Economic Predictions For 2009

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For some inexplicable reason, Bernanke almost undid his previous work by allowing, with Treasury Secretary Hank Paulson, Lehman Brothers to go bankrupt, a move that sparked the systemwide panic he had been so desperate to avoid. Paulson, who for the first few weeks of the crisis had been held up as a superhero economic rescuer, has recently seen sentiment turn against him, with economists and commentators now arguing that the entire crisis may have been muted if Lehman had been rescued. Even that blunder may ultimately have worked out okay though, because it brought in Congress and other fiscal authorities worldwide, who are the only ones with the financial wherewithal necessary to restore lenders’ confidence. Now that governments have agreed to guarantee many of the dubious liabilities that banks and other financial institutions incurred during the great credit boom, the specter of a global cataclysm has greatly diminished, at least for the time being.

That is the good news. But even if another Great Depression is now “off the table,” to quote the sage Jim Cramer, several other parallels with the 1930s still worry me greatly, beginning with the continuing threat of international contagion. Perhaps the most remarkable aspect of the September financial earthquake was how rapidly it spread to places far from the epicenter, such as Iceland and Ireland, and how much damage it did there. Even now, the aftershocks are being felt in countries like Brazil, Hungary, and South Korea. Not since the collapse of the Viennese bank Creditanstalt in the spring of 1931, which unleashed a wave of instability that culminated in the decline of the gold standard, has the international monetary system seemed so fragile. For the U.S. economy, this matters for a couple of reasons. Another big financial collapse in Europe or Asia could well generate more carnage on Wall Street. Even if this doesn’t happen, as economic weakness spreads around the world, American exports suffer.

Second, even after the current round of capital injections, many big banks will be thinly capitalized relative to the quantity of potentially bad loans on their books. In their most recent reporting periods, Goldman Sachs and Morgan Stanley each had on their balance sheets more than $60 billion worth of level-three assets—the ones that can’t currently be valued properly and haven’t yet been written down.

As for the big commercial banks, Citigroup still has tens of billions of dollars’ worth of subprime and other risky securities on its books, and even the supposedly healthy J.P. Morgan and Bank of America are heavily exposed to the junkiest end of the property sector. On top of this, the big banks have massive loans outstanding to leveraged buyout firms and other companies that will struggle to survive the recession. Relative to all of this, even the billions of dollars that each of the big banks stands to receive from the government recapitalization won’t be enough.

Until the U.S. follows the example of the Swiss government, which recently took all of UBS’s toxic assets and shifted them into a separate “bad bank,” most big American banks will continue to hoard capital rather than lend, which means credit will remain hard to come by.

Third, once the recent collapse in commodity prices makes its way through the system, a real danger of deflation could emerge—not on the scale of the 1930s but significant enough to greatly slow a recovery. Oil prices, which I predicted would tumble from their triple-digit highs, have begun falling faster than most people thought; OPEC is now scrambling, belatedly, to rein in production. The threat of rising inflation, which Bernanke and his colleagues were citing as recently as the summer, has already disappeared. In September, the annualized rate of consumer price inflation fell to zero. (The core rate of inflation, which excludes energy and foodstuffs, was just 0.1 percent.) As unemployment continues to rise, wages and prices are sure to be trimmed in many other parts of the economy, which will only add to the incipient deflation.

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