D-process Changing Pension Rules?

Stocks slid worldwide, sending the Dow Jones Industrial Average below 7,000 for the first time since 1997, and Treasuries rose after Warren Buffett said the economy is in “shambles” and American International Group Inc. posted the largest corporate loss in U.S. history:

Berkshire Hathaway Inc. fell 4.7 percent following the worst drop in book value in Buffett’s career at the company. Citigroup Inc. tumbled 20 percent as AIG posted a $61.7 billion quarterly loss and HSBC Holdings Plc said it needs to raise capital, triggering the worst plunge in U.K. banks since at least 1985. Exxon Mobil Corp., the world’s biggest company by market value, fell as oil slid 10 percent. General Electric Co. sank below $8 for the first time since 1994.

“You have almost no reason to own a bank stock,” Keith Wirtz, who helps oversee $20 billion as chief investment officer at Fifth Third Bancorp in Cincinnati, told Bloomberg Television. “There is too much turmoil.”

The Dow decreased 299.64 points, or 4.2 percent, to 6,763.29. The Standard & Poor’s 500 Index dropped 4.7 percent to 700.82, the lowest close since October 1996. Europe’s Dow Jones Stoxx 600 Index tumbled 5 percent, its steepest loss in three months. Nineteen stocks fell for each that gained on the New York Stock Exchange, making it the broadest decline in almost three weeks.

Treasuries rose as investors sought a haven, driving the yield on 10-year notes down 10 basis points, the most in almost two weeks, to 2.92 percent. The dollar climbed to the highest level since April 2006 against the currencies of six major U.S. trading partners. Only seven stocks in the S&P 500 rose.

The MSCI World Index of stocks in 23 developed nations fell 4.9 percent to 713.94, the lowest closing level since the Iraq War began in March 2003. The MSCI Emerging Markets Index slid 5 percent, while Hungary’s forint dropped after European Union banks spurned aid pleas for eastern Europe.

The deepening global recession, a third government rescue for Citigroup Inc. and dividend cuts at companies from General Electric Co. to JPMorgan Chase & Co. have dragged the MSCI World Index to three consecutive weeks of declines. The benchmark has fallen 22 percent this year, adding to last year’s 42 percent slump.

Options investors are paying twice this decade’s average to protect against losses in U.S. stocks through 2011, signaling the bear market that already wiped out $10.4 trillion of equity value may last two more years.

Contracts to protect against a drop in the S&P 500 for two years cost $15,160 on the Chicago Board Options Exchange at the end of last week, compared with $6,875 in 2007, according to price-adjusted data compiled by Bloomberg. That shows traders expect the benchmark gauge for U.S. equities to fluctuate twice as much in the next two years as it has since 2000.

“There’s a real panic in the markets, with some people wanting to buy long-term insurance at any price,” said Peter Sorrentino, who helps manage $16 billion, including $130 million in options at Huntington Asset Advisors Inc. in Cincinnati. “People have lost hope.”

Berkshire Hathaway Class B shares lost $120 to $2,444. Berkshire, which owns stakes in companies from Coca-Cola Co. to American Express Co., posted a fifth-straight profit drop, the longest streak of quarterly declines in at least 17 years, on losses from derivative bets tied to stock markets.

Buffett said the economy will be “in shambles” this year, and perhaps longer, before recovering from the reckless lending that caused the worst “freefall” he ever saw in the financial system.

About 12.9 billion shares changed hands on all U.S. exchanges, 33 percent more than the three-month daily average.

The VIX, as the Chicago Board Options Exchange Volatility Index is known, gained 14 percent to 52.65, the most since Jan. 20. The index measures the cost of using options as insurance against declines in the S&P 500.

Financial stocks in the MSCI World Index dropped 6.9 percent, leading all 10 industries lower. Citigroup decreased 20 percent to $1.20.

HSBC tumbled 19 percent to 399 pence, sending a measure of U.K. bank shares down 16 percent, the biggest one-day decline since the index was created in 1985. Europe’s largest bank by market value said it plans to raise 12.5 billion pounds ($17.7 billion) in a rights offer, increasing concern that banks need more capital.

