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The questions abound:  How long is this going to last?  How bad is it going to get?  What can our government do?  Furthermore, what is its role in the process?

Where should we turn for information?  It’s hard for me to believe any forecasts or models, as this crisis more than likely originated due to the Black-Scholes option-pricing model, a derivatives-based scheme that won the Nobel Prize in Economics in 1997, subsequently encouraged investors to take more risk than usual, and rendered the results shown below.

 

History of Crises

There is, however, one particular forecast based on historical averages that I think is worth citing.  Two major economists, Kenneth Rogoff of Harvard and Carmen Reinhart of the University of Maryland, released a report this past December entitled “The Aftermath of Financial Crises,” in which they averaged the effects of 22 different global economies and their separate reactions after a major crisis.  Their findings are grim.

They found that on average, unemployment rises by 7 percentage points and doesn’t peak until four years after the crisis.  Beginning from the bottom of the American jobless rate, based on this history, U.S. unemployment could rise to 11% by 2011.  As of last week, unemployment reached 7.2%.  This means that in 2008, 2.6 million jobs were lost; that’s the greatest number lost in a year since WWII.

The economists also found that housing downturns last six years, which puts our long term recovery three years away.  Congressional Budget Office acting chairman Robert Sunshine told Senator Jeff Sessions in a Senate Hearing last week that the housing crisis would continue until house prices are proportional to wages.  In 1940, a house cost twice the household’s annual income; that is certainly not the case today, no matter where you live.

Even worse news is that, on average, stock-price declines last three-and-a-half years, and total 55%.  This would bring the Dow Jones Industrial Average down to about 6500 points.  Government debt would reach 86% of GDP, or $12 trillion; currently the debt is about 67% of GDP, and the debt in dollars is now over $10.6 trillion.

 Scary?  What’s scarier still is the lack of any positive qualitative data coming from American industry.  We have become a consumer-based society, instead of a production-based society, and week after week, have record losses in company profits.  Even Wal-Mart posted 8% losses in December!  Here, however, there is some hope, as Rogoff and Reinhart add, “Output falls an average of over 9 percent, although the duration of the downturn, averaging roughly two years, is considerably shorter than for unemployment.” 

The fact is, we cannot begin growing our economy until we begin producing goods and services, instead of just services.  This truth predicates some form of government intervention, something that pains me and others.  Rogoff and Reinhart admit, “Bailout costs are difficult to measure” and, “are, in several cases, only a relatively minor contributor to post-financial crisis debt burdens.”

So does government intervention prevent further market woes?  No, but history shows it does help soften the blow.  This is a tough pill for conservatives to swallow, but doing nothing is not the answer.  This means bailout money must be properly delegated to be successful; although smaller in number, conservatives now play a key role in the oversight process.

Budget (R)eckoning

A Congressional Budget Office report released this week goes on to substantiate the findings of Rogoff and Reinhart.  The federal deficit for 2008 set a record of $455 billion; worse still, the 2009 projected deficit comes in at $1.2 trillion.  At 8.3% of GDP, this one year deficit shatters the Post-WWII record of 6%, set in 1982.  What is as equally damaging to our debt as increased government spending is the $166 billion drop in tax revenue this year compared to last; extending the “Bush tax cuts” and the Alternative Minimum Tax (AMT) patch will drop our tax revenue another $761 billion. 

Americans want everything all at once, and they want it now.  We cannot have a budget this lop-sided, increase our spending, and cut taxes all at the same time.  Forty percent of the upcoming stimulus plan consists of proposed tax cuts.  Tax cuts are a great way to encourage economic growth… if our federal budget can afford it.  Right now, I do not think it can.  I think the tax code should remain untouched; raising taxes discourages growth, and lowering taxes worsens our public debt.

So-called traditional conservatives may take issue with this point, but true fiscal conservatives will not.  Traditional conservatives may also oppose the use of public money to create jobs; for instance, $10 billion used to create jobs in the public sector eventually takes $10 billion out of the private sector through taxes, and there, jobs could be lost.  I agree, unless the $10 billion is used wisely, and is considered an investment in our future.  If government could turn $10 billion into, say $100 billion of future growth in our economy, and could do so while delaying the bill to the American people, then perhaps it is not a drain on the private sector.  Conservatives have to get over this issue, take a different look, and find ways their input could help to reform the broken parts of government, while demanding public money is being used wisely.

Conservatives should also encourage us to trust history instead of government.  America cannot be afraid to take risks; our capitalist system and our free market is based on this principle.  Money cannot come raining down from on high to “save” troubled assets.  The safety nets must end somewhere.  Yes, banks may fail, and businesses may fail; our society, however, may be better for it.

