painful, will be much less than experienced in the past and certainly much less than what occurred during
The Great Depression. Thanks to massive global macroeconomic policy reaction as well as a number of normal safeguards in the U.S. economic system, the unemployment
rate, rather than peaking at 25% of the labor force, as it did during the Depression, is likely to hit no higher than 8.0 – 8.5% in the U.S.
Right now, under current policies the global economy faces two critical challenges: first, there is a widespread
lack of confidence and second, a lack of liquidity. Much analysis has been done of these periods; in fact Ben Bernanke himself has studied financial crises and The
Great Depression in great detail. The basic lesson learned is that when people need more liquidity, the Fed should give it to them. Simple enough, but the Fed doesn’t drop
cash from the sky, although it is likely that right now Bernanke wishes he could. Rather, the Fed traditionally adds liquidity to the economy through open market operations
whereby it buys bonds from banks and provides cash in exchange. Banks then lend this cash to both businesses and consumers who increase spending and boost the economy.
The problem currently is that banks are reluctant to lend due to very shaky balance sheets and a bleak economic outlook. Rather, they are building their cash position
to restore capital adequacy ratios that deteriorated due to poorly performing assets on their balance sheets. Thus, while the Fed has been willingly providing cash to the banking
system, the corresponding boost to lending has not yet occurred.
The inappropriately named “Bail Out Program” evolved as an attempt to remove poorly performing assets from bank
balance sheets and allow loans to once again flow freely. While $700 billion is certainly a large number, life (and economics) is always a relative game. Estimates of one of
the most significant classes of assets in trouble (credit default swaps) are in the range of dozens of trillions of dollars. The intent, rather than to solve the entire liquidity
shortfall, is first to restore confidence. Still, many lenders will continue to increase reserves rather than lend. Rather than removing bad assets, the Treasury has recognized it
can have a much more significant impact by adding equity, taking an ownership position in banks and increasing capital adequacy ratios directly. In addition to freeing funds for
loans, as an owner, the government can encourage additional lending. Over time U.S. Treasury and Fed actions combined with global central bank infusions should increase
liquidity and restore well-functioning credit markets.
When will the market bottom and what strategy should individual investors follow? Bear markets historically tend to settle at roughly 30% below the market’s previous high. We
have already hit the 30% market in both the Dow and the S&P indexes. Now, some math. If you have lost 30% (so every $1 is now worth 70 cents) you will need about a 43%
return on that 70 cents to get back to your original $1. How should you allocate your portfolio to do so?
In money market funds you might take as long as 12 – 15 years to earn 43%; in bonds maybe 7 – 10 years. With equities that have historically averaged 8% returns, the
time to recover your losses would be substantially less. As always, diversification is a must; how aggressive you are depends on your attitude toward risk.
While the U.S. economy will certainly survive the current financial morass, the long-term outlook is not nearly as bright as the period of prosperity that existed during the
1990s. Rather, long-term growth in the U.S. is likely to be slower and inflation and interest rates are likely to be higher during the next decade than in the past ten to
One of the major issues challenging President-elect Obama is that the U.S. debt currently exceeds $9 trillion without including the impact of a significant future shortfall
in both the Social Security System and Medicare. The consequence is that over the next decade, we must all face the following realities:
So how can President-elect Obama soften the effects of these realities?
- The growth in government spending must slow (by much more than “earmarks”);
- Income taxes must rise;
- Social Security benefits must fall and/or Social Security taxes must rise, and;
- Medicare benefits must fall and/or taxes rise.
Tax cuts alone are not the answer. Households are unlikely to spend right now and spending is what the economy needs to rebound from the current recession. In a capitalistic
economy, two critical roles that the government must take on are to act as first, the lender of last resort (as the Fed and the Treasury are now doing) and second, the
spender of last resort. When consumers are reluctant to spend, the government must spend — but it must spend wisely. Now is the time to enact a “new” New Deal. President-
elect Obama’s plan, in fact, includes several facets of such a plan. What is necessary is a significant government investment in infrastructure and research; roads, high
speed rail, energy, education, communication, research in new and emerging areas of science and technology and other areas that over time provide opportunities for businesses
to flourish, for the creation of higher paying jobs and for the development of innovations that continually support sustainable growth.
These investments and the easing of liquidity along with the resulting effects on growth will take time.
So, how should individuals best prepare?
First, as always, diversify your portfolio based on your attitude toward risk and the time until retirement. Too safe a position will imply that you will miss excellent opportunities
that are available right now in stocks that are considerably undervalued. At the same time, be careful not to absorb more risk than you can tolerate — emerging stock markets,
for example, can and have fluctuated by 40% or more each year. As one smart investor once said, “You can either eat well or sleep well.”
Second, increase your savings as appropriate based on a smaller than expected Social Security benefit, a higher cost
of long-term health care and slower income growth.
Third, expect a broad market recovery but think carefully about which sectors may be long-term growth candidates.
Finally, always be a student of history. The fact that the world economy repeats cycles over and over again provides
ample credence to this well known observation by Edmund Burke: “Those who don’t know history are destined to repeat it.”