PNC Financial Services Group Inc. slipped 4.5 percent to $26.12. The fifth-largest U.S. bank by deposits slashed its dividend 85 percent, to 10 cents from 66 cents, to save $1 billion amid “extreme market deterioration.”

International Paper Co. had the steepest decline in a month, losing 10 percent to $5.12. The world’s largest maker of cardboard boxes and office paper cut its quarterly dividend to 2.5 cents a share from 25 cents.

Aggregate dividends by S&P 500 companies will fall 23 percent this year, the biggest decline since 1938, S&P predicts. More than 288 U.S. companies cut or suspended payouts last quarter, the most since S&P records began 54 years ago.

GE, once the S&P 500’s biggest dividend payer, slid 11 percent to $7.60. The only stock left in the Dow Jones Industrial Average from its creation in 1896 is adding to investor pessimism as credit analysts threaten to reduce its AAA rating. The company cut its quarterly dividend by 68 percent, to 10 cents from 31 cents, last week.

GE, whose Chief Executive Officer Jeffrey Immelt bought 50,000 shares at $8.26 each today, pushed a measure of industrial stocks in the MSCI World to a 5.5 percent loss.

AIG was unchanged at 42 cents. The insurer deemed too important to fail will get as much as $30 billion in new government aid in a revised bailout after posting a record loss.

“At the beginning of year, everyone expected recovery in the second half of the year,” said Kevin Shacknofsky who helps manage $1.8 billion at Alpine Mutual Funds in Purchase, New York.

“The negative news coming out of the financial sector, the continue weakness in the housing market and disappointment with government policy is pushing the recovery date beyond the second half of year.”

Raw-material producers and energy stocks in the MSCI World Index slid more than 6 percent. The Reuters/Jefferies CRB Index of 19 commodities fell 5.3 percent, the steepest loss since October. Oil retreated $4.61 to settle at $40.15 a barrel on the New York Mercantile Exchange.

Raymond James Financial Inc. cut its forecast for the average price of oil in 2009 by 28 percent to $43 a barrel as the worldwide economic slump cuts consumption.

Exxon, the world’s biggest oil producer, fell 4.4 percent to $64.91. Freeport-McMoRan Copper & Gold Inc., the largest publicly traded copper producer, sank 13 percent to $26.49.

The MSCI EM Eastern Europe Index slumped 3.8 percent to 88.44. European Union leaders rejected requests for a region- wide aid package, bowing to German concerns that it would put too much pressure on budget deficits in western Europe as the economy slumps.

Deere & Co. and Caterpillar Inc. declined more than 9.6 percent after a government report showed spending on U.S. construction projects fell in January more than twice as much as forecast.

The 3.3 percent decline followed a revised 2.4 percent drop the prior month that was larger than previously reported, the Commerce Department said. Economists had forecast construction spending would decrease 1.5 percent, based on a Bloomberg survey of economists.

The market remained lower even after the Institute for Supply Management’s factory index unexpectedly climbed to 35.8 in February from 35.6 the prior month. A reading of 50 is the dividing line between growth and contraction.

In other markets, crude oil dropped below $40 a barrel, extending yesterday’s 10 percent plunge, on increased concerns that a deepening global recession will limit fuel demand.

Gold fell for the sixth straight session, the longest slump since October, as some investors sold the precious metal to cover losses in equity markets. Silver also declined.

The wave of selling has David Spurr asking "When Will the Selling Ever Stop?" while Henry Blodget examines valuations and asks "How Low Can the Market Go?".

I think these are wrong questions to be asking. The financial landscape has fundamentally changed as deleveraging, deflation and debt are causing a long and painful process which Ray Dalio, Chief Investment Officer at Bridgewater Associates, calls the D-process:

Barron's: I can't think of anyone who was earlier in describing the deleveraging and deflationary process that has been happening around the world.

