Worthwhile Viewing - March 31st

Earth Hour 2009. The Big Picture, The Boston Globe.

Worthwhile Reading - Mar 31st Edition

Wall Street looks ahead: inflation vs. deflation. WSJ.

Financial rescue approaches GDP as U.S. pledges $12.8 trillion. Bloomberg. (hat tip, B.D.)

We modernized ourselves into this ice age. Eric Dinallo, FT.

AIG was responsible for the banks' January and February profitability. Tyler Durden, Zero Hedge.

March economic summary in graphs. Calculated Risk.

Data Watch - March 30th & 31st

OECD and World Bank revised forecasts
- OECD's new forecast is for member countries to contract 4.3% this year, down from its earlier forecast of -0.3% (2009 forecasts for Japan -6.6%, euro area -4.1%, U.S. -4.0%)
- World Bank's new forecast for global growth is down to -1.7%, down 2.6% from its last forecast, while its forecast for developing countries was marked down to 2.1%, from 4.4%

CANADA
- GDP for January came in as expected at -0.7% MoM after -1.0% MoM in December and -0.7% in November
- StatsCan released its payroll employment report for January; payroll employment decreased 117,000 in January, the largest drop since 1991; average weekly earnings have increased 3.2% in the last year

US
- Case/Shiller home prices for January were a bit lower than expected; for the Composite-20 index, home prices are down 19% YoY and down 29% from the peak
- Chicago PMI, the last major regional report before ISM, weakened to 31.4; the regional surveys have sent mixed signals
- Consumer confidence rebounded slightly to 26.0 from the 25.3 record low in February, not as big a bounce as had been hoped for; the present situation components continued to deteriorate, but the 6-mth forward expectations improved a bit; employment prospects worsened, and plans to buy a house, car or major appliance were scaled back

INTERNATIONAL
Japan
- vehicle production was down 56% YoY
- industrial production was down 9% in February and 38% YoY
- household spending was down 3.5% YoY, better than the -4.7% expected
- housing starts down 24.9% YoY
- construction orders also down 24.9% YoY
- Nomura/JMMA purchasing managers index better than expected, up to 33.8

Europe
- Eurozone economic confidence for March fell to 64.6, consumer confidence also fell further to -34, industrial confidence fell to -38, and services confidence to -25, all new lows since the series started in 1988
- Eurozone retail PMI, however, rebounded off lows of 40.6 in November to 44.1
- German unemployment in March increased more than expected; the unemployment rate climbed to 8.1%
- Eurozone CPI was 0.6% YoY, down from 1.2% in February

Forecast Notes

Underlying thesis: the problem of too much debt has not gone away and in fact has gotten worse as the ability to service it has deteriorated, not improved; housing values, the original foundation for all that debt, is still overvalued relative to historic norms and due to fall further; these factors have to be normalized before we will have any sustainable recovery; government interventions are intended to restart the credit cycle and as such are self-defeating

The bursting of the debt bubble is deflationary; the policy response is intended to offset this, and the market is worried that it will be excessive and prove inflationary

Reasonable people can disagree, each with their own good reasons, on this debate; I, for one, remain firmly in the deflationary camp; I believe that government is too small relative to the size of the private economy to offset the downside forces in the broader economy; further, the regular channels of policy traction do not work in a deeply-entrenched credit crunch that is accompanied by serious asset devaluation

For example, the Fed has doubled the monetary base to $1.7T, and may increase it further to $2T or $3T; but that’s still small relative to the $14T of household debt outstanding or the $52.6T of total credit market debt outstanding

furthermore, the monetary base has expanded but has been achieved just by doubling excess reserves at depository institutions to $0.77T, and the banks are just sitting on that; normally, increasing excess reserves would motivate banks to increase lending, because sitting on the money has an opportunity cost, and there would be a significant money multiplier effect due to the nature of the fractional reserve lending system; however, no matter how much reserves are increased now, there is no incentive to increase lending to an already overly-debt burdened and contracting private economy, and every incentive not to given the credit risks involved, and also given that due to the risk of deflation, a dollar tomorrow will be worth more than a dollar today

The Fed’s “printing of money” has not been anything like a helicopter drop; if I were a master counterfeiter and were to fly a helicopter over Toronto and drop millions of perfect hundred dollar bills down all over the city to the public below, it would be like everyone won the lottery, and would certainly lead to incremental spending and economic activity as everyone spent the bulk of their windfall; but that’s not what the Fed has done; what it has done is more akin to me printing a trillion dollars of fake dough then taking it all to my bank and locking it in a safety deposit box; the printing itself does nothing, it’s the dissemination of it that is inflationary

PPIP/TALF/etc useful for solvent banks facing some illiquidity constraints but no panacea for insolvency

Govt still refuses to acknowledge that saving the banks is different than saving the banking system; and whereas the latter is essential, the former is counterproductive; they're using the red herring of the 'no more Lehmans' line as the public justification for their actions when it has a lot more to do with regulatory capture and friends in high places

Despite govt hesitancy to admit and do something about it so far, insolvency, not illiquidity, remains the problem, so there will be more bank failures - big ones; nationalization may be a dirty word for some but bailout has become an even dirtier word so we will, if not soon then ultimately, learn to love the word preprivatization

The writedowns that were never supposed to approach $1T are now well over that ($1.25T) and will exceed $2T if not $3T

It’s not clear that writedowns of mortgages have even peaked yet, given that foreclosures and delinquencies were 11.2% at end of 2008 and still climbing rapidly and home prices are still falling; also, there are many more shoes to drop, particularly credit cards, commercial real estate loans, leveraged loans and, for European banks, Eastern European loans; for instance, the commercial banks are holding their commercial mortgages on their books at average carrying values of 95 cents on the dollar, with many still holding them at 100 cents; construction and industrial loans being carried at 96, construction loans at 90, home equity at 91, etc.; they also have a lot of off-balance sheet stuff still

Leading economic indicators have stabilized but at very low levels, indicating further deterioration though at a slower pace; and LEIs seem to be supported primarily by inclusion of monetary growth, which, given the dropoff in monetary velocity, is not likely to have a stable relationship to how it impacted the economy in normal times

The output gap is wide and getting wider; even if government actions somehow managed to get the economy back to the 2.5% potential real growth rate of the economy (labour force growth of 1.5% and productivity growth of 1%), that would not close the output gap and would not alleviate the deflationary forces; they need to get the economy above potential growth rates to eliminate the deflationary output gap

Nonetheless, nothing goes in a straight line: the U.S. recession may in fact end this year – but, if so, it would then resume early next year before coming even close to regaining the 2007 peak - nasty double dip

Housing may have more false dawns and activity can't fall forever; but crux of the matter is that in environment of worst recession in 75 years with climbing unemployment, falling incomes and a credit crunch, home prices will continue to fall PAST the mean, not just revert to it, which means there is much more home price depreciation to come, so collateral underpinning financial assets will continue to fall in value as will household wealth

U3, now 8.1% but 8.9% NSA, will exceed 10% and U6, now 14.8%, will likely hit 20%; employment-population ratio now under 60% for first time since mid-1980s, despite structural changes in workforce (ie. working females)

Real debt burdens get worse and worse as ability to service debts gets harder and harder - particularly once deflation becomes entrenched - ie not just a commodity phenomenon but a core goods and services one, a la Japan, as excess capacity is rampant throughout the global economy

Vicious circle as aggregate demand is less than aggregate supply --> production cuts --> layoffs and falling incomes --> falling aggregate demand --> rinse and repeat, vicious circle

Europe is a mess; too many countries have too much exposure to loans (banking assets a multiple of gdp) - EUR will fall back to under $1 and may disintegrate altogether as coalition is too fractious

UK is a bigger version of iceland; the $4.4T of foreign liabilities its banks have accumulated are twice the size of the whole economy; there will be a run on the pound as the ability of her majesty's govt to repay all the financial obligations it has taken on will be seriously doubted

Asia's export-dependent economy is a mess; emerging economies were most vulnerable to reversal of the global liquidity pump

Chinese estimates of unemployed migrants (heading back to rural homes or otherwise migrating looking for work) is now over 23 million

social unrest we've seen in Athens and Riga and London and Paris and Kiev will go global and will be particularly worrisome in China

China is the world’s largest surplus country just as the US was in 1930 and is at as much risk as anyone because it doesn't have internal demand to support the jobs, much less the job growth, its vast population has become accustomed to and is losing access to much of the external demand that was the raison d'etre for much of its economy; Chinese leadership may get desperate if conditions continue to deteriorate, and the only potentially effective measure it could conceivably resort to would be massive devaluation of the yuan (like it did in 1993, by 33%), which would be akin to Smoot-Hawley II

Baltic dry falling again, 27% down from March 10 and 85% down from 2008 peak --> oil will fall back to $40 if not $30

Nominal GDP will fall – everywhere; increases in GDP have been fueled by increases in debt, with the marginal efficiency of that debt increase falling over time so that more and more dollars of debt were required to fuel a single dollar of GDP growth (the ratio was about 2:1 from the 50s to the 80s but climbed to 6:1 in the last decade); in other words, the economy has been leveraged; now in deleveraging, the economy will be lucky not to shrink persistently as debt is repaid

