Geopolitical Diary: Measuring the Danger
By: Stratfor.comSeptember 17, 2008
A major U.S. company declared bankruptcy on Monday, and another even larger company in the same industry that had come on hard times was bought by a yet larger company. We state the news on Lehman Brothers and Merrill Lynch & Co. in order to put this in context. American companies come and go, with catastrophic results at times for employees, shareholders, lenders and the general public. Enron, WorldCom, Digital Equipment Corp., Prime Computer and Data General were all major companies-some were household names. Their industries fell on hard times and redefined themselves, leaving shattered companies and lives in their wake.

Clearly the financial industry is in great trouble in the United States. Capitalism solves those problems by annihilating weak companies and clearing space for others to grow and for new companies to emerge. There is a term for this: "creative destruction." It embodies the argument that, without the destruction of outmoded businesses, progress is impossible. It is interesting how badly damaged the old line brokerages have been. Merrill Lynch is an American institution that brought the stock market to the masses. Now something else will fill that space. If we knew what it was going to be, we'd be rich.

When this sort of activity occurs in the computer industry, or the dot-coms, hundreds of billions of dollars are lost. Lives are ruined and former paper billionaires look for jobs as programmers. When it happens in the financial industry, there is another concern. When Enron failed, many financial institutions shuddered and an accounting firm went down with it. When a financial institution fails, the deeper connections with other financial houses raise concerns about a ripple effect. Particularly given the daisy chain of leveraged debt, the fear is that the failure of one firm can trigger a chain reaction throughout the system. That may be true, but it is equally true that an Enron can undermine financial institutions and cause an uncontrolled chain reaction.

Of course, that didn't happen. It is not clear that the failure of Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers and Merrill Lynch will cause such a chain reaction, either. One reason is the Federal Reserve, which is intervening in critical cases to dampen the effect. It is noteworthy that it did not intervene for Lehman Brothers, apparently calculating that the impact would not justify the effort.

>From our point of view, the question is whether these failures will destabilize the United States sufficiently to affect the international system. We are simple folks and we look at simple things. The Standard & Poor's 500 Index is down about 20 percent from its all-time high. The normal decline prior to a recession is substantially greater, and given Monday's news, the situation could be much worse. A liquidity crisis increases the price of money, and yet interest rates remain low. That suggests we are not seeing a liquidity crisis, but simply an unwillingness to lend to firms that are failing. Most healthy companies outside the financial sector are securing financing, but the standards have tightened. That's what is supposed to happen in an economic slowdown. Unemployment has risen, but nowhere near the dramatic numbers seen in the 1970s and early 1980s.

The financial industry is in enormous trouble. The financial system is certainly not experiencing the same pain as a Lehman Brothers employee is. It is not as well off as two years ago, but it is far from extreme straits. The economy has also slowed, but it is not clear that the economy is even in recession. The definition of a recession is simple: the economy contracts. If it does not contract, it may be slowing down, but that is not the same as a recession. At this point there is not yet confirmation that there is even a mild recession-although, as we have said before, it is about time to have one, since we are about seven years since the last one and recessions are necessary correctives.

The only thing we can conclude from the data is that a lot of companies in the financial industry are in deep trouble, that the financial system itself is in much less trouble than this industry, and that the economy is doing fairly well, considering that it is probably heading into recession. The recessions of 1991 and 2001 came and went, and life went on. In spite of the horrific headlines in the press we see no reason to change that view. We would hate to be an employee of a brokerage house right now, but the United States has weathered much worse and it seems to us that the international balance of power will not shift. Certainly, if the numbers change dramatically, then so will our view. But we are struck by how much worse the numbers would have to get for us to re-evaluate our fundamental view.

It was terrible to be a mainframe computer manufacturer in the 1980s. It was awful to own an Internet company in 1999. And it is terrible to be in the financial industry today. That is not the same as the collapse of civilization as we know it.

Stratfor is a private intelligence company delivering in-depth analysis, assessments and forecasts on global geopolitical, economic, security and public policy issues. A variety of subscription-based access, free intelligence reports and confidential consulting are available for individuals and corporations.

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