Last spring, not long after the collapse of Bear Stearns, I decided to steal a trick from the business and economics journalist Doug Henwood. Henwood was in the habit of tracking the number of news media references to “recession” because, as the editors of The Economist had noticed before him, the arc of that number actually turned out to have predictive value in charting the onset of recessions.
So, as talk of the “greatest economic crisis since the Great Depression” became a commonplace in mainstream media practically overnight, I figured to do the same thing with the word “depression.” I began checking in at Google News to see how many hits the string “depression” and “economy” yielded. In mid-March 2008, the number hovered in the 5,000-6,000 range. A month later, it reached 11,500. As of late yesterday afternoon, it stood at 21,631.
This is hardly definitive evidence, it’s true, but here on the ground, the signs only keep getting more dire. In November and December, the rate at which the American economy was bleeding jobs accelerated dramatically. Depending on whose numbers you use, between 524,000 (the Labor Department figure) and 693,000 (per payroll-processing giant ADP) vanished in December alone. Revised BLS numbers for 2008 showed a contraction of more than 2.5 million jobs, over a million of them in the final two months of the year. Many economists think 2009 could be roughly as bad. Consumer confidence has hit all-time lows. And yesterday RealtyTrac reported new numbers that show US mortgage foreclosures topping 2.3 million in 2008, an 81 percent increase from the year before.
And that’s to say nothing of the enormously leveraged and structurally precarious financial markets. Everyone who has followed news of the unfolding crash even casually knows by now that it started in the subprime mortgage market and spread to US and global credit markets. Just how it did so, though, is a subject that the press has not handled so well.
The answer lies in the so-called “shadow banking system,” the vast edifice of non-regulated financial institutions and products devoted to hedging the risk to investors when markets lurch in one direction or another. This is the universe of hedge funds, collateralized debt instruments, “portfolio insurance” and so forth. A couple of important things to bear in mind about these instruments: a) They have the effect of further leveraging the financial system–of turning a dollar’s worth of debt that is backed by some tangible asset, like a house, into $5 or $10 or more worth of potential investor liability in a downturn; b) their popularity has spread the risk throughout the entire credit system.
The use of these instruments is by no means confined to the residential mortgage market. Similar cascading failures could occur in many other areas, ranging from commercial real estate to household credit card debt. Hence the urgency of governments in the United States and around the world in pumping out money to keep banks lending and consumer economies moving, whatever the future consequences of all that additional debt: The downside is quite literally incalculable.
On the last point, Charles R. Morris’s outstanding book The Trillion Dollar Meltdown contains one of the clearest thumbnail sketches of the situation I’ve come across:
Gary Crittenden, Citigroup CFO, may have been the first to tell analysts the truth. At a November  analysts’ call, he was asked if he would confirm that the [subprime mortgage-related] writedowns were finally over. He said he could give no such assurances. His valuations of the complex instruments involved, he said, were just “a reasonable stab” and no more indicative of “where we are going to come out at the end of the quarter than where we would be two weeks from now.” In other words, the CFO of Citigroup did not know how to value his holdings.
In September, mainstream analysts had estimated subprime-related losses to be in the $20 billion range. Just two months later, in the wake of Crittenden’s statement, estimates jumped as high as $400 to $500 billion, which is much closer to reality.
The sad truth, however, is that subprime is just the first big boulder in an avalanche of asset writedowns that will rattle on through much of 2008. An overhang of subprime-like assets, at least as large, is sitting in corporate debt, commercial mortgages, credits cards and other portfolios. Even municipal bonds may be at risk. Loss estimates of $400 to $500 billion barely get you halfway there.
We are accustomed to thinking of bubbles and crashes in terms of specific markets–like junk bonds, commercial real estate and tech stocks. Overpriced assets are like poison mushrooms. You eat them, you get sick, you learn to avoid them.
A credit bubble is different. Credit is the air that financial markets breathe, and when the air is poisoned, there’s no place to hide.
Here is a crude gauge of the credit bubble. Not long ago, the sum of all financial assets–stocks, bonds, loans, mortgages, and the like, which are claims on real things–were about equal to global GDP. Now they are approaching four times global GDP. Financial derivatives, a form of claim upon financial assets, now have notional values of more than 10 times global GDP.
The soaring ratio of credit to real output is a measure of leverage, or financial risk. Think of an inverted pyramid. The more claims are piled of top of real output, the more wobby the pyramid becomes.
It’s a brief and very engaging book, and it belongs on the short list of works about the crisis that everyone with the time to spare ought to read. As it happens, there’s a revised paperback edition coming next month. But it will bear a new title that takes the measure of how much bleaker the picture has become since the hardcover was published last spring: Now it’s The Two Trillion Dollar Meltdown.
Small wonder, then, that “uncharted territory” has become the central cliche of the moment in describing the economy and the financial markets.
What I’ll be doing in this space in the weeks and months to come is following that trip in real time and, where possible, connecting some of the points on the map. I’ll be culling news sites, financial publications, blogs and government data for the most meaningful numbers and developments. I’ll track the political dealings in Washington and elsewhere as politicians and central bankers try to keep the workaday consumer economy from stalling out altogether. And I’ll be talking with expert observers about what they make of the things they’re seeing.