Two Plus Two Equals a Long, Painful Recession

by: Craig Brown

I received a number of comments on my 2009 predictions, some agreeing, some saying I was too pessimistic and some saying I was too optimistic. For those saying I was too pessimistic, let me explain further why I believe this recession will be longer and nastier than most and when we do come out of it, things will not be the same as they were in 2007.

First, the go-go years in the decade leading up to this recession were largely fueled by massive debt. Easy credit leads to foolish levels of over-consumption. So now we are deleveraging, both at the corporate level and at the individual level, though obviously not at the government level. I tend to think times of easy credit are not returning any time soon for the masses, nor should they. As Americans learn to live within their means (by choice or otherwise) the level of consumption in this country will adjust to a new, significantly lower, level, and hopefully it will remain there. That is the good news because if we do find a way to return to our foolish spending ways - as the government seems to be trying to get us to do with "stimulus" packages - then we will simply prolong the problem and increase the eventual pain.

Second, in a normal recession, the weak fold allowing the strong to survive and perhaps become stronger. The faster this process takes place, so long as it is done orderly, the better, at least in terms of moving forward and putting the mess behind us. This will take place in various segments of the economy, but at least for the financial sector we have a very big problem.

We learned from the Lehman collapse that the financial industry is way too interconnected at the moment. Some of this is due to $62 trillion in notional value in the CDS market. There were a variety of knock-on effects that followed Lehman's demise that has the government spooked enough that they are not letting any of the big boys fail. But the usual money-making ways for the financial goliaths are toast, the junk on their books is continuing to fester and they will continue to be a black hole for capital. We will continue to throw money at them and hope time will allow them to get back on their feet. Nonetheless, they cannot all survive.

So here is the problem: we cannot let them fail and the economy cannot support their existence (at least not all of them), so here we are - stuck with a government bailout for a very long time. No easy solution here. We just need to keep them on life support long enough to figure out a way to take a few of them down in an orderly fashion. This is a situation making the cure to this recession very complicated.

If you don't believe me, look at AIG. We have - so far - committed $152 billion for its bailout. Why? Was it to save the millions of policyholders from losing their coverage? NO!! The problems were at the holding company. The insurance subsidiaries are regulated on a state level by state departments of insurance. The subs are having some problems due to their association with their parent, but the books for the subs were generally strong as state insurance departments did their job and made sure the insurance subs had adequate reserves and surplus and did not invest in risky assets. So, again, why would be spend ten times as much salvaging a holding company versus the long drawn out battle we had to support the auto makers, who support millions of jobs? Why??!!

The answer is in credit default swaps. AIG Financial Services got into these big time and just happened to issue a lot of contracts to Eurpoean banks. There, these banks are allowed to use the existence of these CDSs to support their capital structure. Had AIG gone down, it would have taken a host of European banks with it, among a host of other entities. The government had no interest in saving AIG, it had to do so, however, to avoid the knock on effects. Just imagine the calls Ben, Paul, W. and others were getting when AIG was on the brink. Complications like these spell big trouble for any quick recovery.

Third, a recession is a correction; it takes things back to where they should be. Usually, we overshoot and go too far the other way, but eventually we recalibrate back to mean. If you think the last few years leading up to this recession were the mean, you are sadly mistaken. The mean is significantly lower at a level of economic activity that cannot support all the companies out there. So being at mean may in itself feel like a recession. The party is over.

Fourth, Obama's plan, though I like it, will not stop the recession. I like the plan for the following reasons:

  • America insists that something be done and needs hope that it is being done. So Obama has to do something. We could waste more money giving it to financial institutions, or we could spend it in a fashion that at least gives us something we need in the long run, whether or not it ends the recession. Infrastructure spending, alternative fuel and education are worthy causes.This spending will serve us well in the future.
  • Unemployment is on the rise and will continue along that path for some time. We can either spend money feeding and housing the unemployed, or we can give them jobs. The latter allows them to have money to spend, which helps the economy. Not enough, in my opinion, to stop the recession, but better than them living in homeless shelters.
  • Oil will rebound massively a few years from now, if not sooner, as a significant amount of the current supply chain will shut down. Too much of the supply is in nationalized hands and being poorly managed. Spending money now on alternative energy - even though gas prices are low at the moment - is incredibly wise. If the U.S. can develop efficient and cost effective alternatives, we can become a major exporter of energy, not an importer.

Overall, Obama's plan will lessen the pain and pave the way for better times ahead, but I expect it to do little to fix the mess we are in. But I really think there are few cures to the mess other than hunkering down and waiting it out. No one likes to hear this. We all want answers. We all want quick fixes.

I promise I will return to my usual fare of summarizing articles of interest, but I needed to get this out of my system. Now I feel much better. That extra second makes a world of difference.

Disclosures: None.