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Doomed to Repeat History?

A profoundly unpopular Republican President, widely viewed as a massive failure by the populace is succeeded by a charismatic Democrat just as the country peers down the precipice of a deep and prolonged recession, following a historic crash in the stock markets. Unemployment is soaring, and deflationary forces rear their ugly head. The new President promises to put Americans back to work with sweeping public works projects, and leverages new technology to reach out to the citizenry weekly with his message of hope and change, delivered with the skill of a master orator known for his consistently poised and calm temperament.

Yep, Franklin Delano Roosevelt started his presidency in ways that should seem familiar to every American today. Oh, I’m sorry… did you think I was talking about Obama?

Santayana said that “Those who cannot learn from history are doomed to repeat it.” Are we going to see ourselves sink deeper into a depression and stay there for a decade or more before the country returns to a period of prosperity? Or, to quote FDR’s predecessor Woodrow Wilson, is prosperity “Just around the corner?” Nobody knows for sure, but one thing is for certain: the deck is stacked very much against a lasting recovery in the short term.

In the last quarter of 2008, we saw another wave of residential foreclosures, and it was devastating to the economy. What’s next? Commercial foreclosures, starting in Q2-2009. I expect to see examples of huge buildings in urban centers being foreclosed, and construction projects cancelled midstream because the budget no longer exists to complete them. Analysts have estimated that New York’s Financial District will see vacancy rates reach 50-60%, well below break-even. Even the symbol of American prosperity, the shopping mall, has fallen on hard times, and many will likely close their doors in 2009 and 2010.

At about the same time, we will see the next wave of residential real estate foreclosures and failed loans, especially in higher end homes above the 419K limit for Fannie Mae coverage. The first wave of credit card failures is starting now, caused by job losses and salary contraction. If nothing is done to prevent it, this combination of events creates a “perfect storm” that would make the last few months look like the roaring twenties. These times are being described by the financial press as a “credit crisis” or “crisis of liquidity.” However, I think they are wrong… liquidity issues exist w hen an entity has a shortage of cash, but sufficient resources and future income to dig themselves out given a shot of liquidity. However, I just don’t see it that way. We don’t lack liquidity, we lack solvency.

A great example is the U.S. auto industry. They are asking for loans to carry them a few more months, but what happens then? Absent major concessions from the unions, they simply don’t have a viable business model. There is no way for them to return to profitability, so if we give them a shot in the arm in the form of a cash infusion, we’re just postponing the inevitable. We need to face up to the fact that they are insolvent, and act accordingly.

The banking industry is similar. The massive deleveraging that has occurred has resulted in the uncountable reduction in the amount of money in the system. I have doubts in even “Helicopter Ben” Bernanke’s ability to print enough money to compensate and reduce the deflationary forces in the next 12-18 months. People don’t realize how much money the banking system has borrowed from the Federal Reserve in the last 6 months. I think some historical comparison is useful.

Borrowing from Federal Reserve by Depository Institutions (in Billions) 

In the chart above, you can see total borrowing of depository institutions from the Federal Reserve from the Fed’s inception in 1919 through December of 2006. You see a peak in the early 20s to fund World War 1, and then a smaller peak in 1929 following the great stock market crash. There’s a spike in the early 70s that corresponds to the financial crisis of that decade, and then a huge, $8 billion spike in the 80s to deal with the Savings and Loan crisis. With the exception of the S&L crisis, borrowing never hits $4 billion. (The spike in the late ’90s was precautionary borrowing in advance of Y2K in case there were bank runs.)

Now, let’s add 2007 to the mix.

Borrowing from Federal Reserve by Depository Institutions (in Billions) 

As you can see in the chart above, we had to double the scale, as borrowing in Q4 of 2007 approached $15 billion. N ow, let’s add 2008.

Borrowing from Federal Reserve by Depository Institutions (in Billions) 

Yeah, I had to increase the scale by an order of magnitude—instead of 8 billion, we’re looking at almost 700 billion. And these numbers only go through November, because the Fed hasn’t released December numbers yet. In case you’re wondering, these numbers came from the St. Louis Federal Reserve’s web site—you can download and play with them yourself in Excel format here.

If you adjust for the Consumer Price Index (CPI) to cover inflation, it doesn’t change the picture at all.

What I’m trying to communicate here is that this crisis is simply on a completely different scale than anything that came before it.

Historically, no nation has ever recovered when their debt exceeded their GDP by greater than 6%. In 2008 the United States crossed that threshold, and we are on track to exceed 10% in 2009. I don’t see how we can expect a recovery before the end of the next decade.

Is a “New New Deal” the answer, casting Obama as a modern FDR? CNBC’s Andrew Busch cautions against such a strategy:

The New Deal was actually a combination of socialism and cartelization of industry with price controls. These policies failed to stimulate growth and helped plunge the economy into the “Depression within a Depression” in 1937. It wasn’t until these policies were reversed and the NRA was relegated to a minor role in the government that growth returned in 1938. The other major issue was the Federal Reserve. They mistakenly stuck to the gold standard and was forced to raise reserve requirements that cut off the legs of the recovery.

Bottom line, buckle up… we’re in for a choppy ride, and it’s going to get a lot worse before it gets better. In a future post, I plan to take a look at some of the demographic trends that will make a recovery before the 2020’s even harder to pull off.

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