Global Economic Crisis

Ever since the monetary spigots and fiscal deficit pump primers were set on overload in the wake of the global recession that erupted following the Wall Street calamities of 2008, many economists have warned about the danger of a double dip recession. In other words,  the underlying weakness of the advanced economies most impacted by the recession  is so severe, an anaemic recovery may be shortly followed by a quick return to economic contraction. This is in fact what is increasingly likely to occur.

After incurring a flood tide of debt to cover the losses of the private banking sector, many advanced economies doubled down their bets by unleashing another torrent of debt for economic stimulus activity. The Keynesian policymakers assumed that the massive dose of public debt would quickly restore economic growth, thus ending the global economic crisis.

What has in fact  happened is that unprecedented levels of massive growth in the public debt has, at best, bought a feeble, anaemic and jobless “recovery,” with many economists calling for additional deficits for more stimulus spending. However, the bond markets have begun to react to the increasingly unsustainable levels of public debt. Thus, in short order we saw the Greek debt crisis evolve into the European debt crisis. Sovereigns that once boasted of their deficit spending are now in a panic, desperately trying to find ways of shrinking their structural deficits. The UK is joining with major Eurozone countries such as Germany in warning their citizens that austere times lie ahead, as governments reverse direction and begin to cut spending. These sombre voices are being echoed by the International Monetary Fund (IMF) and G20, as those officials, largely American, who are still calling for more deficit spending are now being drowned out by increasingly desperate European sovereigns, who have caught the scent of public default and national insolvency, and the apocalyptic economic repercussions that would ensue.

Now, what happens to a weak and artificial recovery from the worst economic recession since World War II when the fiscal deficits which alone underpin this so-called recovery are sharply curtailed? The answer is clear except to the politicians; double dip recession lies ahead, which will likely transform the global economic crisis into a full-blown synchronized depression.

The world’s third largest economy is sending worrying signals to those whose best hopes for an end to the Global Economic Crisis reside with China. Though Chinese growth projections seems spectacular in a recessionary world, with estimates ranging from 8% to above 9%, there is both more and less to these numbers than meets the eye.

The superstructure underlying China’s impressive growth rate over the past decade and more has been exports, especially to the American consumer, with facilitation from credit flows emanating from Beijing. In a situation where the central government is priming the stimulus pump, growth is being artificially created to a large extent, since domestic demand cannot compensate for China’s ravaged export markets. Factories may still be manufacturing export goods, however, the inventories are surging while shipments abroad are contracting. That appears to be the message revealed in new figures on China’s economic performance.

According to China’s  customs bureau, exports in July declined a staggering  23% from a year ago. This number is apocalyptic, yet on paper China’s GDP keeps soaring. How can an export driven mega-economy experience significant growth simultaneously with its core export sector undergoing a free fall contraction? By flooding the economy with liquidity through  monetary easing, it would appear. However, this is not a recipe for long-term, sustained growth. This policy will only succeed if there is a rapid turnaround in China’s export trade. That is a dim prospect, in light of the continuing decline in employment numbers in most of China’s key export markets, especially the United States and the Eurozone.

Another  revealing statistic to emerge from Beijing involves lending. The first 6 months of 2009 involved a floodtide of easy credit saturating  the Chinese economy. However, in July new loans declined by a massive three quarters from the prior month. It seems policymakers in China are getting more concerned about  the prospect that overly-loose credit will fuel an asset bubble in Chinese equities and real estate, while leading to an increase in loan defaults in the future.

Taken together, we see China engaged in a a series of massive interventions and policy actions in response to the Global Economic Crisis that are not dissimilar from other major economies. These steps are predicated on the hope that massive pump priming will keep the economy from imploding until there is a global recovery, enabling China’s export trade to resume its upward trajectory.

In my view, despite the rosy growth projections, the underlying fundamentals of China’s economy are based on fragile assumptions. If demand for China’s export goods from overseas consumers remains far under peak demand levels for a sustained period, Beijing will confront this reality: the nation’s massive export manufacturing infrastructure cannot indefinitely employ workers who fabricate products that pile up on the docks of China’s major ports. That is the nightmare scenario China’s leadership circles pray never unfolds.

