[DEBATE] : (Fwd) US economy screwed for a long time (Mike Whitney)

[Patrick Bond]

counterpunch

April 9, 2009
Light at the End of the Tunnel? Wrong!
The Decade of Darkness

By MIKE WHITNEY

It's been 21 months since two Bear Stearns hedge funds defaulted, 
setting off a series of events which have led to the gravest economic 
crisis since the Great Depression. No one expected the financial 
earthquake to shake this hard or ripple this fast. The failure at Bear 
triggered a shock in the secondary market where mortgage loans are 
repackaged into securities and sold to investors. That market is now 
completely paralyzed cutting off 40 percent of funding for consumer and 
business loans and thrusting the broader economy into a deep recession. 
Banks and financial institutions have been forced to curtail their 
off-balance sheet operations and build their reserves which have 
ballooned from $45 billion to nearly $700 billion in the last 6 months 
alone. Like millions of homeowners who have seen their home equity 
vanish and their retirement savings slashed in half, the banks are 
hunkering down, hoping they can outlast the deflationary hurricane ahead.

Deteriorating economic conditions have taken their toll on consumer 
confidence and forced businesses to lay off employees that won't be 
needed during the slowdown. The system is hollow as an empty tomb with 
overcapacity. Demand is falling faster than any time since the 1930s. 
Inventories will have to be trimmed and budgets cut to muddle through 
the down-times. Foreign trade has slowed to a crawl, auto sales are down 
by 40 per cent or more, and unemployment is rising at a rate of 650,000 
per month. Policymakers have pushed through a $800 billion stimulus 
plan, but it won't be nearly enough to stop the steady rise in 
unemployment or take up the slack in an economy where industrial output 
has been cut in half, new home construction has dropped to record lows, 
and manufacturing has fallen off the cliff. Economists warn that when 
governments don't step in and provide stimulus to increase aggregate 
demand, consumers cut back sharply on spending and push the economy 
deeper into depression.

Treasury Secretary Geithner and Fed chief Bernanke have lent or 
committed $13 trillion trying to keep the financial system functioning, 
but they've only managed to plug a few holes and avoid a system-wide 
collapse. The financial system is hobbled and unable to provide 
sufficient credit to generate growth. Every sector has suffered 
cutbacks, layoffs and slimmer profits. The problems go beyond toxic 
assets or complex derivatives. The system is plagued with stagnation, 
overcapacity and redundancy. The UCLA-based historian professor Robert 
Brenner sums it up like this in an interview in the Asia Pacific Journal:

"The current crisis is more serious than the worst previous recession of 
the postwar period, between 1979 and 1982, and could conceivably come to 
rival the Great Depression, though there is no way of really knowing. 
Economic forecasters have underestimated how bad it is because they have 
over-estimated the strength of the real economy and failed to take into 
account the extent of its dependence upon a buildup of debt that relied 
on asset price bubbles. In the U.S., during the recent business cycle of 
the years 2001-2007, GDP growth was by far the slowest of the postwar 
epoch. There was no increase in private sector employment. The increase 
in plants and equipment was about a third of the previous, a postwar 
low. Real wages were basically flat. There was no increase in median 
family income for the first time since World War II. Economic growth was 
driven entirely by personal consumption and residential investment, made 
possible by easy credit and rising house prices. Economic performance 
was weak, even despite the enormous stimulus from the housing bubble and 
the Bush administration’s huge federal deficits. Housing by itself 
accounted for almost one-third of the growth of GDP and close to half of 
the increase in employment in the years 2001-2005. It was, therefore, to 
be expected that when the housing bubble burst, consumption and 
residential investment would fall, and the economy would plunge. " 
("Overproduction not Financial Collapse is the Heart of the Crisis", 
Robert P. Brenner speaks with Jeong Seong-jin, Asia Pacific Journal)

The economy is now in a downward spiral. Tightening in the credit 
markets has made it harder for consumers to borrow or businesses to 
expand. Overextended financial institutions are forced to shed assets at 
fire sale prices to meet margin calls from the banks. Asset deflation is 
ongoing with no end in sight. Price declines in housing have reached 30 
percent already and are now accelerating on the downside. This is the 
nightmare scenario that Bernanke hoped to avoid; a savage contraction in 
real estate that drags the rest of economy into a black hole. The 
economist Nouriel Roubini and market analyst Meredith Whitney predict 
that housing prices will drop another 20 per cent before they hit 
bottom. Nearly half of all homeowners will be underwater and owe more on 
their mortgages than the current value of their homes. That will 
increase the foreclosures and push scores of banks into default. 
According to Merrill Lynch's economist David Rosenberg:

"It would take over three years to achieve price stability (in housing) 
The problem is that prices do not begin to stabilize until we break 
below eight months’ supply – and they tend to deflate 3 per cent per 
quarter until that happens. So as impressive as it is that the builders 
have taken single-family starts below underlying sales, their efforts 
are just not sufficient to prevent real estate prices from falling 
further. In fact, even if the builders were to declare a moratorium 
immediately, that is, taking starts to zero, demand is so weak and the 
unsold inventory so intractable that it would now take over three years 
to achieve the holy grail of price stability in the residential real 
estate market."

