It's the writedowns, stupid


Edward Harrison
naked capitalism
Wednesday, March 18, 2009


Edward Harrison here. Today, I want to make the case for seeing writedowns as central to this global downturn. To do so, we need to rewind and compare what is going on today with what we have experienced in the past. Drawing on this comparison, I can demonstrate that traditional policy tools are likely to be ineffective today. Moreover, the present course of action will also prove inadequate. Other more aggressive means must be applied in order to ensure a more stable banking system and a path to recovery. Likely remedies will include a reorganization of large swathes of the U.S. banking system.

Now, looking back, if one hearkens back to 1992 and the election that took Bill Clinton to the White House, 'it's the Economy, stupid' was the phrase that symbolized Clinton's victory and George H. W. Bush's defeat. Today, as we are mired in a deep economic downturn, we should be tempted to bring back that phrase.

But, 2009 is not 1992. This is no garden variety downturn. It is something altogether different. We are not witness to a case of over-production and overheating as is usually the case. It is a case of over-leverage and over-indebtedness. As a result, the key to the outlook for the American economy is fairly simple and it hinges on a single word: credit.

My view of credit
The way I see it, our economic system is not built on work today for money today to consume today. Rather, we work in order to consume today and into the future. The mechanism through which we make this inter-temporal transfer is credit.

Think about any particular year in which you have worked. Certainly, you bought goods and services to consume straight away. But you also purchased homes, cars, television sets, shoes, washer/dryers, and tennis rackets, all to be 'consumed' today and into the future. In effect, you were using money in the present in order to consume later.

Now, here's the thing. Irrespective of whether you saved money from past earnings to buy those goods and services or bought those goods on credit, it was credit that was always behind the transaction. Had you saved, ninety-percent of your savings was loaned out as credit by your bank as soon as you deposited the funds. And if you bought on credit, you were the recipient of a credit loan yourself. No inter-temporal transactions could ever occur without credit. So, in a very real sense, credit is at the core of our system (a longer explanation is here).

Garden-variety recession
In a normal recession, credit becomes tight, but it is not central to the downturn. In fact, 80% of the decline in GDP is due to a de-stocking of inventory. Basically, businesses get ahead of themselves and forecast future demand that turns out not to exist. They are forced to ratchet back production and sell off inventories. In this case, policy makers can step in with fiscal and monetary stimulus and re-kindle domestic demand with a bit of a lag. Bing, presto, we are off to the races again. That's why recessions are over in 12-18 months tops.

Depression
That's not what happens in a depression - and this is a depression. In a depression, what happens is macro disequilibria build up so much and become so unsustainable that when the break in demand happens, there is no bing, presto from traditional policy responses. The leverage and debt in the system is just too large. The debt cannot be worked off without de-leveraging (See my post "De-leveraging").

Ray Dalio of Bridgewater Associates did a fantastic job of explaining this process in a Barron's interview last month.


Barron’s: I can’t think of anyone who was earlier in describing the deleveraging and deflationary process that has been happening around the world.

Dalio: Let’s call it a “D-process,â€