2008-12-01 - Work in Progress - Unfinished

 

From Minsky Moment to Minsky Meltdown to…?

Learning to Stop Underestimating the Likelihood of

“High Impact, Low Probability” Events

 

Liquidity Trap and Depression is a Serious Risk

 

Warning - Unfinished - Work in Progress 

It isn’t called the dismal science for nothing!

The evolution of capital markets prices will be determined largely by (a) the evolution of what will come for the economy and (b) how much of that has already been reflected in asset prices. Such a statement of the seemingly obvious would normally be implicit and left unsaid, but its explicit statement seems warranted by the combination of the extraordinary nature of the times, the degree of uncertainty on the outlook, and the volatility of the markets (perhaps suggestive of the tenuousness of market participants’ convictions, in particular due to the unpredictability to date of government policy interventions).

Clearly, asset prices (credit spreads, equity values and commodity prices, in particular) went from, in September and earlier, pricing in expectations of a moderately bad economic environment to, in October and November, pricing in expectations of a rather worse -- and more intransigent -- economic outcome.

But how bad an economic outcome exactly is likely, and did the markets, at their worst, finally go too far? (And, hence, the bounce from those levels is warranted.) Or is the process that we’ve witnessed this year of the markets continuously playing catch-up to the economic reality (as it evolves, incorporating the various feedback loop effects) ongoing? (And, as such, the worst has not yet been priced in and there are further lows to come.)

Equity and commodity markets, in particular, were relatively slow to discard their optimistic assumptions, including, for instance, that subprime is contained, that housing was bottoming, that there would be global decoupling, that the U.S. consumer is resilient, that the corporate sector has strong balance sheets, that (each successive round of) extraordinary government policy intervention would cure our ills, that emerging markets were exempt from the developed world’s problems, etc.

But does a breach of 800 on the S&P and of $50 on oil suggest that we’ve finally reached capitulation? Or has the severity of the situation still not been fully assessed, implying that as far as markets have retreated, many prices have still not reverted far enough to reach fair values based on a realistic assessment of our ultimate outcome? Or, alternatively, is it perhaps then possible that the process of discarding optimism may be done, and market prices did in fact reach reasonable approximations of fair value, but there remains plenty of room to become even more pessimistic? (Markets, after all, are notorious for overshooting.)

The answers to these questions rely largely on the answer to the following one:

How bad a recession?

As Harry Truman said, a recession is when your neighbour loses his job, a depression is when you lose yours.

The NBER has (finally) acknowledged that the U.S. economy is, and has been for some time, in a recession. This did not require that the U.S. economy post two consecutive quarters of negative GDP growth (the popular rule of thumb). The Business Cycle Dating Committee at the National Bureau of Economic Research (NBER) maintains a chronology of the U.S. business cycle: “The chronology identifies the dates of peaks and troughs that frame economic recession or expansion. The period from a peak to a trough is a recession and the period from a trough to a peak is an expansion… A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough.” The Committee does not apply a fixed rule for how the different indicators that they evaluate are weighted, and they may declare a peak (or trough) in the business cycle anywhere from 6 to 18 months after the fact, with the intention of waiting long enough so that the existence (and timing) of a recession is not at all in doubt. In this case, they waited until December 2008 to identify that December 2007 was the peak of the last business cycle. This current recession, then, is already 12 months long, which is longer than the average post-WWII recession. (At least some of the “experts” on CNBC deemed this a good sign, as it could therefore be taken to imply that the recession must be nearing its end. If only it were true!)

In 2007, it was considered questionable whether the U.S. economy would suffer a recession at all, and, even if so, the consensus was that other global economies would survive relatively unscathed. The notion that the U.S. economy could be at risk of entering a depression was then viewed as outlandish. However, times have changed, and comparisons to 1990s Japan and even the 1930s Great Depression have since become almost commonplace.

Before the Great Depression of the 1930s any downturn in economic activity was referred to as a depression. The term recession was then developed to differentiate periods like the 1930s from smaller economic declines, such as those that occurred in 1910 and 1913. There is, however, no standard definition of what constitutes a depression; the NBER does not declare or define economic depressions. However, it does say that “the term depression is often used to refer to a particularly severe period of economic weakness. Some economists use it to refer only to the portion of these periods when economic activity is declining. The more common use, however, also encompasses the time until economic activity has returned to close to normal levels.”

Though the odds of revisiting the depths of the Great Depression are low, thanks in large part to the lessons learned from that episode (and the macroeconomic policies and countercyclical programs that were the result of those lessons), that is not to say that the probability of A depression is equally low. If a depression is, as most would agree, a prolonged period of recession, or a significant and prolonged downturn in the economy, characterized by declining business activities, falling prices, rising unemployment, increasing inventories (and a degree of public fear), there is certainly some degree of likelihood that such an outcome could result. In fact, it is the purpose of this paper to document that such a risk is indeed quite significant.

The Great One

Marriner S. Eccles served as Franklin D. Roosevelt's Chairman of the Federal Reserve from November 1934 to February 1948. He detailed in his memoirs what he believed caused the Great Depression:

As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth -- not of existing wealth, but of wealth as it is currently produced -- to provide men with buying power equal to the amount of goods and services offered by the nation's economic machinery.

Instead of achieving that kind of distribution, a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations. But by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.

That is what happened to us in the twenties. We sustained high levels of employment in that period with the aid of an exceptional expansion of debt outside of the banking system. This debt was provided by the large growth of business savings as well as savings by individuals, particularly in the upper-income groups where taxes were relatively low. Private debt outside of the banking system increased about fifty per cent. This debt, which was at high interest rates, largely took the form of mortgage debt on housing, office, and hotel structures, consumer installment debt, brokers' loans, and foreign debt. The stimulation to spend by debt-creation of this sort was short-lived and could not be counted on to sustain high levels of employment for long periods of time. Had there been a better distribution of the current income from the national product -- in other words, had there been less savings by business and the higher-income groups and more income in the lower groups -- we should have had far greater stability in our economy. Had the six billion dollars, for instance, that were loaned by corporations and wealthy individuals for stock-market speculation been distributed to the public as lower prices or higher wages and with less profits to the corporations and the well-to-do, it would have prevented or greatly moderated the economic collapse that began at the end of 1929.

The time came when there were no more poker chips to be loaned on credit. Debtors thereupon were forced to curtail their consumption in an effort to create a margin that could be applied to the reduction of outstanding debts. This naturally reduced the demand for goods of all kinds and brought on what seemed to be overproduction, but was in reality underconsumption when judged in terms of the real world instead of the money world. This, in turn, brought about a fall in prices and employment.