Corporate profit impairment is not just a financial phenomenon - Q4/08 was supposed to be a great quarter for earnings due to easy YoY comps but instead had negative earnings, the worst quarter ever on record; now the non-financials will increasingly have their turn

profits are cyclically much more volatile than the economy (b/c they're basically leveraged off economic growth), but much more volatile than stock prices; earnings will fall as much as to 1999 levels

normalized earnings (accounting for the trumped-up nature of earnings and abnormal profit margins from the last decade due to excessive financialization and leverage) seem to be about $40-$50; peak earnings were a fantasy and may not be revisited for decades; assigning an average multiple of 15 would imply fair value in range of 600-750; but in this environment of deleveraging and huge uncertainty, it seems reasonable to demand a greater risk premium now than in a normal environment; in past periods of economic distress, single digit multiples have been common; assuming a multiple of 10, fair value would be 400-500

S&P has not yet bottomed - will fall below 600 in H2; Dow 5000 would not surprise me; TSX 6660 as lows

Fed BoC BoE BoJ SNB BoI will be joined by ECB with a 0 handle and in QE; no hikes until late 2010 and no normalization of rates before 2011 at earliest

Competitive currency devaluation will lead to more obvious beggar-thy-neighbour strategies than those already in play; global trade, already getting slaughtered, will be more at risk as protectionism is already on the rise

It took WWII to pull the world finally out of depression - chinese military aggression, perhaps in siberia, would not surprise me as china clearly even in a slow economy has a large appetite for real assets, and will have the opportunity to take advantage of a very economically-weak but resource-rich neighbour while giving its unstable civilian population something to think about other than overthrowing the govt

FORECAST - year-end 2009:
Universe Bond index: 8%
Long Bond index: 14%
S&P/TSX: 6500 (-28%)
S&P 500: 600 (-33%)
BoC & Fed: 0%
C$: 0.79 USD/CAD
oil: US$35
U.S. recession duration: 72 months before GDP returns to previous peak
(may include double-, triple-dips; Japan-like)
In one word, what will turn U.S. economy around? Normalization (of debt-to-income, home prices (price-to-rent, price-to-income), banking as proportion of economy, global imbalances, income inequality)

Worthwhile Reading - Mar 29th Edition

PPIP: heads or tails? David Kotok, Cumberland Advisors, via The Big Picture.

Less than meets the eye. Alan Abelson, Barron's, via Financial Armageddon.

Fewer companies likely to emerge from Chapter 11. Yves Smith, naked capitalism.

Roadmap to inflation and sources of cheap insurance. James Montier, SocGen, via John Mauldin's Outside the Box.
you've gotta like this kind of candor:

As Albert and I regularly point out during meetings, we have never been more unsure on the inflation/deflation outlook. I have previously said I was torn between the deflationary impact of the bursting credit bubble, and the inflationary pressures of the policy response. When we read something by the deflationists we sit there nodding our heads in agreement, then we pick up something by the proponents of a return of inflation and we find ourselves agreeing with that as well. The respective sides seem deeply entrenched in their positions.
In contrast, we are trying to keep an open mind on the subject. Albert is biased towards a Japanese style outcome, and I am biased towards an inflationary outcome, but neither of us has any strong conviction.

Only a united front at the London G20 can save the world from ruin. Ambrose-Evans Pritchard, Telegraph.

OCC's quarterly report on bank trading and derivatives activities, fourth quarter 2008. Comptroller of the Currency.
insured U.S. commercial banks now have over $200 Trillion of notional value of derivatives: 87% (!!) of that is held by just four banks (no prizes for guessing those are JPM Chase, BoA, Citi and Goldman)

Worthwhile Reading - Mar 28th 2nd Edition

Whitney: regional banks are the future. WSJ Blog Real-Time Economics.

The real AIG scandal, continued. Eliot Spitzer, Slate.

The quiet coup. Simon Johnson, The Atlantic.

Banks buying assets to sell through govt programs... does it even matter? Jake, EconompicData.
the discussion on PPIP is interesting, but what really caught my eye is the chart on commercial mortgage carrying valuations at banks

for similar, see:
The ridiculous marks of toxic assets. Zero Hedge.

Recoveries: down and out. A Credit Trader.

Geithner calls for new rules of the game. Calculated Risk.
key insight:
Imagine if the Federal Reserve had been the "systemic-risk regulator" during the bubble. According to Greenspan in 2005 "we don't perceive that there is a national bubble", just "a little froth", and even in March 2007 Bernanke said "the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained".How would a systemic-risk regulator help if they miss the problem?

Worthwhile Reading - Mar 28th Edition

The new toxic and bad legacy assets programs of the U.S. Treasury: surreptitiously squeezing the taxpayer and the Fed until the PPIPs squeak. Willem Buiter, FT Maverecon.

Moral hazard - lite and strong. Buiter again.

No-one here is going to a food bank. WSJ Blogs, Deal Journal.

WTO details rising protectionism, pushes countries to reverse course. WSJ.

Trade is falling faster in 2009 than in 1930. Progressive Policy Institute.

Six bloggers of the apocalypse. CNBC.

Mr. Taleb goes to Washington. Marion Maneker, The Big Money.

Double-dippers: Citi, BofA buying back laundered loans at lower rates. NY Post.

Watch those baskets: why Citigroup should be allowed to merge with Wells Fargo. John Hempton, Bronte Capital.

The case for letting bankers rip us off. more from Hempton.

Banks' hidden junk menaces $1 trillion purge. David Reilly, Bloomberg.

Canada's budget officer sees 8.5% drop in GDP. Financial Post.

Data Watch - March 25th and 26th

CANADA

yesterday, the Teranet-National Bank national home price index fell 1.6% in January, now down 2.4% YoY and 5.5% from the peak

US

new home sales were up slightly in February to 337k, with upward revisions to both January and December; inventories fell by 2.9% and 30% from a year-ago, but months' supply remains very elevated at 12.2 due to the low pace of sales, less than one-quarter of the 1.4M peak and one-half of normal sales activity

durable goods surprised with a gain of 3.4% in February, with core capital goods doing even better at +6.6%; these gains came, however, off of lower previous-month lows, as January's result was revised down from -5.2% to -7.3%; total and core durable goods orders remain down 29% and 21% YoY, respectively; the inventories-to-shipments ratio fell slightly to 1.88, as inventories fell for the 5th consecutive month, but this time fell by more than shipments, which have fallen for the 7th straight month

MBA mortgage applications were up again, but predominantly refis; refis are up 50% from a year ago, while purchase apps are down by almost a third

Q4 GDP was marked down to -6.3%, worse than the previous -6.2% estimate, but not as bad as the -6.6% expectation; corporate profits fell 16.5% QoQ and 21.5% YoY

initial jobless claims up as expected to 652k, a level its been hovering around for the last 5 weeks, not yet matching the 1982 highs, while continuing claims exceeded expectations, rising to 5560k, now well above the 1974 and 1982 peaks (albeit not population-adjusted), and showing no evidence yet of stabilizing


INTERNATIONAL

German IFO fell as expected to a new low in March of 82.1; current conditions also hit a new low, although the expectations component rose for the 3rd straight month

UK yields ramped higher after a failed long gilt auction, despite BoE QE, perhaps because King had the day before said that they might not use the full 75B pound allotment to fund the QE program

Eurozone M3 came in at +5.9% YoY, which is the lowest its been since 2004, off from the 12.3% peak

in the UK, business investment for Q4 wasn't as bad as expected, but retail sales for February were much worse, now up just 0.4% YoY, lowest since 1995

Japanese CPI and retail trade data comes out this evening; the former is expected to be -0.1% YoY, the latter -3%

Worthwhile Reading - Mar 24th (PPIP) Edition

Lots of material in the blogosphere about the the Geithner plan, aka the PPIP, aka the Geitner put. Much of it focuses primarily on how the plan is a subsidy from the taxpayer to both the selling banks and the private buyers; some of it focuses on why, despite the incentive to get the private buyers to bid up for the assets, it may not be enough to close the gap to where the banks want to sell; some focuses on how the plan can be gamed; some note that if the objective is to clean up the banks, this plan could work, but if the objective is to re-initiate a new credit cycle by getting lending flowing again, then its a pipe-dream; some discuss the unfairness of it all:

Geithner's plan extremely dangerous, economist Galbraith says. Henry Blodget, Yahoo! Finance.

The PPIP: its not the liquidity, stupid; its the marks. Roger Ehrenberg, Information Arbitrage.

The Geithner put, part 1. Nemo, self-evident.

Geithner plan arithmetic. Paul Krugman, NYT.

Some positive comments on the Geithner toxic plan. Calculated Risk.

Felix Salmon misrepresents me. John Hempton, Bronte Capital.

More musings on Geithner plan. Yves Smith, naked capitalism.

Geithner's plan isn't money in the bank. Simon Johnson and James Kwak, LA Times.
key excerpt:

The problem in the market today is that the prices demanded by the banks are much higher than the prices that private buyers (hedge funds, private equity firms, sovereign wealth funds) are willing to pay.

