From the December 2008 issue of Research Magazine • Subscribe!

Post-Crisis World

Monday, October 13 was a great day. Shrugging off the unlucky devil's dozen date and the traditional curse of October, all three main indices on Wall Street moved up by 11 percent. The Dow narrowly missed posting its first quadruple-digit gain in history, but in any case its 936-point rally was the largest ever. The buying spree was something to celebrate, even though it came at the end of a grueling eight-day stretch during which blue chips lost 22 percent. Some analysts promptly called the bottom of the bear market, or at least a time to bargain hunt.

As the Dow on my screen climbed 300 points before the opening bell and kept on rising, past the 9,000 mark by 3 p.m. and straight up in the final hour, I felt sad for an end of an era. Traders and investors were so desperately hanging to the good old days, so eager to believe that all will turn out well, the governments will fix the global financial mess, the banks will resume lending and the stocks will return to their levels at the start of September. Those who failed to buy during this fluky dip would be forever tearing their hair out.

Small Part of EconomyOn the surface, why shouldn't it happen exactly this way? The banking industry is not a dominant part of the economy. It contributes a mere 4 percent of GDP. Even if the entire financial services sector is taken together, it measures just 8 percent. In the U.K., for example, the financial sector is responsible for 14 percent of GDP.

The sector was a contributor to U.S. economic growth, at least before the subprime crisis began to bite in mid-2007, but it has been expanding at an average rate of around 6 percent, not so much faster than the overall economy. And, while paying salaries that are nearly twice as high as those in the average job in the economy, the number of jobs in the sector totals only 4.5 percent of U.S. payrolls.

But these figures do not even begin to describe the role of the financial sector in the economy. Of course, banks play a vital role in providing credit, the lifeblood of economic activity, but the financial sector has been even more crucial for the U.S. economy in recent years because we have been living above our means. We consistently consume much more than we produce -- much more, when measured against the output of goods and services of the rest of the world. Our current account deficit, at around $850 billion a year, equals 1.2 percent of the entire world GDP.

It is logical that when you spend more than you earn you need to borrow or dip into your savings. Our savings rate has fallen to zero or even below, and over the past eight years, our consumer debt has ballooned by $6 trillion, which comes to $750 billion in net new borrowing per year.

During the current presidential election season, both parties have tried to portray the U.S. consumer as an innocent victim of Wall Street greed. In reality, the financial sector was merely a facilitator of a borrow-and-spend spree by the consumer. The Federal Reserve kept interest rates too low over the past 15 years, encouraging the borrowing excesses. Financial wizards kept inventing complex financial instruments so that households could squeeze every last dollar of credit from every asset. They helped millions of Americans transform their homes into ATM machines. Debt securitization and derivatives created new ways to serve the national appetite for credit. In the process, Wall Street securitized so much debt that its leading financial firms went under the moment the economy hiccupped.

Ballooning BubbleWith luck, a coordinated government effort around the world will succeed in recapitalizing the banking sector, guaranteeing deposits and credits, and steadying the nerves enough for banks to resume lending to each other and to creditworthy businesses and solvent consumers. Still, the good old days are never coming back -- or at least not in their old form.

We will not be able to keep taking equity out of our homes and spending it on Chinese consumer goods, Korean and Japanese cars and Saudi, Russian and Venezuelan oil. House prices have fallen by over 16 percent in key markets around the country over the past year, which is a historically unprecedented development. One in six U.S. homeowners has negative equity in his house. In the year to mid-October, $12.4 trillion in equity value disappeared in the global selloff, some $7 trillion in the U.S. alone.

But even if house prices eventually stabilize and start climbing, it will be a good long time until banks are willing to take the same kind of risk they did over the past decade, or use the same kinds of derivatives to facilitate consumer lending. All of a sudden we'll have to -- gasp -- start living within our means.

Not So Bad?At first glance, it doesn't sound like such a disaster -- consuming as much, and no more, than what we earn and even putting aside a dollar or two every week to pay down debts and save up for old age. Boosting the national savings rate at this time may even be a patriotic thing to do. But U.S. consumers have been spending, by some estimates, between 5 percent and 10 percent more than they produce. A 5 percent contraction of the U.S. economy over the next year would be a disaster comparable to the Depression.

On a micro level we will see layoffs, job losses and a sizeable drop in incomes. We'll be consuming no more than we earn, and we'll be earning substantially less. The National Association of Realtors, for example, has 1.2 million registered members. Even if we assume that many are inactive or hold other jobs, realtors everywhere have already become unemployed or underemployed -- a statistic that will not show up in the unemployment data.

This is just one way to look at the post-crisis world. But the repercussions will be far wider, spreading far around the world. The over-consumption bubble in the U.S. allowed a number of auxiliary bubbles to be created abroad, especially in emerging economies. China has invested literally hundreds of billions of dollars into its manufacturing capacity, which will be underutilized if U.S. demand shrinks. The same is true in other parts of Asia, Latin America and to some extent Eastern and even Western Europe. India's high-tech and customer-support industries will slump if the U.S. economy weakens.

Bubbles have popped up in such far-flung places as China, Russia, Brazil and Saudi Arabia, to name just a few rapidly growing countries. They will start experiencing a contraction. This also means that they will no longer have enormous trade surpluses and will not generate dollars to purchase U.S. government debt, further exacerbating tight credit around the world.

Some economists have been saying that the financial crisis will not be enough to drag the U.S. economy into a recession and, even if there is a downturn, it will be short and shallow. After all, aside from its banks, the U.S. has plenty of top-notch, world-leading industries, including pharmaceuticals, high tech, air and space, armaments and entertainment. Even in consumer electronics, the hottest new gadgets come from North American manufacturers, not the Japanese.

This is an important factor, suggesting that, while the U.S. has been the catalyst for this downturn, it is likely to be the first to recover and to help pull the rest of the world out of it as well. However, it should be recalled that U.S. companies were world leaders in a variety of industries and pioneers of new technologies back in the 1920s, as well -- which did not prevent the U.S. economy from falling off the cliff in the early 1930s.

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Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at abayer@kafanfx.com. His monthly "Global Economy" column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past five years, 2004-2008.

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