The Economy Faces a Makeover

Let's assume for a moment that Washington's all-out attack against the spreading global financial panic is eventually successful. Not a big stretch, really. Recent emergency actions by the government—such as having the Federal Reserve buy short-term corporate debt and the Treasury Department sink $250 billion into nine megabanks—are more or less similar to what many other countries have done during credit crises. And ultimately their banking systems stabilized. Wall Street may be forever changed, but it's not going to disappear. Uncle Sam, says Global Insight economist Brian Bethune, has "finally declared war on the financial crisis, and this may well represent a critical turning point."

But turning to where, exactly? Economies don't just return to business as usual after such horrific financial shocks. In perhaps the most famous example, a burst property bubble in Japan caused credit markets there to freeze up solid in the 1990s. The aftermath was not a pretty one. "The result was a decade where growth averaged less than 1 percent [annually]," says David Wyss, chief economist at Standard & Poor's. "Japan lost its AAA bond rating, the stock market is still trading at less than a [quarter] of what it was 20 years ago, and home prices are still down 25 percent from their peak."

Now Washington has been far more aggressive than Tokyo ever was, and that should help limit the damage greatly. But Fed Chairman Ben Bernanke has explicitly warned his fellow Americans that no matter what the success of all the money machinations in Washington, "the broader economic recovery will not happen right away." Think "lost couple of years" rather than "lost decades." And when growth does kick back into gear, we'll find ourselves living in an economy that's undergone an extreme makeover. Conspicuous consumption and borrowing will be out, saving and investment in. Flat-screen-TV-stuffed McMansions and complex financial derivatives will be out, new energy technologies and new infrastructure in. It won't be as much fun for spendaholic America, but it might be just what the country needs.

Downside. But before that healthier future arrives, there's the not-so-small matter of the recession. Bernanke likes to smooth the rough edges, saying the credit turmoil poses a "heavy toll" on economic growth. But in a speech to financial executives in Silicon Valley, Janet Yellen, president of the Federal Reserve Bank of San Francisco, was more direct: "The U.S. economy appears to be in a recession," so with the battle lost, the Fed has moved on to "attempting to mitigate the dark scenario on the downside risk. I believe and I hope that we'll be successful."

Now there are "dark scenarios" and then there are "dark scenarios." The Great Depression is about as dark as it gets. If the United States suffered a downturn as severe today as was seen in the late 1920s and 1930s, the losses would be mind-boggling. Then, the economy shrank by almost half, and the stock market fell by 87 percent. Compared with the tens of trillions of dollars in potential damage, the $700 billion Paulson plan seems like a drop in the bucket. But even less severe downturns caused a massive rise in unemployment. As it is, Wall Street economists are looking for the jobless rate to climb to at least 7 percent or higher from the current 6.1 percent level. That's why so many economists think aggressive government action is necessary. "If we don't get the financial rescue right, then we are going to go through a much deeper and longer recession than we have seen in the post-World War II period," says economist John Ryding. "We have no modern-day experience with such a thing."

So, what is the realistic worst-case scenario? Stanford University economist Nicholas Bloom thinks both Europe and the United States will sink into a severe recession next year, with gross domestic product contracting by 3 percent and unemployment rising by a total of about 3 million. (By comparison, GDP fell by 3 percent in 1973-74 and 2.9 percent in 1981-82.) During the summer, Bloom thought the downturn would be a mild one, more like that seen in 2001. But the escalation of the credit crisis changed his mind. "The current situation has so many parallels with the Great Depression of 1929-1932 that even my updated predictions could be overly optimistic."

Wild swings. What Bloom finds particularly worrisome is the level of uncertainty in the economy as reflected in all the wild trading on Wall Street. Daily 500-point moves now seem commonplace. Volatility among the largest and theoretically safest stocks, Bloom has found, has increased almost sixfold since August 2007 to levels even greater than seen after 9/11, the two Gulf Wars, and the 1997 Asian financial crisis. But it's not just that people are really nervous and uncertain. Previous episodes of volatility subsided after a couple of months. This occurrence is now in its second year, breeding hesitation to invest in new business ventures and expand existing ones. According to Bloom, "2009 will be truly horrible."