In the wake of an unprecedented, coordinated effort by governments around the world, the global financial meltdown has been contained, at least for the moment. Amazing what you can accomplish with a mere $2trillion!
If we're lucky, the panic phase of this crisis may be over – the hoarding of cash, the tidal waves of forced selling and indiscriminate liquidation. As the various initiatives are put in place over the coming weeks, credit should begin to flow more freely again through the financial system and out to the wider economy.
There is no guarantee that the panic won't return, but certainly there is nothing that makes it inevitable. What is significant is that governments have now established that they are willing and able to do whatever is necessary to prevent the financial system from spinning out of control, which is crucial to putting a floor under investor and consumer confidence.
Do not confuse this moment of calm with a stock market bottom or a sign that a serious recession has been avoided.
We are in a bear market and will be for some time. That doesn't mean that you can't have good days or even long strings of good days – what traders refer to as bear market rallies. But for a bear market to become a bull market, there needs to be some evidence that corporate profits have bottomed out and are about to take off again in response to a pickup in the economy – and at this point we're a long way from that.
Nobody should pay much attention to those economic forecasts churned out by computer models. These models are like homing pigeons – the way they are programmed, they desperately want to get things back to “normal” as quickly as possible. And because the models are based on what has happened in the past, they are almost useless in predicting how the economy will respond to extreme events, like the bursting of the biggest credit bubble in history.
A better way to think about the economic forecast is that we are at the beginning of a transition period in which our collective spending as a nation will go from roughly 6 or 7 percent more than what we produce to closer to 2 or 3 percent less than we produce, to accommodate an aging population and the need to put away some savings.
That's a huge swing, and although it won't necessarily come all at once and may be accomplished through different means, there is no way to accomplish this task by producing more. We're going to have to consume less, which means a temporary reduction in our standard of living.
Put another way, we didn't just have a housing bubble and a corporate takeover bubble and a consumer credit bubble and a commodities bubble. In time, those asset bubbles led to the creation of a bubble economy, with too many airplanes and restaurant seats and hotel rooms, too many office buildings and shopping centers, too many investment banks and media outlets dependent on advertising revenue from car companies producing too many cars and home builders producing too many houses. Shrinking all that back to the right size is what the coming recession is all about.
It would be easier if the United States were making this adjustment alone, while most of the rest of the world continued to grow and demand more goods and services from the world's biggest exporter. But unfortunately, the rest of the global economy is also slowing because so many other countries participated, directly or indirectly, in our bubble economy.
Nobody really knows how long or how deep this recession will be. What we do know is that recessions that follow the collapse of asset bubbles tend to last longer than average – and that this was the mother of all bubbles. So it's a fair assumption that this recession will last through 2009 and well into 2010.
Worse still, the recession will take an additional toll on an already weakened financial system. The next shoe to drop will be the hedge funds, which are posting worst-ever losses from investments that have led to record withdrawals. By one estimate, as many as 1,000 hedge funds could close their doors before the shakeout is over, with negative implications for the Wall Street banks that lent them money.
Then comes commercial real estate, where values are already plummeting, vacancy rates are rising and permanent financing is difficult to find. A collapse in this sector would be particularly bad news for regional banks and insurance companies.
And let's not forget all those otherwise sound companies taken over by private-equity firms and management teams that proceeded to load them up with debt. A prolonged recession is almost certain to cause a larger-than-expected increase in the default rates on the “leveraged loans” and junk bonds used to finance those deals, and that will be another direct hit on the major Wall Street banks.
What does all this mean?
It means that, in terms of the stock market, the Dow Jones industrial average will find its way back down near 8,000 sometime in the next few months to see whether that is the new floor, or it is somewhere even below that. “Testing the lows,” as the traders say on Wall Street.
It means that we're in for a lousy economy for the next couple of years requiring another big economic stimulus plan from the federal government – one that needs to be focused less on tax cuts and more on helping the unemployed, preventing cutbacks in vital state and local government services, and creating jobs directly through investments in infrastructure.
And it means that the financial sector is not out of the woods, that more financial institutions will get in trouble and that another round of rescue efforts could well be needed.
This thing ain't going away any time soon.