The Downturnaround Is Here

Photo: Jamie Grill/Getty Images

How do you feel about the economy today? A little worse, maybe, than you did two weeks ago? But a lot better than you did in March? Things feel better to me too, but I can’t explain exactly why. It might be because for most of last fall, I walked around in an apocalyptic trance, and you can’t keep that up forever. I was bewildered by the breadth and intensity of the financial crisis. Among other odd behavior, I convinced myself that if I learned everything there is to know about things like credit-default swaps and “Pick a Pay” Option ARMS, I could defend myself against a dysfunctional future.

I crawled out of bed in the morning and checked the futures on Bloomberg. I read stories about Australian consumer confidence (going down!) and German business confidence (going down!). I stayed up late reading forecasts, mesmerized by the most severe points of view: Nouriel Roubini, the NYU professor hailed as a prophet for braving unpopularity and predicting the collapse years before it happened; Paul Krugman, the Times columnist who went from ritualistically bashing Bush to ritualistically bashing Obama’s bailouts; and cranks who believe the massive leveraging of the American economy will end in the obliteration of civil society. It was just pessimism porn, but I couldn’t get enough of it.

Then, suddenly, in late March, the clouds began to part. The stock market was up, spring was in the air, and I wasn’t overhearing quite as many of those anxious conversations in restaurants about the end times. Even my favorite doomsayers lightened up a bit. Roubini modified his most-dire predictions, calling the chances of a global depression slim. At a conference in Abu Dhabi, Krugman endorsed the new consensus that “the worst is behind us.” Though it’s been subjected to ample rebuttal, as well as ridicule, Federal Reserve chairman Benjamin Bernanke’s declaration in March that he detected “green shoots” of growth in the economy did help turn the tide of negativity. Now observers skim the good news off the surface of the bad: “smaller minus signs,” a “not-so-awful report,” jobless claims showing a “decelerating pace of decline,” corporate earnings “exceeding reduced expectations,” a real-estate market exhibiting “a lessening of adverse adjustment in value,” a world economy at “an inflection point.” The stock-market trough in March became enshrined as “the buying opportunity of a lifetime.” On CNBC, Larry Kudlow put it in terms his viewers could understand: “I’m just an outright bullish humanoid.”

My hysteria had dissipated as well, but I couldn’t fully embrace the religion of recovery. After all, the shops I pass on my way to work seem no busier than they were in November, and many have closed; friends are still losing jobs, to say nothing of the horrifying national jobless statistics; and I get creeped out by all the condo towers still under construction, the toxic assets of tomorrow. The news is often baffling. When the Treasury Department’s “stress tests” revealed that Bank of America needed to raise $34 billion, I was amazed to see the stock soar. I e-mailed a friend who trades distressed securities and asked him to explain it. “Defies the imagination,” he wrote back. “Funny thing is, we think the hole is at least twice that much.”


Just as troubling as all this bad economic news is the immense uncertainty that comes with it. Are we in a recovery or aren’t we? And what does that mean anyway? I went in search of an informed outlook I could believe in, talking to as many forecasters as I could, and zeroing in on four who have a demonstrated track record of getting things right and not merely indulging in the fashionable positions of the moment. Perhaps I shouldn’t have been surprised that they didn’t agree on much.

The Recovery Is at Hand!

Illustration by Kevin Christy
Robert Gordon

Robert Gordon is no doofus optimist. In fact, the 68-year-old economics professor at Northwestern University says he used to be known as the school’s “house pessimist.” As the real-estate bubble developed, he warned his students that Americans could not indefinitely fund their lives by withdrawing equity from their homes. By 2007, he had grown so nervous about the trajectory of the economy, he says, that he removed his retirement savings from the stock market.

But lately, he’s been buying stocks. Recovery, he believes, is well on its way, a view that reflects what has become the mainstream consensus and spurred many investors to pour money back into the stock market. But it’s particularly significant coming from Gordon, who sits on the National Bureau of Economic Research’s business-cycle dating committee, which will eventually decide when this recession formally comes to an end.

