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Jon Markman

SuperModels2/5/2009 12:01 AM ET

Too late to avoid a depression?

Policymakers are quickly running out of time and room for error. And even a brilliant plan -- which we haven't seen yet -- could fail without some good luck.

By Jon Markman
MSN Money

Over the past week, the world's intellectual, business, government and philanthropic elite emerged from World Economic Forum meetings in Davos, Switzerland, with grim faces and warnings of financial doom. You'd almost think they'd met to plot a suicide pact rather than global trade, as the headlines were so gory they could have been mulched into meals for vampires.

Are things really that bad? Maybe not. Your contrarian antennae really have to go up in the face of consensus from a cohort of eggheads, politicos and jet-setters not exactly known for clairvoyance. Their big idea last year: that emerging markets' domestic economies had become so strong that a decline in U.S. and European growth would not derail them. Oops.

Credible economic analysts now say there is still a narrow window of time in which policymakers in the United States, Europe and Asia can avoid a meltdown over the next year by immediately coordinating the injection of real financial adrenaline to banks, companies, households and local governments -- not just rhetoric and indiscriminate spending. Yet that window is closing fast, and if the right steps are not taken soon it may be shut for years.

But governments don't know which steps work because economic theory breaks down at the level of human psychology. Given a set of stimuli -- ranging from tax cuts and longer unemployment benefits to new construction jobs and wider broadband access -- economists try to mathematically determine the choices citizens are likely to make, then use the results to recommend a policy mix to legislators.

The problem is that the models often fail to accurately forecast human behavior, and politicians regularly screw it all up by ignoring the data and diverting funds to pet projects. History is rife with successful financial episodes, such as the New Deal, in which luck and coincidence are later misinterpreted as results of prescient planning.

Slim hopes of an end-zone dance

To prove the Davos set wrong, in short, congressional leaders must make the right choices at warp speed under pressure from special interests. It's a public-policy version of the Steelers' final drive Sunday with time running out in the Super Bowl. Pittsburgh quarterback Ben Roethlisberger, scrambling to elude a rush, had one good shot at throwing the football at an oblique angle to a receiver leaping among three defenders in the corner of the end zone. In times like these, the result set is stark and binary: hero or goat in football, recovery or disaster in the economy.

The Davos pessimists' case for a severe economic dislocation over the next year -- let's go out to the extreme and call it a potential depression -- is easily made, as four key ingredients are in place. Their recipe calls for a blend of cyclical recession, severe deleveraging, a shift of demographics favoring savings over consumption, and inappropriate fiscal and monetary responses by policymakers.

The first three are well under way, so the last one is the decider. Looking back at the Great Depression of the 1930s and Japan's depression of the 1990s, it's clear that government leaders in each case failed to respond quickly enough, then overcorrected, and in general took steps that at the time were considered best economic practices but actually worsened the problems. Our leaders will likewise now try to do the right thing based on currently popular theories, but we cannot confidently say whether they will turn out to be appropriate. You just never know.

The only certainty is that measures must be taken immediately, and every day lost on minutiae such as bank executives' pay or Cabinet nominees' tax follies dampens the likelihood of success. Speed is of the essence, like putting up sandbags to stop a levee break, as we can see in daily headlines now that the darkness of Davos is descending.

The incredible shrinking economies

Layoff announcements over the past three months averaged 50,000 a week until they jumped to more than 100,000 last week. In an attempt to outrun revenue shortfalls, businesses are also cutting back on wages, travel and equipment purchases. But it's a losing battle. ISI Group analysts figure that U.S. corporate profits will decline from their 2007 peak to a 2010 trough by a record 30%, though a 50% fall is not out of the question. They're already down 20%.

Customers are disappearing as wages and jobs falter and families raid their emergency funds. U.S. home equity decline has accelerated to a 30% annual rate, which combined with the stock market plunge, has slashed consumers' net worth by $12 trillion.

Continued: Speed of decline is breathtaking

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