The government has no way to bring down the banks' minimum sale prices, especially without the threat of receivership. So the only option is to induce buyers to pay more than they think the assets are worth in today's generally risky climate, and the only way to do this is through subsidies.

The Geithner plan offers private investors incentives to participate. Those who put up funds will be eligible for government-guaranteed loans to purchase larger shares of the toxic assets. Because these loans do not have to be paid back, investors cannot lose more than the money they invested, even if the value of the assets plummets. At the same time, there is no limit on the amount they can make if things turn out well.

see the article for much more, including three reasons to be concerned the plan won't work

Dark musings. Steve Waldman, interfluidity.
key excerpt:

I am filled with despair, not because what we are doing cannot "work", but because it is too unjust. This is not my country.

The news of today is the Geithner plan. I think this plan might work very well in terms of repairing bank balance sheets.

Of course the whole notion of repairing bank balance sheet is a lie and misdirection. The balance sheets we should want to see repaired are household balance sheets. Banks have failed us profoundly. We want them reorganized, not repaired. A world in which the banks are all fixed but households are still broken is worse than what we have right now. Too-big-to-fail banks restored to health are too-big-to-fail banks restored to power. The idea that fixing legacy banks is prerequisite to fixing the broad economy is a lie perpetrated by legacy bankers.

Data Watch - March 24th

CANADA
the number of Canadians receiving employment insurance rose over 4% in January, the fifth consecutive increase, up 21% YoY

US
Richmond Fed Manuf. index and OFHEO home prices at 10am

INTERNATIONAL
Bank of Israel has cut its interest rate to 0.50% and has started buying government debt, so it too is conducting Q.E.

European PMIs rebounded a bit in March, though remain at depressed levels (Eurozone Manufacturing PMI at 34)

French consumer spending in February surprised to the downside

UK inflation surprised to the upside (3.2% YoY) (currency depreciation not helping import prices)

Mervyn King apparently warned that the BoE may not use its full scope for QE, prompting, along with the CPI surprise, a big sell-off in gilts

Worthwhile Reading - Mar 23rd Edition

My plan for bad bank assets. Timothy Geithner, WSJ.

Geithner's last stand. Robert Kuttner, Huffington Post.

G20 warned unrest will sweep globe. Guardian.

Fed and Treasury - Putting off hard choices with easy money (and probable chaos). John Hussman.

UPDATE:
Public-Private Investment Program Fact Sheet. US Treasury.

Data Watch - March 23rd

light data day today, but most of the attention will be focused in any case on Geithner's long-awaited unveiling at 8:45 of the details of his plans to deal with the toxic assets on bank balance sheets (in some form of public-private partnership designed to obfuscate the size of the government subsidy being handed out)

CANADA

leading indicators, which were expected to fall 0.9% for February, fell 1.1%, plus downward revision to January; the only component of the ten in the index that was up for the month was money supply


US (updated)

existing home sales for February rose 5% to 4.7m, contrary to expectations of a 1% fall; sales of foreclosed properties account for about 2 out of every 5 sales, according to the NAR; median and average prices were both up for the month from January's big drop; unfortunately, inventories were up as well, so months' supply remains just under 10

the Chicago Fed's National Activity Index rebounded to -2.83 for February, as three of the four broad categories improved, though all four remain in negative; December and January were both revised lower

INTERNATIONAL

just 2nd-tier data in Japan (chain-store sales down 5.4% YoY) and Europe (trade deficit widened)

Worthwhile Reading (and Viewing) - Mar 22nd Edition

Rogoff: the worst is over? Are you kidding? Henry Blodget, Clusterstock.

Worthwhile Reading - Mar 21st Edition

NCAA first round winning percentage by seed. Jake, EconomPic Data.

Leading economic indicators (February). Jake again.
note that the only positive contributors are the shape of the yield curve and the increase in the money supply (M2); but its far from clear that old relationships of how expansion in M2 impacted the economy are at all relevant at a (debt-deflationary) time (of deleveraging) when broader measures of money and credit growth are clearly at odds with what is happening to M2

Brutalizing the FASB's attempts at piglipsticking. Tyler Durden, Zero Hedge.

S&P 500 index P/E at troughs: a detailed 80 year analysis. News to U(se).

Save the credit unions! Felix Salmon, Portfolio.com.

Financial crisis caused by culture of complicity. Interview with James Galbraith, Spiegel.

Despair over financial policy. Paul Krugman.

UPDATE:

Obama's Final Four pool entry. ESPN.

Reality Bites

I'm a little late getting to this piece, but it remains well worth posting. What follows is The HCM Market Letter by Michael Lewitt, by way of John Mauldin's Outside the Box, entitled Reality Bites.

"So long as risk is effectively concealed from borrowers and lenders or actually shifted to others, risk-taking will be excessive. The initial phase of excessive risk-taking will manifest itself as an economic boom, but eventually, when actual losses begin to change the perceptions of borrowers and lenders and begin to impinge upon unsuspecting others, the boom will give way to a bust....[A] market system whose credit markets involve risks that are partially concealed from the lender and partially shifted to others will be biased in the direction of excessive risk-taking. And excessive risks are converted in time into excessive losses."

Roger Garrison

The problem with bailouts is that you have to know what you're bailing out. But neither the U.S. government nor anybody else is capable of estimating the ultimate cost of bailing out such corporate giants as Citigroup, AIG, General Motors, Fannie Mae, and Freddie Mac (and the list goes on). There are two reasons for this. First, on a stand-alone basis, these companies are opaque and indecipherable entities. Financial innovation left transparency in the dust. Wall Street devoted much of its intellectual and political capital to concealing the risks it was creating. This concealment was deliberate; products needed to be priced inefficiently to produce profits. Second, these companies are integral parts of a networked global economy; as such, their value is completely dependent on the overall health of that network. Unless the network can be restored to health, these assets will remain severely devalued. Right now, the network is very sick. When a system is allowed to hide risk for so long, it is ill-equipped to manage that risk when it finally emerges from the shadows.

The Economic Policy Conundrum

The Obama Administration is facing a near-impossible task trying to bail the U.S. economy out of the muck of years of ill-begotten economic policies. The biggest challenge facing policymakers is not short-term recovery, however. Eventually, stimulus is likely to arrest the forces of economic collapse and stabilize matters – at least temporarily. But the real problem is sowing the seeds of long-term, sustainable, organic economic growth. This is really the crux of the policy challenge. The United States in the midst of the worst economic downturn in 80 years as the result of a panoply of extremely poor economic policy choices. Economist Roger W. Garrison draws an important distinction between "healthy economic growth, which is saving-induced (and hence sustainable), and artificial booms, which are policy-induced (and hence unsustainable)."2 In other words, monetary policy that kept interest rates low for an extended period of time, tax policy that favored debt over equity, regulatory policy that allowed financial institutions to operate opaquely, and social policy that pushed home ownership regardless of affordability, all combined to create artificial economic demand that could only be financed with debt because the savings (i.e. equity) to purchase them did not exist.

Moreover, as more and more debt was created through financial engineering and policy prescription, the prices of these were bid up higher and higher. This led these products to become grossly inflated in value compared to any inherent economic worth they might possess. Once the bubble burst, their value dropped precipitously. Unfortunately, the face amount of the debt used to purchase these assets did not adjust downward at the same time. Assets that were purchased at inflated prices are now worth a fraction of what they were purchased for, leaving behind a serious dilemma for the owners of these assets and their creditors.

Following conventional economic thinking, the government believes that the solution lies in policies designed to reflate the value of these assets. The problem with this approach is that it is based on the incurrence of trillions of dollars of additional debt to create the demand needed to purchase these assets. Debt begetting more debt is a poor prescription for sustainable long-term economic growth. At best the government may be able to provide a short-term boost to the economy, but what the economy really needs is a solid, organic foundation for growth. Debt-financed government demand can't be sustained indefinitely, which is why this policy is doomed to fail in the long run. The U.S. balance sheet is not a bottomless pit, although it is increasingly coming to resemble a Black Hole. At some point, the economy will have to generate sufficient tax revenue to pay for this government spending or the country will lose its AAA rating and ultimately become a troubled credit. Economic demand will ultimately have to become savings-driven or it will again collapse.

This does not necessarily mean that the government should walk away from creating short-term demand, but it should be extremely circumspect in how it does so. This is where political reality collides with economic reality. The optimum long-term economic solution would be to allow the economy to hit bottom and then begin to rebuild demand naturally. But such a scenario would likely entail an unemployment rate on the order of 15 or 20 percent and an even worse human toll than is already being exacted by the downturn. But it would give the economy an organic base from which to rebuild. The government's job in such a scenario would be to provide the right kind of safety net (not only of financial support but also job and educational training) to see the citizenry through the crisis. What the U.S. really needs is an economic Marshall Plan to rebuild itself, with all of the sacrifice and public service that would entail. Apparently, that is asking too much in today's me-first society. Accordingly, the government finds itself compelled to follow policies that may or may not create unsustainable short-term growth and will have to be carefully targeted to promote sustainable long-term growth.