Dalio: Let's call it a "D-process," which is different than a recession, and the only reason that people really don't understand this process is because it happens rarely. Everybody should, at this point, try to understand the depression process by reading about the Great Depression or the Latin American debt crisis or the Japanese experience so that it becomes part of their frame of reference.

Most people didn't live through any of those experiences, and what they have gotten used to is the recession dynamic, and so they are quick to presume the recession dynamic. It is very clear to me that we are in a D-process.

Why are you hesitant to emphasize either the words depression or deflation? Why call it a D-process?

Both of those words have connotations associated with them that can confuse the fact that it is a process that people should try to understand.

You can describe a recession as an economic retraction which occurs when the Federal Reserve tightens monetary policy normally to fight inflation. The cycle continues until the economy weakens enough to bring down the inflation rate, at which time the Federal Reserve eases monetary policy and produces an expansion. We can make it more complicated, but that is a basic simple description of what recessions are and what we have experienced through the post-World War II period. What you also need is a comparable understanding of what a D-process is and why it is different.

You have made the point that only by understanding the process can you combat the problem. Are you confident that we are doing what's essential to combat deflation and a depression?

The D-process is a disease of sorts that is going to run its course.

When I first started seeing the D-process and describing it, it was before it actually started to play out this way. But now you can ask yourself, OK, when was the last time bank stocks went down so much? When was the last time the balance sheet of the Federal Reserve, or any central bank, exploded like it has? When was the last time interest rates went to zero, essentially, making monetary policy as we know it ineffective? When was the last time we had deflation?

The answers to those questions all point to times other than the U.S. post-World War II experience. This was the dynamic that occurred in Japan in the '90s, that occurred in Latin America in the '80s, and that occurred in the Great Depression in the '30s.

Basically what happens is that after a period of time, economies go through a long-term debt cycle -- a dynamic that is self-reinforcing, in which people finance their spending by borrowing and debts rise relative to incomes and, more accurately, debt-service payments rise relative to incomes.

At cycle peaks, assets are bought on leverage at high-enough prices that the cash flows they produce aren't adequate to service the debt. The incomes aren't adequate to service the debt. Then begins the reversal process, and that becomes self-reinforcing, too. In the simplest sense, the country reaches the point when it needs a debt restructuring. General Motors is a metaphor for the United States.

As goes GM, so goes the nation?

The process of bankruptcy or restructuring is necessary to its viability. One way or another, General Motors has to be restructured so that it is a self-sustaining, economically viable entity that people want to lend to again.

This has happened in Latin America regularly. Emerging countries default, and then restructure. It is an essential process to get them economically healthy.

We will go through a giant debt-restructuring, because we either have to bring debt-service payments down so they are low relative to incomes -- the cash flows that are being produced to service them -- or we are going to have to raise incomes by printing a lot of money.

It isn't complicated. It is the same as all bankruptcies, but when it happens pervasively to a country, and the country has a lot of foreign debt denominated in its own currency, it is preferable to print money and devalue.

Isn't the process of restructuring under way in households and at corporations?

They are cutting costs to service the debt. But they haven't yet done much restructuring.

Last year, 2008, was the year of price declines; 2009 and 2010 will be the years of bankruptcies and restructurings. Loans will be written down and assets will be sold.It will be a very difficult time. It is going to surprise a lot of people because many people figure it is bad but still expect, as in all past post-World War II periods, we will come out of it OK.

A lot of difficult questions will be asked of policy makers. The government decision-making mechanism is going to be tested, because different people will have different points of view about what should be done.

What are you suggesting?

An example is the Federal Reserve, which has always been an autonomous institution with the freedom to act as it sees fit. Rep. Barney Frank [a Massachusetts Democrat and chairman of the House Financial Services Committee] is talking about examining the authority of the Federal Reserve, and that raises the specter of the government and Congress trying to run the Federal Reserve. Everybody will be second-guessing everybody else.

So where do things stand in the process of restructuring?

What the Federal Reserve has done and what the Treasury has done, by and large, is to take an existing debt and say they will own it or lend against it. But they haven't said they are going to write down the debt and cut debt payments each month. There has been little in the way of debt relief yet. Very, very few actual mortgages have been restructured. Very little corporate debt has been restructured.