The warning is crystal clear. Before the onset of the current financial and economic crisis, the U.S. had structural deficits measured in the hundreds of billions of dollars. Now, however, the fiscally toxic combination of Wall Street bailouts and economic stimulus programs requiring massive public borrowing have created the unprecedented phenomenon of multi-trillion dollar deficits, equal to 15% or more of the entire United States GDP. If would be bad enough if only the U.S. was engaged in such staggeringly high levels of public borrowing. However, virtually every major economy on the globe, including China and Japan, America’s two largest creditors, are also engaging in large deficit-financed stimulus programs. At a time when the U.S. requirement for credit is ballooning, its traditional sources of such largesse are under fiscal pressures of their own. Only by elevating yields on its Treasury bills will the United States be able to attract interest in its ever-expanding menu of Treasury auctions.

Raising yields on Treasuries will greatly increase the cost of public borrowing, thus adding to the fiscal imbalance confronting Washington. The growing unease regarding the size of the U.S. deficit by both sovereign wealth funds and private investors, and the real possibility that Washington will lose its coveted AAA status, has implications beyond Treasury yields. Policy decisions that address the nation’s fiscal imbalance may become essential in order to maintain interest in purchasing U.S. public debt instruments. This would mean budget cuts and tax increases, which would greatly increase the likelihood of a double-dip recession.

Given the track record of the U.S. political establishment, I suspect that they will delay a serious  deliberation on the fast-developing fiscal crisis confronting the public finances of the federal budget until it is too late to avoid the most critical consequences. What the recent Treasury auction demonstrated is that Washington may be fast approaching a situation where  insufficient demand exists to satisfy the government’s appetite for borrowed money. What happens then? The most likely result would be monetization of the debt by the Federal Reserve. In effect, the Fed would conjure money out of thin air, and use this newly printed stack of greenbacks to purchase Treasuries that are left behind by global investors and sovereign wealth funds. Should that unhappy day arrive, you can lay the U.S. dollar to rest, for it will not be worth the paper it is printed on.

“Commercial real estate is the next shoe to drop.”

James Helsel, Treasurer of the U.S. National Association of Realtors

 
Pennsylvania realtor and U.S. National Association of Realtors official James Helsel joined with other concerned parties in meeting with a congressional committee last week, conveying a collective message that was saturated with gloom and doom. A commercial real estate implosion has been predicted for months by many observers, including this writer. There is now mounting evidence that this sector of the economy is indeed in the grips of a severe contraction, with all indicators pointing to an accelerating price deflation spiral over a period that may extend to several years.

It has all happened before. In the early 1990s speculators drove the valuations on commercial space far beyond the bounds of prudence. When reality caught up, the worst crash in real estate prices ensued. It now seems increasingly clear that this early 90`s disaster is about to be eclipsed by the commercial real estate crash of the current Global Economic Crisis. In fact, commercial real estate prices have already fallen from their 2007 peak valuation by a greater figure than that which has crippled the U.S. residential housing market. As with the housing market, the commercial real estate contraction will adversely affect the balance sheets of the nation’s banks. However, the dynamics of that impact will be qualitatively different.

The subprime debacle in the housing market overwhelmingly impacted the largest U.S. banks and financial institutions. With commercial real estate, however, the pyramid becomes inverted. The bulk of the exposure to commercial real estate mortgages is held by financial institutions of small to medium size. Deutsche Bank real estate analyst Richard Parkus told the same congressional committee addressed by James Helsel that the four largest American banks have an average exposure of 2 percent to commercial real estate on their balance sheets. In contrast, the banking institutions that ranked between 30 to 100 in order of size had on average a 12 percent exposure to commercial real estate mortgages. What these figures suggest is that a massive collapse in the U.S. commercial real estate market will cripple a large number of regional and community banks, in comparison to a few “too large to fail“  institutions stricken by the subprime housing disaster.

Though publicly quiet on this gathering storm, behind the scenes the economic policymakers in the Obama administration are deeply worried by this growing danger of a wider banking crisis brought on by a massive collapse in commercial real estate. The Federal Reserve is also in a state of high anxiety, for the same reasons. By June of this year, there were already 5,315 commercial properties in default, a figure that is more than double the number of commercial real estate defaults in all of 2008.

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Many loans initiated when the prices of commercial properties were at their peak will be coming due over the next 3 years, including $400 billion by the end of 2009, and nearly $2 trillion by 2012. With unemployment skyrocketing, real disposable income shrinking and nearly 7% of income now being saved by the chastened American consumer, it is a foregone conclusion that a greater proportion of these loans will become non-performing. In the current economic climate, there are simply no options available in terms of refinancing and securitization. As with housing, a glut of foreclosed commercial properties will further depress prices, creating a vicious concentric circle of financial doom.