Unemployment further decreased the consumption of goods, which further increased unemployment, thus closing the circle in a continuing decline of prices. Earnings began to disappear, requiring economies of all kinds in the wages, salaries, and time of those employed. And thus again the vicious circle of deflation was closed until one third of the entire working population was unemployed, with our national income reduced by fifty per cent, and with the aggregate debt burden greater than ever before, not in dollars, but measured by current values and income that represented the ability to pay. Fixed charges, such as taxes, railroad and other utility rates, insurance and interest charges, clung close to the 1929 level and required such a portion of the national income to meet them that the amount left for consumption of goods was not sufficient to support the population.

This then, was my reading of what brought on the depression.

Based on this account, it seems clear that there are a number of parallels between the situation that prevailed in the lead-up to the Great Depression and that which has pertained recently: inequitable income distribution, excessive credit growth and leverage, misallocation of resources and malinvestment, excess consumption.

 

Lesson learned: “You're right, we did it. We're very sorry. But thanks to you, we won't do it again.”

On the occasion of Milton Friedman’s 90th birthday, at a conference at the University of Chicago in November 2002, Ben Bernanke, then a Governor of the Federal Reserve, said: “Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.”

Bernanke was saluting Friedman and Schwartz because they, in Bernanke’s words, “provided what has become the leading and most persuasive explanation of the worst economic disaster in American history”, in their 1963 tome, A Monetary History of the United States. Their view was that the economic collapse was the product of monetary forces, and that the Fed was to blame for allowing the money supply to contract by one-third, turning a garden-variety recession into the disaster it became. This was quite controversial at the time, but the monetarist perspective gained much more credibility during the inflationary episode of the 1970s, and, by 1976, Friedman had won the Nobel Prize.

Bernanke, who has spent a good portion of his professional life studying the Great Depression, and is widely-acknowledged as one of the foremost experts on it, obviously seems intent on ensuring he honours the oath he made to Milton and Anna. The variety of liquidity facilities the Fed has put on offer, to an ever-expanding range of companies (not just depository institutions), and against increasingly suspect collateral, along with the dramatic expansion of the Fed’s balance sheet in recent weeks, is testament to his determination. In fact, the Fed’s maneuverings run contrary to a principle once held dear by many central bankers, Walter Bagehot’s famous 1873 dictum that a lender of last resort in a crisis should lend freely, but at a penalty rate, to solvent but illiquid banks that have adequate collateral.

The problem is, as so succinctly described by Mark Twain, that “to a man with a hammer, everything looks like a nail”. Bernanke’s “hammer” is his understanding of the causes and consequences of the Great Depression, and the alternative policy prescriptions he has determined should have been implemented at the time. His “nail” is this unfortunate current circumstance, which provides the (fortuitous?) opportunity to put his years of research into practice (it must have been fate that one of the world’s foremost experts on the Great Depression was in place to address Round Two!).

None other than Ms. Schwartz, who Bernanke effusively praised for her analysis with Friedman of the Great Depression, believes Bernanke and the Fed are fighting the last war. "The Fed has gone about as if the problem is a shortage of liquidity. That is not the basic problem”, she argues. “The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible." In the 1930s, the country and the Federal Reserve were faced with a liquidity crisis in the banking sector. As weak banks failed, depositors worried that their bank would be next, which prompted bank runs on otherwise healthy institutions. At the time, that Fed also did not heed Bagehot’s advice, but in that case it was by sitting idly by, so bank after bank failed, causing a self-reinforcing spiral, bringing down principally banks that should not have been in distress. But "that's not what's going on in the market now," Ms. Schwartz says. “Today, the banks have a problem on the asset side of their ledgers -- all these exotic securities that the market does not know how to value…Why are they 'toxic'?" Ms. Schwartz asks. "They're toxic because you cannot sell them, you don't know what they're worth, your balance sheet is not credible and the whole market freezes up. We don't know whom to lend to because we don't know who is sound. So if you could get rid of them, that would be an improvement."

As such, Ms. Schwartz actually believed that the first incarnation of the TARP was a step in the right direction, though with a potentially intractable problem: the question of how to price the assets the TARP would acquire. If priced at current market values, the assets’ sale would instantly make many institutions insolvent, which would of course instantly realize the fears that were and are currently locking up the credit markets, as a number of banks failed. This realization is surely why TARP v.1 became TARP v.2, with Paulson changing gears to recapitalize firms directly. Ms. Schwartz believes this change in plan was tantamount to changing the objective from trying to save the banking system to instead trying to save the banks. But by keeping otherwise insolvent banks alive, the government is prolonging the crisis. Rather, "firms that made wrong decisions should fail," she says bluntly. "You shouldn't rescue them. And once that's established as a principle, I think the market recognizes that it makes sense. Everything works much better when wrong decisions are punished and good decisions make you rich."

Predicting the Improbable

Roger M. Kubarych is Chief US Economist of UniCredit Global Research, and is also the Henry Kaufman Adjunct Senior Fellow for International Economics and Finance at the Council on Foreign Relations. It is his view that “nobody likes to pay attention to low probability, high-cost events. We've see this over and over again. And so you bring up to somebody in authority that if this happens and this happens, then this will be the result. It isn't that you are dismissed as being adolescent or puerile, you're just too early. There's a great story that Chuck Brunie has written about Milton Friedman, for whom he managed money. And Brunie talks of once asking Milton that as one of the most distinguished economists in the world why he needed someone like Chuck to manage his money. And Friedman replied, "Chuck, I see things too early."”

It is to be hoped that the advances in economic policies, research, and, more simply, understanding should leave policymakers today better suited to accurately assessing the likely course for the economy. Recent events, however, cast doubt on that view.

At the Cato Institute’s 26^th Annual Monetary Conference in November, 2008, Don Kohn provided the keynote address, in which he explained why, despite the lessons learned from recent experience, he, like many other members of the FOMC, still believes that monetary policy should not be used to influence asset prices. One of his key arguments was that identification of an asset bubble in real-time is very tricky. He now recognizes that the Fed underestimated the scope for housing prices to fall and therefore also underestimated the severe economic fallout and thus the difficulty of mopping up afterwards. After his speech, in the Q&A session, when asked to address the risks of a Japanese-style deflation in the U.S., Mr. Kohn explained his view that the probability of such a scenario unfolding now has increased over recent months, but nonetheless remains very low. However, he did insist that if the Fed did come to believe such a scenario likely, it would act very quickly and very aggressively to prevent it.

Thus, on the one hand, Mr. Kohn insisted the Fed could not identify asset bubbles (even extraordinarily obvious ones like housing, by virtue of fairly basic metrics like price-to-rent and price-to-income ratios). He also effectively admitted the Fed was lacking the insight or imagination to foresee, despite the fact that housing was a clear leading indicator in 8 of the last 10 U.S. recessions, that the unwinding of the housing bubble would have severe consequences. Meanwhile, on the other hand, he attempted to reassure that the Fed would be very proactive, as would be required, to prevent a deflationary spiral if one were to become a risk.

