Why we are headed into Depression

It may be the one-year anniversary of an amazing stock market rally, but economists are sounding rather pessimistic these days.

A growing expectation of a double-dip recession is evident in a new poll of financial executives...the poll found more than half of financial executives predicting another downturn, and most expecting jobs recovery to lag into 2011.

The predictions don't end with just this poll. Nouriel Roubini is also warning of a second leg down, and even more disturbing is this report.

Even as many Americans still struggle to recover from the country's worst economic downturn since the Great Depression, another crisis – one that will be even worse than the current one – is looming, according to a new report from a group of leading economists, financiers, and former federal regulators.

What is important isn't the warnings themselves, it is the why that matters. The why tells the story, not just of how the crisis happened, but also what we should be doing. In this case, the why also tells us much about our economy and are values.
From the report:

The report warns that the country is now immersed in a "doomsday cycle" wherein banks use borrowed money to take massive risks in an attempt to pay big dividends to shareholders and big bonuses to management – and when the risks go wrong, the banks receive taxpayer bailouts from the government.
"Risk-taking at banks," the report cautions, "will soon be larger than ever."

The report centers on the simple fact that the financial system has not been reformed, and is in fact more concentrated than even before the crisis. It also blasts our political leaders for showing none of the backbone and good sense that is needed at a time like this.

Despite the scary quotes, the report doesn't go as far as it probably needs to go. For instance, William Black, the guy who helped clean up the S&L banks in the 90's, has this opinion on the state of the financial industry.

PAUL SOLMAN: What would you have us do about the major financial institutions as they currently exist?
WILLIAM BLACK: First, stop them from getting bigger. The 19 largest institutions are what we call systemically dangerous institutions. Many of them are already insolvent on any real market value basis.
PAUL SOLMAN: What do you mean insolvent? I mean, they're reporting large enough profits, that they can give bonuses to their employees.
WILLIAM BLACK: They were able to get Congress to extort FASB, which is the Accounting Standards Board, to change the rules, so that you no longer have to recognize losses on your bad loans, unless and until you actually sell them.

A country full of broke banks is not a new scenario. It happened as recently as the early 1990's in Japan.
Like Japan, we had a credit-induced stock market and real estate bubble. Like Japan, both bubbles burst around the same time. Like Japan, the government decided to stimulate now and reform later.
The Japanese government used targeted tax cuts and infrastructure spending, with the budget going from positive territory to deeply negative territory, much like we are today. Japan's central bank responded by cutting interest rates to zero, much like we have today.

Japan has run up the national debt equal to 200% of GDP — the greatest Keynesian stimulus program in history — all in the name of stimulating the economy back to health. It has failed miserably. Japan’s nominal GDP is about the same as when the stimulus began. Those who advocated the policy blame Japan’s failure on either the stimulus being too small or not being sustained for long enough – that is, the dosage, not the medicine itself, was at fault...
What ails Japan is a lack of reforms, not stimulus. The prolonged and massive bailout has only allowed a bad situation to continue. As governments around the world look at their own problems, this is the lesson they should draw from Japan – not the wrong one that insists Japan should have spent more.

Throwing money at a problem that is essentially created by easy money is the wrong solution. The country is suffering from decades of malinvestment created with bad debt. That bad debt needs to be washed out of the system. Losses need to be recognized and written off.

Fighting the last war

Right from the start of this crisis, our leaders have prescribed the wrong medicine for what ails us. Ben Bernanke and Timothy Geithner have approached this as a crisis of liquidity (i.e the ability to borrow) instead of one of insolvency. Renown economists such as Paul Kruman and James Galbraith have pointed out this fundamental error to no avail.
What does it mean to make this mistake? A good example of the consequences of this flawed policy are in this mostly overlooked news article.

Nevada Federal Credit Union has a deal for big savers: Withdraw your money and you'll get a bonus...
The financial institution typically uses member deposits, including certificates of deposit and money market accounts, to make loans, which typically bear higher rates than deposits.
Beal figures those interest-bearing accounts are a money-losing proposition in Nevada's current depressed economy.
"We don't have any loan demand right now," Beal said.

Approaching this as a liquidity problem means the prescription is to push down interest rates and making sure that financial institutions can borrow all the money they need from the Federal Reserve. As is evident in the example above, that policy has actually done harm instead of helped.
The problem isn't the ability of banks to get money. The problem is finding credit-worthy borrowers. Everyone from Wall Street to Main Street is already overloaded in debt after purchasing overvalued assets. This weird dynamic has broken the traditional banking model that all financial regulation is built upon.