There is a profound difference between healthy, sustainable demand and unhealthy, unsustainable demand, just as we are living the unhappy lesson that there is a great difference between healthy economic activity (i.e. activity that contributes to the productive capacity of the economy) and unhealthy economic activity (i.e. speculative trading and corporate finance transactions). Propping up bad banks through a "good bank/bad bank" model would simply direct funds to the sustenance of past unhealthy economic activity. Starting a new Economic Reconstruction Bank, as HCM has recommended, could make loans available for new productive projects and direct funds into healthy long-term economic activity.

Another bout of policy-induced growth will not only repeat the mistakes of the past, but leave the economy even weaker, teetering on an unstable foundation of government support that cannot be sustained indefinitely without impairing America's balance sheet, credit rating, and ultimately its geopolitical might. Whether America's short-term political orientation can ever address this conundrum is the greatest question facing policymakers today. HCM has no hesitation in saying that much of what the government has proposed thus far to deal with the crisis won't come close to dealing with the long-term issue of creating savings-induced or organic growth. This means that any near-term relief (i.e. relief that occurs within the next five years) is most likely to give way to years of below trend growth because the economy will be lacking the organic foundation of growth it needs.

Dow 5000 Update

Year-to-date through February 27, the S&P 500 was down 18.62 percent and the Dow Jones Industrial Average was down 19.52 percent. Moreover, strategists and investors are increasingly coming around to the conclusion that corporate earnings are going to be nothing short of horrendous this year and that stocks are headed even lower, as HCM has been arguing for months (without pleasure, we hasten to add). Very recently, three of the smartest forecasters on Wall Street sharply lowered their earnings forecasts for the S&P 500.

• On February 13, David Rosenberg, Bank of America's North American Economist, recently reduced his 2009 and 2010 S&P 500 operating EPS forecast to $46 (from $56) and $55.50 (from $63), respectively.i Mr. Rosenberg is now forecasting an S&P 500 low of 666 based on a 12x multiple of forward (i.e. 2010) earnings.

• Francois Trahan of ISI Group dropped his S&P 500 earnings forecast from $60 to $45 on February 23. Mr. Trahan used a 13x multiple to forecast a potential market low of 585.

• On February 26, Goldman Sachs' David Kostin dropped his 2009 and 2010 S&P 500 operating EPS forecast to $40 and $63, respectively, after deducting $23 and $8, respectively, for provisions and write-downs. Mr. Kostin uses a 13.2x multiple of 2010 earnings (pre-write-downs and provisions) to come up with a year-end 2009 S&P 500 target of 940.

These sharply lower forecasts are consistent with HCM's dim view of corporate earnings, but we believe that all three analysts are clinging to overly optimistic earnings multiples in predicting ultimate stock market lows. At this point, there is clearly a growing Wall Street consensus that S&P 500 earnings will come in well below $50 in 2009 and that the correct multiple on these earnings should be in the 12-13x range. HCM continues to believe that the multiple should be lower based on the fact that (a) we are in a debt deflationary spiral, and (b) government yields are artificially depressed and signal economic distress and do not signal an attractive investment alternative, and corporate yields are extremely high and offer real competition for investor funds.

Last November, HCM set 2009 price targets of 5000 on the Dow Jones Industrial Average (DJIA) and 475 on the S&P 500 based on applying a 7x multiple to Goldman Sachs' then 2009 S&P 500 earnings estimate of $65. (See The HCM Market Letter, Nov. 15, 2008, "Dow 5000") At the time, the S&P 500 was at about 850 and the DJIA was at about 8600. Our low multiple was based on our view that an environment characterized by debt deflation deserves a 6-8x multiple. Now that Mr. Kostin and others have lowered their multiple, it is only fair to raise the question whether we should be further lowering our target prices on these equity indices at this time based on applying our multiple to a lower earnings number.

For the moment, the market remains far above our previous targets. Our targets are intended to be directional in nature and we see no reason to lower them further at the current time. We have made our point, which is that the stock market is likely to head sharply lower in the months ahead. Moreover, the earnings estimates have been lowered primarily based on expectations for further write-offs by financial companies (and non-financial companies that wandered into the financial space). Investors may treat these write-offs and provisions as nonrecurring items and look to higher recurring S&P 500 earnings in pricing the market. While we continue to believe that the multiple should be in the single digits, the correct recurring earnings number remains a moving target. Accordingly, at this time it would be premature to lower our estimate further. Needless to say, we remain extremely comfortable with our prior estimates of 475 on the S&P 500 and 5000 on the DJIA.

A bear market rally is possible at any time. Investors should be aware that as the market moves lower, rallies have the potential to be extremely sharp since they are starting from compressed levels. Such rallies should be used to reduce overall equity exposure. That does not mean that equities should be abandoned totally. There are a number of stocks that are trading at well below book value (even taking into account the declining transfer value of their assets) that may be worth buying in the months ahead. The debt of these companies, which HCM is particularly active in, is even more compelling as an investment. But investors need to identify longer term changes in market behavior and the economic environment before becoming bullish again on stocks. Right now, there are no such signs, such as better employment, housing or GDP numbers, or tightening credit spreads, or improving market technicals. HCM is starting to sense that the forces of denial, as potent as they are, are starting to weaken. Accordingly, investors should structure their portfolios for further equity declines.

The "D" Word

The fourth quarter GDP loss of 6.2 percent (did anybody really believe the 3.8 percent estimate?) illustrates just how deep a hole our economy has to climb out of. The economy fell into this hole almost literally overnight, but it's going to take much longer to climb out. A quick recovery is out of the question. HCM expects first quarter GDP to be in the -6.0 to -7.0 percent range based on our reading of employment, housing and other economic data as well as the data we are seeing from the 200 or so companies in our portfolios across a wide variety of industries. Moreover, based on our view that the stimulus plan will be largely ineffective this year and that more large-scale business failures are in the works (many of them slow-motion car wrecks), we do not expect to see positive economic growth until sometime in mid-to-late 2010 (and then only modest growth).

Investors expecting a conventional bear market/bull market cycle are likely to be sorely disappointed. Over the past several decades, U.S. stock market investors have been conditioned to believe that the market will bottom and then rebound. Bear markets have been brief within the context of a long bull market that stretches back to the 1980s. But the current environment is likely going to be different. We are now experiencing a destruction of wealth on a scale that is both unprecedented and permanent because much of that wealth was built on a fragile foundation of debt; in reality, much of that wealth didn't really exist in the first place. As a result, what people believed to be economically valuable and stable was in fact nothing of the kind. In many respects, the latter stages of the bull market were little more than an illusion. Real corporate earnings and genuine productivity peaked years ago, and the economy has been operating on debt-induced fumes for years.

Accordingly, investors need to prepare themselves for a future that will not resemble the recent past. Ray Dalio, the wise man who runs Bridgewater Associates, noted in a recent Barron's interview that investors need to recognize that the current environment more resembles a depression than a recession: "Everybody should, at this point, try to understand the depression process by reading about the Great Depression or the Latin American debt crisis of the Japanese experience so that it becomes part of their frame of reference. Most people didn't live through any of those experiences, and what they have gotten used to is the recession dynamic, and so they are quick to presume the recession dynamic. It is very clear to me that we are in a D-process." (Barron's, February 9, 2009, "Recession? No, It's a D-process, and It Will Be Long," pp. 38-40.) Mr. Dalio's view is consistent with HCM's long-argued view that we are in a debt-deflationary spiral whose end is nowhere in sight.

The characteristics of our current economic situation are as follows:
• Interest rates have dropped to zero.
• Bank stocks have plunged by 90 percent or more.
• The Federal Reserve's balance sheet has exploded.
• Credit spreads have widened to historic levels.
• The economy is seeing massive asset deflation.
• Debt is being destroyed in record amounts.
• Unemployment is increasing each month.
• The financial industry is shrinking radically.
• Manufacturing activity has slowed sharply.

This is not a situation that is consistent with recent American experience. HCM has previously described a depression as an economic condition in which traditional monetary and fiscal policy is rendered ineffective. For the moment, we are deeply entrenched in such a situation. The question is how long the economy will remain depressed before some of the remedies that have been proposed start to work. Unfortunately, HCM fears we may be in for an extended stay.

For these reasons, HCM believes that after the stock market bottoms, it will drift along at a depressed level for an extended period of time. The American economy will experience less-than-trend growth for a similarly prolonged period of time. The economy will have to absorb trillions of dollars of bad debts and transition its resources away from speculative activities and toward new productive endeavors. The economy has to be completely retooled, and this process will not happen overnight, particularly because such a program must be directed by a highly inefficient democratic political system that is inefficient in reaching consensus about its goals and how to achieve them. Unfortunately, the deeper involvement of the government in the financial and other sectors of the economy is likely to stifle growth, innovation and creativity and further contribute to lower growth for years to come.

Investing Today

This by no means is intended to suggest that investors will be unable to make money. It does suggest, though, that the era of bull market geniuses is probably over. Too many were paid too much for doing too little over the past several decades. Being at the right place at the right time is not going to cut it anymore. But as the debt destruction process plays out, new investment opportunities will arise in the capital structures of restructured and surviving companies.