Photo: Terry Donnelly/Getty Images

The standard measure of an economy is gross domestic product, calculated by adding spending (including government spending) and investment plus net exports. In the fourth quarter of last year and the first of this year, U.S. GDP contracted at an annual rate of more than 6 percent, enough to send shock waves of insecurity through every sector of the economy. The initial pullback was largely caused by a precipitous drop in consumer spending—the combination of a faltering national housing market and the suddenly imploding financial sector turned the formerly hardy American buyer into a wounded beast virtually overnight. Expenditures greater than the cost of a bag of groceries vaporized, causing business investment to plummet and accelerating layoffs. Bam bam bam. You know the story; you lived through it.

But a promising sign emerged in the first quarter of this year, Gordon says. Consumer spending not only stopped falling, it perked up slightly. It wasn’t nearly enough to keep the GDP from continuing to fall, but it convinced Gordon that the economy wouldn’t remain in a tailspin for long. He cites three factors as contributing to stability and positive GDP growth in the near term. The first is the restocking of inventories, which plunged to record low levels as companies slashed production of goods in response to sharply reduced consumer demand. This is one of the basic engines of a normal cyclical recovery. After cutting back too much, companies adjust to their present circumstances and make new orders.

The second factor is real estate. Though prices continue to sag nationally and foreclosures rose in April, there is significant sales activity in the crushed, low-end markets in Florida and California. Whether this is quite the bottom or not, says Gordon, doesn’t matter. What’s important is that the sales are putting people back to work in the real-estate and lending businesses.

Finally, there’s the automobile industry. It’s hard to imagine any good news out of Detroit at this point, but Gordon says it’s coming. Before the recession, annual U.S. automobile sales were about 18 million vehicles. They’ve dropped to half that, an insanely low—and unsustainable—level. At this rate, the average car would have to last 25 years. A typical replacement rate would boost auto sales up to around 15 million a year, and Gordon expects that we’ll start working our way back to that figure this year, buoying the stronger auto companies and putting workers back on the line.

“This is a normal process,” he says. “The economy finds its own bottom. The credit problems are in the process of being fixed.” Yes, American consumers will have to save more and pay down more debts, but this does not lead to breadlines. The financial crisis has been overblown, he believes, obscuring serious problems, like the drug war in Mexico, that will require imaginative, forceful policymaking. Though he expects that the recovery will be slowed by elevated savings rates—because Americans won’t have the value of their homes to fall back on—and that unemployment will take years to retreat to its prebust levels, even the modest improvements will provide a psychological lift. He says he gets the daily e-mail newsletter from RGE Monitor, Nouriel Roubini’s research arm, and he’s noticed a marked “softening” in its tone. “These guys aren’t so sure of anything anymore,” he says. “They had their moment, and they’re going to be embarrassed when it turns around.”

Gordon’s outlook is attractive in its simplicity and lack of pretension. But I couldn’t help but wonder if our present circumstances defy the economic conventions Gordon puts his faith in. Maybe the vast surplus of housing in remote areas of California and Florida will never be fully absorbed. Maybe more people will drive twenty-year-old cars. Sometimes the trajectory of history gets permanently bent.

Gordon discounts these concerns and tries to put me at ease, suggesting that I distract myself from the day-to-day volatility of the market. “The S&P will be over 1,000 at the end of the year”—it’s at about 900 now, dipping below 700 at its lowest—“and we’ll be happily sitting around the Christmas tree,” he says. “It won’t be like last Christmas.”

No, the Recovery Is Not at Hand!

Illustration by Kevin Christy
Gary Shilling

Economist Gary Shilling’s view of next Christmas, on the other hand, isn’t so cheery. The economy won’t stagger back to its feet, he predicts, until around the middle of next year. And even then, growth will be weak, unemployment will be high, and chronic uncertainty about the future will continue to plague us.

Before you dismiss Shilling as a Scrooge, take a look at the thirteen “investment strategies” he recommended in the January 2008 issue of his newsletter Insight. Remember what New York City felt like then? Bear Stearns was trading at 70 bucks a share. The unemployment rate was below 5 percent. European tourists thronged Soho, slapping down plastic for all manner of distressed denim. Life felt normal, or at least what passed for normal back then.

