What Now?

The longest presidential election campaign ever now is history, as voters made their choices in the midst of an economic storm the brunt of which made its presence known in an almost unprecedented two months prior to election day earlier this month.

Americans voted for change, yet it will be the deteriorating economic environment here and abroad which will dictate many of the policies and much of the course of the new administration.

Democrat Barack Obama made history as the first African-American president-elect. The President-elect's choices for key cabinet positions will be telling, and, in the case of Secretaries of Treasury and Defense, the announcements will come preferably sooner rather than later.

More importantly, from an economic perspective, Democrats built a bigger majority in the House of Representatives and took a solid, though not filibuster-proof, majority in the Senate, so gone, at least for two years, will be the opportunity for legislative gridlock. A redeeming feature of our democratic republic, however, lies in our frequent ability to “correct” an imbalance of political power if it is found to have created the capacity for too much fiscal mischief.

But we mistakenly skip ahead to things unknown. We, and the new Administration and Congress, have more pressing issues requiring our collective immediate attention.

Namely, a rapidly deteriorating global economy currently connected to the life-support system of government and central bank interventions now surpassing $3 trillion and a growing number of developing countries in line for International Monetary Fund extensions of credit, including Iceland, Pakistan, Argentina, Ukraine and Hungary.

And the very likely expansion of our federal budget deficit to more than $1 trillion, possibly $1.5 trillion, in FY 2009 which ends next September. For grim perspective, the cumulative federal budget deficits under the entire eight years of the Reagan administration totalled slightly more than $2 trillion.

The president-elect inherits an economy which has shed more than a million jobs in a year, almost half of which occurred in August - October, and a 14-year high unemployment rate of 6.5% (11.8% according to a broader measure including the under-employed, those part-time employees wanting but unable to find full-time work).

America's consumer economy is beginning to shut down in self-reinforcing, circular phenomena of slowing business, job losses, credit contraction, declining tax receipts at all levels of government, pension and investment losses, real estate losses, foreclosures, repossessions and bankruptcies.

Never mind no “official” declaration of recession has been forthcoming. That will come later, perhaps early next year, when it is announced that the current downturn likely began in November 2007.

In the meantime, it certainly feels like a recession, and when consumers both voluntarily and involuntarily curb discretionary spending, it becomes - fait acompli - a recession.

Retail sales have been deteriorating, with many chains seeing October same-store sales falling by double digits ahead of what may be the leanest holiday shopping season in two decades, despite falling gasoline prices, now under $2/gallon in Texas and Oklahoma, taking some pressure off consumer spending.

Shoppers are trimming wish-lists, looking for bargains and "branding-down," to stretch dwindling holiday budgets, and retailers, for their part, are offering huge discounts well-before the traditional post-Thanksgiving start to the shopping season.

Year-to-date U.S. automobile/light truck sales have fallen more than 14 percent, but October auto sales were grim, plunging 38 percent across the board and registering annualized levels not seen in 25 years as buyers avoided showrooms in droves. Prospective buyers now sense better deals ahead and wait.

Auto dealers wait in hope of better-qualified customers as lending standards are tightened (GMAC recently cut off new loans to buyers whose credit scores fall below 700, which effectively excludes more than 25 percent of potential customers.)

GM and Ford shares trade at 50-year lows after reporting massive third quarter losses which, though alarming, are of less concern than the rapid rate at which the automakers are churning through their cash and credit facilities, the so-called cash flow "burn rate."

In 3Q Ford posted negative cash flow of $7.7 billion and General Motors burned through $6.9 billion of cash. At this pace neither company has sufficient cash and credit reserves to survive through 2Q 2009 at best, possibly earlier.

Outgoing Treasury Secretary Paulson's TARP, the $700 billion troubled asset relief plan approved after acrimonious Congressional debate in October, now may be stretched to cover the ailing auto industry as well.

Automaker troubles are not limited to North America. In Europe, heavy truck maker Volvo saw new orders fall by 55% in the 3rd Quarter, but combined with existing order cancellations, the continent's second-largest manufacturer registered net sales of only 115 vehicles, a 99.4 percent decline from the 42,000 units sold a year ago.

State and local governments also are coming to grips with declining income, sales and real estate tax revenues. California governor Arnold Schwarzenegger is proposing a sales tax increase and employee layoffs to patch a $12 billion deficit and Los Angeles is facing a $400 million shortfall.

