Don't let the recent economic numbers showing 3% + GDP growth in the US fool you. That number was a blip, primarily caused by the cash for clunkers subsidy. Things are a lot worse, and will be a lot worse - and here's why.
The stock market is considerably over-valued and will go through a significant decline. As of today, the Dow is around 9,700 and the S&P 500 is 1,036. Based on my criteria for fair value (Graham-Dodd value investing style) - we need to see at least a 20%-30% decline before we're in that territory. The reason I need to see a significant decline in valuations in order to see value is simple.
A stock is traditionally valued by determining the present value of future earning and assigning a multiple to those earnings to come to a stock price. But, both parts of this equation show that stocks are significantly overvalued. Future earnings look to be significantly lower. With credit contracting, consumers must defer spending in order to service debt, depressing earnings. With taxes, both personal and corporate going up in the future to pay for massive government spending, deficits, and entitlements - this will depress both consumer spending. It will also be a double hit for companies as not only do they get hit with lower sales due to depressed spending from taxes, and higher corporate taxes will lower earnings.
Second, inflation - which will happen - as you cannot print all this money to finance massive deficits without eventually causing it, will require a higher discount rate - thus depressing the net present value of earnings. Third, higher interest rates that are a result of inflation will also increase borrowing costs and thus lower earnings as well. Finally, with inflation being a long term issue, bond yields will eventually have to rise to account for this. This will depress the earnings multiple as it is directly related to interest rates. Low interest rates mean that earnings yield (the inverse of P/E) will be low. High interest rates mean that P/Es must drop. If long term Treasury rates hit 10% for example, the earnings yield on stocks must be at least 10% to compensate for the risks of owning stocks. This would imply a P/E of 10. Currently, the S&P 500 has a P/E of 15.44 - so with the outlook for interest rates going up - and earnings being depressed, the market will eventually have to drop significantly to reflect this reality.
Many more banks need to fail in order to get his financial mess cleaned up. The Treasury's actions in propping up de facto insolvent banks will only delay the inevitable. When you look at many of the largest banks, and you bring the liabilities for they bad CDOs back on the books, many of them are technically insolvent. What needs to happen is that bondholders for these banks need to have their debts converted into equity in order to shore up the capital to cushion these losses. Alas, the Treasury and Obama administration seem loathe to force conversions or resolutions of these Zombie banks . These inefficient banks are sucking up capital that can be better deployed better by well run banks that did not make these foolish risks.
Instead, we are now have a cabal of large banks that have the government privilege of being "too big to fail". They will have an implicit advantage in their funding costs due to their preference, and they will be able to take on additional risky behavior due to this preference. This will come at a cost to the economy as a whole, as capital will be inefficiently used to prop them up that could be used to fund other ventures.
Couple these facts with a Federal reserve that is abrogating its duties to provide a sound currency and a Congress intent on creating a welfare state via the printing press - things look pretty bleak in the near term.
The solutions, albeit unpleasant, are simple:
It is apparent that we cannot trust people with the responsibility of being guardians of currency. Fiat currency run by bureaucrats in a central bank have devastated wealth over the past century. The since the inception of the Federal Reserve in 1913 - the U.S. dollar has lost 95% of its value. Same story for the Pound Sterling. We should not be ascribing oracle like powers to men like Alan Greenspan, nor any bureaucrat. We need to go back to a gold standard. The gold standard tempers politicians. When money is backed by gold - politicians cannot print debt recklessly to bribe the electorate. If a government issues too much debt, bondholders can start demanding payment in gold rather than paper - depleting a nation's reserves. We would never be in hock to China as we are now if we had to worry about them one day demanding all our gold in lieu of paper. Gold means that politician and bureaucrats cannot debase currency and lower our standards of living. A gold standard forces governments to live within its means.
If we need a financial regulatory regime - we need to scrap the complex BASEL II schemes. BASEL II allows financial institutions to game the models, allowing excessive risk to be taken. The model itself is flawed - just due to the fact that people are not rational all the time. Complex regulation create regulatory capture, with the revolving door of experts moving back and forth between government and industry, lining their pockets at each step. Today, for all intents and purposes, the U.S. Treasury department and Federal Reserve is an agent of Goldman Sachs. Rather than make more and more complex rules - let's make a simple set of rules that apply to everyone. Simple rules for capital, and what activities may be allowed in order for a institution to be eligible for deposit insurance. Those activities not listed are not allowed and may be pursued by other firms at their own risk - if the screw up, let them fail.
Finally, we need a massive rollback on the scope of the government. A nation created on the notion of free-born citizens, free to succeed or fail and live their lives as they see fit - does not need a government that promises them a utopia free of pain or risk. This means rolling back entitlements, regulation, and the related spending. We need to remove the ability of politician and bureaucrats to meddle in private arrangements, and the opportunity for favoritism by special interests.
We can fix this now, when it will hurt a good bit, or we can fix it later, when it will be a lot more painful. Like it or not, it will need to be fixed, because all of this is not sustainable.