The main economic indicators all point to a long period of retrenchment 
ahead. The slowdown in global trade has hit Germany, Japan, and most of 
Asia particularly hard. The export-driven model of growth has suffered a 
major setback and won't rebound for some time to come. With the heroic 
US consumers unable to continue their debt-fueled spending efforts, 
surplus countries will have to develop domestic markets for growth, but 
it won't be easy. Chinese workers save 50 per cent of what they earn and 
German workers already have a comfortable life without increasing 
personal consumption. Higher wages and lower interest rates can help 
stimulate demand, but cultural influences make it difficult to change 
spending habits. Meanwhile, the economy will continue to languish 
operating well below its optimum capacity.

Capital flows have also suddenly reversed causing turmoil in the 
currency markets. January's TIC data indicates that net capital outflows 
for the US were negative $148 billion in January. Capital is now fleeing 
the country. Financial protectionism has triggered the repatriation of 
foreign investment causing a sharp drop in the purchase of US sovereign 
debt. This is from Brad Setser, an economist with the Council on Foreign 
Relations:

"The obvious implication of the recent downturn in total reserve 
holdings — and the $180 billion fall in the fourth quarter of 2008 
wasn’t driven by currency moves — is that the pace of growth in the 
world’s dollar reserves has slowed dramatically...

The obvious implication: most of the 2009 US fiscal deficit will need to 
be financed domestically. The Fed’s custodial data indicates central 
banks are still buying Treasuries, though at a somewhat slower pace than 
in late 2008. But their demand hasn’t kept up with issuance. (Foreign 
Central banks aren't going to finance much of the 2009 US fiscal 
deficit; Their reserves aren't growing anymore", Brad Setser, Council on 
Foreign Relations)

The United States does not have the reserves to finance it own deficits 
which will soar to $1.9 trillion by the end of 2009. The Fed will have 
to increase its purchases of US Treasuries and monetize the debt. 
Foreign holders of Treasuries and dollar-backed assets ($5 trillion 
overseas) will be watching carefully as Bernanke revs up the printing 
presses to fight the recession and meet government obligations. China, 
Russia, Venezuela and Iran have already called for a change in the 
world's reserve currency. It won't happen overnight, but the momentum is 
steadily growing.

The S&P 500 has soared 23 per cent in the last four weeks, but the 
current bear market rally is misleading. The prospects for a quick 
recovery are remote at best. The fundamentals are all weak. Corporate 
profits are down, GDP is negative 6 per cent, housing is in a shambles, 
and the banking system broken. The Fed has increased the money supply by 
22 percent, but economic activity is at a standstill. The velocity at 
which money is being spent is the slowest since 1987. Nothing is moving. 
The banks are hoarding, credit has dried up, and consumers are saving 
for the first time in 2 decades. The banks' credit-conduit cannot 
function properly until bad assets are removed from their balance 
sheets. But the magnitude of the losses make it impossible for the 
government to purchase them outright without bankrupting the country. 
According to the Times Online, the IMF has increased its estimates of 
how much toxic mortgage-backed paper the banks are holding:

"Toxic debts racked up by banks and insurers could spiral to $4 
trillion, new forecasts from the International Monetary Fund (IMF) are 
set to suggest.

The IMF said in January that it expected the deterioration in 
US-originated assets to reach $2.2 trillion by the end of next year, but 
it is understood to be looking at raising that to $3.1 trillion in its 
next assessment of the global economy, due to be published on April 21. 
In addition, it is likely to boost that total by $900 billion for toxic 
assets originated in Europe and Asia.

Banks and insurers, which so far have owned up to $1.29 trillion in 
toxic assets, are facing increasing losses as the deepening recession 
takes a toll, adding to the debts racked up from sub-prime mortgages. 
The IMF's new forecast, which could be revised again before the end of 
the month, will come as a blow to governments that have already pumped 
billions into the banking system."

Since banks lend at a ratio of 10 to 1; the amount of credit cut off to 
the broader economy will ensure that sluggish growth well into the 
future. If there is a recovery, it will be weak. The Obama 
administration will have to increase its capital injections even though 
they will add to mushrooming deficits. So far, financial institutions 
have only written down $1 trillion or 25 percent of their losses. This 
means the banking system is insolvent. Eventually, Obama will have to 
resolve the bad banks and auction off troubled assets, even though 
political support is rapidly eroding. According to political analyst F. 
William Engdahl, most of the garbage assets are concentrated in the 
nation's five biggest banks:

"Today five US banks according to data in the just-released Federal 
Office of Comptroller of the Currency’s Quarterly Report on Bank Trading 
and Derivatives Activity, hold 96 per cent of all US bank derivatives 
positions in terms of nominal values, and an eye-popping 81 per cent of 
the total net credit risk exposure in event of default.