New York City must now “borrow” a billion dollars from its health-care trust to shore up its battered pension fund as its Wall-Street dominated tax base evaporates in the wake of tens of billions of dollars of losses the last year posted by the city's financial sector, and New York state now projects a 2009-2010 deficit of more than $10 billion largely for the same reason.

Financial losses in stocks and real estate now are estimated to exceed $10 trillion from a year ago, and one of the principal engines of consumer spending, mortgage equity withdrawals, have nearly ground to a halt after ramping up significantly beginning in 1998.

From 2004 -2006, homeowners tapped $700 billion a year of unrealized home price appreciation via home equity loans, refinances and lines of credit, and not quite $500 billion last year. Through 2Q 2008, mortgage equity withdrawals hardly register at $50 billion and could end the year closer to zero.

In 2004 alone, mortgage equity withdrawals of $720 billion equalled six percent of GDP and since 1998, on average, equity extractions easily added four percentage points or more per year to overall GDP, a staggering amount of purchasing power which now has all but disappeared.

Consumer spending likely has peaked at nearly 71 percent of GDP, and a return to its long-term average of two-thirds of GDP, prior to the last decade, signals shrinking economic activity in the absence of more government spending, business investment and an increase in exports. That's the economic model which now makes us all Keynesians - that declining consumption and business investment can be offset by increased, deficit government spending.

The difference, however, in 2008 compared with the Great Depression, is our dependence on investors both foreign and domestic to finance the twin deficits - budget and merchandise trade - of the world's largest debtor nation.

One disturbing similarity between then and now: U.S. non-financial debt as a percentage of GDP now exceeds 350 percent and the only other time in our history when that percentage has been so high was on the eve of the market crash of 1929 when debt/GPD exceeded 260 percent.

Then, as perhaps now, a tipping point was reached. After 1929 the unwinding of debt, the deleveraging, lasted a decade as non-financial debt/GDP retreated to about 130% until the beginning of our participation in World War II.

Once again, what appears now to be emerging is a “balance sheet recession,” in which people and businesses are quickly trying to liquefy themselves by selling assets and paying down debt. This is pattern of the protracted, "L-shaped" recessionary environment which has dominated Japan's economic landscape for nearly two decades.

In Japan, its government reduced interest rates to zero to little avail for years as business and individual borrowers not only eschewed additional credit but strived to repay existing debt. America could follow suit as Baby Boomers, already concerned with declining retirement account values, get some of that old-time savings religion in light of their realization time no longer is on their side and early retirement may be a fading dream.

Ultimately that would be a good thing - a national savings rate more than one percent - but not in the short run as the nation attempts to transform itself away from a consumer-dominated economy. Which is where government spending becomes key.

The 2008 tax rebate, $150 billion fiscal stimulus, had a negligible impact as many recipients paid down debt or saved the rebate. In 2009 we will see government spending directed toward an infrastructure improvement program designed to create jobs and a $500 billion, or more, fiscal stimulus plan may begin to take shape before the end of this year.

There is some good news, some encouraging developments now materializing after a tumultuous September and October. The Federal Reserve's newest lending programs appear to be calming credit markets, unlocking vital short-term credit for companies otherwise shut out of commercial paper markets.

The Fed's $540 billion Commercial Paper Funding Facility, introduced in late October, already has extended more than $260 billion in short-term financing to General Electric and other S&P 500 companies. It's $120 billion of loans to insurer AIG International, one of the largest derivatives players, have eased fears of a domino-effect systemic meltdown of cascading defaults.

And the Fed's Money Market Fund Investing Facility, which quickly peaked in October at $152 billion as funds delivered troubled commercial paper to the Fed to avoid "breaking the buck," now has receded to about $85 billion.

The Federal Reserve's balance sheet has more than doubled in six weeks, ballooning to $2.1 trillion in it's role as lender of "only" resort, and Dallas Fed President Richard Fischer foresees $3 trillion - roughly 20 percent of GDP - by early 2009 as the Fed takes unprecedented efforts to counter the collapse of credit markets.

Yet the deleveraging process will continue until it has run its course, handmaiden of a great, global reassessment of asset valuations across every investment class. As Federal Reserve Board Governor Kevin Warsh recently observed: "We are witnessing a fundamental reassessment of the value of virtually every asset everywhere in the world."