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Economic Update

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Written by Jane Caron, CFA, Chief Economic Strategist

In 2008, Adam Smith's invisible hand formed a rock-hard fist and delivered a series of forceful punches that were felt across world financial markets and economies. From Adam Smith's point of view, this beating was well deserved. In a free-market system, economic participants are supposed to act in their own self interest, which means not only being cognizant of risk but demanding payment for it. In this case, even those who were prudent in their actions were not spared.

Ideally, the build-up of indebtedness and leverage would have been stymied before it resulted in the collapse of the world financial markets and economies. A partial explanation for why the invisible hand remained invisible until recently is that our markets lean toward being free, but large sections are heavily regulated. Many people believe big brother has their backs and do not adequately consider the risks associated with their actions. Regulators, such as the Federal Reserve, provided a false sense of comfort over the last fifteen years by appreciably dampening economic cycles.

The main purpose of an economic downturn is to rid the system of excesses. By voiding this cathartic process, public authorities postpone the day of reckoning and encourage a more forceful correction. This recession is likely to have a fair amount of success in correcting one of the most egregious imbalances in our economy: the current-account deficit. The current-account deficit is a manifestation of the debt-fueled private consumption binge that has been going on for more than a decade, a binge that probably would have continued if credit had remained available.

A new imbalance will emerge though, and that is an onerous fiscal deficit. Indeed, the Congressional Budget Office (CBO) just released their estimates for a FY 2009 budget deficit of $1.34 trillion and a FY 2010 deficit of $843 billion—and these figures do not include the huge stimulus plan that is currently in the works. The consequences of running these massive budget deficits could be disastrous if they become structural rather than cyclical. As it is, debt held by the public is expected to surge from 41% of GDP in 2008 to 55% in 2010 according to the CBO. Not since World War II has there been an increase of this magnitude. One of the main challenges for the Treasury in 2009 will be placing more than $2 trillion in new Treasury debt.

Another potential imbalance is being created at the Federal Reserve, which is also rapidly expanding its balance sheet. Actions at the Fed will not impact federal debt levels unless the Fed experiences outright losses or gains, or fails to maintain price stability. The Fed's balance sheet typically grows in line with the real economy, but emergency actions last year drove total reserve bank credit to $2.25 trillion by December 31, a $1.35 trillion increase in just six months. The composition of the Fed's balance sheet has also changed dramatically. A year ago, 86% of the assets held by the Fed were in Treasuries, compared to just 21% today. A mixture of loans, swap lines, and non-Treasury debt now make up the remainder. Based on lackluster demand at recent liquidity auctions, the Fed appears to have adequately liquefied the banking system. However, banks remain quite restrictive in lending because their balance sheets are still undercapitalized and they face unknown loan losses.

The Fed is doing everything in its power to loosen the lending markets. They lowered the target funds rate to a range of 0 to 25 basis points in December and stated that they expect to keep an exceptionally low funds rate in place for some time. The Fed has also become a large-scale buyer of agency and mortgage-backed bonds in an effort to drive down mortgage rates. So far, they have been as successful in this effort as they were in driving down interest rates in the interbank and commercial paper markets. The Fed has also indicated that they are considering buying Treasury bonds, and are evaluating ways to bring down commercial-mortgage and corporate lending rates among others. All of these actions are potentially inflationary, but that is the intent when fighting deflation. A danger going forward is the potential failure to remove excess liquidity in a timely manner once the economy is showing sustainable growth and moving closer to the full utilization of resources. This danger should not be underestimated.

Our forecast anticipates a very tough year for the economy, particularly in the first half. We expect the level of real GDP to contract by roughly 2% in 2009, while the unemployment rate is expected to rise to near 9%. Three key assumptions behind our forecast are that a hefty fiscal stimulus package of at least $750 billion will be signed in February, financial markets will stabilize, and oil prices will remain low. Even under these circumstances, we expect real GDP to contract at a 7.5% annualized rate in the first half of the year before growing at a 3% annualized rate in the second half.

We believe this recession will go down in the history books as the longest since the Great Depression and possibly the deepest. The National Bureau of Economic Research has already assigned the start date as December 2007. We anticipate reaching a trough in the second quarter of 2009, resulting in an 18-month recession. While that is certainly shorter than the 1929 recession, which lasted for 43 months, it is longer than both the 1973 and 1981 recessions, which each lasted 16 months. From peak-to-trough, we expect this recession to reduce real GDP by nearly 3%, marking the deepest recession since 1973, when real GDP fell 3.1%. The risk is that the real GDP declines by more than we expect, in which case this would prove to be the deepest recession since the Great Depression.

The level of uncertainly surrounding our forecast is high because the actual growth rate will depend on a number of currently unanswerable questions. In particular, we do not know how high the rate of house-hold savings will reach, nor do we know the ultimate level of credit losses. Also, we cannot say with certainty that deflation will be avoided or whether more significant policy mistakes will be made.

Deflation is a great danger to our economy because, when combined with a heavily over-indebted society, it can result in a severe depression. The Great Depression was characterized by a severe financial shock, over-indebtedness, deflation, and inappropriate policy responses. If deflation were to materialize today, the recession would be much longer and deeper than we currently envision. Furthermore, while we are confident that the main policy mistakes made during the Great Depression will not be repeated (overly tight fiscal and monetary policies, no protection for depositors, and a failure to recapitalize banks), we remain concerned about the potential for new mistakes.

The fact that the authorities have been writing the playbook during the game is understandable, given that there are no parallel periods in the post-World War II era to draw on. Some serious miscalculations bode poorly, though. The ramifications of letting Lehman Brothers fail were greatly underestimated. The impact on bank holdings and the ability to finance was not adequately considered when the Treasury left Fannie Mae and Freddie Mac preferred shareholders out in the cold with the shift to conservatorship. Another key mistake was for both the Treasury and the Fed to panic the public by telling Congress that a failure to pass the Troubled Asset Relief Program (TARP) could lead to the death of financial markets. Congress, meanwhile, played a game of brinkmanship that impaired public confidence even further.

Looking ahead, there will be plenty of opportunity for more mistakes to be made, but we are hopeful that President Obama's cabinet choices will avoid making any more grave errors. We also believe that private-sector balance sheets will return to good health over the next few years, but we are greatly concerned about public-sector balance sheets, where politics could interfere with prudence. Should that occur, we expect the bond vigilantes to take the first crack at encouraging more responsible behavior. If they fail, we can expect a return visit from Mr. Smith.