Photo: Stephen Frink/Getty Images

Here’s what Shilling recommended doing with your money:

1. Sell or short homebuilder stocks.

2. If you plan to sell your home, second home, or investment houses anytime soon, do so yesterday.

3. Short subprime mortgages.

4. Sell or short housing-related stocks.

5. Sell or short consumer discretionary-spending companies.

6. Sell low-grade fixed-income securities.

7. Sell or avoid most commercial real estate.

8. Short commodities.

9. Sell or short emerging-market equities.

10. Sell emerging-country bonds.

11. Buy the dollar before long.

12. Sell or short U.S. stocks in general.

13. Buy long Treasury bonds.

If you ever wondered why some people pay $1,000 a year for a monthly newsletter with no pretty pictures, well, now you know. Shilling was an astonishing thirteen for thirteen on his recommendations.

Shilling is 72 years old and works out of a squat office building in Springfield, New Jersey, where he takes his yellow Labrador retriever to work. A beekeeper in his spare time, he’s a small-town Ohio boy who studied physics at Amherst, received a Ph.D. in economics from Stanford, and went to work as an economist on Wall Street in the go-go sixties. He is not a doomsayer, but he does have a pessimistic streak: Donald Regan, who later served as Treasury secretary and White House chief of staff under Ronald Reagan, fired Shilling not once but twice for failing to be sufficiently optimistic about the U.S. economy.

Shilling concedes that it’s quite possible that GDP growth will briefly tick positive, driven by the mere refilling of inventories and modest relief from epic declines in consumer spending. Optimists might hail this moment as the great recovery come at last, but Shilling warns us not to be fooled.

The recovery will hardly feel like one, because the American consumer is changing. “Consumers are going on a savings spree for the first time in 25 years,” he says. “They’ve run out of borrowing power. They relied on their stocks in the eighties and nineties to put their kids through college, early retirement, a few trips around the world. That’s over.”

Housing prices, meanwhile, will continue to drop, says Shilling, dragged down by the massive inventory of unsold homes. And we will endure several more iterations of the government’s bank rescue, as the problems ascend the financial food chain—the trickle-up recession. What started in subprime mortgages is now wreaking havoc on prime borrowers.

The main feature in Shilling’s vision of the future is deflation. Owing to the overwhelming supply of goods, prices must come down, making it difficult for companies to manage their costs. So, for the first time since the Depression, U.S. companies are not only cutting jobs, they’re cutting wages. The average person can’t look five years into the future and realistically project himself as making 25 or 50 percent more. Of course, the upside of that is that prices won’t rise, either, so the cost of living should remain stable or decline. But it won’t inspire much in the way of confidence in the average wage earner. Inflation eases the burden of debt; deflation makes it hell—because while your income goes down and the value of your assets fall, your monthly mortgage payment doesn’t budge.

Deflation is widely considered the major threat to economic prosperity, a primary cause of the Great Depression. And it’s true that acute deflation can be disastrous—when prices fall quickly, consumers put off buying anything significant. If you know that cashmere sweater is eventually going to be 50 percent off, you’ll wait for that to happen. In the meantime, most of the stores that sell cashmere sweaters go broke.

But Shilling has long understood deflation as the basic and mostly benign operating condition of the highly competitive, technologically innovative U.S. economy, alleviated only by “shooting wars,” like Vietnam, when government spending tips the economy into inflation. We shouldn’t be so frightened of deflation, he says; it merely requires us to recalibrate our ideas about certain things, like that real estate automatically appreciates in value. The recent market collapse has certainly helped many of us understand that.

According to Shilling, the transition to this new era of reduced expectation shouldn’t be too awful for most people. “Americans have a lot of frills in their lives they can cut without going hungry,” he says. “The drinking water in this country is clean and safe, so why people pay for bottled water, I have no idea. They’ll take vacations closer to home; what’s the big deal about that? There are things we have gotten used to that won’t be that hard to do without.”