As investors go about reallocating money to new opportunities, they may want to keep in mind something that HCM recently read in The Economist.

"Over the past 35 years it has seemed as if everyone in finance has wanted to be someone else. Hedge funds and private equity wanted to be as cool as a dotcom. Goldman Sachs wanted to be as smart as a hedge fund. The other investment banks wanted to be as profitable as Goldman Sachs. America's retail banks wanted to be as cutting-edge as investment banks. And European banks wanted to be as aggressive as American banks. They all ended up wishing they could be back precisely where they started." (The Economist, "A special report on the future of finance," January 24, 2009, p. 17.)

There are a limited number of investment opportunities that make sense in today's market, and there are a limited number of managers qualified to execute those strategies. Unfortunately, managers in out-of-favor or discredited strategies are now trying to reinvent themselves as managers of the few in-favor strategies in which they have limited or no experience. HCM is seeing this occur in the corporate credit space, where firms that have previously operated in areas peripheral to the credit markets such as private equity or mortgages are suddenly touting their expertise in corporate credit. These managers are wading into uncharted territory. Investors must insure that managers possess the expertise that is required for the strategies for which they are being hired. They have already experienced the disastrous results of private equity firms thinking that doing deals would prepare them for investing in bank loans.

Bank Nationalization

We are quickly learning the flaws of the half-baked approach to supporting the nation's banks that the Bush Administration adopted and the Obama Administration seems hell-bent on continuing. At least the Bush Administration had an excuse – the former Treasury Secretary was a career investment banker who saw the world through the eyes of Wall Street. Perhaps HCM was naïve in hoping that the new Treasury Secretary, having been a career regulator who viewed matters through the opposite end of the glass, would see things differently. We probably should have known better since Mr. Geithner participated in the Bush Administration's bailout. But the quasi-nationalization approach is clearly a disaster for all concerned (the recent article describing the hall of mirrors that used to be Citigroup is a case in point - see The Wall Street Journal, February 25, 2009, "Citigroup Chafes Under U.S. Overseers," p. A1.) There seems to be little disagreement that two of the country's major banks – Citigroup and Bank of America – are in the zone of insolvency. Their assets are worth less than their liabilities and their shareholders have been wiped out in all but name (and in the little drill-bits of stock that trade publicly as make-believe options on their long-term recovery). But the system can't seem to bring itself to admit that these banks have been effectively nationalized in all but name and that taking the final step of nationalizing them is in many respects just a matter of form over substance. The only thing worse than a banking system that has been privatized is one that has collapsed, but that is the choice we are faced with. The Rubicon has been crossed and we need to clear away tons of debris that are clogging up the river before we can cross back to the other side.

Moreover, maintaining the illusion of public ownership has enabled some of the individuals running these institutions to engage in some of the most irresponsible behavior ever seen in the history of American business. HCM is speaking specifically of the pay-out of billions of dollars of bonuses to the executives and employees of Merrill Lynch on the eve of its forced takeover by Bank of America. This act, which Bank of America's Chairman Ken Lewis claims he was powerless to stop (HCM does not believe him) and former Merrill Lynch Chairman John Thain, in what can only charitably be described as a gross breach of conscience and good judgment, somehow sanctioned, are prima facie evidence that the hybrid public/private TARP model is totally untenable and should be shelved immediately. Those banks that can repay the TARP money (or produce a believable plan to do so within three years) should be permitted to do so forthwith, and those that are teetering on the brink of insolvency should be nationalized. Otherwise, the managements of these firms are going to pay more attention to figuring out how to game government compensation limitations than maximizing the value of their troubled assets over the next several years. HCM never thought we would say that there are worse things than nationalization, but there are and we saw them when billions of dollars was paid out to the people who lost even more billions of dollars at Merrill Lynch. This has to have been one of the most brazen thefts in American history.

Let GM Go

General Motors has been insolvent for years. Yet political expediency has prevented recognition of this harsh truth. The company's unions have blocked efforts to bring the company's cost structure into line with changing economic realities. Michigan's powerful Congressional delegation has blocked efforts to improve American automobiles' fuel efficiency, creating an opening for foreign manufacturers with lower cost structures to steal the hearts and minds and pocketbooks of American consumers. Years of bad choices have now left the U.S. government with a terrible choice – whether to give GM billions of dollars of money inside or outside of bankruptcy. The correct decision, as unpalatable as it may be, is painfully obvious. All of the king's horses and all of the king's men are not going to be able put GM back together again. It is time to let this American icon declare bankruptcy in order to maximize the chances of salvaging something out of this American tragedy.

GM is still paying or accruing billions of dollars of annual interest payments on the company's more than $40 billion of debt. The company is negotiating with holders of $27.5 billion of this debt, which is unsecured, to reduce it to $9.2 billion (by exchanging stock for bonds). Yet all of this debt and stock is worthless. Instead of wasting time haggling with debt holders over exchanging a portion of their worthless claims for worthless stock, the company should declare bankruptcy so these claims can be wiped out. GM's ability to meet the government's February 17 deadline was delayed by its inability to come to an agreement its bondholders. The bondholders are institutional investors who believe they are exercising their fiduciary duty to their beneficiaries by trying to squeeze the best deal possible out of the automaker. But the sad reality is that they made a bad investment and should suffer the consequences. We need to stop trying to save everyone from the consequences of their errors or else they will keep making them.

The unions are also trying to salvage an ownership stake out of this mess. The company is negotiating to exchange half of approximately $20 billion of Voluntary Employee Benefit Association (VEBA) obligations into equity. Unfortunately, 100% of the VEBA obligations are likely worthless since GM will never be able to pay them. The VEBA was part of the bargain that the unions made with GM over the years. Workers gained generous wages, benefits and work rules that rendered the company uncompetitive. This was not a secret – the company's loss of market share and weakening financial position was apparent for years to the unions as well as to everyone else. The unions won the bargain but they lost the war. The company doesn't owe the workers anything more than what can be granted in bankruptcy, which is likely a meaningful equity stake in exchange for the VEBA and the billions of dollars of other healthcare and pension obligations owed to current and retired workers. This is undoubtedly a tragedy of enormous human dimensions, but responsibility for it is shared by all Americans who sat by while their politicians and business leaders allowed GM to sink into insolvency. Accordingly, America owes the workers a safety net when they lose their jobs and benefits. But this should be the same safety net society owes all of its displaced workers, not a special one for former GM workers.

Allowing GM to file for bankruptcy will be a blow to the American psyche. But GM has already gone bankrupt in all but name. In suggesting that it will require $125 billion in financing to undergo a bankruptcy, the company may be playing chicken with Congress but is more likely indicating just what a Black Hole of liabilities it has become over the decades. America must have the courage to deal with this reality. Bankruptcy will give the company, and the country, an ability to make the hard decisions that it refused to make before. Either way, GM's failure is going to cost taxpayers tens of billions of dollars. But until we are willing to be honest about our failures, we are never going to put ourselves in a position to avoid future ones.

Obama's Budget

President Obama's is in many respects a dramatic break with the past, although in many respects it falls short of the type of radical tax and other changes that are really needed (but may simply not be politically feasible). We just hope that Mr. Obama's reach does not exceed his grasp. Many things may have changed economically in recent years, but one thing has not: a country can't tax and spend its way into prosperity. Moreover, we are confident that the growth rate assumptions used in years 2, 3 and 4 of our new president's proposed budget are unrealistic. The economy is unlikely to grow at anything close to 3 to 4 percent in those years, and relying on that much growth to close the budget deficit by the end of Mr. Obama's first term will only lead to disappointment. This economy, which shrunk at an annual rate of 6.2 percent in the fourth quarter of 2008 and will almost certainly not show any growth at all in 2009, is not going to magically spring back to life in 2010. Mr. Obama is setting himself up for failure with these projections.

HCM was very happy to see that the Administration is prepared to rid the tax code of the egregious treatment of private equity carried interests, which we have recommended before (see The HCM Market Letter, April 1, 2008, "How to Fix It"). Now that private equity has become a loss-leader for its partners, we would caution those drafting the legislation to make sure that private equity does not gain an unintentional windfall from this legislation. This could occur if private equity partners were permitted to deduct claw-back payments (i.e. repayments of carried interests earned early in a partnership based on losses incurred later in a partnership) at the new higher tax rate if they were taxed on those original payments at the lower rate. In order to prevent such a benefit, if the original payment was taxed at 15 percent, repayment of that money should only give rise to a deduction at 15 percent, not the higher ordinary income tax rate.

We think limitations on charitable deductions are poor public policy. The argument that wealthier people should not receive a greater dollar-for-dollar benefit for charitable deductions than less affluent people is a red herring, particularly in view of the fact that the Alternative Minimum Tax already haircuts high earners' charitable gifts. We also believe that limitations on mortgage deductions would be better handled by limiting deductions for mortgages over a certain dollar amount rather than by income; such a methodology would be more effective in fighting housing speculation.