The Federal Reserve, in particular, has done a number of successful things. The Federal Reserve went out and bought or lent against a lot of the debt. That has had the effect of reducing the risk of that debt defaulting, so that is good in a sense. And because the risk of default has gone down, it has forced the interest rate on the debt to go down, and that is good, too.

However, the reason it hasn't actually produced increased credit activity is because the debtors are still too indebted and not able to properly service the debt. Only when those debts are actually written down will we get to the point where we will have credit growth. There is a mortgage debt piece that will need to be restructured. There is a giant financial-sector piece -- banks and investment banks and whatever is left of the financial sector -- that will need to be restructured. There is a corporate piece that will need to be restructured, and then there is a commercial-real-estate piece that will need to be restructured.

Is a restructuring of the banks a starting point?

If you think that restructuring the banks is going to get lending going again and you don't restructure the other pieces -- the mortgage piece, the corporate piece, the real-estate piece -- you are wrong, because they need financially sound entities to lend to, and that won't happen until there are restructurings.

On the issue of the banks, ultimately we need banks because to produce credit we have to have banks. A lot of the banks aren't going to have money, and yet we can't just let them go to nothing; we have got to do something.

But the future of banking is going to be very, very different. The regulators have to decide how banks will operate. That means they will have to nationalize some in some form, but they are going to also have to decide who they protect: the bondholders or the depositors?

Nationalization is the most likely outcome?

There will be substantial nationalization of banks. It is going on now and it will continue. But the same question will be asked even after nationalization: What will happen to the pile of bad stuff?

Let's say we are going to end up with the good-bank/bad-bank concept. The government is going to put a lot of money in -- say $100 billion -- and going to get all the garbage at a leverage of, let's say, 10 to 1. They will have a trillion dollars, but a trillion dollars' worth of garbage. They still aren't marking it down. Does this give you comfort?

Then we have the remaining banks, many of which will be broke. The government will have to recapitalize them. The government will try to seek private money to go in with them, but I don't think they are going to come up with a lot of private money, not nearly the amount needed.

To the extent we are going to have nationalized banks, we will still have the question of how those banks behave. Does Congress say what they should do? Does Congress demand they lend to bad borrowers? There is a reason they aren't lending. So whose money is it, and who is protecting that money?

The biggest issue is that if you look at the borrowers, you don't want to lend to them. The basic problem is that the borrowers had too much debt when their incomes were higher and their asset values were higher. Now net worths have gone down.

Let me give you an example. Roughly speaking, most of commercial real estate and a good deal of private equity was bought on leverage of 3-to-1. Most of it is down by more than one-third, so therefore they have negative net worth. Most of them couldn't service their debt when the cash flows were up, and now the cash flows are a lot lower. If you shouldn't have lent to them before, how can you possibly lend to them now?

I guess I'm thinking of the examples of people and businesses with solid credit records who can't get banks to lend to them.

Those examples exist, but they aren't, by and large, the big picture. There are too many nonviable entities. Big pieces of the economy have to become somehow more viable. This isn't primarily about a lack of liquidity. There are certainly elements of that, but this is basically a structural issue. The '30s were very similar to this.

By the way, in the bear market from 1929 to the bottom, stocks declined 89%, with six rallies of returns of more than 20% -- and most of them produced renewed optimism. But what happened was that the economy continued to weaken with the debt problem. The Hoover administration had the equivalent of today's TARP [Troubled Asset Relief Program] in the Reconstruction Finance Corp. The stimulus program and tax cuts created more spending, and the budget deficit increased.

At the same time, countries around the world encountered a similar kind of thing. England went through then exactly what it is going through now. Just as now, countries couldn't get dollars because of the slowdown in exports, and there was a dollar shortage, as there is now. Efforts were directed at rekindling lending. But they did not rekindle lending. Eventually there were a lot of bankruptcies, which extinguished debt.

In the U.S., a Democratic administration replaced a Republican one and there was a major devaluation and reflation that marked the bottom of the Depression in March 1933.

