Now that it’s here, we turn our attention to trying to discern, “How bad can it get?” and “How long can it last?”

While such questions can never be answered with anything approaching absolute certainty, there are methods that can be used to assess what may lurk over the horizon. With that goal in mind, this article focuses on – and then expands upon – the recent work of two economists who painstakingly analyzed a substantial number of previous banking and currency crises in an attempt to derive potentially useful lessons. I have then taken their data and applied them to the current circumstances to see where we are, relative to those other experiences.

The Data

The data are from a study called “The Aftermath of Financial Crises” by Carmen M. Reinhart of University of Maryland and Kenneth S. Rogoff of Harvard University. In their study, the authors summarize the results of a broad sampling of banking crises, with between 13 to 22 crises analyzed for each of the variables.

The Reinhart/Rogoff study is based, in turn, on data extracted from an even more comprehensive study of events in 66 countries, titled “This Time Is Different: A Panoramic View of Eight Centuries of Financial Crises,” by the same authors.

I’ve summarized the findings from the latest study in the table below:

The economic measures in the left column show how far the U.S. situation has deteriorated so far. The next columns show the average historical deterioration and the worst case of the crisis analyzed.

I then applied these data to calculate the levels that the U.S. could reach if it followed the path of the historical examples. The projected level is based on the measure analyzed, either from the peak prior to the downturn (e.g., the S&P 500) or from the bottom prior to the downturn (e.g., the lows in unemployment). Thus, as you can see in the table here, the S&P 500 has already dropped from its October 2007 peak of 1565 down to 766. If this crisis were to end up being only “average,” then it would drop to 690.

If, however, the worst case of a 90% drop were to occur, as it did in Iceland last year, then the S&P 500 would trade down to the shocking level of 157. For further reference, if the current crisis were to cause the stock market to fall as sharply as in the Great Depression, the S&P would touch 469.

Duration of Crisis

As you can see in the summary table below, it took 3.4 years, on average, for the stock market to fall from the peak to the bottom. In the worst case, it took five years. With the recent peak in the S&P 500 occurring in October 2007 – just one and a half years ago – the crisis is likely to have some time to go before reaching even an average duration. More specifically, if this crisis turns out to be just “average,” we would not expect to see the low before the first quarter of 2011.

Crisis Horizon: Some Conclusions

The global economic situation continues to deteriorate on all fronts (see charts below).

Housing prices are down 28% from their bubble peak in 2006 but still have a ways down to go to get back to their pre-bubble levels. Even an average downturn will mean that housing remains a problem for several more years. Unless, of course, the government steps in to stave off those resets… a “solution” that carries with it a separate set of problems, making things worse. We continue to expect very serious problems in the commercial real estate sector.

The stock market is approaching a 50% decline, the average of what has been observed in past crises. Further slowing in U.S. corporate activities and profits means additional increases in unemployment, establishing a negative feedback loop that pushes corporate profits – and stock prices – even lower.

The only growth trend at this point is in government bailouts, which are in high gear, indicating we’ll experience the serious growth of outstanding debt seen in other crises. The elevated levels of government borrowing required to fund that spending are absorbing all available credit from foreigners, directly competing with business in need of the new financing that will be required to expand the economy. The combination of declining business activity, coupled with declining levels of household income, will result in declining tax revenues, increasing the budget deficit beyond the size of the new bailout programs. State and municipal governments across the nation are already being confronted with large shortfalls in their budgets, shortfalls that will only widen as the crisis worsens.

The combined business slowing and jobs contraction assure that the GDP will decline. Components of GDP having to do with necessities like food and shelter will continue to bump along regardless of the economic conditions, but the lack of growth in GDP could extend for years as it did in Japan and as it did after the 1929 stock crash.

Inflation/Deflation

Given that we are currently in a deflationary phase, it is easy to dismiss the case for inflation – and many do. We think that is a mistake. Even a summary tabulation of the unprecedented increases in government debt at this relatively early stage in the crisis make a compelling case for higher inflation, if for no other reason than that it shows clear intent on the part of the government to spend “whatever it takes” to offset the deflationary forces now stalking the land.

The research paints a dismal story of years of economic stagnation. In our view, the trend is now firmly established for dollar debasement, a debasement that will eventually overwhelm the deflationary pressures from collapsing asset values. Therefore, don’t listen to the happy faces on CNBC spouting off, for the umpteenth time since this crisis began, that now is the time to jump back in and buy stocks. It isn’t.

