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An Even Bigger Bite Out of GDP?


Annualized rate of decline may be steeper than predicted.


Editor's Note: Jack Lavery, former Chief Economist for Merrill Lynch, is now offering up his expert analysis in a newsletter on Minyanville. Learn more or sign up for a FREE 14 day trial of The Lavery Insight

The Treasury Secretary is clearly at center stage. The Treasury's Public-Private Investment Program was announced on March 23: It will purportedly rid banks of toxic assets, largely mortgage-related. The equity market's initial reaction was a tremendous rally. Since then, caution has re-emerged.

The leaders of the Group of 20 meet in London on April 2. One thing we see them doing is giving more money to the IMF. On the same day that the Geithner plan hit the markets, the World Trade Organization (or WTO) said global trade will decline 9% this year.

While the WTO prediction on global trade is the most negative in its 62-year history, the ugly stench of protectionism is clearly on the rise, and could, in my view, make the WTO outlook for global trade too optimistic. This should make for interesting discussion at the G20 meeting, as will Mr. Geithner's discussion of financial regulation and how Public-Private Investment Partnerships (PPIP) will work.

Treasury Secretary Geithner appeared before Chairman Barney Frank and the House Financial Services Committee on March 25, and outlined what Mr. Geithner sees as necessary changes in financial regulation.

Hedge funds and private equity firms would be subject to increased scrutiny. The key to financing the Geithner plan is government money that does not need congressional approval. The Federal Deposit Insurance Corporation (FDIC) will guarantee loans to private investors at significantly subsidized rates to induce them to purchase toxic assets.

In the current protracted downturn in economic activity, other bank assets may not fare as well as hoped. Household sector net worth has eroded, in my estimation, by roundly $18.5 trillion from the 2007 peak through the current quarter due to falling stock prices and eroding housing valuations.

As the household sector continues to deleverage, it will drive the savings rate inexorably higher, possibly to 8% by the end of this year. With March non-farm payroll employment likely to fall 700,000 or more, in my estimation, (data to be reported April 3) the unemployment rate could jump from 8.1% to 8.6% of the civilian labor force. How do consumer loans fare in this climate of continuing labor market deterioration?

The Federal Reserve's new prospective $1 trillion incremental expansion of its balance sheet is via the stated intent to directly purchase government bonds ($300 billion for openers), and by incremental buying of $750 billion of government-guaranteed mortgage-backed securities, in addition to the $500 billion of mortgage-backed securities the Fed is already in the process of making. The Fed is exercising its ability to print money. Fed policy has the mindset of quantitative easing.

Hindsight says the Resolution Trust Corporation route should have been taken at the outset of this banking crisis. Neither President Obama, nor Secretary Geithner want in my view, want to approach Congress for more taxpayer money at this time. If PPIP doesn't work, they will likely have to do so. Let's hope PPIP works.

The sustained outsized deficit spending going forward, the Bernanke printing press, and the piecemeal way with which the financial system's difficulties have been addressed carry major risks. Even if it all succeeds in appreciably lessening the duration and depth of the downturn, the inflationary risks of the arrows being used in the public policy quiver to combat deflation/depression dangers, are, in my view, quite real.

China and other non-US investors will at some point exhibit a diminished attraction to dollar denominated assets. The requisite foreign capital will still flow in, but the level of interest rates that will be required to attract those flows will be higher than otherwise would be the case.

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