This is hardly reassuring talk from a policymaking institution that has so obviously failed to appreciate the gravity of the situation it found itself conducting policy in. For instance, Ben Bernanke famously declared repeatedly throughout the spring of 2007 that the problems in subprime were likely to remain contained, a mistake he just recently acknowledged. As a second example, the Fed effectively ignored the recommendations of one of its own Governors, Fredric Mishkin, who, at the Jackson Hole Conference in August 2007, urged central bankers to respond quickly and aggressively to large falls in housing prices with immediate large scale interest rate cuts. Mishkin argued, to no avail, that a delay in a policy approach would just guarantee that when easier policy was finally implemented it would be much less effective and therefore need to be of even greater magnitude. This was hardly the only occasion of an FOMC member’s good advice being ignored, as Alan Greenspan continuously rebuffed warnings about the risk due to increasingly unscrupulous behaviour in subprime mortgages, including from former Governor Ed Gramlich. Greenspan has belatedly offered his own unique version of a mea culpa, admitting in testimony in October before the House Committee of Government Oversight that he was wrong about regulation: "I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms," and said his free-market ideology was flawed-- "I don’t know how significant or permanent it is. But I have been very distressed by that fact... I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well.”

 

As Dean Baker, one of the economists who predicted the current predicament, put it in October 2007, “It is disconcerting to hear that the weakness in the housing market is greater "than had previously been expected" will be "more prolonged than had seemed likely" or would persist longer "than previously anticipated." The members of the Federal Reserve Board are supposed to be knowledgeable about the economy and therefore should not be continually surprised by events. The fact that they have been repeatedly surprised by the weakness in the housing market raises serious questions about their competence.” Based on the above, it does not seem credible to believe that government policymakers necessarily have the requisite knowledge, insight and tools to sufficiently address the problems it faces.

 

Are We Japan (Bad) or Are We Sweden (Good)

It is always easier to give advice to others than to put it into action yourself. Many American economists were quite critical of Japanese policymakers in the 1990s.

…

Hypocritical? U.S. has been faster and more aggressive on some fronts (int rt cuts; albeit not as fast as Mishkin and others would have like; missed opportunities in 2007 due to failure of vision) but failing to follow the advice it gave Japan on other fronts (take your pain up front; let/force the weak to die while supporting the strong; use FDIC and bankruptcy for what they were designed for (WAMU example may have been worse than LEH in terms of f’g up prospects of financials raising more capital in the private markets)

…

As Yves Smith, who authors the blog naked capitalism, is fond of saying, “persisting in a failed course of action is not a sign of intelligence.” None of the liquidity facilities enacted by the Fed to date has proven effective at stemming the credit crunch, yet the Fed insists on repeatedly returning to that same old dry well. This goes back to Anna Schwartz’s observation – the fact of the matter is that the Fed’s programs are designed to address a liquidity crisis, but this is not a liquidity crisis, it is a credit crisis (or debt crisis, or solvency crisis).

….

Fed transparency a thing of the past --- disingenuous about quant easing; refusing to disclose the banks it has lent to or the assets it has bought (Willem Buiter calls this a symptom of the Fed’s cognitive regulatory capture; this is a type of concession (in order to avoid stigma?) the banks have not earned, and has not been granted to anyone else, including automakers, who have had to hang their dirty laundry in public, as they should if they’re begging for public funds

….

 

 

Great Depression Round Two – What’s the Right Parallel?

Earlier in this paper, I have alluded to the similarities between the U.S. today and the U.S. in 1930. While those similarities remain germane, to the extent that the imbalances in the U.S. economy over the last decade have left it susceptible to terrible reversals, the more relevant --- and disturbing --- comparison is between China today and the U.S. of 1930.

 

It is China today that plays the part that 1930 U.S. did, while the U.S. today is more akin to 1930 U.K.

 

U.S. then / China now --- world’s largest creditor and exporter

 

1930s Smoot-Hawley --- today, beggar-thy-neighbour exchange rate depreciation, export subsidies; plus collapse of shipping; BDI down 94%, Cass Freight similar; letter of credit for trade n/a; ports (Long Beach, L.A.) => activity slowing, plus what is being offloaded is sitting warehoused not going anywhere

 

…..

China showing signs of slowing dramatically

Exports and investment primary sources of growth; personal spending was growing at a fast rate, but (a) still a very low proportion of economy, (b) very cyclical, and very reliant on income growth (personal savings huge in China b/c no social safety net (nor even a large stable of kids to support you); (c) food a larger component of spending, and growth in spending was in large part a food price effect; (d) factories shutting down like crazy, workers losing their jobs (riots already); investment was for exports, so as X slows, so too does investment;

…

Fiscal stimulus may have had less to it than meets the eye

 

 

Contemporary forecasts of doom and gloom

You no longer have to resort to reading the bearish analysis of prescient economist Nouriel Roubini to receive a significant dose of doom and gloom. In fact, you don’t have to read economists at all, not when chief executives provide assessments such as these:

JP Morgan Chase & Co. CEO Jamie Dimon, November 11, 2008

“We think the economy could be worse than the capital-markets crisis. You really need to separate them because they have completely different effects on our businesses and on most businesses.''

 

Merrill Lynch Chairman and CEO John Thain, November 11, 2008

“Right now, the US economy is contracting very rapidly. We are looking at a per­iod of global slowdown. This is not like 1987 or 1998 or 2001. The contraction going on is bigger than that. We will in fact look back to the 1929 period to see the kind of slow­down we’re seeing now.”

 

Former Goldman Sachs Chairman John Whitehead, November 11, 2008

“I think it would be worse than the depression. We’re talking about reducing the credit of the United States of America, which is the backbone of the economic system…. I see nothing but large increases in the deficit, all of which are serving to decrease the credit standing of America. … I just want to get people thinking about this and to realize this is a road to disaster. I’ve always been a positive person and optimistic, but I don’t see a solution here.”

 

Oppenheimer & Co. Managing Director Meredith Whitney, Nov. 30, 2008

“My outlook has been negative for over a year and, technically, I have been “right” on my calls. Seeing massive capital destruction has brought me no pleasure, but unfortunately I see little on the horizon that would change my outlook. In fact, after observing the US economy so derailed, I feel that I must act as a citizen of this great country to attempt to offer solutions to this economic train wreck we are all involved in. First, I am more bearish today than I have been in the past 18 months.”

 

 

analysis of the global outlook from JPMorgan Chase, once among the most bullish of analysts, in 2007-08 leading voice arguing about risks of global inflation. Now, under the rubric “A bad week in hell”, JPMorgan states that: “Increasingly signs point to a deep and synchronized global recession” ; “Once again, we have taken an axe to near-term growth forecasts for the developed world and will likely follow up with additional downward revisions for emerging economies in the coming weeks. Already, our forecasts suggest that global gross domestic product will contract at a near 1 per cent annual rate” in the fourth quarter of 2008 and the first quarter of 2009” ; “it is likely that the coming six months will see headline inflation dip below zero” ;

JPMorgan expects shrinkage this quarter at an annualised rate of 4 per cent in the US, 3 per cent in the UK and 2 per cent in the eurozone. It is forecasting 0.4 per cent global growth in 2009, with advanced countries shrinking 0.5 per cent and emerging ones growing 4.2 per cent.

