the so-called emerging economies, in particular China and India, would continue to boom and were ‘decoupled’ from the US-Europe-Japan slowdown. China-India would consequently serve as a counterweight to the former and dampen the downturns. However, by year end 2008 it is clear no such decoupling exists. China, India, and other ‘emerging’ economies are now also rapidly slowing down and about to contract as well. The current recession, as an increasingly synchronized affair, appears more and more like a classic depression in that sense. While still in the early stages of such ‘synchornization’, the current downturn is thus ‘epic’ in character and not like a typical postwar recession.
While the current recession shares a number of qualitative characteristics with a classic 1930s-like depression, epic recession differs from the latter in terms of the relative magnitude of the Debt-Deflation and Default effects. In depressions, these are much more severe. On the other hand, the current epic downturn does nonetheless appear to share some common characteristics with a depression in terms of growing global synchronization, in currency volatility, in the degree of systemic credit contraction, as well as systemic financial-banking instability. Epic recession today also shows signs of a growing failure and ineffectiveness of monetary policy as a means to contain the crisis and to re-stimulate the economy.
There is an historical example very much like today’s epic recession. That is the U.S. economy immediately following the 1929 stock market crash but before the banking panic and crises of 1931-32. In many ways that too was an ‘epic’ recession, a very serious economic downturn, driven by debt-deflation but not yet generating the magnitude of defaults that would eventually provoke the more serious banking collapses of 1932 and 1933.
Observers and participants at that time, in late 1929 to early 1931, did not see themselves in the midst of a depression. They rather thought themselves in a serious economic contraction but one that would relatively soon be contained. They did not understand the fundamental dynamic of epic recession: an unstable, hybrid condition and state that could not be maintained as an interim condition. Rather it was a condition or state that must inevitably evolve, either reverting back to a normal recession, or else further toward the great depression of the 1930s.
In retrospect, history shows how that particular unstable state of 1930-31 eventually evolved. How the current, similar unstable state also evolves will be largely determined by government policies and events forthcoming in 2009. Much will turn on the future economic stimulus program of president-elect Obama in early 2009, as well as on the potential contradictions of that program given the already massive US budget deficits. This is new ground for fiscal policy, not even experienced in the 1930s. It remains to be seen whether fiscal policy in 2009, like monetary policy in 2008, was in effect ‘too little too late’. Or whether, given the pending massive budget deficits, it may already be ‘too late’.
To put it yet another way, much will depend whether Obama and his team of centrist advisors see the period immediately ahead as a potential 1933—or only another 1993.