A New Phase of Economic Crisis

Against the Current, No. 135, July/August 2008

Jack Rasmus

IN EARLY APRIL 2008 the general consensus was that the U.S. economy had clearly fallen into recession. A long list of key economic indicators from November 2007 through March 2008 were all flashing red — from retail sales, job loss, business and consumer confidence and spending to industrial production and other prime indicators.

Not only were the indicators recording recession had arrived; some were among the worst in decades. The housing market was registering its worst performance since the 1930s. New home sales were down more than 50%, new home construction down 60%, home prices down 20% (accelerating toward 40% at minimum), two million foreclosures loomed on the horizon, delinquencies were rising sharply, and more than half of home values were “under water” — i.e. worth less than when purchased.

Meanwhile business investment, which peaked at nearly $1.9 trillion in 2006, had fallen off $100 billion in 2007 and continued to decline into 2008. Industrial production was slowing down, and at an accelerating rate, with numbers reported in April twice as bad as predicted. Three hundred thousand jobs were “officially” lost from November to April. Given the U.S. Government’s highly conservative way of defining and measuring unemployment, the real number was easily more than 500,000. Even growth rates in manufacturing output began to slow by early 2008.

Across the entire economy, according to the National Association for Business Economics, sales were plummeting. Retail sales were the worst in 13 years, with auto sales down 20-40%. Consumer spending, which constitutes nearly 70% of the total U.S. economy, dramatically slowed over the half year from October through March 2008.

 As recently as early May, a U.S. Commerce Department report noted consumer spending was at its weakest since the recession of 2001, with some economists noting it was “much more severe than anything we saw in 2001.”

Not surprisingly, with oil, health care and food prices accelerating, and with wage cuts being implemented in a number of industries and hours of work falling, official surveys revealed consumer confidence was at a 28-year low, with 90% of those surveyed indicating the economy in recession.

The consensus by consumers that the economy was clearly in recession was echoed in various business quarters, and by an overwhelming majority of economists. As early as January 2008, research departments at big money-center banks like Morgan Stanley, Merrill Lynch, Goldman-Sachs and others all noted unequivocally that the economy had entered a recession.

By March, according to a survey of more than a thousand chief financial officers by CFO magazine, more than half of corporate CFOs were also indicating recession was here. At the same time, a Wall Street Journal survey of economists reported more than 70% believed the economy was in a recession, with half predicting a worse downturn than in previous recessions in 2001 or 1990-91; a month later, in April, 75% of the same group had upped their prediction of recession and noted the “bottom” was far from being reached.

At the individual capitalist investor level, billionaire Warren Buffet, a well-known predictor of economic trends, declared last March that the United States was in recession “by any commonsense definition.” His views were widely echoed by the Annual Survey of Affluence and Wealth in America conducted by the American Express Publishing Corp., which polls the country’s wealthiest 10% households.

The survey revealed that nearly 80% of affluent Americans — those with annual incomes above $342,000 and investible assets well beyond that — believed by April 2008 that a recession had already hit the economy. Moreover, no less than 76% of those surveyed were negative about future economic prospects, compared to 78% in a prior 2006 survey being positive about the future of the economy.

Adding to the freefall in consumer confidence — and the growing collapse in both planned investment and business investor confidence by early 2008 — was a corresponding fall in confidence by small business. In a survey by the National Federation of Independent Business conducted in March, small businesses clearly believed the economy was already in recession.

This survey recorded the lowest levels of optimism about the economic future since monthly surveys of the group began in 1986. The severe negative outlook of small business was based on expectations of continuing sales decline, as well as on their plans to dramatically scale back employment — the latter point of which bodes poorly for future job losses, since the majority of new job creation is typically the result of small business hiring.

“Beginning of the End”?

Despite overwhelming evidence that the U.S. economy had entered recession and the growing crisis in confidence across the board, in a matter of just a few weeks after mid-April a flood of pundits, Treasury Secretary Paulson and government officials, and various media sources poured forth with contrary declarations proclaiming the economic crisis had stabilized; that the financial crisis was over; that the recession was averted; and that the tax rebates and lower interest rates engineered by the U.S. Treasury, Congress and the Federal Reserve Bank would return the economy to a growth path in the second half of the year.