Be extremely skeptical when you hear some pundit pronouncing that this piece of short-term good news or another is an “all clear” signal. Until we start seeing a systematic improvement in the economic fundamentals – for example, an upward movement in consumer confidence – the only signal the economy will be hearing is that of a runaway train coming straight at it.

Regards,
Bud Conrad

April 23, 2009

Assessing How Serious the Financial Crisis Can Get was originally featured on Whiskey and Gunpowder

There is no question that we are currently experiencing asset price deflation and economic slowing. But we, the editors of The Casey Report, see this as a transitional phase. In our analysis, the truly extraordinary and historic levels of government spending and bailouts being deployed to keep the economy afloat are certain to lead to inflation in the not-too-distant future.

While our long-term view remains solidly in the inflation camp, over the past four months, the U.S.’s financial problems have caused deflation in many important asset classes. Put another way, a reduction in asset prices amounting to about $14 trillion (in housing, equities, etc.) is bigger than the government’s countervailing actions of around $3 trillion — the total, so far, arrived at by combining the measures taken by the Fed with the federal government bailouts.

But there are important differences between a sharp collapse in asset prices and the potentially leveraged stimulus packages.

The Fed’s actions, if taken in normal times, would be multiplied throughout the banking system as banks used the new money to increase their lending and, in so doing, leveraged the funds throughout the entire economy. This time around, however, while the Fed has been extremely accommodating to the banks, even going so far as to make direct loans to them, the effect is moderated. That’s because of tighter lending standards, the need to replenish capital, and the demise of many complex structures, which were previously available for securitizing and selling loans on to others.

As a result, the banking system as a whole is not responding to the stimulus. It can be thought of as pushing on a string. Simply, as large as the stimulus has been to date, it has not yet been enough to offset the effects of the economic collapse. The resulting deflationary pressure increases concern over a downward spiral in the economy.

Another way to view this is that consumers and businesses alike are now anticipating deflation, which makes saving and survival the primary goal (in an inflation, spending becomes the primary goal, unloading the money before it can lose value). Of course, a cutback in spending and demand drives down the price of things, at least temporarily.

But the longer-term expectation is that Bernanke’s assertion –- an assertion now backed up by action –- that the government can and will print new money to any extent needed is the more important force.

As long as there is evidence of serious economic collapse, it can be expected that the bailout programs will be ratcheted up. And, to the extent that the public expects deflation – and so businesses reduce prices to raise cash and reduce inventories –- the wave of price inflation experienced in the spring of 2008 will be moderated. But within the seeds of that positive are the very big negatives that the government, seeing that its extraordinary money creation is not being evidenced in rising prices, will be emboldened to go even further.

This is of great importance because, unlike in the 1930s, there is no limitation on what the government can do, because there is no gold standard to enforce monetary discipline. Instead, the world is afloat on a sea of massive new government spending and credit facilities. After a lag, the stimulus will perform the expected actions of reinstating credit and debasing the currency. But never lose sight of the fact that the government is creating money out of thin air. Some call it bailouts, we would call it legal counterfeiting on an epic scale.

In the New Deal, FDR created the FDIC and guaranteed bank deposits, set minimum bank deposit rates, and brought the discount rate to almost 0%. He cut the dollar/gold exchange rate from $20.67 to $35 and confiscated gold; i.e., devalued the dollar by 40%.

While the beginning of the collapse from too much credit was parallel to the previous experience of the depression, the response today is different. The size of the monetary stimulus and the risk to the dollar from foreign holders — who can also see the implications of the out-of-control deficits — strongly argue for a return to inflation much sooner.

How much sooner? Impossible to say, but remember: deflationary or inflationary fears are not the independent agent that will determine whether or not we will see inflation (though, in the intervening phase, they will certainly be an important economic driver). The Federal Reserve is throwing everything it can at the financial markets to fight deflation. As you can see in the chart below, the Fed has doubled the size of its balance sheet since September.

On December 16, the Fed cut interest rates to a range of between a quarter of a point and zero. That is lower than ever in the 94 years of their existence. And they promised in the accompanying announcement to provide additional funds to “stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level… the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets.”