Like Rogoff and Reihart, I believe in American exceptionalism.   America is different, as a “highly sophisticated global financial center” and an “advanced economy.”  Here’s some more good news:  Mr. Obama believes in American exceptionalism, too.  In his speech at George Mason University this week, he stated:  “We should never forget that our workers are still more productive than any on Earth.  Our universities are still the envy of the world.  We are still home to the most brilliant minds, the most creative entrepreneurs, and the most advanced technology and innovation that history has ever known.  And we are still the nation that has overcome great fears and improbable odds.  If we act with the urgency and seriousness that this moment requires, I know that we can do it again.”

In our actions, let’s be careful to avoid the “Fatal Conceit” that government knows best how its citizens should live, while remembering that this moment is unlike any other.  Rogoff and Reinhart add this:  “One would be wise not to push too far the conceit that we are smarter than our predecessors.”

Who Are the Experts?

As our government moves forward to prevent further market hemorrhaging, how involved should it get in the market?  Should it heed the advice of the chief Ph.D economists running around Capitol Hill and the White House?  Keep in mind, some strategists and economists began predicting our current situation as much as two years ago, and they deserve recognition.  

Meredith Whitney wrote an unusually pessimistic editorial in October 2007 that predicted the downturn of Citibank, the housing market, and the Stock Market in general.  Days later, Citibank collapsed.  She was most recently named CNBC’s “Power Player of the Year” for 2008, over Bernanke and Paulson.  In August of 2008, before the Stock Market collapse (a month later), Whitney was quoted in Fortune Magazine saying, “It feels like I’m at the epicenter of the biggest financial crisis in history.”  She made a name for herself by being the first to issue “sell” signals on Enron.  Now, the Stock Market reacts when she speaks.

Before her prophecy, though, the banker and economist Dr. Kurt Richebacher stated in February 2007:  “The US economy is in danger of a recession that will prove unusually long and severe.  By any measure it is in far worse shape than in 2001-02 and the unraveling of the housing bubble is clearly at hand.  It seems that the continuous buoyancy of the financial markets is again deluding many people about the gravity of the economic situation.”  Dr. Richebacher, considered a follower of Austrian economics, died six months later, before this reality unfolded.

Blogger Mike Whitney (no relation) also made a name for himself with near-perfect predictions in his paper, “The Second Great Depression,” also in February 2007.  In the middle of a stagnant economy, he stated, “The bottom line is that inventories are up, sales are down, profits are eroding, and the building industry is facing a steady downturn well into the foreseeable future.  The ripple effects of the housing crisis will be felt throughout the overall economy; shrinking GDP, slowing consumer spending and putting more workers in the growing unemployment lines.”  At this point, the Dow Jones was hovering around 12,500 points, and in fact grew to 14,000 points eight months later in October 2007, before making its now historic descent.

Dangers of Strategery

Nobody believed these forecasts.  The problem is, nobody believes any now.  Should we, though?  Let’s look towards the world’s top investors to see how they did business in the downturn.

When Citigroup began to falter, its top investor, Saudi Prince Alaweed, raised his share of the company back to 5%, buying at about $33 a share.  It kept falling, and is now hovering about $7 a share.  Warren Buffett, the richest man in America, suffered a 77% drop in earnings at Berkshire Hathaway during the third quarter of 2008 and several of his recent deals appear to be running large losses.  Berkshire Hathaway acquired 10% perpetual preferred stock of Goldman Sachs at $123 only for it to fall to below $60 a share.

These men didn’t become rich by throwing good money after bad.  The problem is, we are in unforeseen economic times, and you really cannot trust anyone but yourself.  While the crisis is new, certain factors remain the same.

This week, a piece in the Wall Street Journal warned, “Beware of market forecasts, even by experts,” and to “ignore the forecasts of inevitably bullish strategists.  Bearish strategists on Wall Street’s payroll don’t survive long.”  

So, if you are investing, be careful, but don’t be afraid.  I’ll conclude my post with a synopsis given by this same Wall Street Journal report:

“Our financial system is driven by a giant marketing machine in which the interests of sellers directly conflicts with the interests of buyers.  The sellers, having (as ever) the information advantage, nearly always win.”

“We can’t say that we haven’t been warned about the perils of ignoring the past.  More than 2,000 years ago, the Roman orator Cato noted that, ‘There must be a vast fund of stupidity in human nature, or else men would not be caught as they are, a thousand times over, by the same snares… while they yet remember their past misfortunes, they go on to court and encourage the causes to what they were owing, and which will again produce them.’”