Where is the U.S. and the rest of the world going to keep getting money to pay for these stimulus packages?

The Federal Reserve is going to have to print money. The deficits will be greater than the savings. So you will see the Federal Reserve buy long-term Treasury bonds, as it did in the Great Depression. We are in a position where that will eventually create a problem for currencies and drive assets to gold.

Are you a fan of gold?

Yes.

Have you always been?

No. Gold is horrible sometimes and great other times. But like any other asset class, everybody always should have a piece of it in their portfolio.

What about bonds? The conventional wisdom has it that bonds are the most overbought and most dangerous asset class right now.

Everything is timing. You print a lot of money, and then you have currency devaluation. The currency devaluation happens before bonds fall. Not much in the way of inflation is produced, because what you are doing actually is negating deflation.

So, the first wave of currency depreciation will be very much like England in 1992, with its currency realignment, or the United States during the Great Depression, when they printed money and devalued the dollar a lot. Gold went up a whole lot and the bond market had a hiccup, and then long-term rates continued to decline because people still needed safety and liquidity. While the dollar is bad, it doesn't mean necessarily that the bond market is bad.

I can easily imagine at some point I'm going to hate bonds and want to be short bonds, but, for now, a portfolio that is a mixture of Treasury bonds and gold is going to be a very good portfolio, because I imagine gold could go up a whole lot and Treasury bonds won't go down a whole lot, at first.

Ideally, creditor countries that don't have dollar-debt problems are the place you want to be, like Japan. The Japanese economy will do horribly, too, but they don't have the problems that we have -- and they have surpluses. They can pull in their assets from abroad, which will support their currency, because they will want to become defensive. Other currencies will decline in relationship to the yen and in relationship to gold.

And China?

Now we have the delicate China question. That is a complicated, touchy question.

The reasons for China to hold dollar-denominated assets no longer exist, for the most part. However, the desire to have a weaker currency is everybody's desire in terms of stimulus. China recognizes that the exchange-rate peg is not as important as it was before, because the idea was to make its goods competitive in the world.

Ultimately, they are going to have to go to a domestic-based economy. But they own too much in the way of dollar-denominated assets to get out, and it isn't clear exactly where they would go if they did get out. But they don't have to buy more. They are not going to continue to want to double down.

From the U.S. point of view, we want a devaluation. A devaluation gets your pricing in line. When there is a deflationary environment, you want your currency to go down. When you have a lot of foreign debt denominated in your currency, you want to create relief by having your currency go down. All major currency devaluations have triggered stock-market rallies throughout the world; one of the best ways to trigger a stock-market rally is to devalue your currency.

But there is a basic structural problem with China. Its per capita income is less than 10% of ours. We have to get our prices in line, and we are not going to do it by cutting our incomes to a level of Chinese incomes.

And they are not going to do it by having their per capita incomes coming in line with our per capita incomes. But they have to come closer together. The Chinese currency and assets are too cheap in dollar terms, so a devaluation of the dollar in relation to China's currency is likely, and will be an important step to our reflation and will make investments in China attractive.

You mentioned, too, that inflation is not as big a worry for you as it is for some. Could you elaborate?

A wave of currency devaluations and strong gold will serve to negate deflationary pressures, bringing inflation to a low, positive number rather than producing unacceptably high inflation -- and that will last for as far as I can see out, roughly about two years.

Given this outlook, what is your view on stocks?

Buying equities and taking on those risks in late 2009, or more likely 2010, will be a great move because equities will be much cheaper than now. It is going to be a buying opportunity of the century.

Ray Dalio is one of the best hedge fund managers in the world and he has an outstanding team backing him up at Bridgewater & Associates. The interview above is worth remembering as we go through the long and painful D-process.

[As an aside, I met Ray Dalio in late 2003 and told him that I was very concerned about deflation long-term. He listened to me carefully and asked: "What's your track record?"]

