Economy Turning Around?

The stock market broke 12,000 for the first time in a long time on news that Europe had reached a deal on the Greek debt crisis, the US economy grew by 2.5% last quarter, and first time unemployment claims fell slightly.  It’s possible the economy may be turning around and we’ll avoid the dreaded “double dip” recession.

If true, this is the best news President Obama could receive.  If next year there is a palpable sense that things have turned around, Obama’s chances of re-election grow considerably.     Still, The recession currently is in its fourth year.   Yes, there has been growth so it’s not technically a recession, but in terms of high unemployment and a tough economy things have been in the dumps since 2007, even before the September 2008 crisis.

President Bush and Obama get little credit for how they mitigated the worst of the crisis.   President Bush’s “bailout” of Wall Street was necessary in order to prevent a further credit squeeze, perhaps pushing us into the Great Depression.   The banks also paid it back, meaning it turned out to be “cost free.”   President Obama’s stimulus package also turned around the bleeding of jobs and prevented states from becoming insolvent in 2009.   Since we never experienced the reality that would have happened without the stimulus it’s easy to dismiss it since it didn’t “fix” the economy and make everything better.   But in 2009 nothing was going to do that.

There is a good chance this spurt of growth will cause economic tailwinds to push the economy forward in 2012.   But while this may save the President’s job, it doesn’t mean the economy is “returning to normal” or that the problems are solved.  It does suggest that we may be able to handle the crisis without total collapse.

Here’s the deal.    Global debt is still way to high, and that’s going to hinder economic growth.   Moreover, states like the US have been consuming more than we’ve been producing, thinking this is OK because we lured in outside investment (the capital account surplus balanced our current account deficit).

At a national level, the US needs to expand its productive capacity and reduce consumption to the point that it more or less balances production.    The trade deficit needs to drop, either through currency devaluation (inflation) or less consumption.   At a global level the issue gets murkier.   Total debt (public and private — one can’t blame governments alone for this) is over 300% of GDP for the industrialized West.   High debt levels have funded a sustained period of living beyond our means.

The good news is that the year to year deficits (how much we’re living beyond our means) have not been dramatically high.   But if you earn $50,000 a year and spend $52,000 a year, in 20 years your debt is probably near $30,000 (thanks to interest).   Small deficits repeated yields high debt, both for governments and for the private sector.   Because yearly deficits were relatively small, and the economy seemed to be growing thanks to the bubbles, people had the illusion that growth would solve the debt problem.   In the US a brief surplus in the federal budget at end of the 90s made it seem like a solution was easy.   The high federal budget deficits in the last decade got rationalized by the aftermath of 9-11.

The brief budget surpluses were thanks to the bubble economy, and did not extend to the private sector — private debt kept growing, in part because no one identified it as a problem.   High debt and cheap credit created this crisis.   It’s different than the classic Great Depression crisis of over production.   Yes, easy credit was a factor there (margin calls, etc.), but the level of pervasive debt was nowhere near what it is now.   That makes this crisis unique and difficult to solve with traditional means.

Obviously it’s important to de-leverage — to pay down debt.   That’s been happening, especially in the private sector.   Governments have not paid down a lot of debt yet, in part because of macroeconomic pressure to stimulate recession weary economies.

Another lesson is the need to reform and re-regulate the financial sector.   The bubble and the extent of the collapse in 2008 was completely avoidable.   If over the counter derivatives had been subject to regulations of reporting and transparency, the big financial institutions could have never packaged dubious mortgages into bonds that confused ratings agencies stamped “triple A”.     That in and of itself would have done a lot to prevent the crisis since it was demand for mortgages to be packaged as bonds that created the intense increase in real estate prices.

Beyond that, incentives matter.   In the past lenders had incentive to be careful about who they lent money to.   If someone can’t pay their mortgage the bank stood to lose a chunk of money.   But when the demand for mortgages was high and brokers did not bear any of the risk, then there was an incentive to just provide the mortgage no matter what — even if it meant lying and arranging absurd loans to people who had no means to pay it back.    That also was engineered by the big banks, who then did all they could to try to decrease their risk (thereby creating systemic risk).