 

Minsky, Money and Liquidity Traps

 

Financial instability hypothesis; Ponzi finance, etc.

 

…..

 

Keynes

“Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”

 

….

 

Quantitative easing – how it works and its limitations

 

….

 

MV = PQ

Velocity falling

Fed pumping up monetary base, but being hoarded, so broader measures of M no change

 

 

Debt, Debt and More Debt

 

No end to this until debt has become supportable ---- a prospect which continues to be pushed into the future by virtue of declining employment and incomes, declining wealth via housing and equity market sell-offs, while aggregate debt continues to increase

 

 

 

Global Imbalances

 

(A) Deflation and lqdty trap à bond rally has room to run

Supply (govt supply) is coming, but its merely offsetting dropoff in bond issuance in private sector (securitized and otherwise), plus bond demand should be expected to rise (private sector balance sheets have bonds at historically low level as proportion of assets; pension funds also have room to add (more LDI when alternative long-duration assets (stocks) not working out too well)

….

But (B) what if global imbalances start to unwind (and quickly)?

That which is unsustainable by definition won’t be sustained

….

Cyclical vs secular --- (A) has been trumping (B) recently and seems likely to continue to do so in short term but not in long term; ? is, when can we expect the tipping point?

Frankly, nobody freaking knows --- no facts to make a good estimation of this on ---- speculation abounds

 

REFERENCES

Bernanke, Ben. “On Milton Friedman's Ninetieth Birthday; Remarks by Governor Ben S. Bernanke at the Conference to Honor Milton Friedman, University of Chicago, Chicago, Illinois; November 8, 2002

Backstrom, Urban. “What Lessons Can Be Learned From Recent Financial Crises? The Swedish Experience”

King, Stephen. “How to Cope With Depression.” HSBC Economics. September 23, 2008.

Krugman, Paul. “Japan’s Trap”. May 1998

Krugman, Paul. “Thinking About the Liquidity Trap”. December 1999

Kuttner, Robert. “The Alarming Parallels Between 1929 and 2007: Testimony of Robert Kuttner Before the Committee on Financial Services”. The American Prospect. October 2, 2007.

Leamer, Edward. “Housing IS the Business Cycle.” NBER. September 2007.

Reinhart, Carmen and Kenneth Rogoff. “Is the 2007 U.S. Sub-Prime Financial Crisis So Different? An International Historical Comparison”. February 2008.

Reinhart, Carmen and Kenneth Rogoff. “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises”. April, 2008.

Schwartz, Anna. “Bernanke Is Fighting the Last War”. Wall Street Journal. October 18, 2008.

Tymoigne, Eric. “Minsky and Economic Policy: “Keynesianism” All Over Again?”. October 2008.

Whalen, Charles. “The U.S. Credit Crunch of 2007: A Minsky Moment”. October 2007.

Wray, L. Randall. “Financial Markets Meltdown: What Can We Learn From Minsky?”. 2008.

 

 

Other Analysts, Economists and Investors Worth Listening To:

Economists (from more alarmist to more conventional)	Analysts and Investors
Nouriel Roubini	Satyajit Das
Robert Shiller	Meredith Whitney
Paul Krugman	Albert Edwards and James Montier
Kenneth Rogoff and Carment Reinhart	Nassim Nicholas Taleb
Joseph Stiglitz	James Grant
Stephen Roach	Jeremy Grantham
David Rosenberg and David Wolf
Jan Hatzius

APPENDIX

 

2008Q3 Forecast Notes (need to include charts to address these points)

None of us has the time here today to fully address all the facts and assumptions that motivate our forecasts and to do those topics any justice, so I’m going to be selective today about what I discuss and focus on.

First, I’ll just briefly review some key forces at play, before digging a bit deeper into one particular topic.

-        In 2006, I focused a lot on how the housing bubble was morphing into the most serious housing recession in the post-WWII period, and how housing has historically been a leading indicator of turning points in the economic cycle, which did not portend well for an economic soft landing.

o    All I can add on this topic is that bottom-callers these days are just as likely to be wrong now as they were in late 2006 and all through 2007

o    Obviously we are now closer to the bottom than we were then, but that does not mean it’s imminent

o    Housing prices remain well above historical norms with respect to either incomes or rents, the overbuilding of the last decade has in no way been worked off, so inventories remain high, foreclosures and delinquency rates continue to climb, and though mortgage rates have come down, affordability has not because of the tightening of credit conditions

 

-        Many times in 2007, I detailed the deterioration in the U.S. labour market, highlighting both the faultiness of the NFP data due to the Birth/Death model, and that year-over-year employment growth slowing as much as it had was historically a very accurate indicator of recession

o    Obviously, the news on this front has gotten no better since then, with 8 straight months of job losses, the main unemployment rate 1.7% higher than its cycle low, at 6.1%, and the most comprehensive measure of unemployment up 2.8% from its cycle low, to 10.7%, the highest since 1994

 

-        Around this time last year, I highlighted a number of leading indicators, in addition the to housing and labour market data, that had also served as useful leading recessionary indicators, including Paul Kasriel’s combination of a yield curve inversion along with a YoY drop in the CPI-adjusted monetary base, the coincident-lagging index, etc.

o    A quick update on this front is that the Chicago Fed NAI was just released for August and its value marked the ninth consecutive month that it indicated a strong likelihood that a recession had begun

 

-        In spring 2007, I focused on the economy’s unsustainable debt growth, and that I believed a Minsky moment would ultimately occur, whereby the credit markets reached a tipping point, unleashing a vicious circle of necessary deleveraging.

o    Clearly, this is ongoing, and the only comments I’d like to add is that the probabilities of either a Japanese-like deflationary lost decade or the most serious recession since the Great Depression are materially higher now than they were when I first forecast their risk

o    What’s more, at the aggregate level, there really hasn’t been much, if any, real deleveraging yet

§   Financial institutions have not raised sufficient new capital to offset the writedowns they’ve taken, so their leverage hasn’t in aggregate been reduced

§   Despite tighter lending conditions, household debt has continued to grow, so income is down and wealth has been down for three quarters in a row, but debt has actually built further

§   So debt burdens all around have become nothing if not more onerous

 

-        I’ve also discussed in the past that the theory about global decoupling would eventually be proven a fallacy

o    On this front, it has become clear that the OECD, particularly Europe and Japan, has recoupled, as the previous period of supposed resilience has been shown just to be a matter of lags

o    Though the outcome for emerging markets is not yet apparent, I’ll stick to my view that they will suffer the same fate, though to a lesser degree, though just to a more lagged extent

 

-        The main topic I’d like to address today, though, is the latest incarnation of government intervention, the Toxic Asset Relief Program, or TARP, which is doomed to failure

o    It will be no more effective than any of the previous cases of government meddling, from the Hank’s MLEC Super SIV and HOPENow to Ben’s liquidity measures and rate cuts to the Bear takeunder, to the inconsistent approaches taken to the GSEs vs AIG vs. LEH vs. Wachovia and WAMU, etc.