We are opposed to raising taxes on capital, but we also recognize that we are in a fiscal emergency and that raising the capital gains tax from 15 percent to 20 percent on the wealthiest Americans would not impose undue hardship and would keep the rate relatively low. We would prefer to see capital gains rates implemented on a graduated scale based on the amount of capital gains reported in a single year. Someone who earns an especially large gain could certainly afford to pay a little more in tax. We commend the plan for maintaining the 15 percent tax rate on dividends, which should not be taxed at all since they are already taxed at the corporate level and remain an extremely inefficient means of returning capital to shareholders.

The biggest problem with the budget – and with any budget, not just Mr. Obama's – is that the government just wastes so much stinking money. The reason people find higher taxes abhorrent is not because they don't want to help those less fortunate than themselves, or fund necessary government programs, but because they don't want their money to be treated like Congress's personal piggy bank. We would love to see the list of the $2 trillion of wasteful programs that Mr. Obama claimed his team has already identified for elimination. The amount of government waste is truly mindboggling, and Mr. Obama must insist on spending discipline if he is to have any chance to keep the budget deficit from exploding over the next four years.

The Coming Meltdown in Eastern Europe

By all accounts, the former Eastern Bloc countries that so successfully navigated their entry into world capitalism after the fall of communism have borrowed themselves into near oblivion and are about to inflict frightening losses on their own banks and Western European banks, their main aiders and abettors. Our good friend John Mauldin has been out front on this story, which has enormous implications for the global financial system. The ever prescient Christopher Wood has also been warning about an Asian-style banking crisis in the region, with serious ramifications for the Western European banks that loaned these institutions by some reports trillions of dollars. This is a story that needs to be followed in the coming weeks because it will have major negative consequences for world financial markets. To state the obvious, this is the last thing the world economy needs to deal with right now.

Michael E. Lewitt

Worthwhile Reading - Mar 20th Edition

Off with the bankers. Simon Johnson and James Kwak, NYT.

How far will mortgage rates fall? Calculated Risk.

AIG. Paul Krugman, Conscience of a Liberal.

Note to the Administration: the AIG flap is because of you. Roger Ehrenberg, Information Arbitrage.

UN panel says world should ditch dollar. Reuters.

Violence on Paris streets as millions protest against Nikolas Sarkozy's handling of economic crisis. Telegraph.

Data Watch - March 20th

CANADA

A bounce from December was anticipated for January retail sales, but the bounce exceeded expectations, as total sales were up 1.9% and ex-autos they were up 1.3%; sales remain down 5.8% YoY. The monthly bounce was more than just a price effect, as volumes were up similarly; new motor vehicle sales were up 5.5% for the month but still down 23% YoY.


US

No data today, but Bernanke speaks at noon on the financial crisis.

This comes a day after the TALF program was modified to expand the list of eligible collateral; it will now accept AAA rated tranches of ABS backed by floorplan loans, vehicle leases, as well as loans/leases for business equipment and for mortgage servicing rights.

It is also, of course, the day after the House overwhelmingly approved a 90% tax on bonuses paid this year to employees of AIG (Arrogant. Incompetent. Greedy.) and other firms that have accepted large amounts of federal bailout funds.


INTERNATIONAL

the Baltic Dry Index fell yesterday for the 7th consecutive day, still well higher than the lows it plummeted to late last year (up 170%), but still down 85% from its 2008 highs

German producer prices fell more than expected in February, dropping the YoY rate to 0.9%

Euroland industrial production through February is now down over 17% YoY, from 12% at the end of January

Its Bigger Than You Think

In No Return to Normal in the Washington Monthly, James K. Galbraith explains why the current crisis, and its solution, are bigger than most anyone thinks. (highlights are mine)



Barack Obama’s presidency began in hope and goodwill, but its test will be its success or failure on the economics. Did the president and his team correctly diagnose the problem? Did they act with sufficient imagination and force? And did they prevail against the political obstacles—and not only that, but also against the procedures and the habits of thought to which official Washington is addicted?

The president has an economic program. But there is, so far, no clear statement of the thinking behind that program, and there may not be one, until the first report of the new Council of Economic Advisers appears next year. We therefore resort to what we know about the economists: the chair of the National Economic Council, Lawrence Summers; the CEA chair, Christina Romer; the budget director, Peter Orszag; and their titular head, Treasury Secretary Timothy Geithner. This is plainly a capable, close-knit group, acting with energy and commitment. Deficiencies of their program cannot, therefore, be blamed on incompetence. Rather, if deficiencies exist, they probably result from their shared background and creed—in short, from the limitations of their ideas.

The deepest belief of the modern economist is that the economy is a self-stabilizing system. This means that, even if nothing is done, normal rates of employment and production will someday return. Practically all modern economists believe this, often without thinking much about it. (Federal Reserve Chairman Ben Bernanke said it reflexively in a major speech in London in January: "The global economy will recover." He did not say how he knew.) The difference between conservatives and liberals is over whether policy can usefully speed things up. Conservatives say no, liberals say yes, and on this point Obama’s economists lean left. Hence the priority they gave, in their first days, to the stimulus package.

But did they get the scale right? Was the plan big enough? Policies are based on models; in a slump, plans for spending depend on a forecast of how deep and long the slump would otherwise be. The program will only be correctly sized if the forecast is accurate. And the forecast depends on the underlying belief. If recovery is not built into the genes of the system, then the forecast will be too optimistic, and the stimulus based on it will be too small.

Consider the baseline economic forecast of the Congressional Budget Office, the nonpartisan agency lawmakers rely on to evaluate the economy and their budget plans. In its early-January forecast, the CBO measured and projected the difference between actual economic performance and "normal" economic performance—the so-called GDP gap. The forecast has two astonishing features. First, the CBO did not expect the present recession to be any worse than that of 1981–82, our deepest postwar recession. Second, the CBO expected a turnaround beginning late this year, with the economy returning to normal around 2015, even if Congress had taken no action at all.

With this projection in mind, the recovery bill pours a bit less than 2 percent of GDP into new spending per year, plus some tax cuts, for two years, into a GDP gap estimated to average 6 percent for three years. The stimulus does not need to fill the whole gap, because the CBO expects a "multiplier effect," as first-round spending on bridges and roads, for example, is followed by second-round spending by steelworkers and road crews. The CBO estimates that because of the multiplier effect, two dollars of new public spending produces about three dollars of new output. (For tax cuts the numbers are lower, since some of the cuts will be saved in the first round.) And with this help, the recession becomes fairly mild. After two years, growth would be solidly established and Congress’s work would be done. In this way, the duration as well as the scale of action was driven, behind the scenes, by the CBO’s baseline forecast.

Why did the CBO reach this conclusion? On depth, CBO’s model is based on the postwar experience, and such models cannot predict outcomes more serious than anything already seen. If we are facing a downturn worse than 1982, our computers won’t tell us; we will be surprised. And if the slump is destined to drag on, the computers won’t tell us that either. Baked into the CBO model we find a "natural rate of unemployment" of 4.8 percent; the model moves the economy back toward that value no matter what. In the real world, however, there is no reason to believe this will happen. Some alternative forecasts, freed of the mystical return to "normal," now project a GDP gap twice as large as the CBO model predicts, and with no near-term recovery at all.

Considerations of timing also influenced the choice of line items. The bill tilted toward "shovel-ready" projects like refurbishing schools and fixing roads, and away from projects requiring planning and long construction lead times, like urban mass transit. The push for speed also influenced the bill in another way. Drafting new legislative authority takes time. In an emergency, it was sensible for Chairman David Obey of the House Appropriations Committee to mine the legislative docket for ideas already commanding broad support (especially within the Democratic caucus). In this way he produced a bill that was a triumph of fast drafting, practical politics, and progressive principle—a good bill which the Republicans hated. But the scale of action possible by such means is unrelated, except by coincidence, to what the economy needs.

Three further considerations limited the plan. There was, to begin with, the desire for political consensus; President Obama chose to start his administration with a bill that might win bipartisan support and pass in Congress by wide margins. (He was, of course, spurned by the Republicans.) Second, the new team also sought consensus of another type. Christina Romer polled a bipartisan group of professional economists, and Larry Summers told Meet the Press that the final package reflected a "balance" of their views. This procedure guarantees a result near the middle of the professional mind-set. The method would be useful if the errors of economists were unsystematic. But they are not. Economists are a cautious group, and in any extreme situation the midpoint of professional opinion is bound to be wrong.

Third, the initial package was affected by the new team’s desire to get past this crisis and to return to the familiar problems of their past lives. For these protégés of Robert Rubin, veterans in several cases of Rubin’s Hamilton Project, a key preconception has always been the budget deficit and what they call the "entitlement problem." This is D.C.-speak for rolling back Social Security and Medicare, opening new markets for fund managers and private insurers, behind a wave of budget babble about "long-term deficits" and "unfunded liabilities." To this our new president is not immune. Even before the inauguration Obama was moved to commit to "entitlement reform," and on February 23 he convened what he called a "fiscal responsibility summit." The idea took hold that after two years or so of big spending, the return to normal would be under way, and the costs of fiscal relief and infrastructure improvement might be recouped, in part by taking a pound of flesh from the incomes and health care of the old.

