Friday, March 20, 2009

How Bad Will It Get?

To help shed some light on this question, Carmen Reinhart and Ken Rogoff (former chief economist at the IMF) produced a short but useful paper a few months ago: The Aftermath of Financial Crises.

The authors looked at major financial crises (as opposed to looking at "garden variety" recessions) from the past in terms of five key macroeconomic indicators: real home prices, real equity prices, unemployment, real GDP, and real government debt.

Reinhart and Rogoff (2008a) included all the major postwar banking crises in the developed world (a total of 18) and put particular emphasis on the ones dubbed “the big five” (Spain 1977, Norway 1987, Finland, 1991, Sweden, 1991, and Japan, 1992). It is now beyond contention that the present U.S. financial crisis is severe by any metric. As a result, we now focus only on systemic financial crises, including the “big five” developed economy crises plus a number of famous emerging market episodes: the 1997–1998 Asian crisis (Hong Kong, Indonesia, Malaysia, the Philippines, and Thailand); Colombia, 1998; and Argentina 2001. These are cases where we have all or most of the relevant data that allows for thorough comparisons. Central to the analysis is historical housing price data, which can be difficult to obtain and are critical for assessing the present episode. We also include two earlier historical cases for which we have housing prices, Norway in 1899 and the United States in 1929.

The results from the paper, along with the current US numbers, are as follows.

The average peak-to-trough decline in real home prices for these financial crises is 35.5% with an average duration of about 6 years. The US Case-Shiller composite 10 index is currently down 28.3% from its peak in June 06 and the composite 20 index is currently down 27.0%. Given what we know about what's still out there and given where we are now, it looks like we'll exceed the average decline.

The average historical decline in equity prices is 55.9%. The average decline lasts 3.4 years. The S&P 500 recently fell to a low that was 57% below its Oct. 2007 high. It is currently about 50% down after the last week's bear market rally. S&P is currently estimating 2008 operating earnings to be $50/share. I've seen a number of level-headed analysts predict $40/share for 2009. Assuming a generous (for a crisis) P/E of 15, this puts the S&P 500 at 600 (the low so far has been 676). A more plausible P/E of 12 puts the S&P at 480. An S&P of 600 puts the Dow somewhere in the neighborhood of 5,800 while an S&P of 480 could put the Dow around 4,600. Pretty scary numbers and well below the historical average calculated by Reinhart and Rogoff.

The third indicator looked at by the authors is the unemployment rate. Granted, the current official methodology for calculating unemployment is lousy and the official number significantly understates the real problem. But the authors used official numbers so we'll go with that. The average total increase in the unemployment rate is 7 percentage points over a period of 5 years. Currently, the US rate has risen from 4.1% to 8.1% –- a four percentage point increase. It looks like we're headed for an official number that could top 11 percent.

Next up is real GDP. On average, this indicator fell a whopping 9.3% over an average timeframe of two years. The US real GDP has just begun to fall (it peaked in Q2 2008 and it's only fallen about 1%) so there's not much of a comparison here yet. But a 9% drop in GDP would make the current situation look like a cake walk.

Finally, we come to real government debt. On average, this value rose 86%. The authors say this about debt:

Reinhart and Rogoff (2008b), taking advantage of newly unearthed historical data on domestic debt, show that this same buildup in government debt has been a defining characteristic of the aftermath of banking crises for over a century…. As Reinhart and Rogoff (2008b) note, the characteristic huge buildups in government debt are driven mainly by sharp falloffs in tax revenue and, in many cases, big surges in government spending to fight the recession. The much ballyhooed bank bailout costs are, in several cases, only a relatively minor contributor to post–financial crisis debt burdens.

If we start with the federal debt at the end of FY2008 -- $10.0T -- then this indicator is the most disturbing of all. An 86% increase in the federal debt is a scary number and when (not if) interest rates push back up near 10%, rolling that mountain of debt over into pricier notes will send the federal interest payment well north of $1T per year. Combine that with the rising cost of social services such as Medicare and Social Security and this looks like a thundering freight train with very wobbly axles. Obama's budget forecasts -1.2% GDP growth this year followed by 3.2% in 2010, 4% in 2011, and 4.6% in 2012. These numbers are beyond laughable. Part of the problem is the administration's crazy unemployment estimate which it puts at 8.1% for the whole of 2009. But it already hit 8.1% in February and it's rising quickly.

By contrast, the consensus of forecasters surveyed by Blue Chip Economic Indicators in February predicted that the GDP will fall by a larger 1.9 percent this year and then increase at weaker rates of 2.1 percent in 2010, 2.9 percent in 2011 and 2012 and 2.8 percent in 2013.


For 2010, when the administration is forecasting the deficit will decline to $1.17 trillion, the administration is forecasting that the rebounding economy will boost revenues by 8.9 percent. Based on the stronger growth, the administration is forecasting steadily declining deficits in coming years with the deficit dropping to $912 billion in 2011, $581 billion in 2012 and $533 billion in 2013.

These GDP numbers still look quite optimistic to me (economists have consistently underestimated the extent of this crisis and even pessimists and bears have had to revise down their early estimates). These deficit numbers are fantasy. In reality, federal tax receipts will tank while federal spending explodes. How bad will it get? We are not a responsible nation and we are in the midst of a self-imposed world of hurt. The non-doctored math looks ugly.

(end of post; ignore continue reading statement below)



Blogger Garrett said...

Hi Derrick,

Nice post. I have to believe we're headed below 5000 on the Dow. Also, some bears were predicting drops in housing prices below 2001 (where our housing boom began on the Coast) but we're already starting to exceed that in some categories in LA and we have a long way to go. Hmmm, will it all end in Pyrrhic inflation?

3/22/2009 12:02 AM  
Blogger Derrick Olliff said...

I hear ya. Housing prices aren't done. A 4500 Dow wouldn't surprise me considering the fact that a crisis recession P/E of 12 is hardly pessimistic. An official (for what it's worth) unemployment number of 12% wouldn't surprise me either.

In another Reinhart & Rogoff paper I'm currently look at, they make the point that financial crises and currency debasement are practically joined at the hip. It's nice to have empirical confirmation of this although it's almost true by definition. Sovereign states can't declare bankruptcy so their two favored means of default are (1) just don't pay the money back, and (2) inflate. And inflate they do. It's easier and less politically radioactive than things like raising taxes, cutting services, etc. So if history and human nature are any guide, why would we be any different? The dollar is the world's reserve currency and some significant nations like China hold a chunk of US debt. They'll certainly complain about any US attempts to side-step its debt via inflation but we'll probably just find other ways to buy them off.

3/23/2009 1:48 PM  

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