§   The TARP simply reshuffles the deck chairs on the Titanic; it doesn’t do anything to solve the problem of bad assets (leveraged-up exposure to less-than-creditworthy borrowers), its just a proposal for the taxpayer to take on the burden of the private sectors greed-fueled mistakes

§   Either the TARP buys assets at true market value, which locks in losses for the company selling the assets and meanwhile also establishes a real market price to which other institutions must mark their similar exposures down to, forcing their insolvency; or it pays substantially inflated values, which exposes taxpayers to the credit risk, and inculcates a policy of privatized profits / socialized losses, while not solving the problem as foreclosures and defaults continue rising

§   The only approach that has a chance of working is a taxpayer-to-taxpayer relief program that addresses income inequality to stem tide of defaults

 

2008-03-25: US Labor Market

2007-12-17

My intuition and understanding about stock valuation metrics comes mostly from authors like John Hussman, as well as Clifford Asness and Robert Arnott 

I’ve included links to (and excerpts from) a bunch of their writings

 

Arnott:

http://www.ft.com/cms/s/2/af1d2ac4-9fcb-11dc-8a08-0000779fd2ac,dwp_uuid=d8e9ac2a-30dc-11da-ac1b-00000e2511c8.html

excerpt:

Many observers point out that, following an unprecedented peak in valuation multiples (price-earnings ratios as well as price-sales, price-book and price-dividend ratios) at the peak of the bubble in 2000, p/e ratios are now back down to their long-term historical norms. That’s true. But that’s only because prices and earnings are both well above their historical trends. 

….There is a very long history of real prices and real earnings moving in a surprisingly consistent – and parallel – corridor around a long-term growth trend, albeit with large swings in prices, earnings and the p/e ratios. 

There’s also a long history of reverting back to the trend. When earnings are 40 per cent or more below the trend (2002, for instance), subsequent real earnings growth averages about 10 per cent – over and above inflation – for the next 10 years, which is terrific. When earnings are 40 per cent or more above the trend, subsequent earnings growth tends to disappoint, with average real growth of zero – just matching inflation – over the next 10 years. 

Where are we today? Both prices and earnings are 60 per cent above trend. This suggests either that things are different this time, that prices and earnings have built a base from which to leap to new heights, or that both may disappoint.

 

Hussman:

Long-Term Evidence on the Fed Model and Forward Operating P/E Ratios

http://www.hussmanfunds.com/wmc/wmc070820.htm

 

Adjusting P/E Ratios for the Profit Cycle 

The growing gap between traditional P/E ratios and P/Es adjusted for the profits cycle

http://www.hussmanfunds.com/rsi/adjustingpes.htm

 

Profit Margins, Earnings Growth, and Stock Returns 

Investors consistently overpay for stocks in periods when profit margins are high 

http://www.hussmanfunds.com/rsi/profitmargins.htm

 

Recessions and Stock Prices 

Recession-induced bear markets are much different than "stand alone" declines 

http://www.hussmanfunds.com/rsi/recessionbears.htm

 

Fair Value - 40% Off (Not a Forecast, but Don't Rule it Out)

http://www.hussmanfunds.com/wmc/wmc070402.htm

Valuations Revisited 

Long-time readers will recognize some of the following arguments from various studies I've presented in recent years, but I believe that it is important for investors to understand how profoundly incorrect and potentially dangerous it is to accept the incessant argument that stocks are cheap on a "forward operating earnings basis." As AQR's Cliff Asness has previously noted, the belief that the current “price to forward operating earnings” multiple is reasonable is based on an apples-to-oranges comparison. It is the trailing P/E on reported net earnings that has a historical average of about 15, not the forward P/E on estimated operating earnings (which Asness estimates as having a historical norm closer to 11). 

Even that average for the trailing P/E is itself biased upward because earnings typically collapse during recessions, driving P/E ratios to extreme levels during those periods. Those get added into the average, and results in a “historical norm” of 15. If you correct for those spikes, the historical average P/E for the S&P 500 is even lower. 

To correct for the uninformative spike in P/E ratios during recessions, we can make the assumption that a given earnings level, once achieved, is likely to be achieved again even if the economy encounters temporary weakness. While that's not necessarily a reasonable assumption for an individual stock, it is much more reasonable for a diversified index like the S&P 500. Forming price/earnings ratios on the basis of the peak level of earnings-to-date (what I call the price/peak earnings ratio), we get a much better behaved measure of valuations that is more reliably correlated with subsequent long-term returns. Note that the word “peak” doesn't imply that earnings are about to decline – only that the P/E calculation uses the highest level of earnings achieved to-date. 

On that basis, the current price/peak earnings ratio is about 17.5, well above the historical average of 14 for the price/peak earnings ratio. 

But we're just getting warmed up. If we look closely at S&P 500 earnings, we find that we can draw a 6% growth trendline connecting earnings peaks from economic cycle to economic cycle as far back as we care to look. So even though earnings sometimes grow rapidly from the trough of a recession to the peak of an economic expansion, at rates sometimes exceeding 20% annually, we also find that the peak-to-peak growth rate has been very well contained historically at just 6%. 

Unfortunately, if we a) calculate the S&P 500 price earnings ratio based on those “trendline” earnings or b) look at periods where actual earnings were within 10-20% of that trendline connecting historical earnings peaks, we find that the average S&P 500 price/earnings ratio drops to just 10. 

Currently, S&P 500 earnings are again at that trendline. In fact, given the unusual spike in profit margins, they have actually moved slightly (but not significantly) above that line. On that basis, the current price/earnings ratio, normalized for the position of earnings at present, is about 75% above its historical norm (alternatively, the historical norm would be about 40% below current levels).

