Interesting Times

By Roger Altman, 4/5/09    

The rare nature of this recession precludes a cyclically normal US recovery. Instead, we are consigned to a slow, painful climb-out, as are nations such as Japan and Mexico that depend on US demand. The implications for US policy include a likely second round of stimulus, much more federal capital for the banking system and stunning budget deficits that will slow key initiatives for President Barack Obama, such as healthcare and energy reform.

What is unusual is that this is a balance-sheet driven recession, centred on the damaged financial condition of both households and banks. These weaknesses mandate sub-normal levels of consumer spending and overall lending for about three years.

In contrast, most postwar recessions had a different sequence – rising inflationary pressures, a monetary tightening to counter them and, then, a slowdown in response to higher interest rates. This was the pattern of the sharp 1980-81 slowdown.

None of that happened here. Instead, we saw a housing and credit market collapse that caused enormous losses among households and banks. The result was a steep drop in discretionary consumer spending and a halt to lending. To see why recovery will be slow, we can look at the balance sheet damage. For households, net worth peaked in mid-2007 at $64,400bn (€47,750, £43,449bn) but fell to $51,500bn at the end of 2008, a swift 20 per cent fall. With average family income at $50,000, and falling in real terms since 2000, a 20 per cent drop in net worth is big – especially when household debt reached 130 per cent of income in 2008.

This debt derived from Americans spending more than their income, reflecting the positive wealth effect. Households felt wealthier, despite pressure on incomes, because home and financial asset values were rising. Now that wealth effect has reversed with a vengeance. The crisis and unemployment have frightened households into raising savings rates for the first time in years. They had been stagnant at 1-2 per cent of income but have surged to nearly 5 per cent. With reduced incomes, only cutting discretionary spending can produce higher savings. This explains why personal consumption expenditures fell at record rates at the end of 2008.

Consumer spending, however, has approximated 70 per cent of US gross domestic product for the past decade and dominates our economy. But household balance sheets will not be rebuilt soon. Home values will keep falling through mid-2010 and there is no precedent for equity markets, still down 45 per cent from their peak, to make those losses up in just two years. It is illogical, therefore, to expect a full snap-back in the consumer sector in 2010 or 2011. This alone mandates a drawn-out, weak recovery.

The second key sector is the financial one. According to the International Monetary Fund, western financial institutions, mostly in the US, have realised $1,000bn of losses on US-originated assets since the crisis began. The IMF has estimated that unrealised losses may amount to another $1,000bn. With residential and commercial real estate steadily declining, this is possible. This is why the banking sector cannot make new loans. These losses are eating into banks’ capital and shrinking their capacity to add assets. Funds from the Troubled Asset Relief Program are only replacing lost capital, not increasing it. When might they end? With key categories of toxic assets still losing value, the answer is: not soon. The scale of lending needed to support a normal cyclical recovery will not materialise.

A third constraint on recovery may involve the federal balance sheet. The fiscal and monetary engines are currently on full throttle. But, within two years, concerns over budget deficits and inflation may revive, compelling the Federal Reserve to raise interest rates and Congress to adopt deficit reduction steps. These actions, contractionary by definition, could occur before a full recovery has asserted itself. On that basis, the federal balance sheet would also limit a full recovery.

This weak outlook is likely to force a second injection of spending rises and tax cuts in 2010 to prod demand. Despite public opposition, substantially more federal capital will be required for banks. The deficit outlook will worsen, perhaps to $1,000bn annually over 10 years. That will force a slowing of Mr Obama’s investment plans. That is a shame, because those investments are needed, but this balance sheet recession will be too deep.

The writer is chairman and CEO of Evercore Partners and former deputy Treasury secretary in the Clinton Administration