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There is little doubt that the US is entering a recession. The IMF's latest report also forecast that the world is entering a major downturn. The bigger questions are:

  • How long and how deep is the US slowdown?
  • Most importantly, will the US slowdown drag down the rest of the world?

As for the depth question, we have a good idea. Econobrowser pointed to a study that indicates the presence of financial stress is indicative of deeper recessions. How long it lasts and its effects on the world depends on the policy response.

What’s the policy response?
In Charlie Rose’s interview with Warren Buffett, Buffett stated that the depth of the slowdown is dependent on the policy response:

Unemployment is going to go up under any circumstances. The 6.1 is going to go higher. But whether it goes and quits at seven or whether it quits at ten or 11 or 12 depends on, among other things, the wisdom of Congress and then the wisdom of -- in terms of carrying out the plan that Congress authorizes.

Best and worst case analysis

As the financial markets went into cardiac arrest in the last few weeks, many observers began to compare the current period in the US to either the Great Depression of the 1930s or Japan’s Lost Decade in the 1990s.

I beg to differ. I have constructed best and worst case scenarios that may be better analogies.

Best case: German reunification

When the Berlin Wall came down, West Germany made the political choice to exchange West German Marks for East German Marks at a 1:1 ratio. The decision shocked the financial markets. I recall describing it at the time as a giant LBO of unproductive Soviet era assets which would create a drag on the German economy. The world began to slow down because of this macro shock and the Iraqi invasion of Kuwait toppled the world over into recession.

Yet the adjustment period was surprisingly mild. Germany underwent a couple of years of tough adjustments, followed by a period of anemic growth in the mid-90s (see analysis here). The former East continues to have problems, but overall Germany, Europe and the rest of the world were not dragged down by the macro shock in 1990. Germany has the reputation as an engineering powerhouse, whose principal export is its intellectual property.

The US parallels are obvious. Like Germany, the US is being weighed down by unproductive assets. Like Germany, much of US exports is intellectual property. It has an open economy, people from all over the world flock to its universities and its intellectual property exports have enabled it to re-invent itself periodically. I lived in Boston for nearly a decade and have seen it firsthand. Research on radar was done in Boston during the Second World War. Over the successive decades, companies based in the area have demonstrated that Boston is a center of innovation. Examples include Digital Equipment, Lotus Development, the dot-coms during the tech bubble. The biotechs that dot the landscape today are a testament to the brainpower that is the source of intellectual property exports and America’s competitive advantage.

If the US were a company, it could be best described as right business model but bad balance sheet. The solution to such cases is to re-capitalize the balance sheet so that the enterprise can continue. In his interview, Buffett opined that:

[W]e've got the same plants out there we had two years ago. We got the houses. We've got people that are more productive than they've ever been in the history of this country. We've got a wonderful economic formula in this country. But right now it is being - it's been brought to a halt by …the de-leveraging that's going on right now that has caused the credit crisis…

I think confidence will come back. I will tell you this, this country is going - will be living better ten years from now than it is now. It will be living better 20 years from now than ten years from now. The ingredients that made this country, the miracle of the world. We had a seven for one improvement in the average American's standard of living in the 20th Century.

If the German reunification analogy holds true, then the United States will likely suffer a deep recession for 1-2 years, but the rest of the world will recover relatively quickly.

Worst case: Depression of 1870

There have been some in the blogosphere that have suggested a better analogy for the current times is the Depression of 1870 , which lasted for about a decade:

The parallels are striking—it started with a housing bubble which popped and generated a mortgage crisis. Financial markets fell apart when investors, relying on complex financial instruments, did not consider counter-party risk.

The financial troubles began initially in Europe but eventually spread to America, culminating in the Panic of 1873. Such episodes of booms and busts no doubt heavily influenced works of later economists such as John Maynard Keynes as he sought out policy responses to smooth out these periods of volatility.

While a decade-long depression is possible, it is less likely and represents the worst case apocalyptic scenario imaginable. The authorities did not have the policy levers that are available today, however flawed they may be. Bernanke is known to have studied the Great Depression of the 1930s and he is no doubt determined to avoid such an outcome.

Policy response is key to resolving the crisis

Surprisingly, policy response so far has been relatively ineffective. I have written before that the overwhelming issue is solvency in the banking system and not liquidity. So far, the economic consensus concurs with that view. A partial list includes the following:  BCA ResearchJohn Cochrane , Paul Krugman, Greg MankiwNouriel Roubini, and Luigi Zingales and Diamond et al. Warren Buffett also agrees with the approach:

So there is - there are two things needed in the system. The one that's needed overwhelmingly is liquidity. When people are trying to de-leverage, there has to be somebody there to buy. And they don't have to buy at fancy prices, but to buy.

And then there's also a capital problem with some of the institutions. We have provided capital here with a couple institutions recently. The federal government did that in the '30s for the RFC and I think there could well be a proper role for government in that.

The UK is partially nationalizing its banking system and Gordon Brown urged the world to follow suit. The New York Times reported that the US Treasury is considering similar steps and the WSJ  reported that it may insure all bank depts. Hank Paulson is quoted as saying: “We will use all the tools we’ve been given to maximum effectiveness, including strengthening the capitalization of financial institutions of every size.”

Former Fed Chairman Paul Volcker wrote in the WSJ indicating that we have the tools to fix the problem, we just need the leadership. In other words, all is not lost.

Source: Where We Go from Here: Best and Worst Cases