Exploring the worst-case scenario | Reuters

Exploring the worst-case scenario

Sun Oct 12, 2008 3:10pm EDT

By Emily Kaiser

WASHINGTON (Reuters) - The global economy is drawing closer to a dangerous downward spiral and time may be running out for world leaders to find a way to stop it before it inflicts lasting damage.

Economists are beginning to warn of a depression-like cycle where an inability to obtain credit stalls growth, triggering more defaults and still tighter lending terms. Governments have unveiled one unprecedented move after another in the past three weeks to boost confidence and get banks back in business, yet so far nothing has been able to arrest the fall.

The world's richest nations agreed on Friday to do whatever it takes to restore normal order to credit markets that have essentially shut down, choking off the flow of money to borrowers who normally would have no trouble obtaining loans.

  That seems to be the key. Either they get credit moving very soon, or critical mass is reached and a chain reaction of insolvency starts.

  I am presently in Brevard, NC, in the large area of the southeast of the US that was very short on gasoline for a few weeks and essentially completely out for at least a few days or a week, a story that was conspicuously under-reported. Gas is back and has been for some time, and prices are now dropping to national norms (I saw $3.15/gallon today), but roads, stores and restaurants are eerily quiet. Doesn't look like there will be a big xmas sales season in these parts.

"With no desire to exaggerate, this might be considered the financial pre-conditions of a depression," Citigroup economist Steven Wieting wrote in a note to clients.

"Evidence suggests credit rationing is inhibiting day-to-day activities for many firms, with a harsh and worsening backdrop for consumers," he said. "Sadly, some risk exists that financial events could still unfold like a proverbial 'dam break.' This might leave policy-makers treating very serious and lasting damage to the financial system, rather than preventing further erosion."

  Critical mass and meltdown or not. Even if not, extensive damage has already been done.

CONSUMER SPENDING CAVES

Since the bankruptcy of investment bank Lehman Brothers and government rescue of insurer AIG (AIG.N: Quote, Profile, Research, Stock Buzz) in mid-September, U.S. consumer confidence has tumbled almost as sharply as stocks, and spending has slowed dramatically.

  All those retail stores that make two thirds of their money in xmas-season sales? They're gone. Shorting them will be a one-way bet if there is still anything left to short. Since the stuff they are selling mostly all comes from China, it won't directly hit what manufacturing there is in the US, but it should be obvious that seasonal hiring will be low to non-existent except perhaps at Mall Wart and the other major hawkers of the cheapest junk from China that helped dig the debt part of this whole. Then in January if not before, massive layoffs of retail workers is a given. More defaults on consumer debt, more foreclosures, giant sucking sound.

Consumer spending accounts for two-thirds of U.S. economic activity, so if it remains weak, the economy would surely sink into recession, dragging much of the world with it.

  What's with this 'would'? The economy is in recession, whatever the fake government stats say. Consumer spending will continue to slow even if the banking system is saved and the credit markets restart. As bone-dumb as many Americans are, judging by recent Presidential elections, they are not about to run out and spend everything they can right after a stock market crash that now ranks with and may exceed the crash of 1929. It will take six months or a year of stability after a halt to foreclosures and bankruptcies before non-essential expenditures regain favor. It's just that simple.

The bigger risk is that it reinforces and deepens the credit crunch.

Banks are already reluctant to extend credit, primarily because they are paying the price for previous lending mistakes. As that slows economic growth, companies are cutting jobs, which in turn means more people may miss payments on mortgages, credit cards and auto loans, driving up bank losses and forcing them to clamp down even harder on lending.

Once that cycle gets going, it is difficult to stop.

  It is already going. The question is just if it has gone critical or not.

Lena Komileva, head of G7 market economics at Tullett Prebon in London, said there was a risk policy-makers would have to "start again from scratch" if they cannot quickly turn investor sentiment around.

"If this scenario were to unfold, governments would have to effectively nationalize the entire flow of funds in G7 economies and start lending directly to businesses and consumers. Surely, they can do better than this," she said.

Can they? We should know soon. The FT headline is Scramble to avoid collapse. Seeing that headline at FT means it will be a very near-run thing if the radical measures described work, and no great surprise if they don't. In that event, what would be left other than a worldwide program of massive liquidity support (printing money) and direct provision of credit? And then if that doesn't work, it's just plain over and time to let the thing run its course as quickly as possible and make plans for a rebuilding, and most importantly restructuring, of the world economic system.