But adapting to a chronically slow-growth economy may be more difficult for New Yorkers because the city has profited from three powerful trends that Shilling sees coming to an abrupt end: a relatively cheap dollar that drew tourists and overseas investment, loosening of trade restrictions that encouraged money to zip freely around the world, and deregulation that allowed financial firms to leverage up and massively compensate their executives. Shiller forecasts a stronger dollar amid global weakness (“the best-looking horse in the glue factory,” as one currency expert puts it), a new era of protectionism as governments respond to internal political discontent, and a federal clampdown on Wall Street.

Photo: Joseph Van Os/Getty Images

Perhaps I’m primed to believe Shilling’s more negative predictions, but they do seem convincing. While oil has started to climb again, and many analysts warn that hyperinflation is right around the corner, many prices are falling—houses, cars, shoes, handbags. Fabulous time to be a shopper, but as producers, which we all are, in one way or another, we suffer. After talking to Shilling, I feel like recovery in New York will be a slow grind, indeed—like a marathon, but not the kind run by Kenyans. More like the kind run by Vinnie from Queens, puking the last ten miles but eventually crossing the finish line.

Yes, a Recovery Is at Hand, but It’s a Fake!

Illustration by Kevin Christy
Jeremy Grantham

Like Shilling, Jeremy Grantham entered 2008 bracing himself for the worst. Then again, Grantham is what’s known as a “permabear,” so he’s pretty much always braced for the worst. But what separates Grantham from most permabears is that he manages $78 billion (for the Boston-based firm GMO). Which means that he can’t simply indulge his pessimism-porn fantasies.

Grantham, a 70-year-old Englishman, moved to the United States in the sixties to go to Harvard Business School, then worked as an investment manager before cofounding GMO, in 1977. He is a devout believer that markets always, always, always revert to long-term trend lines, which makes him a curmudgeon during boom times, when prices fly off the charts. His quarterly letter for investors has become a must-read of the stock-market intelligentsia: erudite, witty, and often bristling with moral outrage. For years, his favorite whipping boy was Alan Greenspan, the former Fed chairman, whom he saw as putting the U.S. economy on the road to ruin by allowing the housing and finance bubbles to inflate unchecked. This became the conventional wisdom, but Grantham was slagging him when Greenspan was still a wildly popular sage. According to Grantham, Greenspan understood as early as in 1997 that a bubble was forming but did nothing to temper it. Instead, “he became an efficient market advocate suddenly and started talking about ‘Who am I to disagree with tens of thousands of well-informed investors?’ In other words, the market knows best, which is of course the most sublime bullshit possible.”

Grantham saw an era coming to a shattering conclusion. “We’ve had a very sympathetic marketplace for 25 years,” he told me last May, after Bear Stearns failed, but before Lehman Brothers did. “We’ve had inflation coming down, the Russians folding up their tent, China becoming fully fledged capitalists. India finally cutting through a little of their red tape. It’s been a heavenly environment.”

Grantham has a pet theory he calls “the presidential-cycle effect.” Going back 75 years, he discovered that the stock market tends to perform best in the third year of a presidential term—because that’s when incumbent administrations need to demonstrate to voters that they deserve reelection. So they goose the economy with spending while the “independent” Federal Reserve chairman obliges with rate cuts. In the first year of an administration, the stock market typically does least well, because policymakers save their bullets for closer to the election.

The financial crisis, however, has thrown the presidential cycle out of whack. The need to stabilize the economy and calm nerves has turned Obama’s first year into a “year three”–like environment of low rates and megastimulus. That sets up the stock market to do very well, potentially hitting as high as 1,100 on the S&P by the end of the year, which is consistent with Gordon’s outlook.

But whereas Gordon forecasts relative stability from there, Grantham sees a dramatic pullback and then a long muddling-through period that will be a “life-changing shock for hundreds of millions of people,” he wrote in his May 2009 quarterly letter, titled “The Last Hurrah and Seven Lean Years.” “No longer as rich as we thought—undersaved, underpensioned, and realizing it—we will enter a less indulgent world, if a more realistic one, in which life is to be lived more frugally. Collectively, we will save more, spend less, and waste less. It may not even be a less pleasant world when we get used to it.”