The chance of a return to normal depends, in turn, on the banking strategy. To Obama’s economists a "normal" economy is led and guided by private banks. When domestic credit booms are under way, they tend to generate high employment and low inflation; this makes the public budget look good, and spares the president and Congress many hard decisions. For this reason the new team instinctively seeks to return the bankers to their normal position at the top of the economic hill. Secretary Geithner told CNBC, "We have a financial system that is run by private shareholders, managed by private institutions, and we’d like to do our best to preserve that system."

But, is this a realistic hope? Is it even a possibility? The normal mechanics of a credit cycle do involve interludes when asset values crash and credit relations collapse. In 1981, Paul Volcker’s campaign against inflation caused such a crash. But, though they came close, the big banks did not fail then. (I learned recently from William Isaac, Ronald Reagan’s chair of the FDIC, that the government had contingency plans to nationalize the large banks in 1982, had Mexico, Argentina, or Brazil defaulted outright on their debts.) When monetary policy relaxed and the delayed tax cuts of 1981 kicked in, there was both pent-up demand for credit and the capacity to supply it. The final result was that the economy recovered quickly. Again in 1994, after a long period of credit crunch, banks and households were strong enough, even without a stimulus, to support a vast renewal of lending which propelled the economy forward for six years.

The Bush-era disasters guarantee that these happy patterns will not be repeated. For the first time since the 1930s, millions of American households are financially ruined. Families that two years ago enjoyed wealth in stocks and in their homes now have neither. Their 401(k)s have fallen by half, their mortgages are a burden, and their homes are an albatross. For many the best strategy is to mail the keys to the bank. This practically assures that excess supply and collapsed prices in housing will continue for years. Apart from cash—protected by deposit insurance and now desperately being conserved—the American middle class finds today that its major source of wealth is the implicit value of Social Security and Medicare—illiquid and intangible but real and inalienable in a way that home and equity values are not. And so it will remain, as long as future benefits are not cut.

In addition, some of the biggest banks are bust, almost for certain. Having abandoned prudent risk management in a climate of regulatory negligence and complicity under Bush, these banks participated gleefully in a poisonous game of abusive mortgage originations followed by rounds of pass-the-bad-penny-to-the-greater-fool. But they could not pass them all. And when in August 2007 the music stopped, banks discovered that the markets for their toxic-mortgage-backed securities had collapsed, and found themselves insolvent. Only a dogged political refusal to admit this has since kept the banks from being taken into receivership by the Federal Deposit Insurance Corporation—something the FDIC has the power to do, and has done as recently as last year with IndyMac in California.

Geithner’s banking plan would prolong the state of denial. It involves government guarantees of the bad assets, keeping current management in place and attempting to attract new private capital. (Conversion of preferred shares to equity, which may happen with Citigroup, conveys no powers that the government, as regulator, does not already have.) The idea is that one can fix the banks from the top down, by reestablishing markets for their bad securities. If the idea seems familiar, it is: Henry Paulson also pressed for this, to the point of winning congressional approval. But then he abandoned the idea. Why? He learned it could not work.

Paulson faced two insuperable problems. One was quantity: there were too many bad assets. The project of buying them back could be likened to "filling the Pacific Ocean with basketballs," as one observer said to me at the time. (When I tried to find out where the original request for $700 billion in the Troubled Asset Relief Program came from, a senior Senate aide replied, "Well, it’s a number between five hundred billion and one trillion.")

The other problem was price. The only price at which the assets could be disposed of, protecting the taxpayer, was of course the market price. [MW: a minor quibble: its not particularly clear that even paying market prices would've protected the taxpayer if those market prices were not yet low enough at the time of taxpayer-support to be consistent with the ultimate credit performance of the underlying exposures, given that we don't yet know how far collateral value (home prices) will ultimately fall, nor how high unemployment, foreclosures and defaults will ultimately rise; in any case...] In the collapse of the market for mortgage-backed securities and their associated credit default swaps, this price was too low to save the banks. But any higher price would have amounted to a gift of public funds, justifiable only if there was a good chance that the assets might recover value when "normal" conditions return.

That chance can be assessed, of course, only by doing what any reasonable private investor would do: due diligence, meaning a close inspection of the loan tapes. On the face of it, such inspections will reveal a very high proportion of missing documentation, inflated appraisals, and other evidence of fraud. (In late 2007 the ratings agency Fitch conducted this exercise on a small sample of loan files, and found indications of misrepresentation or fraud present in practically every one.) The reasonable inference would be that many more of the loans will default. Geithner’s plan to guarantee these so-called assets, therefore, is almost sure to overstate their value; it is only a way of delaying the ultimate public recognition of loss, while keeping the perpetrators afloat.

Delay is not innocuous. When a bank’s insolvency is ignored, the incentives for normal prudent banking collapse. Management has nothing to lose. It may take big new risks, in volatile markets like commodities, in the hope of salvation before the regulators close in. Or it may loot the institution—nomenklatura privatization, as the Russians would say—through unjustified bonuses, dividends, and options. It will never fully disclose the extent of insolvency on its own. [MW: the looting (bonuses at AIG and the GSEs is bad enough, but it is the gambling-for-redemption that is the major problem]

The most likely scenario, should the Geithner plan go through, is a combination of looting, fraud, and a renewed speculation in volatile commodity markets such as oil. Ultimately the losses fall on the public anyway, since deposits are largely insured. There is no chance that the banks will simply resume normal long-term lending. To whom would they lend? For what? Against what collateral? And if banks are recapitalized without changing their management, why should we expect them to change the behavior that caused the insolvency in the first place?

The oddest thing about the Geithner program is its failure to act as though the financial crisis is a true crisis—an integrated, long-term economic threat—rather than merely a couple of related but temporary problems, one in banking and the other in jobs. In banking, the dominant metaphor is of plumbing: there is a blockage to be cleared. Take a plunger to the toxic assets, it is said, and credit conditions will return to normal. This, then, will make the recession essentially normal, validating the stimulus package. Solve these two problems, and the crisis will end. That’s the thinking.

But the plumbing metaphor is misleading. Credit is not a flow. It is not something that can be forced downstream by clearing a pipe. Credit is a contract. It requires a borrower as well as a lender, a customer as well as a bank. And the borrower must meet two conditions. One is creditworthiness, meaning a secure income and, usually, a house with equity in it. Asset prices therefore matter. With a chronic oversupply of houses, prices fall, collateral disappears, and even if borrowers are willing they can’t qualify for loans. The other requirement is a willingness to borrow, motivated by what Keynes called the "animal spirits" of entrepreneurial enthusiasm. In a slump, such optimism is scarce. Even if people have collateral, they want the security of cash. And it is precisely because they want cash that they will not deplete their reserves by plunking down a payment on a new car.

The credit flow metaphor implies that people came flocking to the new-car showrooms last November and were turned away because there were no loans to be had. This is not true—what happened was that people stopped coming in. And they stopped coming in because, suddenly, they felt poor.

Strapped and afraid, people want to be in cash. This is what economists call the liquidity trap. And it gets worse: in these conditions, the normal estimates for multipliers—the bang for the buck—may be too high. Government spending on goods and services always increases total spending directly; a dollar of public spending is a dollar of GDP. But if the workers simply save their extra income, or use it to pay debt, that’s the end of the line: there is no further effect. For tax cuts (especially for the middle class and up), the new funds are mostly saved or used to pay down debt. Debt reduction may help lay a foundation for better times later on, but it doesn’t help now. With smaller multipliers, the public spending package would need to be even larger, in order to fill in all the holes in total demand. Thus financial crisis makes the real crisis worse, and the failure of the bank plan practically assures that the stimulus also will be too small.

In short, if we are in a true collapse of finance, our models will not serve. It is then appropriate to reach back, past the postwar years, to the experience of the Great Depression. And this can only be done by qualitative and historical analysis. Our modern numerical models just don’t capture the key feature of that crisis—which is, precisely, the collapse of the financial system.

If the banking system is crippled, then to be effective the public sector must do much, much more. How much more? By how much can spending be raised in a real depression? And does this remedy work? Recent months have seen much debate over the economic effects of the New Deal, and much repetition of the commonplace that the effort was too small to end the Great Depression, something achieved, it is said, only by World War II. A new paper by the economist Marshall Auerback has usefully corrected this record. Auerback plainly illustrates by how much Roosevelt’s ambition exceeded anything yet seen in this crisis:

[Roosevelt’s] government hired about 60 per cent of the unemployed in public works and conservation projects that planted a billion trees, saved the whooping crane, modernized rural America, and built such diverse projects as the Cathedral of Learning in Pittsburgh, the Montana state capitol, much of the Chicago lakefront, New York’s Lincoln Tunnel and Triborough Bridge complex, the Tennessee Valley Authority and the aircraft carriers Enterprise and Yorktown. It also built or renovated 2,500 hospitals, 45,000 schools, 13,000 parks and playgrounds, 7,800 bridges, 700,000 miles of roads, and a thousand airfields. And it employed 50,000 teachers, rebuilt the country’s entire rural school system, and hired 3,000 writers, musicians, sculptors and painters, including Willem de Kooning and Jackson Pollock.

