Jim Jubak

Jubak's Journal10/31/2008 12:01 AM ET

What's scary about this recession

Don't expect the US economy to burst out of its sharp downturn anytime soon. Here's why, and how investors can deal with a protracted slump.

By Jim Jubak

The financial crisis is looking less, well, crisislike.

Global financial markets aren't out of the woods by any means, but each day we seem to inch a little further from the brink.

For example, the commercial paper market, the market for short-term debt that global businesses use to finance their day-to-day operations, has started to function again. The amount of commercial paper issued and sold to investors by companies jumped 46% on Oct. 27 from the amount issued Oct. 25. The worry not so long ago was that this market would freeze up completely, leaving companies unable to finance their basic operations.

Take a quick, short breath of relief. And then start worrying about the real economy. Every day the signs -- such as the 159,000 jobs lost in September and the Oct. 30 report of a 0.3% drop in U.S. gross domestic product in the third quarter -- are clearer that the United States, along with Japan and Europe, is almost certain to slip into a recession by the end of 2008.

And, unfortunately, it's not going to be your normal recession. It will last longer than usual. It's likely to be resistant to the traditional medicines of interest-rate cuts and increased government spending. And the recovery, when it comes, is likely to be less than robust. Some might call it anemic.

After the flood

Let me tell you why I think we're looking at something other than a normal recession and what that means for investors.

Recessions are a normal part of the capitalist business cycle. Recessions wash out excesses in the system by shaking out inefficient companies, thus clearing the way for new competitors, and they work to keep supply and demand in sync over the long term.

In the past 50 years, we've had recessions (or recessionlike economic downturns) in 1969-70, 1973-75, 1980-82, 1990-91 and 2001.

Some of these have been relatively mild: The 2001 recession saw three quarters of negative growth, but the economy contracted by just 0.6%, 1.6% and 0.3% in those quarters. Some have been much more painful: In the second and fourth quarters of 1981 and in the first quarter of 1982, the economy contracted by 2.8%, 4.6% and 6.5%, respectively. Some downturns are extremely brief: The recessions of 1990-91 and 2001 lasted for just three quarters each. Some go on and on: The downturn that began in the second quarter of 1980, when the economy contracted by 7.9%, didn't fully release its grip on the U.S. economy until the fourth quarter of 1982, 10 quarters later.

There's bad news in those numbers. The evidence says recessions will be longer than average if they follow a financial crisis, especially if that financial crisis was caused by efforts to keep the economy humming by flooding the market with cheap capital.

Unfortunately, that's a very good description of where the U.S. economy stands right now.

The pin that popped the bubble and set loose the current financial crisis was the collapse of inflated housing prices. Those high prices led people to take out mortgages they couldn't afford from banks that should have known the money wouldn't be repaid.

But homebuyers and mortgage lenders were by no means alone in their love of cheap money. We're now suffering through the reaction to a global three-ring circus of leverage. Hedge funds, private-equity investors and even banks borrowed directly in Japan, the U.S. or wherever money was cheap in order to buy more debt, stocks, real estate and commodities than they could have bought with their own money. Pension funds, insurance companies, company chief financial officers and money market funds borrowed money indirectly by buying derivatives created with that borrowed money.

Why not increase your buying power by borrowing 30 times your actual capital, as Lehman Bros. (LEHMQ, news, msgs) did before its collapse, when you could borrow at an interest rate below the inflation rate, thus ensuring that, in real terms, you paid back less than you borrowed? After all, the bull market, fueled by this borrowing, virtually guaranteed a profit.

Video on MSN Money

Global crisis © image100/Corbis
The crisis takes a turn
The global financial crisis is now a global currency crisis. Take a look at Brazil's currency, which is down 33% since May, and where companies are losing billions on currency bets, Jim Jubak says.

When the assets -- starting with real estate and gradually expanding to take in stocks, commodities, corporate loans, commercial paper and the derivatives based on them -- that were the foundation of this mountain of leverage fell in price, all that borrowing had to be unwound, as creditors demanded more collateral on loans and borrowers rushed to sell before asset prices fell further and creditors demanded even more collateral.

That fear, compounded by uncertainty about what anything that had been purchased with borrowed money was really worth, drove financial institutions such as Bear Stearns, Lehman Bros. and Washington Mutual (WAMUQ, news, msgs) to -- and then over -- the edge of insolvency. And it created a credit crunch as even the lenders with money decided it was better to sit on the cash rather than make a loan that might not be repaid.

Continued: 5 steps down

 1 | 2 | 3 | next >

Rate this Article

Click on one of the stars below to rate this article from 1 (lowest) to 5 (highest). LowHigh