 

 

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=381480

Fight the Fed Model: The Relationship Between Stock Market Yields, Bond Market Yields, and Future Returns 

CLIFFORD S. ASNESS 

AQR Capital Management, LLC

December 2002

Abstract:      

The "Fed Model" has become a very popular yardstick for judging whether the U.S. stock market is fairly valued. The Fed Model compares the stock market's earnings yield (E/P) to the yield on long-term government bonds. In contrast, traditional methods evaluate the stock market purely on its own without regard to the level of interest rates. My goal is to examine the theoretical soundness, and empirical power for forecasting stock returns, of both the "Fed Model" and the "Traditional Model". The logic most often cited in support of the Fed Model is that stocks should yield less and cost more when bond yields are low, as stocks and bonds are competing assets. Unfortunately, this reasoning compares a real number to a nominal number, ignoring the fact that over the long-term companies' nominal earnings should, and generally do, move in tandem with inflation. In other words, while it is a very popular metric, there are serious theoretical flaws in the Fed Model. Empirical results support this conclusion. The crucible for testing a valuation indicator is how well it forecasts long-term returns, and the Fed Model fails this test, while the Traditional Model has strong forecasting power. Long-term expected real stock returns are low when starting P/Es are high and vice versa, regardless of starting nominal interest rates. I also examine the usefulness of the Fed Model for explaining how investors set stock market P/Es. That is, does the market contemporaneously set P/Es higher when interest rates are lower? Note the difference between testing whether the Fed Model makes economic sense, and thus forecasts future long-term returns, versus testing whether it explains how investors set current P/Es. If investors consistently confuse the real and nominal, high P/Es will indeed be contemporaneously explained by low nominal interest rates, but these high P/Es lead to low future returns regardless. I confirm that investors have indeed historically required a higher stock market P/E when nominal interest rates have been lower and vice versa. In addition, I show that this relationship is somewhat more complicated than described by the simple Fed Model, varying systematically with perceptions of long-term stock and bond market risk. This addition of perceived risk to the Fed Model also fully explains the previously puzzling fact that stocks "out yielded" bonds for the first half of the 20th century, but have "under yielded" bonds for the last 40 years. Finally, I note that as of the writing of this paper, the stock market's P/E (based on trend earnings) is still very high versus history. A major underpinning of bullish pundits' defense of this high valuation is the Fed Model I discredit. Sadly, the Fed Model perhaps offers a contemporaneous explanation of why P/Es are high, but no true solace for long-term investors. 

2007-11-26 - Hussman Wisdom

“Generally speaking, when valuations are stretched (on normalized earnings) and both market action and economic measures have turned negative (as they have now), you can expect that “buying-the-dip” will result in a brief feeling of genius and success followed by profound regret.” 

http://www.hussmanfunds.com/wmc/wmc071126.htm

2007-11-07: The Catastrophist View

I agree we should always question our assumptions and have someone play devils advocate.

But I don't agree that, having done that, it is elitist to think it possible to come to the correct conclusion ahead of the market - as investment mgrs that's always our goal, right? (Altho I guess its possible to be way too ahead of the mkt)

The article below offers some insight on our dilemma (ie. Is the stock market telling us we're wrong or missing something crucial)

But first my own summary:

US stocks are up nearly double digits this YTD in a year when we've witnessed:

• Payrolls job growth, despite being hugely boosted by inane B/D assumptions, slowing to under population growth
• Household employment stats worse yet
• Monetary policy, previously too long easy, became restrictive, now impacting with a lag
• Inverted yield curve for most of past year, historically a reliable leading indicator
• Huge consumer debt burdens increasing even worse as credit card debt escalating in recent mths
• $100 oil - almost
• Sinking home prices - conservatively estimated down 5% YoY so far
• Housing recession ongoing a year after many were calling its bottom
• Glut of housing on market likely to take years to digest
• Homeowners affected by rate shock of resetting mortgages - but worst not til 08
• Tightening lending standards - and seemingly borrowing appetites
• Delinquencies and foreclosures rising quickly
• Nonres construction finally showing signs of slowing, following res constr with a lag
• Confidence surveys sliding
• Same store sales less than stellar
• Ongoing twin deficits
• Imminent fiscal crisis due to entitlements and demographics with front edge of baby boom now retiring
• State and local govt budgets getting pinched from declining corporate and property tax revenues
• Fiscal ease therefore less likely as countercyclical option as with 2002 bush tax cuts particularly with Dems controlling house
• Falling greenback
• Opaque balance sheets
• Unknown exposure to off balance sheet risks in SIVs
• Massive writedowns of alphabet soup related assets
• Fasb 157 requirement to soon start disclosing level 1, 2 and 3 assets at time of market suspicion of what's on the books
• Credit crunch with TED spreads and the like blowing out
• Shutdown of the LBO and CDO markets at least for now
• CP drying up as mmkt investors flee to safety
• Structured finance and debt repackaging which served as staple of markets for last few years losing credibility
• Ratings agencies downgrading in what could possibly turn into a vicious spiral particularly if monoline insurers get affected
• Corporate profits (at least domestic sourced if not yet multinatl) regressing to the mean from unsustainable record levels
• Stocks expensive relative to normalized earnings (see Hussman's articles)
• Food prices rising
• Reduced foreign fund infusions into US as Asian and MidEast govts break $pegs and diversify reserves means reduced financing for private capital investment
• Japan reentering recessionary conditions and euro area growth faltering - even without yet seeing much slowdown in US PCE

So have we really been too pessimistic about stocks or have stocks remained too optimistic for too long on the basis of, best as I can tell, just the following:

• Corporate profits still doing well (for now - and why shouldn't they keep it up)
• Fed will reflate
• Weak $ will help exporters
• Fed will reflate
• Income growth seems okay
• Fed will reflate
• China's booming
• Fed will reflate
• Housing is the only weak spot in the economy (its contained)
• Fed will reflate

Anyhow...

--------------------------

 

The Catastrophist View 

What would it take to send the U.S. economy—and New York’s—into free fall? A doomsday primer.

By Duff McDonald

Published Oct 28, 2007

New York Mag

Peter Schiff is laughing at me. I’ve just asked him to entertain the following notion: that we dodged a bullet during August’s financial-market turmoil and, with the stock market bouncing right back from every dip, things might be okay. So why worry?

He stops laughing. “Why worry?” he asks. “Because we dodged a bullet but are about to step on a hand grenade.”

Sitting in a corner office of a nondescript building just off I-95 in Darien, Connecticut, Schiff, the president of brokerage Euro Pacific Capital, and author of Crash Proof: How to Profit From the Coming Economic Collapse, will spend the next hour spelling out a singularly pessimistic view of the American economy. And he will do so while exhibiting a curious juxtaposition unique to the bearish prognosticator: He speaks of disaster with a smile on his face. No, he’s not happy about our impending doom. But he is happy that people are finally taking him seriously.

Some people, anyway. The recessionary fears that were sparked by the global liquidity crisis in August have eased, largely because of a resilient stock market and a belief that the Federal Reserve’s interest-rate cut in September curtailed deeper losses. When Goldman Sachs invested in its own imploding Global Equity Opportunities hedge fund in August, calling it an “opportunity” and not a “rescue,” people laughed. Guess who laughed last? Goldman, which had reportedly enjoyed a $370 million gain on its $2 billion rescue by October. The optimists stay focused on stories like Steve Jobs’s next stroke of genius.

But Schiff, whom CNBC calls “Dr. Doom,” has not, as bears do when winter approaches, gone off to hide in a cave. Why not? Because every single one of the underlying economic factors that he has identified as cause for concern has worsened. And his is no longer a lone voice in the woods. If you don’t care to listen to a man nicknamed Dr. Doom, you can listen to people like former Federal Reserve chairman Alan Greenspan, esteemed bond-fund manager Bill Gross, or famed money manager Jeremy Grantham. They’re part of a growing chorus of voices that are saying many of the same things as Schiff.

