December 2009

Hi, I’m Rand Westlund, and today we visit another aspect of The Quest for Normalcy. To repeat the foundation of this quest, remember that we had two decades of really, really good times, which is abnormal. Most people don’t think this way. They want the too-good times to be normal, and only see bad times as abnormal, because abnormal carries negative connotations. Still, having such a good experience for such a long period of time is abnormal. Now, after the extraordinary stress of the last couple of years, which was also abnormal, we find the economy in this quest for normal conditions.

So recall: the economy entered recession in late 2007, in a normal correction mode for a recovery gone too far. In the fall of 2008, we posited that, pre-recession, everyone colluded in a grand illusion: the presumption of loans deserved, advantages earned, and the right to possess everything within reach – right now. Such an environment, with incentives gone wild and unbridled risk-taking, is not normal.

A. J. P. Taylor, a 20th century English historian, once said: “Any event, once it has occurred, can be made to appear inevitable in the hands of a competent historian.” If we apply this quote to today, it means this recession was foreshadowed by events transpiring prior to it. However, even if this recession is viewed as inevitable, its miseries were not. Though various observers suggested that the excesses had to correct, few anticipated the far-reaching ferocity of the correction.

And so, by the Fall of 2008, deteriorating conditions produced a flight from risk, caused money flows to stop, stymied decision-making, and the economy effectively screeched to a halt. The halt spooked markets, culminating in a freefall in stock prices and interest rates in early March. I believe this period of time will now be known as the Panic of 2008. What does a Panic look like? Let’s look at a series of charts that illustrate the face of panic. We’re not going to focus too closely on the specific details, but rather, the striking downdrafts traced by each indicator as the panic rolled across the economy. The Bloomberg Financial Conditions Index – as the realization of systemic distress took hold, what had been a recessionary slowing in the availability of credit turned into a refusal to share monies through the system… The ISM Manufacturing Index – while settling into slowdown mode as recession took hold, the freezing up of money movement abruptly halted industrial activity, as companies found they could not get the credit needed to fund operations, inventories, and the like… Change in Nonfarm Payrolls – as conditions worsened, companies were forced to downsize to protect their survival (see our webcast dated October 15, 2009 for more discussion of employment conditions)… The 10-Year Treasury Yield – while Treasury yields trended lower in typical recessionary fashion, the panic caused the yield to dive as “everybody” wanted to park their money in US Government securities, the safest thing on the block...

Consumer Confidence – and finally, even as the recession lowered consumer confidence, reports of the extent of previous excesses multiplied into growing distress and fear...

As the panic spread, calls for the government to do whatever was necessary to stabilize conditions were widespread. The Federal Reserve and Treasury complied and initiated massive government actions and promises. In the view of many, only the government stood in a position to underwrite the terms necessary to quell the panic. The government’s actions could not fix the overages—there are always consequences to accept for previous excesses—but a system in free fall required an extraordinary response.

Now, since the bottom in March, many elements of the economy have experienced rather stunning ascensions. Let’s look at the charts again. Note where current levels stand in comparison to those when the Panic began, and also when the recession began at the end of 2007. Conditions…Manufacturing…Payrolls…Treasury Yields…Confidence… In each case, the picture shows a significant re-fill of the drop off the cliff. Even Consumer Confidence, with the nagging worries, at least displays a return of stability.

A spirited debate has arisen among commentators, strategists, and economists as to whether the economic revival is sustainable. For those who doubt, the main support is the rapid climb itself, given a belief that the government intervention is the only cause for the re-fill. For those who do not doubt, myself included, the emphasis is on a system working to correct overages, and government intervention helped prevent further damage (though some believe that some of the government intervention may actually hurt the system’s ability to correct). The key point is that one cannot look only at the right side of the V’s shown in these charts. The right side is a response to the left side; and that is the beauty of the capitalist system—it adapts and corrects.

So, where do we go from here? The proof of recovery lies ahead. Activity is coming back, confidence is coming back, and the potential for positive outcomes is building. As these and other charts demonstrate, we fell off a cliff in the fall of 2008. As we have passed the anniversary of those cliffs, we can see a more-regular, positively-sloped ramp in most data. A regular ramp is really quite positive, and the continuing upward path is anticipated in the recovering equity markets. Improving conditions reflect the normal dynamics of the emergence from recession—the aftermath of panic just heightens the uncertainties.

The memory and analysis of recent events will lead to changes in the system and its oversight. History records another memorable episode like the present, namely, the Panic of 1907. What started as a money shortage in New York banks due to over-lending joined with recessionary conditions to produce rapidly-falling confidence and widespread distress. At that time, J. P. Morgan and a troupe of bankers met the deterioration head-on, creating a money trust to shore up the financial system and restore confidence. It staved off further erosion, but intense government scrutiny thereafter vilified the saviors, and led to the creation of the Federal Reserve in 1913 and other government attempts, since the 19-teens, to address systemic shortcomings by adding regulations and safety nets. The Panic of 2008 offered a particularly compelling environment in which to apply some of the lessons learned from the Panic of 1907 and earlier Federal Reserve actions, prompting extraordinary government measures. The quelling of panic and the gradual withdrawal of these extraordinary measures should foster a more solid economy, a more normal economy, and greater potential in the days to come.

Thanks for listening in, and have a great day!