At this time individuals and companies alike are sensing deflation and, as a result, are raising cash… in the process deleveraging the extreme debt loads. That is causing downward pressure on asset prices and, soon, a serious contraction in the economy as more and more companies lay off workers and cancel spending. This will not be a happy holiday season. And it will be a long-term recession and maybe even a protracted depression.

But the fact of the extraordinary deficit spending is there for all to see and, over time, more and more will see it. And, more to the point, understand it. In fact, thanks to the Internet and always-there financial media, the shift in sentiment can happen almost on a dime. Slowly at first, and then faster, fears over inflation will return, but this time they will be well founded.

The economic downturn could be protracted, but that does not mean that the deflation will be protracted. Instead, once we are through this phase, we expect to see poor economic conditions, but against a backdrop of rising inflation. Stagflation is a word that remains in our vocabulary.

Inflation or deflation — whatever the current market trend, there is a way to play it. Every crisis contains opportunity as well as danger… and many of those who manage to mitigate the risk and grab the opportunity have made a fortune in times like these.

Making the trend your friend and riding the market “riptides” that can lead to exceptional returns in the double, triple or even quadruple digits is easier than you think… with a little help from experts who have been correctly predicting – and profiting from — these riptides for years. Learn more here.

Regards,
Bud Conrad

December 25, 2008

Battle of the Flations was originally featured on Whiskey and Gunpowder

The Federal Reserve was never envisioned to be lender of last resort to a whole slew of investment banks, money market mutual funds, and commercial paper issuers.

The situation is not easy to sort out, for the simple reason that the extent of their actions is not presented by the Fed via clear and concise data. Instead, the data is complex and hard to analyze, partly because of the piecemeal way the actions were taken, but also probably due to a desire by the Fed to avoid public scrutiny and criticism.

Digging into the details of the Fed’s balance sheet reveals, however, the complete change of composition and direction of the Fed. The most obvious change is that they have doubled the size of their assets and liabilities. A year ago, the Fed’s assets consisted almost entirely of government Treasuries and a little gold.

That is a clean, safe balance sheet.

The only important liability was the currency they issued (our paper dollars). They also had a small reserve of deposits from all the banks. When Greenspan wanted to give the economy a boost by lowering short-term interest rates, he would create some money and buy Treasuries. He could also do the reverse.

Bernanke has turned this upside down. Initially he made focused loans to big banks. But then the loans became bigger than the reserve deposits, leaving the banks in total as net borrowers. The concept of a fractional reserve no longer applies when the reserve is net negative.

To fund yet more loans, Bernanke then sold off half of the Fed’s Treasuries. And he traded Treasuries for toxic waste of poor-quality mortgage-backed securities. And he encumbered half of the remaining Treasuries with “off balance sheet” swaps of about $220 billion. (Does this sound like Enron accounting?) The balance sheet started with $800 billion of mostly reliable assets and now has about $250 billion of unencumbered Treasuries.

The biggest source of funding is from the Treasury. Banks are leaving deposits in the Fed now that the Fed is paying interest.

The important conclusion is that the paper dollars are now issued by a far less soundly structured Fed, an organization that is more interested in bailing out the financial community than defending the dollar.

The other side of the balance sheet shows that the Fed has borrowed and taken in deposits to fund the loans that are as big as the issuance of currency. In effect, the Fed has doubled its footprint and doubled its responsibilities. Mostly under the covers, they added almost $1 trillion new credit to the financial world in about two months.

There are additional important Fed actions not included in their balance sheet. For example, they invented a Money Market Investor Funding Facility (MMIF) to guarantee up to 90% of $600 billion of loans to that sector. They do this through special-purpose vehicles established by the private sector (PSPVs). The latest Commercial Paper Funding Facility (CPFF) started October 27 and has issued $143 billion so far. These are both in addition to the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility initiated September 19. The programs are beyond keeping up with.

Nothing like this has ever been done before by the Federal Reserve. In time, the consequences in terms of confidence in the dollar will be bad.

Regards,
Bud Conrad

November 12, 2008

A hearty thanks to Bud Conrad. This is Bud’s first appearance in the Whiskey Room and we’re thrilled to have him, but after reading that last bit I really need a stiff drink. Good thing this is a bar.

“Nothing like this has ever been done before by the Federal Reserve.” I can’t be the only one who feels a little anxious after reading that. If you want to be able to sleep soundly tonight, you could take some Xanax.

Backfield in Motion at the Fed was originally featured on Whiskey and Gunpowder