Their bearish arguments come in many shapes and sizes, but here’s the basic one: The past five or six years have been deceptively fortunate ones for the U.S. economy. That’s because any troublesome developments—the surge in oil prices from $28 per barrel in 2003 to about $87 today, for example—have been papered over by rising home prices. Home equity has been used to buy flat-screen TVs, SUVs, and more homes. Wall Street bought up all this debt from lenders, thereby allowing them to lend more.

The softening of real-estate prices in most parts of the United States put a crimp in this system, but it hasn’t stopped it. The question is, what, if anything, will? What will bring on the apocalypse that Schiff and others believe is inevitable? They see it like this:

THREAT NO. 1

The Bottom Continues to Fall Out of the Housing Market

Manhattan’s gravity-defying real estate aside, it’s quite clear the nation is experiencing a genuine housing crisis. In August, pending home sales dropped 6.5 percent, and they currently sit at their lowest level since 2001. The National Association of Realtors conducted a recent survey that showed more than 10 percent of sales contracts fell through at the last moment in August, primarily owing to disappearing loan commitments from banks. The crisis will only deepen, when more borrowers see their adjustable-rate mortgages adjusted upward. There was a foreclosure filing for one of every 510 households in the country in August, the highest figure ever issued, and by one estimate, more than 1.7 million foreclosures will occur in the country by the end of 2008. That’s not just subprime borrowers: According to the Federal Housing Finance Board, while nearly 35 percent of conventional mortgages in 2004 used ARMs, some 70.7 percent of jumbo loans—those above $333,700 (the jumbo threshold in 2004; it’s now higher)—did too.

Historically, bond-market investors have been the boring counterparts to their equity-market brethren. But in his October Investment Outlook, famed bond investor Bill Gross was anything but. The managing director of money management firm pimco pointed out that the Federal Reserve is caught in a bind: It must continue to lower interest rates to ameliorate this burgeoning housing crisis, but in doing so, it “risks reigniting speculative equity market behavior, and … a run on the dollar.” (More on the dollar later.) Gross doesn’t have the answers but observes that the Fed is “in a pickle, and a sour one at that.” Worse yet, concerns that a rate cut might be inflationary actually caused bond yields to rise in the wake of the rate cut, something that doesn’t normally happen. The Fed’s influence, always overstated, might turn out to be nonexistent in a credit market that remains on edge.

Hedge-fund veteran Rick Bookstaber, the author of A Demon of Our Own Design, spells out a potentially disastrous scenario that could unfold regardless of what the Fed does: Continued foreclosures result in a further drop in housing prices, which results in further foreclosures, which result in a further drop in housing prices. Even for those of us not selling, reduced home values result in a reduced sense of security, which results in reduced consumption, which results in a slowing economy, which … you get the point.

THREAT NO. 2

The Derivatives-Related Meltdown, Part II

Anybody who glances occasionally at the financial pages these days knows that mortgages issued to home buyers are packaged together (in a process called securitization) into a collateralized-debt obligation, or CDO. That’s what’s known as a derivative, a security whose value depends on the value of other securities. The price of the CDO, you see, is “derived” from the prices of the underlying mortgages. (It works with credit cards, too, or bank loans—any kind of debt will do.)

In principle, the idea of a CDO makes perfect sense. In buying $5 million worth of a CDO, an investor has essentially lent money to an entire portfolio of homeowners, instead of placing all his eggs in one basket, say, by funding a single $5 million mortgage. In the real-estate-crazy environment of the past decade, the CDO market took off like a rocket. But the buyers of these derivatives made a critical error—they confused the spreading of risk with the elimination of risk. A booming economy made this confusion not just possible but irresistible. With relatively few defaults in the first half of the decade, investment firms, including many hedge funds, came to see CDO returns as a sure thing and loaded up on them, often borrowing money to do so, taking on debt to buy debt and thereby setting up a potentially deadly chain reaction. The readiness of the secondary market to buy all these mortgages encouraged the lenders to run wild and lend to anyone who walked through the door, leading—inevitably, in retrospect—to a decline in loan quality. Analyst Christopher Wood of Asia-Pacific investment house CLSA succinctly defines the problem in his highly readable newsletter Greed & Fear: “[Securitization] has one fatal flaw, which will ultimately prove to be its undoing … it removes the incentive of those making the loan to worry about whether the loan is a good credit.”

Still, it all held together until mortgage defaults began to cut into the yields of these CDOs and holders looked to sell them, only to realize their value had slipped. Forced liquidations as a result of that “price discovery” were a primary factor in Bear Stearns’ hedge-fund calamity in August. And it’s not over yet: The aftershocks of the mortgage meltdown are still being felt, as banks such as Citigroup and Deutsche Bank announce multibillion-dollar write-downs.

Each time one of these write-downs has been announced, the market has had a curiously positive response, taking the news as a sign that the worst was over and the banks were cleaning up their books. But because these derivatives are linked to other debt, there’s no reason to be certain that trouble won’t bleed into other markets. Among other things, the liquidity crisis froze the market in structured investment vehicles (SIVs), a nifty bit of financial engineering that banks use to profit from the spread between short-term debt and long-term debt. No one yet knows how nasty these losses could turn out to be because SIVs are stashed, Enron style, off the books.

THREAT NO. 3

Consumers Run Out of Steam (and Take the Economy Down With Them)

The U.S. economy, for all its worldly sophistication, is driven by mall shoppers and late-night Amazon addicts—70 percent of the gross domestic product is accounted for by consumer spending, which is buttressed by debt. According to the Federal Reserve, total U.S. household debt was, as of August, $2.5 trillion—a 24 percent increase in the past five years. Total credit-card debt, including gas cards and the like, was $915 billion.

The willingness of consumers to keep spending and piling on debt in the midst of a slowing real-estate market is hailed on Wall Street as an act of patriotism, which Schiff considers perverse. Imagine, he suggests, that you ran into a good friend and asked him how he was doing. His reply: “I took out a third mortgage, maxed out my credit cards, and emptied out my kids’ college savings account so I could buy a bigger TV and a new car, and we’re going to Greece on vacation over the holidays. Things are great!” Schiff lets the idea sink in and then finishes the thought: “And we’re celebrating the fact that we’re doing this as a nation?”

In a recent interview, John Santer, a district director of NeighborWorks America, a community-based nonprofit, pointed out that 43 percent of American households spend more than they earn each year, and fewer than six in ten have enough savings to last them three months if they were suddenly out of a job. So where’s the money coming from? From 1991 to 2005, Americans borrowed $530 billion against the value of their homes each year.

James Glassman, a senior economist at JPMorgan Chase, told a Tulsa, Oklahoma, luncheon crowd in early October that before 1985, consumer spending grew in line with income, but since that time, it’s grown half a percent faster on an annual basis. As a result, household savings, which once reached 10 percent of income, is now literally negative. “My guess is that in five years we’ll look back and realize … that the consumer we knew for twenty years is coming to an end,” he said.