The old definition of banks, "take demand deposits and make commercial loans," has been changed in practice to a new one: "borrow money guaranteed by the government and make real estate loans." The implications of this structural shift for systemic financial risk have yet to be worked out.

The year long stock market rally has managed to push bank equity values up and give them the appearance of health, but their underlying portfolios are still full of toxic assets that have continued to fall in price. Thus the insolvency of the banks has continued. William Black says that this is all by design.

The administration and industry do not want the public to know that the financial system brought us to the brink of a Great Depression and that Treasury and the Fed only delayed that catastrophe by adopting policies that (1) increased “moral hazard”, which makes future crises more likely, and (2) combine the worst elements of “crony capitalism” and the “socialized losses.”
There has been no honest examination of the crisis because it would embarrass C.E.O.s and politicians...
Instead, the Treasury and the Fed are urging us not to examine the crisis and to believe that all will soon be well. There have been no prosecutions of the chief executives of the large nonprime lenders that would expose the “epidemic” of fraudulent mortgage lending that drove the crisis. There has been no accountability.

The first step toward fixing this mess is creating accountability. The idea that it was a "few bad apples" has been floated, but few have fallen for it. Very quietly, Wall Street has been losing one lawsuit after another from angry investors. Wall Street has paid out $430 Billion in damages to victimized investors in 1,500 different lawsuits. Yet the SEC is unable to bring a single criminal charge against a bank CEO.
It isn't just Black who thinks the crisis was caused by fraud. Elizabeth Warren also suspects massive fraud, as does Janet Tavakoli, Congress woman Marcy Kaptur, economist Max Wolff, and economics professor James K. Galbraith.

You had fraud in the origination of the mortgages, fraud in the underwriting, fraud in the ratings agencies.

Instead of doing what is right, both the Bush and Obama Administrations have worked hard to eliminate accountability. If anything, there appears to be an ongoing cover-up that spans both White House administrations and both parties in Congress. The fraud even appears to stretch into the Federal Reserve itself.
The news media has participated in this sham by covering the crisis in a way that takes all the human elements out of it.

What's a little fraud between friends?

As Elizabeth Warren has pointed out repeatedly, few wealthy investors "took a haircut" from their bad investments, few CEO lost their jobs, and no Too-Big-To-Fail bank was broken up. Nothing has changed on Wall Street, except that there are fewer banks where bankers are free to commit fraud.
Reform is important, but prosecuting the fraud is even more important. The crisis happened because no one was sure of the extent of the fraud, so everyone stopped loaning money to each other, and buying each other's financial products. There was a crisis of trust. Trust must be restored before the system starts working properly again, and to do that the criminals must be held accountable.

The public will need to "hold the perpetrators of the economic disaster responsible and take what actions they can to prevent them from harming the economy again." In addition, the public will have to see proof that government and business leaders can behave responsibly before they will trust them again, he argued.

There was a three year gap between the 1929 stock market crash and the Pecora Commission, which exposed to the public massive fraud and conflicts of interest that caused the crash. During that three year period the country sank into Depression. The results of the Pecora findings was the Glass-Steagall Banking Act of 1933, the Securities Act of 1933, and the creation of the SEC.
The economy would never have recovered without these reforms, the reforms would never have happened without the Pecora Commission, and the Pecora Commission would never have been created without a collective decision that people had to be held accountable for the fraud.

Until the collective outrage of the American citizens overwhelms the politician's loyalty to their corporate sponsors, and some of these criminals are prosecuted, then we will continue to follow the path of Japan. One year of sluggish growth and high unemployment will follow the next, while the government runs up enormous deficits in the false hope that the next stimulus bill will finally do the trick.

This is one of the instances where the moral and just thing also happens to be the smart thing to do. The criminals must be exposed and punished. The speculators on Wall Street must recognize their losses. The financial monopolists must be broken up.
It seems so simple. What lies between us and this logical outcome is a broken political system and a wealthy criminal class.

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Comments

27 months, 9 to go

Although technically positive GDP growth will claim a recession is over, also technically a recession that goes on for 36 months is classified as a Depression.

I really can see the possibility and what I found from last Friday's unemployment report in the MSM was astounding...
all sorts of headlines claiming job growth was "just around the corner" and I am like, uh, what? From where?

Even when one goes off of cyclical events, frankly I don't see it and it's not that I am by nature a Doom & Gloomer (yes I am), I mean I went digging around in the stats and theory and finally said, "Jesus, some sort of public relations thing has to be behind these headlines, this projection, just is not in reality!"

I mean I can be wrong, but ya know, show me de money and I didn't see it.

I believe we're going to get hit with a double dip, or at least very low GDP quarterly growth.