So three things need to be done:  pay back debt (de-leveraging), increase production, and create a functioning regulatory regime for the financial sector to prevent future credit orgies.      Increasing productive capacity usually involves investment, which works against paying back debt.    However, at a global level if the economies of export led growth countries like China start switching towards more internal consumption and less reliance on trade (something the recession is forcing them to do — bankruptcies are growing in China), then rebalancing is possible.   Things won’t be as cheap in the US so consumption will decline, but domestic production will grow, as will jobs.

Regulating Wall Street is a tougher nut to crack, thanks to the intense lobbying power of the big financial institutions.   Public pressure like “Occupy Wall Street” helps, and President Obama’s new found populism could give him support to push effective reform in a second term.    One can understand his coziness with Wall Street in the depths of a recession — you don’t want to scare the big economic actors.   But if the economy starts growing so too does the governments independence from big money.

So far my worst fears about this recession/depression have not been realized.   It’s not been the quick recession many predicted back in 2008.   It’s not just another business cycle recession.   There still is a long way to go.   But perhaps we’re turning a corner and it’s possible to see a way out of this that avoids catastrophe, even if there will be no return to the heady consumerism of 2006.    And just maybe we’re relearning the importance of virtue — focusing on the importance of work, family and values rather than material consumption.

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  1. #1 by Black Flag® on October 28, 2011 - 01:37

    You jest!

    The banks lent too much money in relation to bank capital. So, they need capital. They can’t get it. Investors think they are too risky. So, the banks twisted the arms of the stupid, ignorant politicians to pony up.

    There was nothing in the bailout that solved a damn thing – it merely delayed and deepened the reckoning.

    You think Greece is going to change?
    You are naive.

    You think the rest of the PIIGS are going to ‘smarten up’ and avoid being another Greece?
    You are naive.

    Yet, in response to this total mess, stocks soared.
    The same investors who lent money to Greece now think the problem is solved.

    Stupid is what stupid does.

    So, the big banks won this round.

    But the haircut – now closer to be more a guillotine – is coming.
    Greek bonds will be devalued by 50% or more. The banks will lose a lot of money.

    That guarantees more summits, more assurances from Merkel that she will not surrender her nation’s honor while bending over for the banks, and more funding from the EU government in last-minute deals behind closed doors while avoiding their citizens.

    There will be more emergency summits.
    There will be more bailouts.
    The taxpayers have not yet begun to feel the pain.

    This is the new economy for the new Europe.

    It will continue until the euro and the EMU break apart.

    • #2 by Jeff Lees on October 28, 2011 - 03:37

      And if they did nothing and allowed Greece to default, the “tax payers” would be better off?

  2. #3 by TitforTat on October 28, 2011 - 20:14

    Interesting post. For whatever reason it made this song come to mind. 😉

  3. #4 by Alan Scott on October 29, 2011 - 18:41

    Sometimes letting something fail is the first step to recovery. In the US, the banks were too big to fail and had to be bailed out . All of the slow bailouts of underwater mortgagers has delayed the housing recovery. Some people you just can’t save . Keeping people in houses that have no hope of paying on, is counter productive.

    This has reduced worker mobility. There are areas like North Dakota that have jobs. If you are stuck in a house in Illinois or California, you can’t move to Texas or N. Dakota where you can get a job . You have people squatting in homes, which are deteriorating and are unattractive to buyers going through them . The squatters have every incentive to make them unattractive. If the squatters were not there, the houses could be repaired and would have to come down to a price the market will bear . You would get people in those homes that can afford to live in them . The squatters could relocate to better states .

    As far as government stimulus , there is a piece in the Wall Street Journal on Harrisburg Pa. For years they have done the borrow and spend path to ruin . Pennsylvania is like the EU. They have to bail out Harrisburg because it is the State Capital . Harrisburg has bucked all attempts at helping it except writing it a blank check . Harrisburg and Greece. In Harrisburg they are not rioting. Where is Occupy Harrisburg ? Oh wait, they only want to protest Corporate wrong doing, not municipal mismanagement .

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