Ultimately, the coming collapse in the U.S. commercial real estate market is not only inevitable; it is round two of the banking crisis. Having barely escaped alive from the consequences of the subprime housing collapse due to trillions of dollars in taxpayer aid and quantitative easing from the Federal Reserve, combined with Timothy Geithner’s stage-managed “Stress Test,“ it is difficult to see an escape route for the American banking sector once the ravages of the commercial real estate storm have hit with gale force. That must be what the Obama administration and the Fed are frantically consulting on behind the scenes, hoping against hope that they have a TARP 2 ready in time. In the final analysis, a very large number of small to medium sized banks in trouble can pose just as great a systemic risk to the global financial system as was the case with a small number of banking giants. What happens to the concept of “too big to fail“  in that scenario?

When he unseated the Democratic Governor of America’s most populous state six years ago in a recall election, Republican challenger Schwarzenegger lambasted incumbent Gray Davis as a typical “tax and spend” liberal. In his thick Austrian accent, Arnold Schwarzenegger promised a new dawn of uninhibited free enterprise growth, facilitated by fiscal responsibility on the part of state government combined with a low rate of taxation. Well, another political promise bites the dust. However, Governor Schwarzenegger demonstrated uncharacteristic candor when he addressed a joint session of the California legislature and accurately outlined the brutal reality underlying California’s dire fiscal crisis.

California is financially bankrupt. The state coffers are bone dry, confronting a $24.3 billion budgetary deficit. This appalling number is likely to grow worse, as the state’s official unemployment rate, currently at 11.5%, is projected to exceed 12% by the end of the year. Already, California is experiencing its worst unemployment rate since the Great Depression. Factoring in discouraged and underemployed workers, the actual unemployment rate in California exceeds 20%. Amid this melancholy economic stew, the state’s legislature is mired in partisan political paralysis. With state government a triumph of ineptitude over responsibility, it appears that desperation is the only remaining option for America’s largest state. In this case, desperation means asking the U.S. taxpayers for a Federal bailout.

For the present, the Obama administration has been resistant to being the banker of last resort for the state of California. The reasoning is cogent in the extreme; if the U.S. government bails out California’s state government, a precedent will be created whereby every deficit-ridden state, county and municipal governmental authority in the U.S. will come crawling to Washington D.C. with hat in hand. However, political realities often override sound economic calculations. California’s powerful congressional delegation will undoubtedly impose severe pressure on President Barack Obama, forcing him to ignore the danger of precedent and add California to the already long list of corporate wards of the U.S. ship of state.

If California were an independent country, its $1.8 trillion GDP would rank as the sixth largest in the world. It is the leading center of high technology and manufacturing in the United States, and it is no exaggeration to state that California’s economic fortunes are interlinked with the remainder of the United States. Unfortunately, all the indicators for California’s economy are pointing south with abandon. The University of California at Santa Barbara recently released its highly regarded state economic forecast. According to the director of the center that publishes the UCSB forecast, economist Bill Watkins, “California’s economy continues its descent into the depth of its most serious recession since World War II…It is possible that when this is over this recession will meet the technical definition of a depression in California.”

If California is headed towards a devastating economic depression, how can America avoid a similar destination? In the meantime, political incompetence continues to reign in Sacramento, while the rating agencies brace for a major downgrade in California bonds.

With the financial and corporate sector having been proven wanting in responding to the Global Economic Crisis, it has been left to the politicians to rescue the global economy from a second Great Depression. What is now occurring in the political corridors of power in California reveals the entrenched limitations of what elected officials are capable of doing amid the unfolding economic disaster. In the final analysis, it may be that California will face the inevitability of defaulting on its debt, or as with the U.S. government bailout of the auto industry, some form of structured bankruptcy.

Could this be what the United States as a whole is in store for, once its wallet and credit are as dried up as in the forlorn state of California?

Now we are in 2009, with the subprime mortgage securities debacle having been the underlying cause of the state of insolvency afflicting America’s largest banks. The U.S. government, including Congress, Treasury and the Fed, have injected or issued backstop guarantees to the tune of $13 trillion, in a frantic effort aimed at keeping these zombie financial institutions artificially alive. Yet, in this truly global economic and financial crisis, events in other parts of the world may render mute and futile all the trillions of dollars the U.S. is borrowing to save the American and global financial system. As in 1931, it may well be the Austrian banking sector that is the final nail in the coffin of the current globalized financial order.