According to Grantham, we have the government bailout to blame for the coming lean years. “If we had let all the reckless bankers go out of business, we would not have blown up our houses or our factories or carted off all our machine tools to Russia, nor would we have machine-gunned any of our educated workforce, even our bankers!” he wrote. “Moral hazard would have been crushed, lessons learned for a generation or two, and assets would be in stronger, more-efficient hands. Real economies are much more resilient than they are given credit for. We allow ourselves to be terrified by the ‘financial-industrial complex,’ as Eisenhower might have said, much to their advantage.”

Photo: Juho Kuva/Getty Images

I find it hard to wrap my mind around Grantham’s vision of a Frugal America. His mathematical case is persuasive, but I suspect Americans will do almost anything not to let it drag on for as long as seven years. We’ll work longer hours, we’ll be more efficient, we’ll scour the Earth for another credit card—anything but climb in a hole like the Japanese after their credit-bubble burst. The recent jump in consumer confidence, heralded as the single greatest monthly uptick in six years, suggests that Americans will take the merest whiff of optimism and inhale deeply.

On the other hand, maybe that’s because we’re clueless knaves who refuse to accept that the free ATM is busted for good.

There Will Be No Recovery!

Illustration by Kevin Christy
Peter Schiff

Grantham’s “seven lean years” have a certain biblical bleakness to them, but there are far bleaker visions out there. Gordon, Shilling, and Grantham all share a fundamental, if somewhat shaken, faith that the difficulties of the U.S. economy are surmountable, given time. Attacking that assumption is the obsession of the Über-bears, of whom the most vehement is 46-year-old Peter Schiff, a stockbroker and former commodities trader. His father, who wrote the 1985 book The Great Income Tax Hoax: Why You Can Immediately Stop Paying This Illegally Enforced Tax, is a libertarian martyr, now serving a thirteen-year prison term for tax evasion. The younger Schiff runs a stock brokerage in Connecticut called Euro Pacific Capital that has been bearish on the U.S. economy for a decade. That should have produced spectacular returns in 2008, except that Schiff didn’t anticipate markets around the world getting clobbered right along with ours, a miscalculation for which he has been savaged in the investing community. As Doug Kass, a columnist for, said of Schiff, “He’s in the Cassandra camp. It’s not a good way to make money.”

Be that as it may, Schiff’s formerly fringe ideas have found mainstream acceptance over the last six months. He’s an excitable character, prone to outbursts on CNBC, but his views have a certain punitive logic that play well on guilty consciences: We’ve had our flush times, now we have to pay for them. “There is no recovery anywhere in sight,” he bellowed over the phone to me. “There is just a bigger and bigger depression. We can’t go back to Americans buying cars they can’t afford and buying houses they can’t afford and buying gadgets they can’t afford and going to overpriced universities. We can’t go back to all the things that got us to where we are.”

Making matters worse is the government, which Schiff says is battling hopelessly to preserve the status quo. Our leaders have learned the wrong lesson from history. His interpretation of the Great Depression is that government intervention hindered recovery, just like it is doing now. “Unemployment’s going to get very high because the government’s making it impossible for companies to be formed to employ people,” he says. “They’re not letting that happen. They’re trying to keep people entrenched in jobs that need to go away.”

The recent market rally is meaningless, the spasmodic last kicks of a dying system. The economy of the last twenty years has been “phony,” he says, conjured out of thin air. Productive elements of the economy have been liquidated and sent overseas in pursuit of a service economy in which nobody makes anything useful. The financial superstructure cannot be maintained, and as it collapses, Americans will have to reconstitute its industrial base, a messy, painful transition that could take twenty years, he estimates, during which time Asia will flourish, leaving us in the dust. Baby-boomers will be denied the retirement of their dreams, forced to work into their seventies and eighties to make ends meet.