But is the economic crisis over?  Does the recent Bear Stearns Investment Bank bailout by the Federal Reserve represent the end of the financial side of the crisis? Do recent government reports that the Gross Domestic Product was a positive 0.6% in the first quarter, and that April job losses were only 20,000, constitute ample evidence that the downturn in the real economy has leveled off? And will the tax rebates succeed in returning the economy to sustained GDP growth?

In short, do events of recent weeks represent the “beginning of the end” in terms of both financial and real economic instability? On all counts, the answer is “No — only the end of the beginning.” Here’s why.

The first phase of the financial crisis, to date, is not even half over and most likely will continue for several more years. More subprime mortgage-like market busts are yet to come, punctuated by highly visible bank, non-bank financial institution, and/or major corporate bankruptcies.

Phase One of the financial crisis dates from events commencing in late 2006 with the start of the collapse of the subprime residential U.S. mortgage market. The subprime crisis then burst upon the general economic scene in late summer 2007.

The first phase then continued throughout the remainder of 2007, as other credit markets linked to or affected by the subprime crisis were in turn impacted. These included markets like collateralized debt obligations (CDOs), which bundled subprimes with other assets, the asset backed commercial paper market, commercial property, leveraged buyout loans, junk bond and corporate high yield bond markets.

Just about every major short-term debt market was impacted to one degree or another. The result has been a contraction of lending dollars amounting to several trillions, now working its way through the real economy and grinding it to a halt.

By early 2008 the “infection” had spread beyond even the above short-term credit markets, to what were once relatively more stable longer-term credit markets associated with bond insurance, sections of the municipal bond markets, prime residential mortgage lending, the broader commercial paper market, and middle and small business loan markets.

By March 2008 initial signs appeared that the crisis was beginning to impact the $50 trillion credit derivatives market, a key market in which big investment bank players like Bear Stearns and Morgan Stanley were especially exposed and at risk.

At that point wealthy investors and non-bank financial institutions like Hedge Funds began pulling their money out of Bear Stearns. The risk of a “wholesale” run (in contrast to a “retail” bank run by small depositors) on the entire investment bank sector began to appear a reality.

The Federal Reserve and Treasury quickly stepped in to head off the bank run by bailing out Bear Stearns and guaranteeing $29 billion in subsidized loans for its subsequent merger with another bank giant, J.P Morgan/Chase. At the same time as the Bear Stearns bailout, the Federal Reserve rewrote its own charter and opened up loans to virtually all banks, investment and other, making available another $200 billion in low-cost subsidized loans to banks, supplementing a prior $200 billion the Fed had previously put up.

By April, in other words, the Federal Reserve had provided more than $400 billion in loans, amounting to more than half of all the available total $800 billion the Fed had on hand. The Bear Stearns bailout, the $400 billion, and assurances all financial institutions could get access to subsidized low cost loans from the Fed marked the end of Phase One of the financial crisis.

The Fed action did temporarily head off the first bank run event of the continuing financial crisis. But stopping a bank run is not the same thing as resolving a general financial crisis in any fundamental sense. And the Fed’s $400 billion committed to date amounts to well less than half the $1 to $1.5 trillion estimated total bank losses due to the financial crisis.

Knowing full well that even its $400 billion subsidization was insufficient to cover bank losses to come, the Fed began pushing banks to also raise additional capital on their own to help cover the remaining $1 trillion or so projected losses. Banks and other financial institutions have thus been desperately attempting to raise billions more, by issuing new stock and by selling off securities and assets at firesale prices.

However, only $100 billion or so in new capital have so far been raised by the banks. The banking sector is still short by nearly $1 trillion. And until that remaining $1 trillion is “worked off,” the material basis for the financial crisis will not have been resolved. In the interim, the financial crisis will almost certainly erupt once again, commencing a “second phase.”

Transition to Phase Two

The second phase of the crisis will likely involve a credit market other than subprimes, and its precipitating event will involve a solvency crisis associated with some other major financial institution. Among the banks, the most likely next bankruptcy candidate will be Lehman Brothers, which is particularly exposed to losses in both residential and commercial mortgages as well as derivatives. Another highly exposed institution is Merrill Lynch.

In Europe, the most exposed include the French bank Societe General and the Swiss UBS Inc. One or more major hedge funds may also play the precipitating role in the next phase of the crisis. Or it may involve a major non-bank financial institution currently suffering massive losses, such as the world’s largest insurance company, AIG Inc., which recently announced additional losses now approaching a total of $20 billion. Or phase two may come from a market direction and institution unforeseen at the moment. But come it will.