With the fall of communism, former East Bloc European states were encouraged to borrow heavily by their Western brethren, with Austrian banks leading the way. Governments in Eastern Europe borrowed massively to finance the modernization of their industries, with the goal of providing lower-cost industrial goods and commodities to consumers throughout Western Europe. In addition, consumers in Eastern Europe were encouraged to borrow money in Euro currency at low interest rates for homes and consumer durables. When the Global Economic Crisis hit Europe, demand destruction afflicted the highly leveraged new industrial plants in Eastern Europe. In addition, the consumers who unwisely borrowed money from Western banks in Euros were devastated by the collapse of their home currencies. A new housing crisis has arisen in lands as diverse as Hungary, Bulgaria and Romania.

The non-performing assets on the balance sheets of European banks are enormous, and have affected many countries throughout the Eurozone. However, in terms of percentage of toxic assets to GDP, no European state is in as precarious a state as Austria. More than $250 billion in bad assets are poisoning the balance sheets of Austrian banks, a sum equal to more than 62% of the nation’s GDP. By way of comparison, if the admittedly shaky U.S. banks held toxic assets in the same ratio to GDP, this would equal $8.7 trillion dollars in bad assets. If America’s banking disaster was on the same scale as Austria’s, it would require a dozen TARP programs to cover the holes on the balance sheets.

Is another Credit-Anstalt catastrophe in the works? The macroeconomic data emerging from Europe looks increasingly gloomy. In addition, the European Union is proving to be both disunited and uncoordinated in facing up to mounting evidence of a financial avalanche that may bury the Union and everything else with it, including the common currency. Policymakers throughout Europe are arguing over Eastern European stabilization funds, protectionism versus “free trade,” and other issues, both real and distractions, while the financial underpinning of the entire European economic system is ablaze.

Just as Iceland was the first nation to become nationally insolvent due to bank failures stemming from the Global Economic Crisis, Austria may be fated to endure a similar disastrous outcome. Should Austria’s banks fail as spectacularly as did the Credit-Anstalt back in 1931, the impact on the world’s financial and economic order will be at least as catastrophic and likely much worse. It is indeed timely for Paul Krugman to state the obvious regarding the looming Austrian banking crisis, irrespective of the indignation pouring out of Vienna.

Will 2009 prove to be 1931 redux? The indicators favor the pessimists far more than the optimists. Nobel Prize winning economist Paul Krugman has issued a sober warning, which hopefully will not be drowned out by the hyperbole of reality-denying European politicians.

How significant is the exposure to the coming implosion in the commercial real estate market? I have seen some estimates in the range of $7 trillion, however, the ultimate number may be significantly higher. Commercial properties encompass a vast array of buildings in developed and developing economies, from small, medium and large sized office buildings to shopping malls of all dimensions. Strip malls and mega-shopping complexes are losing tenants, with no one lining up to replace them as the Global Economic Crisis curtails demand by consumers. With fewer tenants and constricted income, property owners unable to service their outstanding loans are deleveraging, as mentioned above. Keep in mind that this is not just a New York City phenomenon; London and Budapest, Los Angeles and Berlin, Seattle and Tokyo are already seeing this torrent of economic destruction at work. As the implosion in commercial real estate accelerates, the already fragile global banking and credit system will be hammered again. In a worst case scenario, the blow about to be delivered by this next bursting asset bubble may prove to be mortal for the global economy.

There is another inference to draw from Premier Wen’s presentation on the economic problems confronting Beijing. While not belittling the acute and dangerous challenges that the Global Economic Crisis poses for China, the nation’s leadership seems to have taken a long view that suggests the following: by playing her cards carefully, China may be able to exploit the Global Economic Crisis in such a manner that she will emerge as the dominant economic power in the world.

With the United States reduced to literally begging China to buy her Treasuries, a vital imperative necessary to finance Washington’s stratospheric deficits, it may be that China is already positioned for global economic dominance, so long as she succeeds in maintaining her social cohesion during the difficult years that lie ahead.

There are apparent to me several signposts that clearly point to a downward spiral of accelerating velocity. One of these signposts involves the worsening statistics chronicling the effects of the Global Economic Crisis. Japan’s Q4 of 2008 growth figures show GDP contraction of 12.7%, with every indication that this measure of economic deconstruction will grow even more dire in Q1 of 2009. We already have figures indicating that in January, Japan’s exports declined by almost half from a year ago.

