Tuesday, December 2, 2008

the cost of recovery

Last January, back before I was posting these things on a blog, I wrote in one of my email commentaries, “I predict we will learn later this year that a recession started this quarter – the first quarter of ’08.” As it turns out, we were already in a recession as I wrote those words – but just barely. Recessions typically aren’t officially diagnosed as such until several quarters after they began – often after they have already technically ended. The body that is (by law, no less) the official arbiter of when recessions begin and end in this country is the Business Cycle Dating Committee of the National Bureau of Economic Research. Yesterday, they decreed that the previous economic expansion ended, and the current recession began, during December of 2007.
The average recession since the Great Depression has lasted 10 months. That means the current recession is already longer than the
average post-Depression recession. If it lasts through next April – and I don’t know of any economic forecasters who think it won’t – it will be longest since the Great Depression. (The Great Depression officially lasted 43 months, from August 1929 through March 1933. But the economy fell into a deep recession again in May of 1937 and the economy generally stagnated until World War II.) I expect the current recession will run into 2010.

The previous recession (the mildest of the post-World War II recessions) ended in November 2001. The ensuing expansion lasted 73 months. By contrast, the expansion of the ‘90’s (which started March 1991 and ended March 2001) lasted 120 months.

wasn’t the only bad news yesterday. The Institute for Supply Management's survey of manufacturing activity was weaker in November than it had been since 1982 (the end of the recession that currently holds the record for the worst since the Great Depression). And the manufacturing slump has extended to Europe and China. Also, the Commerce Department reported that construction spending in the US fell 1.2% in October. And demand for US Treasury bonds was so high that investors were willing to accept a yield on a 10-year bond of only 2.73 percent -- a record low -- meaning investors were willing to lend the US government money at that rate for a decade.

The markets didn’t like yesterday’s news, and the S&P 500 declined by 8.9%.

And the bad news continues today. Auto sales in the US are in
full-blown depression mode, falling 37% last month to their lowest level in 26 years. (And it wasn’t just US auto makers. Chrysler did the worst, with a 47% sales decline. But Nissan did worse than GM – declining 42% vs. GM’s 41% fall. US sales declined more at Toyota (-33.9%) and Honda (-31.6%) than they did at Ford (-30.6%). So let’s not demonize the US guys too much.) And since the automakers are the country’s largest consumers of steel, plastic, glass and electronics, what is bad for GM is bad for the country.

The thing that makes the current recession particularly scary is that our standard policy responses are proving ineffective – monetary policy, in particular, is nearing the end of its rope. Previous recessions didn’t throw into doubt our economic models to the same extent as this one. (It didn’t take a genius to figure out the dot.com bubble was going to burst – a company with no revenue model, let alone any prospect of profitability, probably wasn’t going to sustain a multi-billion dollar valuation for long.)

As Berkeley economist Brad DeLong

Let me say what things I was "expecting," in the sense of anticipating that it was they were both likely enough and serious enough that public policymakers should be paying significant attention to guarding the risks that it would create:

(1) A collapse of the dollar produced by a panic flight by investors who recognized the long-term consequences of the U.S. trade deficit.


(2) A fall back of housing prices halfway from their peak to pre-2000 normal price-rental ratios.

I was not expecting (2) plus:

(3) the discovery that banks and mortgage companies had made no provision for how the loans they made would be renegotiated or serviced in the event of a housing-price downturn.

(4) the discovery that the rating agencies had failed in their assessment of lower-tail risk to make the standard analytical judgment: that when things get really bad all correlations go to one.

(5) the fact that highly-leveraged banks working on the originate-and-distribute model of mortgage securitization had originated but had not distributed: that they had held on to much too much of the risks that they were supposed to find other
people to handle.

(6) the panic flight from all risky assets--not just mortgages--upon the discovery of the problems in the mortgage market.

(7) the engagement in regulatory arbitrage which had left major banks even more highly leveraged than I had thought possible.

(8) the failure of highly-leveraged financial institutions to have backup plans for recapitalization in place in the case of a major financial crisis.

(9) the Bush administration's sticking to a private-sector solution for the crisis for months after it had become clear that such a solution was no longer viable.

We could have interrupted this chain that has gotten us here at any of a number of places. And I still am trying to figure out why we did not.

All of this just emphasizes again the need for the strongest possible policy responses. Unfortunately, the responses to date have been pretty extreme. By some accounts upwards of $8.5 trillion has already been devoted, just in the US, to combating this crisis. (Bloomberg had put the tally at $7.76 trillion before last week’s additions. The New York Times rounds that up to $7.8 trillion. The Los Angeles Times is now using the $8.5 trillion figure.)

