From GDP to Jobs to Trade and Fear, Full Economic Recovery Could Take Years

What we have come to call the Great Recession represents a hole in the American economy on the scale of the Grand Canyon—and we are nowhere near assembling a good enough footbridge across it. Let's first take a survey of what confronts us.

The gap between what the economy is producing now and what it would produce at full capacity is reckoned at 10 percent, the highest since the Great Depression. In the past two quarters, we have had the sharpest decline in gross domestic product since the end of World War II. The gap may not be closed until the middle of the next decade, making it likely that this recession will be not only the most severe but the longest since the end of WWII. At least $25 trillion of national wealth has vanished.

If we look at the geology of the big fault, we see the dynamic effects of the real and perceived loss of wealth: the plunge in house prices; the revival of the habit of saving, with consequent cutbacks in consumer spending and investment; the collapse of the stock market, which affects everyone sooner or later; and the rapid rise in unemployment.

Take housing. The value of the most important asset on the balance sheet of the average family—the home that 67 percent of American households own—has declined by an average of just under 30 percent. And there are still outstanding risks. If home prices were to fall another 20 percent, the average mortgage debtor would have lost all of the remaining equity in his or her home, producing more abandoned houses and foreclosures and undermining what is left of the market. Housing starts have fallen about 75 percent, down to about 460,000 units this year from the peak of 1.8 million units several years ago.

Take savings. Americans just a couple of years ago were saving virtually nothing from their incomes because they thought the rising values of their homes and financial assets provided adequate security. They have now increased their savings from zero percent to over 4 percent of disposable income. Since every dollar of savings means a dollar not spent on consumption, these savings represent a reduction of at least $420 billion of consumer spending. Furthermore, the savings rate is expected to rise to at least 8 percent, which would be consistent with the historical average for the current level of household wealth—and some polls indicate it might rise much higher as consumers conclude they need to rebuild their net worth, especially those who are close to retirement and need to replenish their retirement savings.

The natural effect of shocks to financial security inspiring the safety-first impulse to save and reduce debt will play out in even more downward pressure on business activity. We still have too much output capacity, too much overhead, and too many assets earning inadequate returns to spark substantial new expenditures on investment. In the first quarter, capital spending plummeted by a 38 percent annual rate. This overhang of excess capacity will further underscore labor capacity excess and continue to weaken wage growth, hence holding back consumer spending. The consequences are therefore bleakly negative not just for retail but for capital investment and hiring and may go on for a couple of years. Industrial production is already down 12.8 percent from a year ago, and capacity utilization is down to 69.3 percent—the lowest since records began in 1967.

Job drain. It is not really surprising in these circumstances that jobs have been shed at a faster pace than at any other time in the past 50 years. Instead of creating the 125,000 jobs each month we need to deal with new entries into the labor force, we are now losing more than 600,000 jobs a month. The financial sector, which had grown into a more central part of our economy, is now a major nega-tive, since each financial job lost causes three nonfinancial jobs to be cut—a record multiplier. The unemployment rate is estimated to peak at around 11 percent. The workweek is at a record low of 33.2 hours. The broader measure of unemployment that includes people who are working part time because they can't land a full-time job has risen to a fresh peak of 15.8 percent, making 24.7 million people effectively unemployed. The long-held notion that unemployment is a lagging indicator has been eroded; indeed, in these unusual circumstances it could very well be a coincident or even a leading indicator.

