Yes, 2008 was a pretty bad year. Most of the major stock market indices are down roughly 40%, five major financial institutions disappeared or were, in effect, nationalized, and credit markets literally froze over. Past sins finally caught up with the Big Three auto companies, their credit ratings fell to junk status and some form of bankruptcy looked increasingly likely. The National Bureau of Economic Research concluded that a recession started in December 2007 (as we suggested in a January blog).
But it certainly wasn't as bad as the gloom and doom purveyed by excited thirty-something journalists and somber-voiced TV evening news impresarios. The unemployment rate has a long ways to go before it reaches the 10.8% of late 1982, much less the levels of the 1930s. Over 140 million people are still at work. Double-digit inflation and interest rates are not in anyone's immediate forecast.
Much less frequently remarked upon, but certainly a major downer, is the tarnished global reputation of the United States as a land of innovative and skillful financiers and risk managers. Barney Madoff did his bit, too, on the investment management side.
Good News. The best news is that the credit crisis - that truly frightening run on the banking system following Lehman Brothers collapse in September - is over. While its effects linger, contributing to lender caution and excess demand for liquidity by businesses, the danger of a financial system implosion has past, thanks largely to unprecedented activity by the Federal Reserve and the U.S. Treasury. Commercial bank deposit flows have steadied and money market fund asset levels crept back up.
Bad News. There are three unpleasant legacies flowing from the events of 2008. First, the recession still has a ways to run and the unemployment rate will move up sharply. However, the recovery (third quarter of 2009?) may be more sprightly than many assume. The massive inventory liquidation that began in the second quarter of 2008 provides the basis for a vigorous resumption of ordering and increased production later in 2009.
Secondly, it is not clear how and when the Federal Reserve and the Treasury will extricate themselves from their massive intrusion into the financial system. For example, at what point will the Fed declare its guarantee of money market fund shares no longer effective? When will the Treasury shed itself of control of insurer AIG? At what point will the government stop being lender of last resort to the entire finance company sector? The longer the government remains entangled in these ways with the financial system, the more politicized that relationship will become - decisions regarding lending, defaults, dividends, and executive compensation will become ripe fodder for Congressional complaint and intervention, as the debate over the Big Three auto bailout legislation amply demonstrates.
The third troublesome legacy of 2008 is the inflationary potential of the $1.3 trillion in additional Federal Reserve credit (a doubling from a year ago) that has been pumped into the economy over the past 12 months. Most of this money has gone to the commercial and investment banks, but it also includes $40 billion for AIG and $24 billion for money market funds. Fear of "choking off the recovery" will generate political pressures on the Fed to go slow in draining its massive liquidity injection out of the banking system. But failure to act promptly will raise inflationary expectations and long term interest rates, perhaps bursting the current "bubble" in Treasury bond prices.
Oh, Yes - Public Pensions. Take the three developments sketched out above and it is clear that 2009 should be an interesting year. And I haven't even touched on what a 40% fall in equity prices has done to the public pension system - but that is grist for an upcoming note.
