The US Economy: Running Out of Options.

December 17th, 2008

The US Economy: Running Out of Options.

I hoped I would go my lifetime without ever seeing the S&P 500 be down 40% in a year, but the reality is slowly settling in, especially seeing the Emerginvest global heat map for the last quarter on a daily basis:

However, as bleak as it has been, there is no shortage of exceedingly dire news with economic reports or predictions on how long the recession will last. Americans have just begun to feel the first repercussions of the omnipresent economic talk in their daily lives with massive job losses, and an overall pervasive sentiment of belt-tightening.

A few of the news highlights from the past two weeks:

Massive Job Loss

The widely discussed report that 500,000 jobs were lost in November alone, seemed to put a face to the recession for the majority of Americans. While many people only have a vague idea of the intricate workings of the banking credit system, or how credit swaps are conducted, half a million jobs in a single month is a very clear and unmistakable picture. Plus assuming that most economists are right in predictions that it will get worse before it gets better, it depicts a very dark year ahead – with unemployment reaching nearly 10%.

Disastrous Housing Reports

A NYTimes article entitled: “Housing Starts Plunged 19% in November,” put it perfectly:

“The construction of new homes plummeted in November by the largest amount in almost a quarter-century as builders slashed production in the face of a recessionary economy.

The Commerce Department said Tuesday that new home starts fell to a seasonally adjusted annual rate of 625,000 from a downwardly revised level of 771,000 in October.

That is a drop of 18.9 percent, the steepest since March 1984. The total is far below the 740,000 pace that Wall Street economists expected.”

With plummeting housing prices, estimates put the total loss of home value at nearly a trillion dollars for the US. While many Americans are attempting to forestall selling their homes at extremely depressed values (20% or so on average), housing inventory is building up, causing a massive plunge in housing starts.

Failing Auto Industry

We are all intimately aware of the cry for help from the US auto industry. Personally, I believe it has a much more widespread psychological impact than a potential economic one. Congress will not let the three fall at this point – if for no other reason that the economy can’t absorb the estimated million jobs lost in total from its collapse. If this was in an economic boom era, that answer might be different. However, the mere fact that a company like GM who has been an American icon for fifty years, needs to have Congress infuse them with a large amount of cash to not go bankrupt, strikes a deep resonating chord for most working class Americans.

So, the two questions are:

What will happen with the economy in the next 12 months and what will the federal government do to curb it?

First, to the question of where are we going, John Mauldin’s weekly newsletter was exceedingly insightful about the state of the economy. In addition to the enumerated problems above, he pointed out that a full one-fourth of homeowners are “underwater,” or in other words their houses are worth less than their mortgages. According to Mauldin, that number is expected to climb to nearly half of all homeowners with mortgages. He suggests that the massive number of underwater mortgages will mandate a government subsidy at some point which could equal close to $1 trillion.

He also stated that “retrenching consumers will keep pushing up delinquencies on credit cards, home equity, auto and student loan debt, which will result in big writedowns for their many institutional holders. Collectively, these four categories amount to $4.4 trillion, dwarfing the $0.7 trillion in subprime loans.”

Amongst many issues which seem to build on each other - between consumer retrenching, commercial paper and credit institutions freezing up, the housing meltdown, and a number of other equally important issues, he uses an erudite example of a “tsunami in a swimming pool,” where each time the wave hits one sector, it gets reflected back at another – reverberating throughout the different areas of the economy. He describes the federal government’s programs as attempting to build dams in the middle to buffer the sides, however unless they’re big enough, the waves will simple gain momentum as it goes.

Which leads to the question of what the federal government plans to do.

In the short term, the fed is plainly running out of options. The interest rate cut at 0.25% is the lowest rate on record. Unfortunately, the interest rate is typically the main tool the fed uses to control the economy, and when it hits the wall of virtual 0, mostly theory remains on how to proceed.

A NYTimes article entitled: “As Rates Near Zero, the Fed Turns to Unproven Methods,” states that:

“In itself, analysts said, the move will be anticlimactic. Because demand for interbank loans has been so low, the actual Fed rate has been close to zero for a month. The real change will be in how the Fed tries to fight the recession from here on.

After Tuesday, the Fed will have to resort to mostly untested tools for promoting growth, because it cannot reduce its benchmark interest rate below zero,”

In addition to:

“The Fed must now turn to an approach called ‘quantitative easing,’ because it involves injecting money into the economy rather than aiming at an interest rate. The Fed has almost no experience with this approach.

‘This is a whole new world,’ said Richard Berner, chief economist at Morgan Stanley. ‘You don’t have a whole lot of historical precedent for knowing how this is going to work and what the unintended consequences could be.’

The risks include provoking inflation or yet another speculative bubble. “

Clearly, the Fed is only half of the story, and Obama’s proposed stimulus packages, the TARP, and TALF programs, the buying of commercial paper, and other mechanisms will constitute the largest response. However, until Obama is sworn in as president, they simply won’t be put into place, and it seems as if the Fed’s new policy, in combination with the new wave of economic stimulus packages from the upcoming Obama administrations, will largely be shaped as we proceed into these uncharted waters.

Regardless of what form they come in, hopefully the breakers will be big enough for the tsunami.

Disclosure: Emerginvest is an international finance portal, providing analysis and data on 120+ world markets to help individuals find investments from around the world. Emerginvest provides impartial information about world stock markets, and does not have any holdings in foreign equities.

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