naked capitalism

The Wall Street Journal so often presents the optimistic case that it’s important to reinforce those occasions when it provides a less than cheery view. Of course, a journalist is only as good as his sources, and the bullish bias is in large measure due to the insistent upbeat posture of CEOs and sell-side analysts who are oft quoted in the business press.

The Journal even went so far as to give two separate cautionary messages. The first was in “Bulls’ Optimism May Be Premature,” which warned that while first quarter earnings so far had exceeded expectations, fourth-quarter estimates looked a tad unrealistic:

First-quarter earnings-per-share are on track to post a 15% decline from a year earlier, according to Thomson Reuters. Yet analysts still expect earnings to be up 10% for the full year. That translates into a slight loss in the second quarter, solid earnings growth in the third quarter and a fourth quarter that would be the most profitable in history.

Thomas Lee, equity strategist at J.P. Morgan Chase & Co., thinks expectations for the fourth quarter are too high. The consensus forecast of roughly $93 a share for the Standard & Poor’s 500 stock index as a whole would amount to “unprecedented profitability,” he says. Meanwhile, the only two sectors that have posted record profits are energy and materials, which combined contribute just one quarter of all the profits from companies in the S&P 500.

The companion dose of sobriety came from Greg Ip in “Economy May Face Prolonged Pain, History Suggests.” While Ip no doubt read the Kenneth Rogoff/Carmen Reinhart paper on financial crises, which looked at eighteen countries that had suffered financial crises. They concluded the US situation bore a strong resemblance to the worst five, and their progress indicate that the worst is yet to come for the US.

Ip, who is widely believed to have privileged access to the Fed (and is therefore also believed to carry messages from it) focused on the similarities to the 1997 crisis in South Korea. Even though the narrow financial crisis was resolved rather quickly, the damage to the economy was severe and sustained, with growth failing to return to its pre-trauma level. Note he also made a surprisingly bald statement about the Fed’s worries at the end:

The economic fallout from a crisis depends on how much underlying economic factors — such as consumption, investment and asset prices — are out of whack with their fundamental determinants. The 1987 stock-market crash and the near-collapse of hedge fund Long Term Capital Management in 1998 threatened the heart of the financial system. But the underlying imbalances were largely limited to the financial markets themselves: stocks overvalued relative to earnings in 1987, and excessive hedge-fund borrowing in 1998. Thus, once the Federal Reserve’s rescue operations had mitigated the threat to the financial system, the economic fallout was limited.

The current crisis is different. For several years, U.S. home prices and home construction kept climbing past levels considered sustainable. Homes became collateral for trillions of dollars in borrowing. That depressed savings, inflated consumption, fueled rapid lending and loosened loan standards.

When home prices stopped rising, the diciest mortgages began to default, triggering the crisis. But even now, prices are above most estimates of sustainable levels, and household saving has barely picked up….

For a parallel, the U.S. might look to South Korea. Its financial crisis peaked on Dec. 24, 1997, when its currency, the won, hit a record low against the dollar…..Over the ensuing year, the won rose 63%. But the Korean economy sank into a deep recession. In 13 months, the jobless rate soared to 7.9% from 3%. The economy shrank 6% in 1998, a huge shock to a country accustomed to 8% growth.

Korea’s economy had been bolstered for years by overinvestment by its chaebols, or industrial conglomerates….

But in early 1997, several chaebols, which had been losing competitiveness, began to experience difficulties. When Korean banks lost their ability to borrow overseas, many failed; those that survived severely cut back lending. The chaebols slashed investment and laid off thousands. Many went bankrupt. Layoffs and recession were a shock to Koreans who “were so used to high growth and very low levels of unemployment,” Mr. Kim says.

Ted Truman, a scholar at the Peterson Institute for International Economics who worked on the Korean rescue as a Fed official, says the overexpansion and excessive borrowing of Korea’s corporate sector in the run-up to its crisis are analogous to the overexpansion of housing and consumption in the U.S. in its crisis. In each case, a collapse in the affected sector severely wounded the financial system. Korea’s recovery was led by exports, much as exports are proving a cushion to the U.S. now.

Korea’s recovery began in 1999. Mr. Kim says that capital investment never fully recovered and that economic growth, while a healthy 4% to 5%, hasn’t returned to the precrisis pace. Unemployment is deceptively low, he says, because of hidden unemployment, such as students who can’t find jobs staying in school. Korea’s lesson to the U.S., he says, is that “imbalances must be corrected.” A recovery doesn’t need a full resolution of those imbalances, he says, only a “convincing sign that change is taking place.”

The risk for the U.S. is that weakness goes beyond the correction of housing excesses and begins to feed back into the financial system and then, again, hurts the wider economy.

By contrast, says Nouriel Roubini, an economist who heads RGE Monitor, a financial- and economic-forecasting service, the U.S. financial system has adjusted only to the losses on mortgage loans. He predicts that a wave of defaults on industrial loans, municipal bonds and consumer credit is coming, which will trigger another wave of financial-system distress.

Fed Chairman Ben Bernanke believes such feedback effects are what made the Great Depression great. Mr. Bernanke’s awareness of such risks is why he cut rates last week and, despite signaling a pause, is still focused on the risks that the U.S. economy may deteriorate further.