The D-process has been merciless on most hedge funds as they face a fresh wave of redemptions:

The economy's gotten worse, the stock market has tanked further, and a host of new scams have been turned over. Yep, nothing that's happened in the last quarter has made investors any more inclined to be invested in hedge funds. Thus, funds can expect a fresh round of crippling redemption requests:

WSJ: Among the managers expecting withdrawals are New York-based D.E. Shaw & Co. and Och-Ziff Capital Management Group LLC, which together manage more than $50 billion in assets. Huw van Steenis, an analyst at Morgan Stanley in London, says he has seen "no deceleration" in investors' requests to pull money out of hedge funds.

As a result, he estimates that assets under management in the global hedge-fund industry will shrink by as much as 30% this year due to withdrawals, following a 20% decrease in the second half of last year. That will leave total assets at less than $1 trillion, down from their peak of more than $1.9 trillion in mid-2008.

With hedge funds AUM down nearly 50% from its peak, we wonder if the only investors left are pension funds and the like that are flailing desperately from some kind of outsize return in order to meet retiree guarantees. They know that plain vanilla long investing, or conservative T-bill investing has no hope of getting them, so trudge on with hedge funds they must.

And it's not all bad news for these funds: Across the board they were flat in January, which makes a big turnaround from last year.

The fresh wave of redemptions are also a product of hedge funds closing the gates of hedge hell. There is nothing that pisses investors off more than hedge fund managers that put up gates so they can collect management fees while their performance heads south. However, redemptions might push the market to support levels (it is worth noting that even good hedge funds are experiencing outflows, adding more selling pressure in equity markets).

Regardless, pension funds are still turning to hedge funds. Reuters reports that the UK's second-largest pension fund, the Universities Superannuation Scheme (USS), said it was sticking by a medium-term plan to double exposure to alternative assets such as hedge funds and private equity:

The 23 billion pound pension scheme confirmed the target as it announced its first appointment to a new hedge funds team on Monday.

USS currently has 10 percent exposure to alternatives, making it already one of the more adventurous UK pension funds.

Its plan to increase that to 20 percent, coupled with specific move to boost hedge fund investment, will be comfort to an industry which struggled with poor performance and heavy outflows during a turbulent 2008.

"We believe that the current turmoil in the hedge fund industry represents a compelling investment opportunity for investors like USS who are able to take the long-term view," said USS's head of alternative assets Michael Powell.

[Sigh! Why do they use words like "compelling" when we are in the midst of a D-process?!?]

There have been fears that conservative long-term investors such as pension schemes could be put off future allocations to hedge funds.

USS said on Monday that Emily Porter, previously an investment director at Key Asset Management, has joined as a portfolio manager for USS's Absolute Return Strategies programme. She is the first of a number of hires USS plans to make as it builds its internal hedge fund investment skills.

About a quarter of USS's allocation to alternatives will be made by the Absolute Return Strategies programme. Until now, much of USS's alternatives exposure has come in private equity and infrastructure investment.

USS acts for 378 universities and academic institutions and has about 250,000 members.

I am more hopeful on some hedge funds in the next couple of years than private equity or real estate which tend to lag the economic cycle, but I am weary too, knowing full well the true reasons hedge funds performed so poorly in 2008. In any case, investors are catching on and are now demanding more changes to hedge funds.

As for pension plans, deficits soar amid market turmoil. The UK's 200 largest final salary pension schemes saw their pensions deficit soar by £16bn last month to £45bn:

The pension plans are now in their worst position for a year as their assets have tumbled due to the recent stock market falls, according to data from Aon Consulting, an employee risk and benefits management company.

Aon Consulting is now is urging the Government to review the payouts which pension funds must legally make, to help employers manage their pensions burden.

Currently, pensions must be increased in line with inflation but during a period of deflation, schemes are not able to reduce the amount that is being paid out.

Sarah Abraham, actuary and consultant at Aon Consulting, said this legal requirement represents "a significant risk to employers" as once a period of deflation is over and prices come back to previous levels, schemes are still required to pay increases.

She said this leaves pensioners with "a substantial increase in purchasing power and schemes with a bigger deficit".