Moreover, the longer it takes the banking sector to “work off” that remaining $1 trillion in losses, the more that amount will rise in terms of total projected losses, because additional financial institution losses will rise as non-financial corporate defaults and bankruptcies accelerate while the current recession drags on and/or deepens. For example, both Standard & Poor’s and Moody’s rating agencies predict a tenfold increase in business defaults in the coming 18 months.

Added to this are further losses forthcoming as a result of the projected sharp rise in consumer credit card and auto loan defaults. In fact, various sources predict that the coming consumer credit defaults may result in bank losses in 2008-09 at least as large as those experienced to date as a consequence of the subprime mortgage debacle of 2007-08.

In other words, the financial crisis is currently at a juncture and in a transition stage. The problem, now much bigger than subprime mortgages, has spread widely to other longer term credit markets, and will worsen further as a result of sharp acceleration in both corporate and consumer credit defaults and bankruptcies expected over the next 18-24 months.

Joint Federal Reserve-Treasury efforts of the past month have merely headed off the first run on the banking sector; they have not resolved the fundamental financial instability deeply plaguing the financial system. Moreover, it is doubtful that the Federal Reserve, having shot off its gun in the amount of $400 billion and half its available ammunition, will have the resources to contain yet another “Bear Stearns” event involving Lehman Brothers or some other financial institution.

The longer or deeper the current recession runs, the more likely other financial markets will subsequently implode in turn. This brings us to the second “spin” topic of recent weeks — the claim that the recession itself has been averted.

Manipulating GDP and Jobs Data

The official spin that the real economy has also stabilized is based on a reference to two sources of data.

The first involves officially released figures indicating that the U.S. Gross Domestic Product, or GDP, did not fall in the first quarter of 2008 but actually rose a modest 0.6%. The followup argument is that $168 billion in tax rebates will subsequently refloat the real economy in the second half of 2008, leading to general recovery.

The second general argument involves data released in early May, which indicated that jobs for April had declined “only” by 20,000 instead of the 70-80,000 jobs lost in preceding months. Both sources of evidence, however — GDP and the leveling off of job losses — are grossly misleading, even erroneous, and do not reflect the true condition of the economy.

Despite overwhelming evidence that the real economy entered recession sometime in the latter half of 2007, official GDP data initially recorded a 0.6% growth in the economy for the fourth quarter of 2007. Despite the continued further deterioration of economic indicators in the first quarter of 2008, a similar 0.6% growth was recorded for the most recent period as well.

It is important to note, however, that the reported GDP data is only an initial estimate. It will be revised later in the year, and then revised again after that. The final revisions will almost certainly show the economy declined, at least in the first quarter of 2008 if not the last quarter of 2007 as well.

More important than future downward revisions, the 0.6% first quarter GDP growth was almost exclusively the result of an aberrant one-time surge in business inventories. And if the one-time boost in business inventory spending is adjusted for, then GDP actually declined by 0.2%, not rose by 0.6%, in the first quarter.

The aberrant growth in inventories in the first quarter will also mean a deeper than typical decline in GDP in subsequent quarters. A recent Lehman Brothers Investment bank economic report noted: “A big inventory contribution in one quarter means a payback in another quarter.”

In addition to the inventory factor, the federal government also contributed to a false positive GDP number in the first quarter by moving up additional defense purchases into the quarter, even though deliveries of actual products will occur much later. Had this not occurred, the first quarter GDP would have resulted in a further GDP decline of 0.8%.

Another way to show that GDP actually declined in the first quarter is to look not at monthly averages — as the federal government does in its official GDP estimates — but at where total output of the economy was on January 1, 2008 then compare the total to where output was on March 31, 2008. When this more accurate method of estimation is made, GDP falls from $11.701 trillion on December 31, 2007 to $11.686 trillion on March 31, 2008 — or a clear decline of about $100 billion.

While Bush administration officials and their network of pop-economist pundits have been spinning the GDP numbers for the best public relations effect, even largely conservative business economists have not been as sanguine. As John Ryland, chief economist of Bear Stearns noted, the merely “technical” manipulation of GDP by the Commerce Department “in no way alters our view that the economy has fallen into recession.”

Lehman Brothers economists expect a significant 1.0% drop in GDP in the second quarter of 2008, while Morgan Stanley bank economists predict a decline in GDP of 2.0%. Hardly an indication of recession having been averted!

