This Weekend's Contemplation #2 - Is the Perfect Storm Headed Our Way?

Market Watch has an interesting article about a potential credit crunch and what it may mean for us. But once again, the economy is a dynamic process, not a linear process, so no one is sure what will really happen. But, considering all the news, isn't it prudent to begin preparing for a weaker economy. Personally, I believe the dark clouds you see on the horizon that seem to be getting closer isn't smog.

Could the turmoil in the markets in the past few weeks be the precursor of a full-blown credit crunch that could force the U.S. and global economies into a recession?

Some observers think that the markets are exhibiting classic signs of a so-called "Minsky moment," when overleveraged borrowers must finally pay the piper for their euphoria. The result, they say, will be a credit shortage that could bring down even innocent bystanders in their wake.

Academics, economists and money managers are all sounding the alarm. Financial markets are counting on the Federal Reserve to drop interest rates to cushion the fall, and yet senior officials at the central bank have insisted that the markets must discipline themselves.

Market professionals seem resigned that the fallout is inevitable, and has already begun with losses in several rocky sessions on Wall Street.

"The feeling I have today is that of watching a very slow motion train wreck," wrote Jeremy Grantham, chairman of GMO LLC, which manages about $150 billion in assets.

The S&P 500 index is now pricing in a recession starting in late 2007 and lasting for most of 2008, led by the financial sector, said David Bianco, chief equity strategist at UBS. "We believe the market expects this recession to slash S&P 500 [earnings per share] by about 10%," Bianco said.

Most economists don't share that view. Of the more than 50 economists surveyed by the Blue Chip Economic Indicators, (many of whom have been warning about the housing bubble for years), none predict even one quarter of negative U.S. growth over the next two years.

A growth recession, with rising unemployment along with slow growth in output and sales, "is a certainty," said Dimitri Papadimitriou, president of the Levy Economics Institute, a think tank at Bard College. That's where economist Hyman Minsky fleshed out his theories of a credit-business cycle, which emphasized a close connection between the creation and destruction of asset bubbles in financial markets and the timing of economic expansions and recessions.

The last two recessions, Papadimitriou said, follow the Minsky analysis to a "T." In the current cycle, he said, "economic activity will decline. The only debate is whether it'll be a soft landing or a hard landing."

While the stock market's gyrations are proof that credit-crunch fears are on the mind of many investors, thus far only a minority of market participants say they believe it will happen. Most seem to think it's far-fetched, largely because the global economy is strong, with ample reserves of liquidity.
"I think the market wants to believe that we're pretty much done with the shakeout, that the economy has been OK, and that the impact is more of a financial-related impact than an economic impact," said Paul Nolte, director of investments at Hinsdale Associates. "As long as those economic numbers stay solid, then we're fine."

Despite some signs that the carnage in the subprime sector has already slowed consumer spending growth, the problem is still mostly a financial one, said Tony Crescenzi, chief bond market strategist for Miller Tabak & Co., who asserts that corporations still have a ready source of funding for projects that will help the economy grow.

The loss of funding for the leveraged buyouts is a "yawn." Crescenzi said. "Good riddance to LBOs," which add no value to the economy except in the very long run.

In a research note to clients this past week, Crescenzi pointed to several factors that "weigh against the possibility of a broader credit crunch and make it likely that market turmoil will subside and credit formation will return to levels sufficient to power continued economic expansion."

Among Crescenzi's positive factors: Corporations are flush with cash and other highly liquid assets, some $1.7 trillion by one account. Banks are well capitalized. Money-supply growth rates are strong worldwide.

Still, even a skeptic such as Jay Bryson, global economist for Wachovia, acknowledges that "there is a significant risk that credit availability could become seriously impaired."

In a genuine credit crunch, Bryson explained, lenders broadly curtail credit - including for well-qualified borrowers. In such a scenario -- even if interest rates were to come down - the supply of credit wouldn't match the level of demand.

"Credit is the mother's milk of economic expansion," said Mark Zandi, chief economist for Moody's Economy.com.