"Flexibility over benefit structures is needed to allow employers to deal with their defined benefit pension promises," she said.

"The current rules around pension increases were designed at a time when deflation was not a consideration.

"Under the current legislation, schemes are effectively penalised for periods of deflation because in the long-term they are forced to give increases to pensions that are in excess of increases in inflation.

Mark my words: a long and painful D-process will add to renewed pressure to change the pension rules.

I leave you with an excellent article by Martin Feldstein, Fall in US household wealth likely to spur a long recession:

The massive downturn in the US economy will last longer and be more damaging than previous recessions because it is driven by an unprecedented loss of household wealth. Although the fiscal stimulus package that US President Barack Obama recently signed will give a temporary boost to activity sometime this summer, the common forecast that a sustained recovery will begin in the second half of the year will almost certainly prove to be overly optimistic.

Previous recessions were often characterized by excess inventory accumulation and over-investment in business equipment. The economy could bounce back as those excesses were absorbed over time, making room for new investment. Those recoveries were also helped by interest rate reductions by the central bank.

This time, however, the fall in share prices and in home values has destroyed more than US$12 trillion of household wealth in the US, an amount equal to more than 75 percent of GDP. Previous reactions to declines in household wealth indicate that such a fall will cut consumer spending by about US$500 billion every year until the wealth is restored. While a higher household saving rate will help to rebuild wealth, it would take more than a decade of relatively high saving rates to restore what was lost.

The decline in housing construction has added to the current shortfall in aggregate demand. The annual number of housing starts has fallen by 1.2 million units, cutting annual GDP by an additional US$250 billion. While this will eventually turn around as the inventory of unsold homes shrinks, the recovery will be slow.

So the US economy faces a US$750 billion shortfall of demand. Moreover, the usual automatic stabilizers of unemployment benefits and reduced income tax collections will do nothing to offset this fall in demand, because it is not caused by lower earnings or increased unemployment.

Although the recently enacted two-year stimulus package includes a total of US$800 billion of tax reductions and increased government spending, it would be wrong to think that this will add anything close to US$400 billion a year to GDP in each of the next two years. Most of the tax reductions will be saved by households, rather than used to finance additional spending.

Moreover, a substantial part of the spending will be spread over the following decade. And some of the government spending in the stimulus package will replace other outlays that would have occurred anyway. An optimistic estimate of the direct increase in annual demand from the stimulus package is about US$300 billion in each of the next two years.

The stimulus package would thus fill less than half of the hole in GDP caused by the decline in household wealth and housing construction, with the remaining demand shortfall of US$450 billion in each of the next two years causing serious second-round effects. As demand falls, businesses will reduce production, leading to lower employment and incomes, which in turn will lead to further cuts in consumer spending.

To be sure, an improvement in the currently dysfunctional financial system will allow banks and other financial institutions to start lending to borrowers who want to spend but cannot get credit today. This will help, but it is unlikely to be enough to achieve positive GDP growth.

A second fiscal stimulus package is therefore likely. However, it will need to be much better targeted at increasing demand in order to avoid adding more to the national debt than the rise in domestic spending. Similarly, the tax changes in such a stimulus package should provide incentives to increase spending by households and businesses.

Although long-term government interest rates are now very low, they are beginning to rise in response to the outlook for a sharply rising national debt. The national debt held by US and foreign investors totaled about 40 percent of GDP at the end of last year. It is likely to rise to more than 60 percent of GDP by the end of next year, with the debt-to-GDP ratio continuing to increase. The resulting increase in real long-term interest rates will reduce all forms of interest-sensitive spending, adding further to the economy’s weakness.

So it is not clear what will occur to reverse the decline in GDP and end the economic downturn. Will a sharp US dollar depreciation cause exports to rise and imports to fall? Will a rapid rise in the inflation rate reduce the real value of government, household and commercial debt, leading to lower saving and more spending? Or will something else come along to turn the economy around.

Only time will tell.

But time is running out for many pension funds that underestimated the depth and length of the D-process. They remain mired in the old way of thinking and that will end up costing all of us dearly.