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Now that policy makers worldwide have finally stepped in to stop the bleeding, we have had a relief rally of monumental proportions. Most global indices were deep into oversold territory, meaning that there was lots of pent-up demand for a turn to the upside. A big rally to the upside was baked into the cards. However, these are purely technical factors and they have no relationship to the underlying fundamentals of the economy.

The coordinated actions this past week mark the end of the ‘acute’ phase of the credit crisis. This is now over. But, we will be left with the ‘chronic’ problems of slowing growth that include global rebalancing, increasing savings, purging excess debt and leverage and running out the clock on this recession. In this chronic phase, the question is how deep and how long the recession will be. And, I believe these questions will start to take center stage before long.

I was reading a blurb in the NY Times that reminded me of the so-called real economy that I anticipate will move center stage shortly. The article was about the home retailer Linens-n-Things, a company I see as a poster child for the deadweight loss we wish to avoid in this downturn.

The retailer, which initially struggled amid a housing slowdown and a decline in consumer discretionary spending, was finally taken down by a credit crisis that prevented possible buyers from getting the credit to fund a purchase.

“If capital markets weren’t so tight, I think this chain might possibly have survived,” Mr. Schaye told Reuters. “There’s just no financing to do these deals at all.”

The company had filed for bankruptcy protection in May and has already closed more than 100 stores. It had been under pressure from its creditors to rush closing its remaining 371 stores, according to court documents.

As of Dec. 31, the company was one of the largest purchasers of home furnishings in the United States, employed some 17,500 people and had a vendor base of about 1,000 suppliers, according to court documents. At that time, the company was operating 589 stores in 47 states and seven Canadian provinces.

But the sharp decline in the housing market and a slump in consumer discretionary spending undermined the company’s ability to pay its suppliers.

And though some investors were interested in buying the company, they were hindered by the lack of ability to borrow money, Mr. Schaye told Reuters.

“I actually thought there were going to be a couple of people who would (submit an offer) at the 11th hour, but they just didn’t get there,” he said.
NY Times

You will notice that this is a company that could have and should have continued as going concern, even in a garden variety recession. However, excessive leverage and a credit crisis caused it to be liquidated, and now 17,500 people will be unemployed.

This scenario will be repeated in numerous places in North America, Europe, Japan, and ANZ — and will serve as notice that it is the real economy where we work and live that sustains the economy.

Undoubtedly, the United States is in recession. The likes of Paul Krugman and Paul Volcker have said so. But, I like to think of recession not as a state, but a change in state (and certainly not a state of mind as U.S. politician and McCain advisor Phil Gramm has offered).

Recession is like decelerating in your car from 100 to 40. But, it could easily be like going from 70 to 20. It is the change in economic growth that makes recession, not the absolute level of growth. When an economy slows from 7% growth to 2% growth, that is recession as much as slowing from 4% to -1%. In fact, when we talk about fast-growing emerging economies like China, we are talking about slowing down from 10% breakneck growth to a 5% amazing-for-us-but-not-for-China kind of growth. Five percent growth is a recession in China.

So, that begs the question, what clues should we be looking for to know how we’re doing going forward then? It’s the four horsemen of the economy:

  1. How much we spend: retail sales
  2. How much we earn: real earnings growth
  3. How much we make: industrial production
  4. How much we work: employment

Right now, the data for the U.S. and much of Central and Western Europe as well as for New Zealand, Singapore and Japan point to recession. However, that could always change. My analysis says that this global recession will last until at least late 2009 and this will be the deepest recession in post World War II history. Nevertheless, its depth and duration are still somewhat dependent on policy responses globally. Purging debt, increasing savings and bringing the shadow banking system to heal would all be positive developments in making this recession as quick as possible.

Now that the acute phase of the credit crisis is coming to an end, expect to see a lot of data here in the coming days and weeks on the four horsemen of the economy. The data should help us understand where things are headed.

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