There have been moments, I won’t lie, when I have entertained such apocalyptic fantasies. But I pull back from the edge by reminding myself that to agree with Schiff, you have to see the last 50 years of globalization—which has improved the lives of hundreds of millions of people outside the United States. You have to see the likelihood that the rest of world can and will prosper while its largest economy tumbles into a bottomless pit. You have to believe that the Chinese are going to view their vast holdings of U.S. dollars as a “sunk cost” and leave us to ruin. You have to believe that the anti-American sentiments now coursing around the globe represent not just a reaction to the credit crisis and the supreme arrogance of the Bush administration but a permanent shift in opinion.

How did you come to view the world this way? I asked Schiff.

“Well, that’s just the way it is,” he said. “That’s not the way I see it.”

But so many reasonable people disagree, I said. Are they all deluded?

“There are a lot of people who believe crazy things,” he replied. “People have believed crazy things all throughout time. When Galileo said the Earth revolved around the Sun, everybody thought he was crazy. Or when Columbus said the world was round, and they said, ‘Everybody knows the world is flat, what are you, an idiot?’ People can believe stupid things.”

The Recovery Is All in Our Minds.

Last Tuesday, I woke up in Peter Schiff–land. Maybe it was because I’d spent the weekend catching up on recent editions of Christopher Wood’s weekly newsletter, Greed & Fear. Sobering stuff: about the United States’ “appalling” monetary policy, the sustainability of the “countertrend rally,” and a forecast of gold reaching $3,000 an ounce (it’s below $1,000 now). Later that morning, when the new Case-Shiller index was released, indicating that the housing market had not yet hit bottom, my mood soured further.

Then, just an hour or so later, the consumer-confidence figure came in much higher than expected, and markets around the world went bananas. Wednesday morning, in the elevator up to my office, I read on the Captivate Network monitor that 75 percent of business economists predict the recession will be over in the third quarter of this year. That’s like, tomorrow. Sure, the consensus view of economists is often alarmingly wrong. But even .190 hitters don’t strike out every time. Maybe this is their moment. The world was starting to feel more like Robert Gordon–land.

Then I read a June 2009 report from the London outfit Absolute Return Partners: “The poorest two-thirds of U.S. households are effectively bankrupt, and the wealthiest one-third are facing substantial tax hikes. This combination is lethal for U.S. consumer spending, and what is poisonous for U.S. consumers is bad for the global economy.”

For all their expertise and carefully reasoned argument, these economists could not offer me the reassurance I was looking for. In fact, I will admit to simply being more confused than before, and exhausted.

But maybe that’s a good thing.

There is a term that stock-market veterans use to describe what happens to investors at the bottom of a market: capitulation. The idea is that people eventually tire of trying to understand the market. A series of illogical rallies and devastating crashes robs them of all conviction. Trading volume evaporates. People quit believing they have any clue what’s going to happen next. They give up. And then, gradually, a recovery begins. It’s almost imperceptibly slow because everybody’s too busy mowing their lawns and attending their kids’ piano recitals and otherwise trying to forget they ever heard of the stock market.

Perhaps this idea of capitulation applies to the economy as well. Maybe recovery won’t happen until people like me stop asking “Are we there yet?” Maybe the answer I crave won’t be fully understood for years after the fact, so I should just stop looking.

A good plan, except for this: Capitulation isn’t something you can just decide to do. It’s a process that happens to you. My belief that I can know what the world is going to be like tomorrow has to be wrung out of me, like beads of water from a towel.

Until that happens, my approach is a kind of default pessimism—so if the economy tanks, I have the satisfaction of being right; and if it doesn’t, I have the satisfaction of still having my job. Mostly, I’m just trying not to think about it quite so much. With luck, I’ll stop checking the futures on Bloomberg. I’ll read blogs about rock bands and ridiculous celebrities instead. And one day I’ll realize that I haven’t thought about the economy even once, and that’ll tell me the recovery is here.

Bonus Interviews
Niels Jensen on Europe’s Economic Outlook
James Grant on Finding Promising Opportunities
Stephanie Pomboy on Why China Is the New King
Amar Bhide on How the World Will Adjust

The Downturnaround Is Here