Broken system and a uber rich criminal class. hmmm, ever wonder if you were a Russian Serf in a past life? Maybe the unwashed masses in France? This is just random thoughts but what is really happening....talk about cyclical! We have history showing us, over and over and over when you get a narrow group of elites and then trade deficits > 5% of GDP and massive debt....you are almost guaranteed "social unrest" eventually.

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economic facts & propaganda

Another piece of ‘soft’ evidence that the economy is slipping back, is in today’s fascinating blog article at Naked Capitalism: “The Empire Continues to Strike Back”

One quote: “The campaign to defend Geithner and Emanuel, both architects of the administration’s finance friendly policies has gone beyond what most people would see as spin into such an aggressive effort to manipulate popular perceptions that it is not a stretch to call it propaganda.”

If things are going well, then there would be no need defend Geithner and Emanuel et al with “propaganda”. The facts would speak for themselves and they could just brag about them.

In election years: if the facts are on your side, argue the facts; else propagandize.

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Great Article, but.

You have written an excellent piece explaining who the players are in the financial chicanery. The American economics profession has been avoiding the cause of this problem. In the article you allude to the fact that "there are no creditworthy borrowers". Why? Answer is the wage productivity gap according to Dr Ravi Batra. There are other contributing factors as well. Regressive taxation and fees on the poor and middle class. All while giving tax cuts to the upper brackets. We have to reset the economy of the U.S.; the idea that reforms will fix our deep foundational problems is wishful thinking. In 1973, manufacturing was over 30 percent of economy. Last year it was hovering at an anemic 11 percent. To quote Dr. Batra "without production you have nothing". The nation desperately needs an industrial policy and review of all trade treaties and foreign currency manipulations. You spoke of our trade gap the current deficit probably can't be funded with paper assets any longer. We have to have the courage move in a different direction away from the corruption of neoliberal economics professed by friedman, rand, greenspan, summers, geitner, and bernanke. The laws of economic physics can't be suspended forever.

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Wile E. Coyote Syndrome

Good article.

I call the current economic situation the Wile E. Coyote Syndrome because it reminds me of the old cartoon where the Coyote runs off a cliff and then hangs in mid-air for a while.

From what I'm reading now on the MSM econ sites, more and more commentators and analysts are beginning to glance downward and discover the ground is far below their feet. I figure the plunge and the tiny puff of smoke far, far down will come soon enough.

Then things will really become "interesting." The Coyote always survives, but even though the USA has become quite cartoon-like in many respects, I don't have such high hopes for us.

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recession, depression lets call the whole thing off

It was such a fine idea tying all our boats together in the spirit of globalization, except when one boat sinks it drags the rest underwater. Ooops. The double dip will be upon us by late summer, Commercial Real Estate is collapsing, more Alt-a loans are defaulting, the census temp workers will be laid off, and the evidence of widespread fraud by Lehman, Geithner, Bernanke, Goldman and the usual suspects will become common knowledge to the point where some people will pull money out of the rigged game of Wall Street. The government will continue to pour money into Wall Street through its backdoor/inside connection with Goldman & other big banks but it will become so glaringly obvious that only the greedy fools of Wall Street will continue to believe in the bull market of 2010.

Between Peak Oil, Peak Aging, and outsourcing, the economy doesn't have a chance - the fraud is just the normal looting that takes place at the end of an empire, of course Wall Street has figured out a way to amplify it to nose bleed levels, but thats what the big crooks do for a living.

The mere demographics of our aging population, our declining output of oil and gas, and the wholesale outsourcing of entire economic sectors like manufacturing to overseas markets, means this little jitney is barrelling down the mountain with no brakes and no steering wheel. I'm investing in canned goods, and the only silver lining I expect to find is in the silver coins I've been buying. I said good bye to wall street when they said goodbye to main street, its food and silver from here on out.

Good luck and God bless, the times ahead will be very trying and the new nation will not much resemble this one.

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while I can believe a double dip

I'm not sure who this guy is or what exactly is his justification in hard data.

I'll have to go dig around more on the analysis on currency manipulation, I'm working on it (if it was stopped). But I have huge questions on the well know MNC manipulation of using China as their jobs base to import and resale products with a "U.S. label" on it.

I'm sure this would cause some to bring back their operations to the U.S. because the cheap labor/cheap currency was no longer available.

On Financial reform though it's looking so bad we are not going to see anything on the great gambling casino/rigged game ....so Economic Armageddon redux or ? If Goldman Sachs has wiped out most of the competition and it's just a few players mostly trading these derivatives at the table..
is this like no limit poker now and what is really the money pool made of?

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