America’s tottering economy is receding so severely, the statisticians cannot keep track of the staggering rates of decline. The Commerce Department had to revise the Q4 of 2008 GDP figures from negative 3.8% to more than 6% GDP contraction. Unemployment numbers are swelling at an alarming rate, while the public and private debt ratios are entering into astrophysical red shift territory, so rapid is their spread from any realistic possibility of fully servicing them.

Beyond the fiscal doomsday being portrayed by the macroeconomic data, there is the looming banking apocalypse that is now gripping almost every economy on the globe, major and minor. In both the U.S. and U.K., almost the entire banking sector is insolvent, being kept on life support by massive infusions of government IOUs that are being backed by what amounts to an intergenerational commitment from the taxpayers. The banks of the European Union have on their balance sheets, according to a leaked secret European Commission document, $24 trillion of toxic assets. Iceland is already bankrupt, with Eastern Europe about to follow down the path of national insolvency.

All the dire news I just chronicled cannot be viewed in isolation, but must be seen as a devastating continuum, in which the negative news emerging from one economy impacts another, creating a destructive chain reaction that is close to achieving the point of irreversible criticality. And with the global economic order about to undergo nuclear fission, the policy makers are reacting in thoughtless panic and hysteria, stampeding into a rush of Keynesian irrational excess. Despite the fact that unsustainable debt was a principal driver of the Global Economic Crisis, the sovereigns of the world are replicating the worst habits of the consumer and private sector. Staggering levels of deficit spending are being enacted into policies, unmindful of the inability of the global financial world to absorb and sustain such stratospheric levels of unfunded spending. Neither are the policy makers cognizant of the inconvenient fact that with so many economic actors swamping the global credit markets to fund levels of deficit spending that defy the human imagination, it is inevitable that interest rates will rise to crippling levels, choking off private capital. In their frantic efforts to rescue the global economy and bailout irresponsible financial institutions and ineptly run conglomerates at any price, the politicians are planting the seeds of a bitter harvest for all.

The world is facing the equivalent of a world war, with the Global Economic Crisis playing the role of the Axis. It is humanity’s misfortune that instead of Winston Churchill or Franklin Roosevelt to lead and inspire us, we are left with the likes of Timothy Geithner and Nicholas Sarkozy. It may be our fate to be led down the path of economic perdition, with the highway to hell being paved with mediocrity and ineptitude.

Not only did the statisticians of the U.S. government miss the true rate of economic descent in Q4 by a country mile; they were completely dislocated from the true rate of economic disintegration afflicting all strata of U.S. econometrics. Take for example exports, which supposedly showed some growth in the preliminary estimate, but are now shown in actuality to have been in decline. Ditto for inventory expansion. If anything, the corrected Q4 numbers tell us that the American economy is in free fall, and neither the public nor private sector analysts can give us a reliable appreciation of how severe the economic decline is in the United States in anything approaching a timely manner. In contrast, the Japanese government at least has been able to track its own economic implosion with much more accurate and timely numbers.

I point out the wide gap in the preliminary Q4 number and the corrected results because it is a reminder to be weary of the likely attempts by both government and Wall Street to downplay the American economic contraction while hyping the projected upside. The Obama administration has just unveiled a budget that projects a stratospheric deficit of $1.75 trillion dollars, a number equivalent to roughly 12% of the GDP. In their budget projections, Obama’s economic advisors are projecting a total GDP contraction in all of 2009 of just a little over one percent. Based on the revised Q4 contraction of negative 6.2%, how can the Obama administration believe the American economy will rebound in the middle of 2009 and sustain a modest decline in annual GDP? The answer is that President Obama’s economic team needs a GDP decline limited to just above 1% to keep the administration’s promise of cutting the gargantuan deficit in half by the end of its first term in office, at least on paper.

Political expediency may dictate how those in Washington deal with economic projections, however the Global Economic Crisis is not a respecter of political requirements. The U.S. is in a severe recession, and likely entering an economic depression. Any belief that the United States will halve its deficit while continuing with its accelerated public spending is pure fantasy.

As with the revised Q4 number on GDP, the unvarnished data that is yet to emerge throughout the course of 2009 will end up being far worse than is being currently forecast.