The Great Recession Is Won – But How Goes the Great Deleveraging?
by TJ Marta January 04, 2010

2009 – The World Celebrates the End of the Great Recession

During Q4’08 and Q1’09, the world held its breath in unadulterated horror at the specter of the utter destruction of the world financial system and global economy. The deterioration of the US and UK banking and financial systems, culminating in the failure of Lehman Brothers (LEHMQ.PK), brought the global order to the brink of a 21st Century Great Depression. Revelations in 2009 of secret US and UK government meetings planning for feared societal collapses in late-2008 attest to just how close the world came to Armageddon.

However, historic policy responses from leaders and governments around the globe arrested the downward financial and economic spiral and actually began to lift markets and economic activity. Economists and pundits retreated from comparisons with the Great Depression and adopted the term, Great Recession. During H2’09, the Great Recession had apparently ended in most countries.

By year’s end, many countries had begun removing policy stimuli, and some even began hiking interest rates. Interest rate futures for most countries now price in central bank tightening during 2010. The major equity bourses around the globe ended 2009 near the levels in place in Sep’09, just before the world began seriously unraveling.

The consensus economist outlook according to Bloomberg is for economic growth to return to growth in most countries and in some cases, to even approach trend growth. Unemployment, being a lagging indicator, is expected to rise in most developed countries in the early part of 2010 before peaking and receding in the latter half of the year. Some economists even talk about a “V-shaped” recovery here in the US.

Happy 2010 – The Great Deleveraging Continues

Unfortunately, we believe the “V-ers” are as wrong now as they were in failing to appreciate (or see at all) the fat tail risks presented by the financial leverage in the first place. In celebrating the victory over the Great Recession, the “V-ers” focus narrowly on economic growth. They ignore the quality of the growth and the dynamics of factors that don’t fit neatly into econometric models. The term, “Great Recession” is totally inadequate in explaining what we are experiencing. The term, “Great Deleveraging” better encompasses the wide swath of factors at play.

Some of the factors we believe will prevent a “V-shaped” recovery fall within, or at least fairly close to, the purview of straightforward economic analysis. Joblessness will continue to rise as human capital that has been misdirected for years is forced to find new value. Consider that housing experienced a bubble that expanded for roughly three years and that the overhang of unsold inventory indicates lost jobs will remain lost for years to come. The bubble on Wall Street in terms of securitization lasted longer, arguably since the ramping of computing power at the end of the last century in preparation for Y2K. While fewer jobs than in housing have been displaced, the economic impact due to the loss of much of the securitization market could be just as great. Finally, the auto unions have made the US auto manufacturers largely nonviable for upwards of 40 years, and the pain of creative destruction for the two generations of autoworkers involved will be something greater than that of most cyclical downturns.

Another factor lies just as far outside what economists generally considered their area of concern prior to the financial crises as did the toxic assets that eventually blew up: commercial real estate. Commercial real estate is expected to suffer massive refinancing problems in 2010, which will put increased pressure on local banks and their ability to provide intermediation for local businesses, the backbone of the American economy.

Unfortunately, the problems go even deeper – down to the depths of the legitimacy of governments, even the American experiment, including the American hegemony that has ensured something close to global stability since the end of WWII. The government of Iceland has fallen, that of Mexico stands on the brink, and investors and analysts are increasingly calling the solvency of Japan, Greece, Spain, Ireland, the UK and even the US into question. In terms of the American experiment, analysts and policymakers question the US dollar so regularly that its downfall goes almost unquestioned. And perhaps most basically, the most elemental power behind the American colossus, the US military, is being questioned, with Iran thumbing its nose much as Hitler did to Chamberlain in 1938.

Developments are so far outside the norms of the period upon which most econometric analysis is based that it can at best be described as a base case assuming that none of the numerous potentially catastrophic scenarios takes place. The situation going into 2010 is very similar to that at the beginning of 2007 when we began warning of the financial crisis: all will be well, unless reality bites. Yes, the Great Recession is over. However, before the Great Deleveraging is over, it will have seared new and harsh lessons into the memories of investors and citizens the world over.

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