Roger Ehrenberg, an ex–Wall Streeter and author of the financial blog Information Arbitrage, forecasts extreme financial pain. “You’ve got a weaker dollar, declining economic fundamentals, and a debt-strapped consumer—I’d call that a bad fact set,” he says. “Lay on top of that the mortgage problem and declining home values, and you can paint a pretty ugly picture.”

THREAT NO. 4

That the Rest of the World Decides They Don’t Need Us and the Dollar Tumbles Hard

The dollar is falling, possibly collapsing, depending on whom you talk to. The greenback has sunk close to its lowest point in the post-1973 floating-exchange-rate era, so low that it’s been overtaken by the Canadian dollar—affectionately known as the loonie—for the first time since 1976. How low will it go? When Alan Greenspan was asked by Lesley Stahl of 60 Minutes last month what currency he’d like to be paid in, his response was telling: “[The] key question … is, ‘In what currency do you wish to hold your assets?’ And what I’ve done is I diversify.” Translation: He isn’t betting on the dollar. And neither is the majority of Wall Street.

Here’s why catastrophists see that as a major problem: About 25 percent of our government debt is held by foreign governments, with the major holders being Japan ($610.9 billion), China ($407.8 billion), the U.K. ($210.1 billion), and our friends in the Middle East, the oil-exporting countries ($123.8 billion). When the current Fed chairman, Ben Bernanke, cuts rates to soften the housing blow for Americans, he also weakens the dollar by making dollar-based investments less attractive. And when the dollar weakens, so, too, does the value of these gigantic positions held by the foreign governments. At some point, they’re no longer going to tolerate the losses we inflict on them by lowering rates, and if that happens and they start dumping dollars, watch out for the peso.

The bulls will tell you that foreign governments understand the American economy is the key to global economic health, and that they’ll suck it up and take it when we devalue their debt. To which Schiff offers another analogy. Imagine if five people were washed up on a desert island: four Asians and an American. In splitting up their duties, one Asian says he’ll fish; another will hunt, another will look for firewood, and another will cook. The American assigns himself the job of eating.

“The modern economist looks at this situation and says the American is key to the whole thing,” says Schiff. “Because without him to eat, the four Asians would be unemployed.” The alternative: Without the American, the Asians might eat a little more themselves and even spend some time building a boat. This is happening as we speak: With the rise of the Chinese consumer class, the local citizenry is now spending, and the country is no longer totally dependent on exports. Which means they’re no longer totally dependent on us.

Readers of the financial press are surely familiar with the buzzword of the moment, decoupling. It’s used to describe how U.S.-Europe and U.S.-Asian trade relationships are becoming less dependent at the same time as European-Asian ties are growing. Most Asian nations, including China, are seeing more rapid growth in exports to Europe than to the U.S. And the U.S. now accounts for a declining share of European exports. The bearish interpretation: that the longtime global embrace of the dollar is loosening.

THREAT NO. 5

That We Don’t See It Happening Because It’s a Slow-Motion Train Wreck

Last but not least, we can circle back to the Dow Jones Industrial Average making new highs in October—14,087.55 on October 1—offering hope that our equity portfolios will carry us through to the other side of whatever it is we’re on the wrong side of. Before addressing the fact that the equity market might just be clueless, there’s one last dollar-related point to make. The true value of a stock portfolio isn’t really its quoted worth in dollars—it’s what you could buy with that portfolio if you were to sell it.

Given that we as Americans don’t manufacture that much anymore (we’re a service economy!), we are largely talking about foreign-made goods, such as flat-screens from Korea or cars from Germany. Over time, if the dollar continues to slump, foreign manufacturers will raise prices to compensate for what they’re losing in the exchange rate. In that light, a Dow at 14,000 with the euro at $1.42 is really no different from a Dow at 13,000 with the euro at $1.33. (One reason the price of oil has risen so high is that it is quoted in dollars, and the sellers thereof have had to continually jack up the per-barrel price to maintain their own purchasing power at home and elsewhere.)

Still, a rising Dow is better than a falling Dow, and the bulls are piling into every rally. Which still doesn’t impress Jeremy Grantham, chairman of Boston-based money manager GMO, in the least. “The equity market is always slow to pick up on someone else’s crisis,” he says, referring to the turmoil in both the housing and fixed-income markets. “And so you’ve got a slow-motion train wreck that has to work itself through the system.”

How will it work itself through? Grantham points to the recent strength in profit margins, fueled by—you guessed it!—our plummeting savings rate, and says there’s nowhere to go but down. “If you start with an overpriced market and bring profit margins down, that’s more than enough to bring stock prices down,” he says. “It is the most certain mean-reversion in all of finance.” Grantham calculates that the U.S. stock market will have to fall by a full third before it gets to its “fair value.” At which point we will likely be in full-blown recession. And when that happens, Schiff says, we will see a country in downsizing mode, “selling the consumer goods we’ve been buying back to the Chinese. It will be one big, giant repossession.”

So assuming all this is true, that Schiff and his fellow doomsayers are right about the rotten core of the U.S. economy, how will this affect New York City? We’ve grown accustomed to the idea of our local economy, particularly the real-estate market, being inherently stronger than the nation’s and possibly immune to whatever woes strike the rest of America. Wall Street, after all, makes money on downs as well as ups, and the stampede of foreigners and foreign cash could, if anything, be aided by the weak dollar.

Last week, though, the argument against New York invincibility was implicitly made when Merrill Lynch announced a larger-than-expected write-down of $7.9 billion dollars in its third quarter alone, primarily due to losses in the credit markets. Numbers as large as that can paradoxically seem trivial due to the abstract nature of accounting—a “write-down” involves no movement of real-life cash, just a readjustment of some theoretical values—but here’s something nontrivial to consider: Merrill Lynch is one of the largest employers in New York City. While so far only a few Merrill bigwigs have been shown the door, it’s almost certain that a chunk of the company’s rank and file will soon follow. All told, New York–based financial companies had already announced more than 42,000 layoffs as of October, according to one study, and the pace could pick up through the end of the year. That’s people who won’t be bidding up new apartments, who won’t be going out to dinner five times a week, who won’t be testing the outer limits of their credit cards at Barneys. The downstream effects of this could be even more severe, as every Wall Street job is estimated to account for another 1.3 to 2 jobs, meaning that additional job losses could push 100,000.

Meanwhile, the public sector is feeling it, too. A recent report by Nicole Gelinas, published by the Manhattan Institute, forecast a budget deficit for New York City next year and predicted that Mayor Bloomberg, who enjoyed a string of budget surpluses until this year, will likely be forced to leave his successor with a double whammy: a deficit and a projected 50 percent increase in outstanding debt. Of course, the catastrophists could be dead wrong, as they have been for going on a decade now—but to them, it sure smells like the seventies all over again.