Where is this Economy Heading?

As economic conditions appear to be improving and equity markets all over the globe signal better times ahead, it’s not hard to assume that the worst might be behind us, that we will start pulling out of this deep recession just as we have pulled out of so many others with robust growth. Two really good opinion pieces that I’ve read over the past couple of days offer a different take on where we might be heading.

John Carney writing at Clusterstock takes a look at the recovery of the financial sector and doesn’t like what he sees. He starts by noting that the assumption is the banking crisis is behind us yet no one can tell you what fixed it. In fact, it’s in many respects in worse shape as many of the banks’ asset classes continue to deteriorate. His hypothesis is that the financial system was not “fixed”, it’s simply become a creature of a government policy of no failures. And therein lies the problem.

As Carney sees it, the guarantees that the financial system currently enjoys short circuits the normal signalling systems of the market. The banks and the government regulators no longer have accurate data upon which to base decisions. He compares the current situation to that which brought down Fannie and Freddie:

It was this calculational chaos that brought down Fannie Mae and Freddie Mac. Even when closely supervised by regulators and with well-intentioned executives in place, the mortgage agencies were unable to properly evaluate the size of their balance sheets, the content and quality of their portfolios or the appropriateness of their business models. They were the original ‘flying blind’ financial institutions, operating under the benefits and hazards of ‘No Failure’ even before the collapse of Lehman Brothers.

And there is every reason to believe that this calculational chaos will also bring down financial institutions covered by the government’s implicit guarantee. The question is not, really, whether banks will fail like Fannie and Freddie. The question is how many will fail. Or, perhaps, how many will be able to avoid the fate through some bit of luck. Financial prudence and managerial skill will not be enough.

William Pesek writing for Bloomberg looks at things on a little broader scale and worries that we’re facing a prolonged period of economic recovery followed quickly by a backwards slide. Not exactly the Japanese “lost decade” syndrome but something along those lines. Somewhat like Carney, he sees the failure of governments to address root causes as the driver of a W shaped economic environment:

Here’s how it would look: Each increase in gross domestic product would fizzle as quickly as it began, undermining rallies in equity markets. Not a lost decade, yet not one that investors would enjoy. Such a scenario would reflect steps that policy makers are taking to restore growth.

From Washington to Beijing, officials are still treating the symptoms of the crisis, not the cause. Throwing money at the problem was fine for a while. It is now time to revamp regulations, retool economies and restore trust in markets.

Consumers worried they won’t have a job in a month need to rely on the economic outlook. Investors must be confident that the top-rated security they are buying won’t soon be worthless. Banks need to be sure that money they lend won’t lead to more bad loans. Restoring that trust will require bold action by governments and market regulators.

I’ve been pretty much in the same camp as Pesek for some time. I think that we could have a nice little recovery during the rest of this year but I don’t see anything that will sustain it over any meaningful period of time. It’s going to be pretty much driven by government programs that aren’t sustainable for much longer. When that crutch vanishes, I expect that most economies are going to stumble once again.

If Carney is right and we’re headed towards a financial system vulnerable to failure of one or more major financial institutions then a repeat of the past year is a very real possibility. I find little in the analysis that either furnishes to quibble with and don’t take much long-term comfort from their writings.

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