You’re exhilarated when the stock market zooms 10 percent in a day, right? Think again. Of the ten one-day miracles in investment history, when stocks have soared 9 to 15 percent, seven of those days were in 1929 or the 1930s. Two of them were in October of this year. Similarly, of the 15 best weeks in market history, 13 occurred during the 1929 crash or the following Great Depression. One of the rowdiest up weeks ended October 31 of this year. The 15 worst months? Twelve were in 1929 or the subsequent depression, and one was October of this year.
Conclusion: financial panics — up or down — tend to occur in grim times. Since the stock market these days is amazingly volatile (panicky, really), should we be expecting another depression? After all, stocks, bonds, commodities, and residential real estate are all deflating amid the volatility.
Local economists agree that the nation will not stumble into a depression, but they disagree on just how bad the economy will get. Importantly, they unanimously agree that the devilishly and deliberately complex financial derivatives are a root cause of the current downturn worldwide because nobody knows if the banks holding these exotic instruments are solvent. The government should make sure they are regulated and transparent, but the $700 billion bailout isn’t accomplishing that.
Let’s consider the national economy first. It contracted in the third quarter as consumer spending, which makes up more than 70 percent of economic activity, plummeted 3.1 percent, the biggest decline in 28 years. Consumer confidence is at record-low levels, even as the Federal Reserve lowers interest rates and pumps reserves into the banks. This could be the bleakest Christmas spending season since 1980.
Ross Starr of the University of California, San Diego says we are in for a “very severe” recession. “I expect double-digit [10 percent or more] unemployment,” he says. “This is no joke. There is no way out of it. It will last through the third quarter of ’09.” He says this downturn will be similar in severity to the very difficult period in the early 1980s, when the central bank was raising interest rates to squeeze inflation out of the system. There was a mini-recession in 1980 and then a steep recession in 1981–82. Today, the difficulties in housing and the credit crisis will be “two big causes,” says Starr.
But on the same campus, economist Jim Hamilton is not so gloomy. He says the fourth quarter of this year will shrink more intensely than the third quarter did (0.3 percent). “I don’t see consumption picking back up; I don’t see housing picking up; there is pressure on state governments,” says Hamilton. “This is looking like a global recession. It will take a bite out of exports.” But after the contraction in the second half of this year, the economy may or may not continue declining through 2009, partly because the Federal Reserve and U.S. government have acted so aggressively to add liquidity to markets, says Hamilton. “I don’t know how long this will last.”
Across town at San Diego State University, Raford Boddy, emeritus economics professor, says, “This [recession] will be deeper. It may not be as deep as 1973–75, but it will be deeper than 1990–91 and 2000–01. Consumers are scared. Home remodeling and things related to remodeling, like new stoves and refrigerators, are in trouble, and autos are in trouble. Credit-card problems are hitting. The construction industry is really in trouble; the overbuilding of the last four years will take away from what would have been done now.” One possible bright spot: companies may spend more on machinery and electronic equipment to enhance productivity.
But William Carter of the investment firm QInsight Group and a lecturer in business cycles at San Diego State is far less bearish. “We will have slow growth in the U.S., but it will be nowhere near as slow as most of the forecasts you’re reading,” says Carter. “We may have two or three quarters of near-zero growth, and it will be closer to two than three. It’s true that consumers are overleveraged [too deep in debt] and have low savings, but American consumers change their habits only when they believe their changes in income and wealth are permanent. They have to believe that not only will they be unemployed but be unemployed for a long time,” says Carter. It will be a close call whether the current downturn is officially called a recession, he says.
All four academic economists agree on one thing: the quadrillion dollars of derivatives floating around the world are a critical contributor to the global meltdown. Derivatives are miasmically complex securities that are derived from assets such as bonds, stocks, or currencies. Derivatives are not assets, or even investments. They are out-and-out gambling vehicles, and they have come to dominate the financial world. When commentators talk about “exotic instruments of unknown value,” they are talking about derivatives.
Banks won’t loan to other banks because “they are so frightened of these derivatives and balance sheets of [other] banks,” says Carter. The credit markets are frozen because of this uncertainty about their fellow institutions. Carter would like to see a national exchange on which the complex derivatives are traded, thus providing price transparency.
“We need a centralized clearinghouse” to keep track of these financial exotica, says Hamilton. “We need a single agency to look at them from the perspective of financial stability. The SEC [Securities and Exchange Commission] looks at fraud, and the CFTC [Commodity Futures Trading Commission] looks at manipulation. Stability is more important.”
Starr points out that derivatives “are immensely leveraged. You never know where the next bankruptcy is going to fall. We need accounting rules that require liabilities to be fully stated, requiring transparency. Let’s know where the bodies are buried.”
Boddy has suggested ways by which banks could begin to lend to each other once the value of the toxic derivatives is determined in the marketplace. The government’s $700 billion bailout package won’t accomplish that, he says. The schemes to buy stock in banks, thus pumping capital into them, and to buy derivatives directly, will not work, he says. “For God’s sake, don’t buy those toxic things,” says Boddy, who calls some of them “putrid, bloated carcasses.” If the Troubled Asset Relief Program (TARP) buys such malodorous junk, “It will just get some of the worst assets off the balance sheets of the banks.” He proposes a plan by which TARP will buy a small percentage of the smelly assets and then take bids for them. “The goal is price discovery, not capital injection. Through price discovery, TARP will discover what the assets are worth. Then they can be repackaged and sold on the open market. Without confidence in the values of the remaining assets on the balance sheets, the banks will be uncertain whether they are dealing with insolvent banks.”
He says, “Comprehensive price discovery will tell which banks are solvent and which are not, so banks can get back to lending. Banks will not extend credit to other banks so long as they fear that the counterparties might be bankrupt.”
And if banks don’t lend, we could see the ugly deflation we fear.