The other data used to argue that the real economy has stabilized in the past month are jobs data from the U.S. Department of Labor. Here the “spin” notes a jobs loss in April of “only” 20,000 compared to job losses of 70-80,000 in preceding months. But once again the government’s techniques for estimating job loss are questionable, and the real truth is in the details.

First, monthly job loss and unemployment figures are merely statistical estimates, not real numbers. They are collected by the notoriously unreliable monthly “Current Population Survey” conducted by the Bureau of Labor Statistics, which undertakes a phone survey of households each month. This survey is biased toward middle- and upper middle-class employees with stable residences. It fails to accurately record job conditions for the less skilled, manual workers who are often more seriously impacted by initial shifts in the economy.

In addition, the survey does not accurately account for the “hidden unemployed” in the economy, grossly underestimates the number of so-called discouraged workers who are willing to work but not recorded as out of work by the government, and considers anyone who worked as little as one hour in the survey period as being “fully employed.” More than 30 million part-time and temporarily employed workers are thus largely overlooked or underestimated, and millions more urban youth and others on the margin of the labor force are unaccounted for altogether.

Were these limitations of the government data and methodology for estimating unemployment corrected, official U.S. unemployment rates today would average in the range of 10-14% instead of the official 5% or less.

As a result of the government’s current survey-estimation approach, ridiculous monthly job loss data are often reported.

For example, the government’s estimation of April job losses included an adjustment based on an estimate of “net jobs added or lost by newly opened or closed businesses,” i.e. what is called the “net birth/ death adjustment.” In April, this particular adjustment technique resulted in a bump up in payrolls by 267,000 jobs — a grossly ridiculous estimation given the highly negative sentiment and job creation plans by small businesses recorded in March, as noted at the outset of this article.

In fact, real job losses in April continued in manufacturing and construction at 50,000 a month on average each, similar to the first quarter, with retail jobs falling another 28,000. In other words, actual April job losses tracked with those of preceding months.

A similarly questionable “adjustment” reducing estimated monthly job loss numbers in April is the government’s claim that 300,000 new part-time jobs were added in the month. What this statistic most likely means is that hundreds of thousands of fulltime workers were laid off, or “converted,” from fulltime employment to part-time status during the month — in other words, 300,000 now working half-time, but still considered fulltime by the government.

This conversion is the equivalent, however, of at least an additional 100,000 fulltime workers being laid off. The 20,000 job loss should therefore actually be 120,000. This kind of shift or conversion from fulltime to part-time employment in the work force is typical in recent decades of early stages of recession, now that a huge pool of more than 40 million so-called contingent workers (part-time, temporary, contract) exist in the economy today.

A far more telling real statistic concerning job loss is that the total number of unemployed rose in 2007 alone by nearly a million, from 6.7 million to 7.65 million. That’s a 13.2% increase. Whenever a 13% rise in unemployment occurred in the course of a year it has always been followed by a recession three months later. That has occurred nine times since 1945, corresponding to the nine official recessions since then.

Dull Stimulus

The final point worth addressing is the claim that the recent $168 billion fiscal stimulus of tax rebates will succeed in lifting the economy back to a more or less permanent growth path. In fact, however, the rebates will have a very small and quite temporary effect on the economy.

Barely 25% of the $168 billion will result in additional spending to boost the economy over the summer. That’s a mere $35 billion or so — an amount that will be far more than offset by gas and oil price increases, and several times that in state and local tax and fee increases before the end of 2008.

Even J.P. Morgan/Chase economists estimate the percentage of the $168 billion that will actually be spent at no more than 30%. Most of the approximately $100 billion in consumer rebates will go toward paying off existing debt. The $70 billion or so going to business will not result in additional business spending, given the current environment, but will likely be used to subsidize business tax payments.

Like the Federal Reserve Bank’s lowering of short-term interest rates, the Bush-Congress tax rebates will prove to be too little too late, and will have virtually no effect on the emerging recession.

A more likely explanation is that both sets of policies — tax rebates and interest rates; Bush-Congress and Federal Reserve — were designed primarily to buy time until November. They aren’t designed to resolve the crisis, whether financial or in the real economy, but to temporarily “manage” or slow the pace of the crises in order to pass the buck to the next administration after the November elections.

Copyright by the author.

ATC 135, July-August 2008