There’s a lot of bad news about the economy but we’re not in a recession.
The stock market is doing fine.
We have hope.
Lower interest rates should heat up the economy later this year.
Still, don’t expect a high-revving economy for another three years. The subprime crisis has taken that big of a toll.
So get ready for a nasty slump in consumer spending, probably the worst in three decades. After years of borrowing aggressively and spending far more than they produce, U.S. consumers will reduce their discretionary spending on autos, clothing, furniture, vacations and the like. The cutting has clearly begun. Goldman strategist David Kostin expects real growth in consumer spending of less than 1% in both 2008 and 2009, the first time growth would be so low for two straight years since World War II.
But at least the dimensions of consumer retrenchment — repaying debts, cutting spending, rebuilding savings — are known. The same cannot be said of the infirm financial system.
We know that credit losses have impaired bank balance sheets and that the necessary write-offs will reduce banks’ lending power. But because of the way Wall Street bundled and securitized mortgages and other assets into complex, murky derivatives, we still don’t know the extent of the damage to the financial system. "No one understands how the tentacles reach out," says Jeremy Grantham, chairman of GMO, a money manager in Boston. "We’re all flying blind."
Government regulation of the financial industry will likely increase significantly and the industry will be transformed — but into what? Writes Pimco bond guru Bill Gross: "The private credit markets have forfeited their privileged right to operate relatively autonomously because of incompetence … and excessive greed. Whether you know it or not — whether you like it or not — you are bailing out Wall Street."
Gross expects the government to force Wall Street to reduce debt-to-equity ratios — currently a towering 30 to 1. Moves like that could reduce risk in the system but will mean less-abundant and higher-priced credit for borrowers.