09/28/2009 05:12 am ET Updated May 25, 2011

The Economy: Cycling Along With the Training Wheels On

There is a sharp divergence of views about the economy’s near-term prospects. Some speak of a V-shaped snap-back, others of a W-like double-dip, yet others of an L-pattern driven by a secular change in consumer spending.  This seems just one more indication of how elusive the nature of this crisis has remained.   

Statements by Alan Greenspan, Ben Bernanke and Henry Paulson that they did not see the crisis coming convey the same sense of confoundment.  Economists David Greenlaw and Jan Hatzius, for their part, crisply expressed a similar feeling of disconnect when they asked: “can we understand how a shock of roughly $250 billion to the leveraged intermediary sector might cause the type of turmoil that we have documented?” (Leveraged Losses: Lessons from the Mortgage Market Meltdown) 

The origins and dynamics of the crisis will be a subject of debate for years to come, but one big question mark has been whether this is a traditional economic recession, so to speak, or if something more lethal has been at play due to the financial context.  The stock market has been reacting as if this has been a traditional recession and it is pretty much over. Could the market be misreading things?

Looking back, the fact was that well into the credit crunch and through much of 2008, the real economy had continued performing remarkably well.  There were some exceptions: the Californian economy (which began weakening in 2006), the automotive industry (since 2005) and housing. Other than these trouble spots, though, productivity had continued increasing. The U.S. economy had absorbed relentless increases in raw materials with nary a sign of inflation.  Corporations, cash-rich from years of deleveraging, were largely unaffected by the credit contraction of 2007.   Few would have disagreed with Fareed Zakaria’s comment in May 2008 that “global growth is the story of our times. It explains the rise of liquidity – the ever-growing piles of money moving around the world – that has kept credit cheap and assets (including real estate, stocks, and bonds) expensive.” (The Post-American World)

It is doubtful that the economy had truly been weakening on its own. In fact, as far as industry is concerned, into late 2008 there were few of the signs typical of a recession – the gradual loss of visibility on customers’ needs, the shortening of procurement forecasts, increased lumpiness in orders, etc. Rather, all the way through September and October 2008, the pace of business activity remained good and companies continued to hire.  Housing and the turmoil on Wall Street beginning in 2007 were being monitored with circumspection, but their impact was muted by buoyancy in capital goods, the proliferation of infrastructure projects around the world, the seeming resilience of consumer spending in the face of ever higher gas prices, and rising demand for consumables generally as world living standards improved.

It was not until mid-November – two full months after the Lehman and AIG collapses – that a pullback occurred, and when it did it was an abrupt one.  Without warning, orders were put on hold. A freeze gripped industry, hiring stopped, capital spending was curtailed and everyone stood still, as if a switch had been flipped.

But this type of suspension of activity is emblematic not of a recession, but of a sudden concern about liquidity and cash retention.  The successive seizures that started with banks’ unwillingness to lend to one another on even an overnight basis had finally spread beyond Wall Street.  

Since liquidity fears will ultimately lead to recessions, we seem to end up in the same place. The problem is elsewhere: it is that when they are too violent these fears can trigger a loss of faith in the system’s pricing and valuation abilities. This is what happens when speculative frenzies end, when the value of a currency or of money itself (viz. John Law) is thrown in doubt, when financial panics occur. In November 2008, a panic did occur. It is just that the Fed’s massive injection of liquidity contained it and successfully masked from most people that this is what was happening. Nevertheless, it is now clear that these interventions did not prevent uncertainty about prices and valuations from setting in.

Prices are more than a market-clearing mechanism; they must also provide information about and sustain long-term value – so the framework exists in which investments can be made and plans involving stakeholders entered into.  The government spending programs that were then put in place have been mainly geared to sustaining and stabilizing precisely this aspect of the system. While diverse at the micro level, all these actions had one thing in common at the macro level: propping up asset prices. This objective is not articulated as such, but that is the fundamental effect of these undertakings. A by-product, of course, has been high bank profits which some hoped would be able to partly make up for the hole left by toxic asset write-downs.

These actions have had tangible results: both the credit and equity markets have been more stable. The question is: can the system function on its own without all this government assistance? Despite all the spending, uncertainty about prices and values seems pervasive. Oil is in the $70s but the drilling rig count has dropped 50% to levels that reflect skepticism whether the implied information is reliable. Freight services are down 40%+.  Retailers other than those distributing cheap products made in Asia and Latin America are down, as are food distributors. The American consumer seems convinced that the sale will still be on months from now, that it might actually be for an even greater discount then, or that perhaps the purchase can be skipped entirely.

Some people have been warning of inflation down the road as a result of government spending-induced deficits.  The graver risk seems to be not inflation but deflation. Were it not for government spending, prices would probably be declining now.  In short, we are on the verge of a deflationary spiral.

This could be set off in earnest by a number of built-in risks in today’s environment: rising unemployment, the prospect of a weakening dollar, a resurfacing of toxic asset losses (the result of Alt-A resets and further defaults and foreclosures), a shock from a bank failure or a misplaced market bet.  International coordination may also erode as different regions face different challenges. When Gordon Brown exhorted all to forsake any “protectionist” impulse in the crisis, he had a point.

For the U.S. economy, a two-pronged approach seems necessary to get long-term growth going again. The first is a removal of toxic assets. These assets are unlikely to ever come back and will actually deteriorate further.  The PPIP program, which started earlier this summer, will not achieve this since it ended up giving participating investors enough latitude to trade in distressed paper but avoid the truly toxic assets (essentially turning PPIP into a variation of TARP but with different players and free equity instead).

The second prong consists of fiscal and other tools to help American manufacturing and products and services that are exportable become the new economic engine: enhanced tax credits for investments, R&D and engineering projects, employee continuing education; a lowering of corporate taxes in certain sectors and incentives for maintaining or repatriating jobs. Manufacturing investment regions should also be considered, as well as a GI bill-type program and home equity grants for veterans.

The non-fiscal tools consist of government technology transfers as occurred when know-how in transistors, radars, sensors, the internet and most recently GPS was made available to the civilian economy – spawning new industries and firms. This would require a systematic scanning of government-sponsored research, DARPA projects, and university collaborations.  

Some observers have asked whether we are in 1929 or 1932. The good news is that the world is so different today that we are probably in neither. We don’t have outhouses to go at night for our bodily needs. Fresh water is available at the turn of a tap. We have air-conditioners to keep us cool and refrigerators to preserve our food. The internet, cell phones, GPS devices, iPods, all have immensely enhanced our quality of life. (Of course, they have also made comparison shopping easier and enabled a new breed of investors to trade commodities electronically – perhaps contributing to the froth and volatility.)  

On the other hand, we face challenges unknown in the 1930s. The globe has 6 billion inhabitants with that much more potential for instability. Travel and communication is taken for granted, yet the mere unavailability of oil or electricity would take us back centuries. Work specialization and dependency on complex distribution channels have also diminished our ability for self-sufficiency.