In other words, Roosevelt employed Americans on a vast scale, bringing the unemployment rates down to levels that were tolerable, even before the war—from 25 percent in 1933 to below 10 percent in 1936, if you count those employed by the government as employed, which they surely were. In 1937, Roosevelt tried to balance the budget, the economy relapsed again, and in 1938 the New Deal was relaunched. This again brought unemployment down to about 10 percent, still before the war.

The New Deal rebuilt America physically, providing a foundation (the TVA’s power plants, for example) from which the mobilization of World War II could be launched. But it also saved the country politically and morally, providing jobs, hope, and confidence that in the end democracy was worth preserving. There were many, in the 1930s, who did not think so.

What did not recover, under Roosevelt, was the private banking system. Borrowing and lending—mortgages and home construction—contributed far less to the growth of output in the 1930s and ’40s than they had in the 1920s or would come to do after the war. If they had savings at all, people stayed in Treasuries, and despite huge deficits interest rates for federal debt remained near zero. The liquidity trap wasn’t overcome until the war ended.

It was the war, and only the war, that restored (or, more accurately, created for the first time) the financial wealth of the American middle class. During the 1930s public spending was large, but the incomes earned were spent. And while that spending increased consumption, it did not jumpstart a cycle of investment and growth, because the idle factories left over from the 1920s were quite sufficient to meet the demand for new output. Only after 1940 did total demand outstrip the economy’s capacity to produce civilian private goods—in part because private incomes soared, in part because the government ordered the production of some products, like cars, to halt.

All that extra demand would normally have driven up prices. But the federal government prevented this with price controls. (Disclosure: this writer’s father, John Kenneth Galbraith, ran the controls during the first year of the war.) And so, with nowhere else for their extra dollars to go, the public bought and held government bonds. These provided claims to postwar purchasing power. After the war, the existence of those claims could, and did, establish creditworthiness for millions, making possible the revival of private banking, and on the broadly based, middle-class foundation that so distinguished the 1950s from the 1920s. But the relaunching of private finance took twenty years, and the war besides.

A brief reflection on this history and present circumstances drives a plain conclusion: the full restoration of private credit will take a long time. It will follow, not precede, the restoration of sound private household finances. There is no way the project of resurrecting the economy by stuffing the banks with cash will work. Effective policy can only work the other way around.

That being so, what must now be done? The first thing we need, in the wake of the recovery bill, is more recovery bills. The next efforts should be larger, reflecting the true scale of the emergency. There should be open-ended support for state and local governments, public utilities, transit authorities, public hospitals, schools, and universities for the duration, and generous support for public capital investment in the short and long term. To the extent possible, all the resources being released from the private residential and commercial construction industries should be absorbed into public building projects. There should be comprehensive foreclosure relief, through a moratorium followed by restructuring or by conversion-to-rental, except in cases of speculative investment and borrower fraud. The president’s foreclosure-prevention plan is a useful step to relieve mortgage burdens on at-risk households, but it will not stop the downward spiral of home prices and correct the chronic oversupply of housing that is the cause of that.

Second, we should offset the violent drop in the wealth of the elderly population as a whole. The squeeze on the elderly has been little noted so far, but it hits in three separate ways: through the fall in the stock market; through the collapse of home values; and through the drop in interest rates, which reduces interest income on accumulated cash. For an increasing number of the elderly, Social Security and Medicare wealth are all they have.

That means that the entitlement reformers have it backward: instead of cutting Social Security benefits, we should increase them, especially for those at the bottom of the benefit scale. Indeed, in this crisis, precisely because it is universal and efficient, Social Security is an economic recovery ace in the hole. Increasing benefits is a simple, direct, progressive, and highly efficient way to prevent poverty and sustain purchasing power for this vulnerable population. I would also argue for lowering the age of eligibility for Medicare to (say) fifty-five, to permit workers to retire earlier and to free firms from the burden of managing health plans for older workers.

This suggestion is meant, in part, to call attention to the madness of talk about Social Security and Medicare cuts. The prospect of future cuts in this modest but vital source of retirement security can only prompt worried prime-age workers to spend less and save more today. And that will make the present economic crisis deeper. In reality, there is no Social Security "financing problem" at all. There is a health care problem, but that can be dealt with only by deciding what health services to provide, and how to pay for them, for the whole population. It cannot be dealt with, responsibly or ethically, by cutting care for the old.

Third, we will soon need a jobs program to put the unemployed to work quickly. Infrastructure spending can help, but major building projects can take years to gear up, and they can, for the most part, provide jobs only for those who have the requisite skills. So the federal government should sponsor projects that employ people to do what they do best, including art, letters, drama, dance, music, scientific research, teaching, conservation, and the nonprofit sector, including community organizing—why not?

Finally, a payroll tax holiday would help restore the purchasing power of working families, as well as make it easier for employers to keep them on the payroll. This is a particularly potent suggestion, because it is large and immediate. And if growth resumes rapidly, it can also be scaled back. There is no error in doing too much that cannot easily be repaired, by doing a bit less.

As these measures take effect, the government must take control of insolvent banks, however large, and get on with the business of reorganizing, re-regulating, decapitating, and recapitalizing them. Depositors should be insured fully to prevent runs, and private risk capital (common and preferred equity and subordinated debt) should take the first loss. Effective compensation limits should be enforced—it is a good thing that they will encourage those at the top to retire. As Senator Christopher Dodd of Connecticut correctly stated in the brouhaha following the discovery that Senate Democrats had put tough limits into the recovery bill, there are many competent replacements for those who leave.

Ultimately the big banks can be resold as smaller private institutions, run on a scale that permits prudent credit assessment and risk management by people close enough to their client communities to foster an effective revival, among other things, of household credit and of independent small business—another lost hallmark of the 1950s. No one should imagine that the swaggering, bank-driven world of high finance and credit bubbles should be made to reappear. Big banks should be run largely by men and women with the long-term perspective, outlook, and temperament of middle managers, and not by the transient, self-regarding plutocrats who run them now.

The chorus of deficit hawks and entitlement reformers are certain to regard this program with horror. What about the deficit? What about the debt? These questions are unavoidable, so let’s answer them. First, the deficit and the public debt of the U.S. government can, should, must, and will increase in this crisis. They will increase whether the government acts or not. The choice is between an active program, running up debt while creating jobs and rebuilding America, or a passive program, running up debt because revenues collapse, because the population has to be maintained on the dole, and because the Treasury wishes, for no constructive reason, to rescue the big bankers and make them whole.

Second, so long as the economy is placed on a path to recovery, even a massive increase in public debt poses no risk that the U.S. government will find itself in the sort of situation known to Argentines and Indonesians. Why not? Because the rest of the world recognizes that the United States performs certain indispensable functions, including acting as the lynchpin of collective security and a principal source of new science and technology. So long as we meet those responsibilities, the rest of the world is likely to want to hold our debts.

Third, in the debt deflation, liquidity trap, and global crisis we are in, there is no risk of even a massive program generating inflation or higher long-term interest rates. That much is obvious from current financial conditions: interest rates on long-maturity Treasury bonds are amazingly low. Those rates also tell you that the markets are not worried about financing Social Security or Medicare. They are more worried, as I am, that the larger economic outlook will remain very bleak for a long time.

Finally, there is the big problem: How to recapitalize the household sector? How to restore the security and prosperity they’ve lost? How to build the productive economy for the next generation? Is there anything today that we might do that can compare with the transformation of World War II? Almost surely, there is not: World War II doubled production in five years.

Today the largest problems we face are energy security and climate change—massive issues because energy underpins everything we do, and because climate change threatens the survival of civilization. And here, obviously, we need a comprehensive national effort. Such a thing, if done right, combining planning and markets, could add 5 or even 10 percent of GDP to net investment. That’s not the scale of wartime mobilization. But it probably could return the country to full employment and keep it there, for years.

Moreover, the work does resemble wartime mobilization in important financial respects. Weatherization, conservation, mass transit, renewable power, and the smart grid are public investments. As with the armaments in World War II, work on them would generate incomes not matched by the new production of consumer goods. If handled carefully—say, with a new program of deferred claims to future purchasing power like war bonds—the incomes earned by dealing with oil security and climate change have the potential to become a foundation of restored financial wealth for the middle class.

This cannot be made to happen over just three years, as we did in 1942–44. But we could manage it over, say, twenty years or a bit longer. What is required are careful, sustained planning, consistent policy, and the recognition now that there are no quick fixes, no easy return to "normal," no going back to a world run by bankers—and no alternative to taking the long view.

A paradox of the long view is that the time to embrace it is right now. We need to start down that path before disastrous policy errors, including fatal banker bailouts and cuts in Social Security and Medicare, are put into effect. It is therefore especially important that thought and learning move quickly. Does the Geithner team, forged and trained in normal times, have the range and the flexibility required? If not, everything finally will depend, as it did with Roosevelt, on the imagination and character of President Obama.