The reality of the economic situation – or at least the current perception of it – is starting to set in. While the Paulson plan has prevented a collapse of the financial system, the economy still faces some significant problems. The housing market still faces a huge inventory of homes and prices have not stopped falling yet. The retail sales number this morning shows that consumers are reducing their spending. Corporations are holding off on spending until the economic picture is more clear. Intel reported good earnings last night but they also said that the next quarter was impossible to predict due to the uncertainty.

From Heard on the Street:

Citigroup, for example, now expects U.S. gross domestic product after inflation to contract by 0.8% next year and unemployment to top 8.5%, up from 6.1% in September. HSBC, meanwhile, expects that corporate earnings in 2009 will come in 30% to 40% below consensus expectations.

And even if the government’s latest actions make it possible for banks to fund themselves, they are still sitting on rapidly souring mortgages, along with credit-card and auto loans that are nose-diving with the economy.

That is why the government should take additional steps to ensure that banks more aggressively provision for bad loans. A clearing of balance sheets is needed to let banks grow again and to eventually attract new, private capital to replace government preferred holdings.

The sooner the bad loans are written off, the sooner the economy can recover. Will the capital provided  by the Treasury be enough to offset the losses? I think so; a $250 billion capital injection is enough to support $2.5 trillion in loans at  10 to 1 leverage. If that isn’t enough, things are a lot worse than I think.

I think the last month is similar to what happened after 9/11. Economic activity came to a complete halt over the last month as everyone waited to see what the government would do. Now that the plan is in place (at least I hope all the elements are known now), things should slowly get back to some semblance of normal. Things will not recover as fast as they did after 9/11 though. Back then, people were refinancing their mortgages and spending the cash (at least some part of it). That isn’t available this time around and spending will take longer to recover. But it will recover.

One thing that seems lost in the day to day wild swings in the market is that what is going on right now is not only necessary but good for our long term economic health. We are too deep in debt and we need to pay it down. That can’t be accomplished without a reduction in spending and an increase in savings. It may take a while but in the long run that will be good for our economy. We will rebuild our capital base and make new investments. That is how real growth is created, not through monetary expansion. The growth of the last few years was an illusion that has now been revealed. The Fed’s actions in the early part of the decade only put off the day of reckoning. If we had just suffered through the necessary recession after the internet bubble, we wouldn’t be in this situation. Instead the Fed softened the blow through low interest rates and the result is a harder blow now. We’ll get through it but it didn’t have to be this bad.

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