And then there's the giant overhang of deficits and debts accumulated by households, consumers, and the worlds of business and finance, as well as cities, towns, states, and the federal government (follow California's fiscal collapse as a template of things to come). That is why the International Monetary Fund reported that U.S. banks have taken only about half of the write-downs they face, not to speak of those that will have to be absorbed by insurance companies, pension funds, hedge funds, and other nonbank institutions. Our four largest banks—Citigroup, Bank of America, Wells Fargo, and JPMorgan Chase—are menaced now by their conventional loan portfolios, separate from the $150 billion or so they have written off from the decline in the value of their securities. According to Fortune magazine, the big four hold $3.6 trillion in credit cards, student loans, auto loans, home equity mortgages, commercial real estate, and other consumer and business loans that are deteriorating at shocking speed. Default rates on credit card loans have already almost doubled, from 3.8 percent to 7 percent, since 2007. Rising unemployment rates can trigger more defaults on every type of consumer credit device: mortgages, subprime mortgages, home equity loans, credit card loans, student loans, etc.

The number of of credit cards issued to small businesses rose from 5 million to 29 million between 2000 and 2008, a credit card binge that resulted in an increase in spending from $70.4 billion to $296.3 billion over the same period, according to the Nilson Report. Today, business bankruptcy filings and associated credit card defaults have been rising faster than those on the consumer side, so card issuers have been aggressively scaling back available credit line balances by at least $500 billion today to those same small-business owners who relied on their cards to provide short-term financing, frustrating the attempts of the Federal Reserve to ease the credit crunch. Meredith Whitney, a banking expert, predicts that credit card defaults will exceed 10 percent.

Loan losses. The banks estimate that their defaults across this and other similar consumer loan categories will approach 1 percent above the highest unemployment rate, which, if the latter reaches 11 percent, will amount to a 12 percent loss factor, or $450 billion in losses over the next three years. If bank loans perform in this way, with such levels of default, we face the possibility of more episodes of acute distress. The financial sector still stands on a mountain of excessive, poor-quality loans made to the private sector at a time when the banks remain exposed to extraordinary debt on and off their balance sheets. The entire financial system is still, therefore, at risk.

There's no relief in sight through recovery in the rest of the world: GDP elsewhere has fallen faster. Global trade has decreased by nearly 10 percent and will decline more if President Obama and Congress succumb to instinctive (and primitive) protectionist policies advocated by unions and supported by populist demagogues. Our exports are already falling rapidly, although less so than in countries like China and Japan (down 40 percent). Mexico's economy has declined at the annualized rate of over 21 percent, Japan's and Germany's by about 15 percent on an annual basis. We are in the midst of the first absolute global contraction since the end of WWII.

Where do we go from here? We have assembled some construction materials for our bridge-building across the Grand Canyon: the stimulus program and the government support to the financial world from the Treasury Department and the Federal Reserve Board. The dismaying fact is that the $787 billion federal stimulus has devoted so many of its dollars to social welfare programs such as health, education, and general welfare—not to speak of pork barrel spending—that it is simply inadequate to fill in the $1 trillion-plus hole in annual demand that we may well experience. The Government Accountability Office estimates that from Oct. 1, 2008, through Sept. 30, 2010, only $160 billion in new spending will end up as stimulus. That report should have provoked an immediate outcry and resolute action, but it has been ignored. The economy may not be in a free-fall, but it is still rolling downhill, and the deeper the downward spiral goes, the more it will feed on itself. The Obama administration, in all its manifestations, is great at cheerleading (better than the Republican Party is at hollering), but it is little use talking the confidence game while failing to provide the resources necessary to justify that confidence and revive the real economy.

What is to be done?

It is critical that we develop significant standby stimu-lus programs in case the more pessimistic views prove correct—a pessimism that has been justified by the depressing numbers that have come out. This will involve preparing infrastructure development and big, shovel-ready projects so that we can accelerate their passage from the planning stage into the development stage without unconscionable delays. This is where the concentration should be because a dollar invested in infrastructure generates a much greater future output than a dollar of transfer payments or a consumption-stimulating tax cut or social program, such as expenditures on education or healthcare.

Given the facts as they are, after the alarm has sounded loudly and the prospects are still dismal, we can appreciate why today the difference between an optimist and a pessimist is that an optimist thinks this is the best of all possible worlds—and the pessimist fears he may be right.

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