Now, in fairness, there are a lot of apples and oranges (and some kiwis and papayas) getting mixed up here. These figures include equity infusions, asset purchases, and all manner of loans and loan guarantees. Included, for example, is $2.4 trillion to buy commercial paper. But that is the size of the entire commercial-paper market. While the US government has committed to being the “buyer of last resort” for that paper, no one believes the government will end up on the hook for the whole thing or even a substantial portion of it. Similarly, the US government has committed to purchasing up to $600 billion in money-market funds but has only (“only”) actually laid out $70 billion to date. The government has guaranteed $1.5 trillion in bank debt but hasn’t yet paid out anything in connection with that commitment. Still, the magnitude of the government’s financial commitment is staggering – equal to roughly 60% of our GDP and approaching our $10 trillion in national debt. And if you really wanted to exaggerate the commitment, you could include the entire $5 trillion or so of loans in the portfolios of Fannie Mae and Freddie Mac (rather than just the explicit commitments made to date) because it is generally assumed that the US government stands behind the guarantees of those companies. If the US government was actually ever called upon to make good on all these commitments, we would probably already be using our furniture for cooking fires.

Talking Points Memo has a
good summary of some of the components of the bailout:

- The Troubled Assets Relief Program, in which Congress allocated $700 billion to the Treasury to buy equity stakes in financial institutions.
- A Federal Reserve program, announced in October, to buy up to $2.4 trillion in commercial paper that companies use to pay bills. That figure represents what eligible issuers could sell, but the Fed has said it does not intend to buy anywhere near that amount. Earlier this week the Washington Post
put the amount that it had so far put up at $266 billion.
- A combined Fed-Treasury effort,
announced yesterday, to buy up to $800 billion in mortgage- and asset-backed securities, in order to unfreeze credit markets.
- A Fed program,
announced last month, to purchase up to $600 billion in US dollar commercial paper and certificates of deposit, in an effort to provide liquidity to money markets.
- The Citigroup bailout,
announced over the weekend, in which Treasury, the Fed, and the FDIC have agreed to shoulder up to $249.3 billion in losses from the company's risky assets.
- Since September, Treasury has spent at least $26.57 billion in making direct purchases of mortgage-backed securities. It has said it will continue to make such purchases in the months ahead,
reports CNBC.
- Treasury has also
spent $200 billion combined to prop up Fannie Mae and Freddie Mac, by purchasing preferred stock when they were taken over by the federal government back in September.
- And
according to CNBC, it has spent up to $144 billion in additional mortgage-backed securities purchases by Fannie Mae and Freddie Mac, since their portfolio limits were expanded at the time.
- Meanwhile, the Federal Housing Administration spent $300 billion to refinance failing mortgages, in an effort
launched this fall to rescue the housing market.
- And the
$29 billion in financing in March for JPMorgan Chase's government-brokered buyout of Bear Stearns.
- The Fed
has made up to $900 billion in loans to financial institutions. As of Nov. 19, it had extended $415.3 billion in credit.
- The Fed also has continued its regular discount window lending, but
at a much higher volume than normal. It loaned $91.5 billion last week, up
almost 200 percent from the usual weekly average of $48 million over the last
three years,
according to Bloomberg News.
- The Fed and Treasury will support AIG to the tune of $152.5 billion, in equity
purchases and loans,
it was announced earlier this month.
- The FDIC last week
announced that it will make available up to about $1.4 trillion in loan guarantees, to encourage bank-to-bank loans.

Another wag, Jim Bianco (quoted on the excellent financial Web site
The Big Picture), came up with a total bailout cost of $4.6 trillion (obviously Bianco lacks ambition). He then puts that in context with some other big government expenditures:

Marshall Plan: Cost: $12.7 billion, Inflation Adjusted Cost: $115.3 billion
Louisiana Purchase: Cost: $15 million, Inflation Adjusted Cost: $217 billion
Race to the Moon: Cost: $36.4 billion, Inflation Adjusted Cost: $237 billion
S&L Crisis: Cost: $153 billion, Inflation Adjusted Cost: $256 billion
Korean War: Cost: $54 billion, Inflation Adjusted Cost: $454 billion
The New Deal: Cost: $32 billion (Est), Inflation Adjusted Cost: $500 billion (Est)
Invasion of Iraq: Cost: $551b, Inflation Adjusted Cost: $597 billion
Vietnam War: Cost: $111 billion, Inflation Adjusted Cost: $698 billion
NASA: Cost: $416.7 billion, Inflation Adjusted Cost: $851.2 billion

TOTAL: $3.92 trillion

Bianco understates the cost of the Iraq war, of course. He is only using the cost to date to the extent it has taken the form of supplemental appropriations. Nobel Laureate economist Joseph Stiglitz calculates the cost of the Iraq war at
$3 trillion. So go ahead and gross it up by another $2,450 billion and add it back in to the estimate above. It's still comes to only $6.37 trillion.

No matter how you calculate it, these are big numbers.

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