Wednesday, April 23, 2008


The Bottom Is Up Ahead

Wall Street leaders suggest the crisis has played out. But no one has a handle on it, and we probably won't hit bottom before 2009.

You'd think that Wall Street would be feeling embarrassed and humiliated enough about its own performance that its top executives and strategists would have the good sense not to be out there peddling fresh nonsense about how the credit-market crisis has pretty much played itself out.
Don't be fooled by the latest sucker rally on stock markets or predictions that the "worst may be behind us." The first thing you need to remember is that these guys still don't have a handle on what they're dealing with -- nobody does. And even if they did, we know that when it comes to their own balance sheets, or to the outlook for the markets and the economy or designing a new regulatory framework, they simply cannot be trusted.
To figure out where things are in this crisis, and where they are headed, it's important to understand how we got in this mess. Let me posit two possibilities.
One explanation is that we got here because mortgage bankers and brokers were sleazy, investment bankers were greedy for fees, banks were incompetent, rating agencies were compromised, and regulators either were blinded by deregulatory ideology or chose to look the other way.
Obviously, there is a good deal of truth in all of that. And if you accept that as the basic story, then you might well think that the crisis will be over as soon as the bad loans are acknowledged and written off, the banks are recapitalized, and new rules are put in place to make sure it never happens again.
But what if that isn't the whole story? What if, for the better part of a decade, the United States had been living way beyond its means, consuming more than it produced and investing more than it saved? What if China and Taiwan and Saudi Arabia and even Japan were willing to finance that trade deficit on easy terms because it allowed them to peg their currencies to the dollar in a way that generated higher job creation and economic growth in their home markets? And what if this mutually advantageous imbalance in trade and investment flows wound up creating a huge supply of cheap dollar-denominated credit that virtually invited the bankers and brokers and rating agencies and private-equity firms in U.S. markets to throw caution to the wind and make ill-advised lending and investing decisions?
Not only is this a plausible explanation, but I think it is the underlying story. And if that is the case -- if the story of the credit bubble and its bursting is more fundamentally about macroeconomic imbalances than microeconomic failures -- that has very different implications for where we go from here.
For what it means is that things won't be "fixed" simply by having the financial sector write off its losses and bad loans and promise to do a better job next time with risk management. Rather, it will require a reduction in the overall standard of living in the United States so that the country as a whole begins to live within its means.
What does that mean exactly?
In practical terms, it means that households will have to reduce consumption, increase savings and stop piling up credit card debt or using home equity as an ATM.
It means that the federal government stops running huge operating deficits by raising taxes or dramatically cutting national security and entitlement spending.
It means that the price of homes return to levels that reflect the incomes of the people who live in them, and the price of office buildings and shopping centers reflect the cash flow from tenants.

It means that the price of stocks, bonds, commodity futures and derivatives return to levels that reflect real cash flows and risk-adjusted economic values, not speculative values based on continued availability of cheap and easy money.
Such a broad reduction in wealth and living standards will take many forms. It will come in the form of higher unemployment and stagnant wages and falling income, which take statistical form in slower or even negative economic growth. It will come in the form of inflation and its first cousin, a lower value for the dollar. And it will manifest itself in lower values for pension funds, 401(k) accounts, university endowments and house prices.
You don't have to have a PhD in economics to see that this adjustment is underway. But it would be folly to assume that it is anywhere near completion. After all, it took many years for our collective standard of living to get out so far out of whack, and it's highly unlikely that we are somehow going to reverse things in a couple of quarters. And the bubbles in commodities and commercial real estate are still to pop.
Moreover, at every step along the way, households and companies, lenders and investors, politicians and taxpayers are going to look for ways to delay such painful adjustments or push them off on someone else. We all know that, just as things overshot on the way up, they are likely to overshoot on the way down.
There are no forecasting models I know of that can reliably predict how long all this will take. But simple logic, and our experience with the real estate debacle of the 1990s and the tech bubble of 2000, suggests that the turmoil in financial markets won't be over until the end of 2008, at the earliest. And since there is a lag of at least a year between what happens in financial markets and what happens in the economy, it's unlikely that the economy will bottom out much before the end of 2009. After that, look for another annoyingly slow and "jobless" recovery.
And that's the good scenario -- what happens if there are no nasty surprises.
What is important to keep in mind is that this will be a process of markets correcting for their own excesses and imbalances. Government can take modest steps to control the speed of the adjustment process or distribute the pain in different ways, but trying to prevent it will only make things worse.

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