The five are, in declining order of importance: JPMorgan Chase which 
holds a staggering $88 trillion in derivatives (€66 trillion!). Morgan 
Chase is followed by Bank of America with $38 trillion in derivatives, 
and Citibank with $32 trillion. Number four in the derivatives 
sweepstakes is Goldman Sachs with a ‘mere’ $30 trillion in derivatives. 
Number five, the merged Wells Fargo-Wachovia Bank, drops dramatically in 
size to $5 trillion. Number six, Britain’s HSBC Bank USA has $3.7 
trillion. ("Geithner’s ‘Dirty Little Secret’: The Entire Global 
Financial System is at Risk", F. William Engdahl, Global Research)

These five banking Goliaths are at the center of political power in 
America today. Their White House emissary, Timothy Geithner, has 
concocted a rescue plan--the Public-Private Investment Program--which 
will provide 94 per cent funding from the FDIC for the purchase bad 
assets. The program is designed to keep asset prices artificially high 
while transferring the bulk of the losses to the taxpayer. The plan has 
been widely criticized and has even raised a few eyebrows even among 
usually-supportive members of the establishment like the Financial Times:

"US banks that have received government aid, including Citigroup, 
Goldman Sachs, Morgan Stanley and JP Morgan Chase, are considering 
buying toxic assets to be sold by rivals under the Treasury’s $1,000bn 
(£680bn) plan to revive the financial system.

The plans proved controversial, with critics charging that the 
government’s public-private partnership - which provide generous loans 
to investors - are intended to help banks sell, rather than acquire, 
troubled securities and loans.

Banks have three options if they want to buy toxic assets: apply to 
become one of four or five fund managers that will purchase troubled 
securities; bid for packages of bad loans; or buy into funds set up by 
others. The government plan does not allow banks to buy their own 
assets, but there is no ban on the purchase of securities and loans sold 
by others." (The Financial Times)

It's a multi-billion dollar shell game with myriad opportunities for 
fraud. In theory, the banks could create their own off-balance sheet 
operations (SIVs or SPEs) and use them to purchase their own bad assets 
taking advantage of the government's 94 percent low interest non 
recourse loans. It's a swindle and another windfall for Wall Street.

Geithner's plan does not fix the problems with the banks, it only delays 
the final outcome. The next leg-down in the recession will push many of 
the undercapitalized banks into receivership. Geithner's PPIP won't 
change that. As housing prices fall and foreclosures rise, the capital 
position of many of the banks will become untenable leading to a rash of 
bank failures. An article in Monday's Wall Street Journal puts adds some 
historical perspective to today's financial crisis:

"The events of the past 10 years have an eerie similarity to the period 
leading up to the Great Depression. Total mortgage debt outstanding 
increased from $9.35 billion in 1920 to $29.44 billion in 1929. In 1920, 
residential mortgage debt was 10.2 per cent of household wealth; by 
1929, it was 27.2 per cent of household wealth....

The causes of the Great Depression need more study, but the claims that 
losses on stock-market speculation and a monetary contraction caused the 
decline of the banking system both seem inadequate. It appears that both 
the Great Depression and the current crisis had their origins in 
excessive consumer debt -- especially mortgage debt -- that was 
transmitted into the financial sector during a sharp downturn.

Why does one crash cause minimal damage to the financial system, so that 
the economy can pick itself up quickly, while another crash leaves a 
devastated financial sector in the wreckage? The hypothesis we propose 
is that a financial crisis that originates in consumer debt, especially 
consumer debt concentrated at the low end of the wealth and income 
distribution, can be transmitted quickly and forcefully into the 
financial system. It appears that we're witnessing the second great 
consumer debt crash, the end of a massive consumption binge." (From 
Bubble to Depression? Steven Gjerstad and Vernon L. Smith, Wall Street 
Journal)

Two leading economic historians, Barry Eichengreen and Kevin H. Rourke, 
have written an article "A Tale of Two Depressions" which has been 
widely circulated on the Internet. It illustrates (with graphs) how the 
global economy is plummeting faster now than during the 1930s.

Stockbrokers aren’t selling apples yet, but the velocity of present 
downturn is worse than the Great Depression. Manufacturing, industrial 
production, foreign trade, capital flows, consumer confidence, housing, 
and even stocks are falling faster today than after the crash of 1929. 
So far, Bernanke's monetary bandaids have prevented the wholesale 
collapse of the financial system, but that could change. The economy 
continues its downhill slide and it looks like there's nothing to stop 
it from falling further still.

Mike Whitney lives in Washington state and can be reached at 
fergiewhitney at msn.com