Last March, I posted on whether we were at the beginning of the Greatest Depression. Back then, my reasoning was that there was $6.1 trillion in financial toxic waste -- in the form of Collateralized Debt Obligations (CDOs) -- in our financial system resting on a sliver, a mere $340 billion, in capital.
Therefore, a 6% decline in the value of that toxic waste would wipe out the bank capital. (I should have added in another $6 trillion in mortgage-backed securities). When you consider that Merrill Lynch sold $31.6 billion of its CDOs last year for 22 cents on the dollar, you realize that toxic waste needed an 80% haircut rather than a 3% one -- and voila -- you've wiped out all the capital!
If you look at some basic statistics comparing the current economic situation with that of the Great Depression, you might think that we are in relatively great shape. Our unemployment rate now is 7.2% -- at its nadir, 25% of the population was unemployed in the Great Depression.
What jumps out at me is that it is not that helpful to compare the worst of the Great Depression with where we are now -- which could be the first inning rather than the worst part. New estimates suggest banks will take $3.6 trillion in asset write-downs before this is all over and that they currently have $1.4 trillion in capital -- this leaves a $2.2 trillion capital gap because banks need to add capital after they take write-downs.
Until that capital gap is closed -- and my hunch is that it could be bigger than $2.2 trillion -- we are in a deflationary spiral. That's because banks are going to be very reluctant to lend money, which will mean that companies and people can't purchase goods. Since 70% of GDP growth depends on consumer spending, that lack of purchasing will cause companies that make goods to cut their prices to get excess inventory off their shelves and then reduce their idle capacity.
This will add to the number of unemployed people who spend less and who can't borrow money to make up for the gap between their expenses and their income. So the companies will cut back further, which keeps the cycle going down. Perhaps economic stimulus can reverse this cycle -- I hope so, because the Fed and Treasury's combined $8 trillion in capital injections and loan guarantees have so far failed to do the trick.
Is this the Greatest Depression? I'd say it's too early to tell.
Peter Cohan is president of Peter S. Cohan & Associates. He also teaches management at Babson College. His eighth book is You Can't Order Change: Lessons from Jim McNerney's Turnaround at Boeing.











Reader Comments (Page 1 of 1)
1-22-2009 @ 4:26PM
Iridium said...
You have to remember that the unemployment rate today is as much a fake statistic as the inflation reports. The unemplyoment figure only counts those recieving benefits.
Those taking welfare in the inner cities aren't reported as being unemployed. Welfare is seperate from unemployment and if those people were counted the unemployment rate would be close to 20% of the nation.
See welfare clowns are actualy employed. They are employees of the federal government and thier job is to vote democratic. For that job some of the people that know how to play the system walk away with more than $100k per year in benefits.
1-23-2009 @ 2:44AM
jojo said...
Peter-I heard you tonight on NPR's "all things considered".
I thought you did an excellent job in presenting a sane alternative to the "shovel MORE good money down an opaque financial rathole" meme that predominates debate on the subject of taxpayer bailouts.
i actually felt a bit encouraged tonight to hear your point of view being expressed on the airwaves....hope to hear much more of you on NPR & elsewhere.
Your insights & prescriptions into these matters are correct.
btw There is a traders blog I visit daily at
http://www.tickerforum.org/cgi-ticker/akcs-www
(general & breaking links in particular) &
http://market-ticker.denninger.net/
where yours are the consensus views....