08/23/2009 05:12 am ET Updated May 25, 2011

The Green Sprouts of Recovery and the Party Spoilers

What a difference a fortnight makes! Two weeks ago, as the G8 were meeting, concerns lingered about continued weakness in world economies. "Crude tumbles on doubts about economic rebound" and "EU: crisis could cripple euro economy potential" were some of the headlines on July 6. "Commodities slide on doubts about economic rebound" was the follow-up on July 8. A few days later, pundits from Robert Bianco to Warren Buffet suggested that a second stimulus package would probably be needed in order to lift the economy out of its slump.

By this week, more measured minds thankfully prevailed. On July 20, the experts were observing that for all the naysayers, markets were telling a different story, with "stocks [geared to] rally anew on more signs of economic health." Just a few days earlier, Goldman Sachs, JP Morgan and Bank of America had all announced significantly better than expected results. Even Nouriel Roubini, Dr. Gloom himself, weighed in with the assessment that the economy was no longer in a "free fall" and the recession would likely end later this year.

All this is really great news. It's finally over. And with the TARP funds mostly back in government coffers, Wall Street can now look forward to resuming large bonus payments, perhaps even making up for the lean years. The good old days are returning. Phew, that was close, but we have at last turned the corner.

Or have we? Let's see.

1) Government support. While much publicity has surrounded the return of TARP funds by banks, much less emphasis has been placed on the extent of continued government support in the financial markets. We are left with the impression that the government - in reality distinct players like the Fed, the Treasury, the FDIC, and others -- pushed around Wall Street executives and imposed unreasonable constraints on their operations which are only now being removed.

The reality is that the interbank payments system would still be frozen were it not for the liquidity that the Treasury and the Fed have maintained in the markets. We can see this from the still extraordinarily high level of borrowings at the discount window (at $388 billion certainly an improvement from the almost $700 billion of November 2008, but an astounding level compared to the $200-$500 million that prevailed before the crisis) as well as the $744 billion in excess reserves maintained at the Fed (this is down about 15% from its May 2009 high, but an equally astounding figure when compared to the $2-$3 billion pre-crisis level).

Longer-term forms of funding for banks such as commercial paper would also be almost non-existent were it not for the FDIC's backing. These are just for starters -- in addition, there are the purposely low interest rates, the debt guarantees that no one talks about anymore, the $30 billion backstop on Bear Stearns assets, the $309 billion in guarantees on Citicorp debt, the repurchases of mortgage-backed securities, and numerous other programs. Without all these, bank earnings would not be anywhere near where they are and one shivers even imagining how, left unaided, banks would be interacting with one another in even such prosaic areas as overnight loans.

2) The debt elephant in the room. Small businesses have been disproportionately affected by sudden changes in bank lending standards. Without warning, many of them have been thrown into the maelstrom of struggling almost on a daily basis for inventory and receivables financing. However, while "getting the banks lending again" is a true problem in specific areas, at the macro level it has turned into a misleading leitmotiv. Many people believe that this is the central problem ailing the economy and that if banks could be compelled to start lending again, much of economic activity would return to normal.

In reality, at the level of the national economy, it is not more debt overall that is needed, it is less debt. The American consumer has already sensed and begun acting on this. Like it or not, we are in fact facing the prospect of a secular reduction of debt back to historical norms. While there is much talk about the U.S. government debt, which is around $11 trillion (and of which around 27% is held by foreign countries), few people seem focused on the fact that a staggering $53 trillion of debt is outstanding in the domestic market. This compares to $20 trillion in 2000. For sure, this problematic in light of the large declines in asset values that have occurred. But it is even more worrisome when compared to GDP since this means to total domestic debt stands at an unprecedented 3.7 times the total output of goods and services in the U.S.

3) Main Street. Many Americans felt a tinge of pride at the unparalleled superiority of weaponry displayed by U.S. Armed Forces in the Iraq and Afghan wars. It is not merely that American armaments were shown to be the most precise and versatile, it is also that it was clear for all to see that these capabilities are pretty much unmatched in the world - as in: "Gee, I never knew something like this was even possible."

Not such a long time ago, it was not just in the military realm that U.S. companies led. U.S. aircraft were the standard, American civil engineering firms dominated, products from steam turbines and pumps to building controls and signal transmission were American preserves, American shipyards were the envy of the world. Overseas when one said of something that it was the Cadillac of its category, everything had been said.

In this recession, it is unnerving how little attention has been devoted to how American manufacturing firms have been affected. Much of the commenting and reporting has been about the performance of financial players, technology companies and commodities like fertilizers, oil, or aluminum. It is no wonder that some have been under the impression that perhaps things are not that bad.

It is easy to downplay the sector by saying that it employs "only" 11-12% of U.S. workers and to act as if all has been said about manufacturing that needs to be said by focusing on the automotive industry and vaguely alluding the "unions" and "mismanagement" and "unfair competition." But in reality, American manufacturing before the crisis was holding the promise becoming once again a significant engine of growth as infrastructures in China, India, Brazil and the Middle East were built.

On that score, what is happening on Main Street is very bad indeed. When a Caterpillar announces that revenues are down 44%, this is not just unfortunate, it is terrible. Bearings are down 40%, trailers 70%, oil & gas equipment 50%, and guidance for the second half of 2009 is hardly more encouraging.

So, while there may be isolated signs of improvement, it is hard to avoid the sense of a gap between the predictions of an incipient recovery and the stark reality of a financial system still on life support for many basic functions, a secular deleveraging process and a deeply affected manufacturing sector.

What should be done? In subsequent articles, we will offer up some ideas for discussion.