Six months ago, very few mainstream economists or economic commentators were willing to accept the existence of conditions that typically imply recession or even depression. Today, we are seeing a significant number, but still in the minority, of the best and brightest of our economists predicting conditions that typically lead to recession and even depression.
I view Bloomberg as the most serious of the national TV commentators on economics and markets. They have shifted from virtually no pessimistic talk six months ago to now about 30% predicting bad things coming. Take the economic papers delivered at Jackson Hole with the Fed last week. There is a marked change in attitude. However, a change in consensus attitude does not mean we have a consensus that a depression is coming.
The conditions that are indicative of recession or depression include 1) a looming financial crisis for banks with real estate loans, 2) deflation, 3) the futility of the country to have government print the money to spend our way out with stimulus, 4) a growing consensus (at least in a considerable number of Republicans and fiscally conservative Democrats) that the country can not afford to pump more debt onto the national balance sheet.
However, it makes sense to look at the the indicators mentioned above to see where we are going.
- Housing Collapse. The housing market will be declining significantly in the next year or two. There will be increasing unemployment and we should soon pass again the 10% number of unemployed. There is not, and will not be, the earning power for the current debtors to pay their mortgage loans. Banks and other indirect lenders such as holders of CLOs (Collateralized Loan Obligations) will experience a substantial loss of value due to the coming reduction of housing prices and the related non payment of mortgage loans. Most banks are holding properties off the market and not marking these assets to market, creating a false impression of solvency. We are on the verge of massive bankruptcies such as Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC). The rate of falling house prices will accelerate rapidly in the next two years. Defaults will grow rapidly during the next two years. It is conceivable that it will be 6 years for the downturn to play itself out.
- Deflation. Banks face the major losses on these mortgage portfolios. The amount that will be lost will be so great that this becomes the major driver for the coming deflation. (Full understanding of this argument requires one to understand that write-offs of bank credit have the practical result of reducing the money supply which in turn causes the deflation. For further explanation of this, see Robert Barbera´s book The Cost of Capitalism.) Then, of course, there will be even less jobs and less consumer spending which will become a self enforcing driver of the economy to the downside. The conventional argument is that stimulus can offset this market decline. However, there are coming losses of many trillions invested in the housing market and government stimulus can only cover a few trillions. There is no practical capacity for the government to offset the magnitude of decline in the money supply that is coming, which makes deflation inevitable.
- Stimulus. The government and the optimists hope that stimulus can provide a solution here. First, as stated in the point above, there is not nearly enough money creation capability in the Fed to offset the enormous losses coming to the economy, and therefore the reduction in the money supply. Additionally, the Fed gun is essentially empty. You cannot make lending rates negative, and we are already essentially at zero. You can buy bonds and drive down longer term rates, but this will back fire. It is not helping to create employment. It is only funding many buyouts at ridiculously low costs of funding. Almost all of these buyouts inevitably lead to employee reductions by the new owners, thereby reducing employment. Thus the Fed measure of putting up low cost money into the market will now cause reductions in employment not increases in employment. In short, there is nothing we can do that we can do that we have not already tried and failed. This author has reported in prior articles over the last several years that stimulus does not work at the end of the economic cycle. At the end of the economic cycle, there are not good investments to be made in de novo business which generate employment. The money ends up going for financial transactions (.i.e. buying other businesses). Stimulus only works at the beginning and middle of the economic cycle, where it is rarely used. As we observe objectively the results of stimulus, this truth can be empirically verified; specifically, the stimulus money is not used for new investments that create jobs. The apologists for the stimulus say thousands of teachers have jobs that they otherwise would not have. It is true that some teachers have jobs because of the stimulus, but the fact remains that net employment is down very substantially. The government can not directly employ all those who need jobs. Furthermore, employment will decline further in the next several years because the general economy will be declining.
- Deficits and Debt must be reduced. Now we have a growing number of people who do not believe stimulus works and that the country can not afford adding to the national debt. Ironically, whether we try more stimulus or not, the results will be the same. Deflation. More stimulus now may delay for a year or so the inevitable truth, but it has the bad effect of making the resolution of the problem even more costly. No stimulus means the economy will take its natural course which is down. History will say we had a housing bubble peaking in 2006, which required a nationwide bank bailout in 2008 by the national government, which leads in 2010/2012 to growing recognition that the country is not very solvent, leading to a great increase in interest rates in 2011/2014 to permit the US government to continue to sell its paper. Long term bond holders will experience enormous losses caused by the increase in interest rates. The loss of bond principal values caused by the increase in interest rates and the increased cost of funding business and mortgages will be the capstone to the coming depression
We have witnessed in the last 6 months a growing concern over the future. By 2012, we will have clear evidence in the markets of the fact that we are in recession, or more likely depression.