Recession

Copyright © 2008, Greenwich Financial Management Inc., a registered investment advisor.

What everyone has expected is now official: the United States economy has entered a recession. The National Bureau of Economic Research announced that according to its metrics, the recession began last December. The Bureau's measure takes into account declines in gross domestic product, personal consumption, employment and housing prices. See NBER release.

The Dow fell by 680 points (7.70%) on the day of the Bureau's pronouncement (Dec. 1st), although it’s hard to say how such unsurprising news could move investors. Perhaps it was time to end the winning streak which had brought us five consecutive positive days in US stock markets, taking us up from 8121 to 8840.

By any reckoning, the problems facing the U.S. and world economy are grave. Although central banks--notably including the US Federal Reserve--have been acting aggressively to add liquidity, the private banking sector is pulling liquidity back out.

The decline of commodity prices reflects and anticipates the magnitude of the contraction. I was recently driving in central Pennsylvania and saw regular gasoline offered at $1.68 per gallon. For consumers, this is an isolated bright spot. For parts of our country such as Texas that are energy producers, it’s scary. As discussed in last week’s column, fear of deflation is growing, and with it, further concern for the solvency of borrowers large and small.

John Maynard Keynes described a dilemma he called the “paradox of saving.” As an economy contracts, people tighten their purse strings, seeking to save more; as a result, total demand goes down, and as a whole, everyone makes (and saves) less. We must avoid a potential collapse in demand for goods and services and in the money multiplier. (Thus, although it was not exactly inspiring when President Bush urged us after 9/11 to keep shopping, there was a rational basis for it.)

There are a number of key economic decisions facing the incoming Obama Administration. One has already been made: the Bush era tax cuts will be extended. This decision helps head off a divisive fight in Congress and is also stimulative, or at least it is not contractionary. A second major decision involves the big three US automakers. All three, but particularly GM and Chrysler, face imminent financial collapse. Bankruptcy may be unavoidable, but the government may have to play a role in providing debtor in possession (DIP) financing. A third decision involves government spending stimulus; President-Elect Obama is expected to propose to Congress huge initiatives in infrastructure, which could also be helpful, though there is a lag in putting such projects in motion.

The Fed has acted with extraordinary aggressiveness and innovation. Economist Peter Fisher has described their efforts as “appropriately hyperactive.” (Source: Bloomberg News Service.) He added that similar consistent efforts after the stock market crash of 1929 might have shortened or forestalled the Great Depression. There will of course come a time when the Fed will need to mop up some of the liquidity it is now creating, perhaps in a year or two, or face the danger of runaway inflation.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

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