How Long Will The Recession Last?

Recession is coming. The only questions are how long and deep it goes. That was a consensus among six economists gathered at MIT Thursday to discuss the meltdown.

I want to highlight the remarks of Simon Johnson, a former chief economist at the International Monetary Fund who is now a professor of entrepreneurship at MIT.

He called the last two weeks stunning.

"Two and a half weeks ago ... the people who run this economy were still telling you and everyone else that the fundamentals of the American economy were fine. They didn't mean long-term productivity, they meant we were going to avoid a recession.

Two weeks ago they said they'd like 5 percent of GDP in small unmarked bills placed outside Mr. Paulson's office.

I do not know anyone alive who has ever seen this happen in this country. This doesn't happen in the United States of America. This happens in other countries."

Johnson blames consumer bank runs and at least some of the nervousness in the commercial banking market on what he calls a "fundamental" breakdown in communications, and a "failure of economic leadership that is absolutely stunning."

He says the key to preventing an economic crisis that might possibly be worse than the Great Depression is to restore confidence in the banking system. To do that, he says, requires four things:

1) Stop the runs. He says upping deposit insurance to $250,000 is okay, but better would be a simple blank guarantee that every deposit will be covered (which in fact the FDIC has always done). This is paramount. Until confidence stabilizes, he argues it is premature to try to fix the system.

2) Once confidence is restored, the government must address the issue of bank capital, an find a way to inject capital into financial institutions.

3) After confidence is restored and the banks recapitalized, then a very big fiscal stimulus package can be assembled and applied to the broader economy, to help bring it out of what may be a very deep recession.

4) The Death Spiral of mortgage defaults and foreclosures will continue to happen, and he says we're a year past the market's ability to solve this problem. The government has to step in and limit the losses from foreclosure. It will probably take two to three years to deal with the problem of bad mortgages.

Simon also stressed that the crisis is global, or at least Western. Ireland saw a bank run this week, and Italy saw pressure on its banks. He told the crowd gathered at MIT's Sloan School that Europe, in fact, was in far worse shape than the U.S. because it was in denial. "If you think Washington is in disarray, compared to Europe it's making a serious attempt to get people's heads around the issue and address the reality," he said.

Simon has posted a Web site about the crisis, baseline scenario, in which he expands on these points and debunks conventional wisdom about the current crisis. It's an interesting read -- and chilling.

I focused on his remarks because he addressed the possible solution, and spoke after the other four economists on the panel had discussed aspects of how things got this bad all of a sudden, after bumping along for close to a year. One spoke on the absurd rise in real estate values over the last decade, another on why it was so hard to tell what mortgage-backed securities are worth, a third on why fair value accounting isn't really at fault, and the fourth on issues in the financial system that exacerbated problems. They were all generally understandable, and if I can find a link to a video of the discussion, I'll post it.

The bottom line is that none of these economists seemed to think we were anywhere near being out of the woods. In fact, more than one freely professed that it was impossible to tell how bad things were because it was still impossible to figure out just what mortgage-backed securities were worth, if anything. There is not one underlying cause to the collapse of the financial system, save perhaps fear. It is, as I noted last week, caught up in an information cascade that it seems unable to escape.

But Andrew Lo, the MIT economist who was the moderator of the panel, closed on an optimistic note, sort of:

"For months and possibly years we'll be in recession....(But) U.S household net worth is $53 trillion. We will get through this."