Latest Economic Threat: Optimism

5 things that could still go very wrong with the economy

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While explaining his bank-bailout plan before Congress recently, Treasury Secretary Tim Geithner fielded a skeptical question: “What’s the backup plan?” asked one member of Congress. “If everything fails, what do we do?”

“This plan will work,” Geithner answered. “We just need to keep at it.”

Here’s one way to interpret that: There is no backup plan. If everything fails, we’ll be stuck in a financial quagmire for years.

[See more companies at risk of failing.]

But Tim Geithner is an optimist, and for the moment he’s riding a minor swell of optimism over the economy. In a recent New York Times poll, just 34 percent of respondents felt the economy is getting worse, down from 54 percent in December. In January, just 7 percent of people thought the economy was getting better. Now it’s 20 percent.

Economic readings, too, show a few signs of life. Car and home sales have inched up. Lenders have loosened tight credit standards. Employment reports have been lousy – but no worse than expected (which amounts to good news these days.) Plus, Washington’s big stimulus plan is finally kicking in. And of course the stock markets have bounced back to the heady levels of … two months ago.

[See how bailouts can butcher capitalism.]

Well, it’s better than nothing. But the jury’s still out on whether the recent rise in the markets is a genuine recovery or a sucker’s rally, and you could say the same thing about the broader economy. Here are some of the biggest things that could still go wrong.

The bank-bailout plan doesn’t work. Geithner has devised a clever way to start buying up those notorious “toxic assets” that have caused deep losses at banks like Citigroup, Bank of America and Wells Fargo, without the political firestorm that would erupt if the government just bought the rotten assets outright. But his public-private partnership idea has lots of loopholes and might still produce some unsavory results, like outsized profits for rich investors at taxpayer expense. “There are a lot of ways this could be gamed,” says Dirk van Dijk, director of research at Zacks Invesment Research. “There’s enormous potential for collusion.”

The basic problem is that massive amounts of housing-related securities held by banks are worth just a fraction of their face value. And the banks are so short of cash already that if they sold those at market value – which right now is about 30 cents on the dollar – the losses would be so great that many banks would instantly become insolvent.

[See how secrecy could wreck Geithner’s bank-rescue plan.]

Geithner’s plan basically aims to subsidize the price of those securities, by putting the government on the hook for most of the losses if buyers overpay. But even that may not be enough to overcome the huge gap between fair market value and the banks’ asking price – a gap of perhaps 40 or 50 percentage points. “That could lead to a market that doesn’t have a lot of activity,” says van Dijk. A few months from now, the government may have no choice but to revisit an ugly option it has dodged so far: Bank nationalization.

The government might still have to take over a bunch of big banks. If the public-private investors don’t buy up a meaningful amount of mortgage-backed securities from the banks, then they’ll still have ticking time bombs sitting on their balance sheets. At some point, regulators may have no choice but to force the banks to declare the losses instead of pushing them into the future indefinitely. That would require the banks to come up with more capital to cover the losses. If they couldn’t, they’d have to ask the government for more bailout money.

[See why the markets hate the idea of bank nationalization.]

Would politicians say yes, acutely aware of the rising ire of bailout-weary voters? And could they plausibly give more money to banks after sending GM and Chrysler on a path toward possible bankruptcy? Bet against it. And if the feds start taking over banks, the stock markets will tank, since nationalization means the stock becomes worthless. Fear over who’s next could depress stock values for months.

Overoptimism. Part of the problem through the recession so far has been unrealistic expectations - about a quick return to a normal economy, government intervention that will make everything right, the belief that we’ve outsmarted the business cycle. One reason consumer confidence is dismal is that expectations have repeatedly been set too high, producing deep disappointment when happy days refuse to materialize on the timetable we prefer. Some of our economic problems are profound, and will take years to work out. Expecting otherwise is a setup for more disappointment.

[See why the GM bailout is a good model for troubled banks.]

Consumers stop shopping. Despite huge declines in net worth and deep worries over jobs, consumers have continued to spend at a decent rate. That’s why there’s some hope that sales of cars and other costly items will pick up later in 2009. But it could easily go the other direction. “I'm still shocked at how cavalier the market was about [the latest] jobs report,” wrote Charles Payne, CEO of the research firm Wall Street Strategies, in a note to clients. With more than half a million people losing their jobs every month, that means “more people [who] will be living off savings, could soon foreclose, and will certainly not be buying anything like flat screen televisions and automobiles.” American consumers may be the most resilient in the world, but optimism tends to decline along with cash flow.

Jobs don’t return quickly. No matter how buoyant the stock market, the employment outlook is grim. The economy has already lost 5 million jobs since the recession started, and the final tally could be 7.5 million or more. Startling job-loss numbers will most likely continue for the next several months, with the unemployment rate rising from 8.5 percent now to 10 percent or higher a year from now, when many economists think it will peak. The optimistic scenarios call for job losses to moderate by this summer. “If that doesn’t happen,” said Mark Zandi of Moody’s Economy.com in a recent podcast, “then the recession will extend to 2010 and policymakers will have to go to Plan B for everything.” Uh-oh.

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Geithner, Tim
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  • Rick Newman

    Rick Newman is the author of Rebounders: How Winners Pivot From Setback to Success and the co-author of two other books. Follow him on Twitter or e-mail him at rnewman@usnews.com.

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