IMPEACH BUSH

WASHINGTON (MarketWatch) -- Even before the latest squeeze in the credit markets, the U.S. economy had slipped into what could be a relatively lengthy recession, economists say.

The latest data, covering activity in August and September, make it all but certain that the academic economists will eventually declare that the economy is in a recession.

The big economic forecasting firms are in the process of updating their forecasts following the release of key data on consumer spending. While the final numbers aren't available yet, forecasters say it doesn't look good.

The economy seems to be on the "edge of the abyss," said Joel Prakken, chairman of Macroeconomic Advisers, which will update its forecast on Friday.

"Anyone who's wondering if there's a recession should stop wondering," said Nigel Gault, U.S. economist for Global Insight, which will release its updated forecast on Monday. "The recent data were deteriorating sharply" even before factoring in the latest impact of the credit squeeze.

Global Insight doesn't think the recovery will be quick or powerful. The economy will likely contract for three quarters and then show weak growth in the second quarter next year.

If the recession lasts from December 2007 until April 2009, as Gault suspects it will, it would be the longest since the Great Depression. And the recovery, when it comes, won't feel anything like a boom.

"It's difficult to see a real rapid recovery, certainly at the beginning," Gault said. Typically, the economy recovers when the Federal Reserve lowers interest rates to stimulate credit-sensitive consumer purchases of housing and autos. See earlier story on why the recession will be protracted.

But with credit markets jammed and consumers already reeling from too much debt, lower rates won't have the usual impact on the economy. "The Fed won't have any ammo left," Gault said.

Fed policymakers may not try to stimulate the economy too much anyway, figuring that the current crisis stems from exactly that medicine: The Fed kept rates too low for too long after the 2001 recession in a bid to drag the economy out of the jobless recovery.

Contrary to the conventional wisdom, a recession is not defined as two consecutive quarters of declining gross domestic product. So far, we've had just one quarter of negative growth (the fourth quarter of 2007), although revisions next summer could certainly drop one or two quarters this year below zero.

Rather, the economists at the National Bureau of Economic Research, who are the arbiters of recession dating, say that "a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales."

Four of those indicators have been declining significantly since the first of the year. Employment has fallen at a 0.7% annual pace, incomes are down 1% (even with the rebate), output is down 2.8%, and sales are down 1.3%.

Only GDP has bucked the trend, rising at a 1.8% annual rate. How can that be? Can the economy really contract while GDP is growing?

The answer is yes, under certain circumstances like now, when exports are booming while domestic consumption and investment are weak.

GDP is the total value of goods and services produced in the United States, including domestic consumption and investment as well as goods and services sold overseas and unsold goods put into inventories. We get the income from making exports and inventories, but we don't get the utility from using those goods and services. See related column.

Gault of Global Insight notes that gross domestic income, which should by definition equal GDP, has not been nearly as strong as the economy measured from the output side. GDI is up just 0.2% from a year ago compared with 2.1% for GDP. Gault suspects that GDP will ultimately be revised lower to match the weaker income figures.

In the past year, our economy has come to look like a banana republic's: All the output goes to exports, and not to domestic consumption and investment.

In the past year, most of the GDP growth has come from increased exports and a reduced appetite by Americans for foreign-made goods. Consumer spending, which typically accounts for 70% of the economy, has contributed only about 40% of the growth over the past year.

And consumer spending seems almost certain to decline in the third quarter, which ended Tuesday. We won't see September consumption data for another month, but the trend through August was horrible. With auto sales dropping to a 16-year low and chain-store sales weak, September may have been even worse. And that was before the credit markets really seized up.

We haven't seen even one quarter of declining consumer spending since 1991, but it could fall as much as 2.3% annualized in the third quarter, said economists for Morgan Stanley. That could be enough downdraft to offset any upside from exports. Housing will continue to be a drag, and business investment seems to be weakening as well.

The unemployment could reach 7% before it's all over, said Prakken.

The major risk now is that the downturn could worsen if the credit squeeze is not fixed. "The further tightening of credit conditions and declines in equity markets will weigh heavily on the outlook for growth in the coming quarters," said Prakken of Macroeconomic Advisers.

"It could be much worse in the short-term," said Gault, adding that the deeper the contraction is now, the sooner the healing process could begin.

Rex Nutting is Washington bureau chief of MarketWatch.

But a success is exactly what Goldman Sachs Group Inc. is shaping up to be at this stage of the credit crisis. If we were to begin the long journey back to stability today, Goldman would undoubtedly emerge even more powerful than before.

Did anyone expect another outcome?

Commercial banks such as Citigroup Inc., Bank of America Corp. and J.P. Morgan Chase & Co. are obvious winners in the credit debacle. They've been able to buy battered banks at fire-sale prices. America is about to become a country with three national banks that have big broker/dealers as subsidiaries.

These new superbanks will be formidable, but there is a question of how much risk-taking they'll be willing to stomach. Logistics are an issue too. They're integrating firms that may have been priced like single-branch banks but, from an infrastructure standpoint, are giants of American finance.

Morgan Stanley whose stock is 65% off its high, has shored itself up by selling a 20% stake to Tokyo's Mitsubishi UFJ, but will still need to add deposits, just like Goldman.

Only Goldman, by virtue of its investment from Warren Buffett and its ability to buy retail bank deposits, will be the last bulge-bracket investment bank unencumbered by commercial-bank ownership.

You don't have to be a conspiracy theorist to recognize that a series of decisions and events have transpired to put Goldman at the top of the heap. Well before the credit crisis, people worried about Goldman's influence in the markets. Several former executives of the investment bank have senior roles in government and at the New York Stock Exchange, and its analysts are among the most powerful in the space.

Let's limit the discussion to the start of the credit crisis in the summer of 2007. Just before the market turned, Goldman traders got a hunch and began shorting and hedging the mortgage securities that were eating away at rivals' revenue. Trading revenue soared 70% that quarter to $8.23 billion.

It was Goldman's last quarter in a series in which each new profit report exceeded expectations and prior results. Goldman's share price was in shouting distance of $300. It was also when grumblings about the investment bank's transparency became louder. That's important because Goldman continues to give few details about its "proprietary trading" business. What is it exactly? No one knows for sure.

Industry collapse

What followed was notable for what didn't happen: write-downs. Goldman has admitted to less than $5 billion in write-downs, including the $1.1 billion when it reported earnings Sept. 16. That's on a balance sheet of $1 trillion.

In between those earnings announcements, Goldman lost its biggest competitor in prime brokerage, Bear Stearns Cos., on March 17. In September, it also lost the biggest competitor in debt underwriting, Lehman Brothers Holdings Inc., and a big rival in investment banking, Merrill Lynch & Co., in an emergency sale to a commercial bank.

Judging by the government's reaction, Morgan Stanley and Goldman should have been next -- either through a crisis sale like Merrill or a liquidation like Lehman. Investors sent their stocks reeling. Morgan Stanley quickly began talks with Wachovia Corp., while Goldman kept quiet.

During all of this, Goldman Chief Executive Lloyd Blankfein was in the middle of talks about the future of another crippled company, American International Group Inc.

(AIG:

AIG at the New York Federal Reserve. As Gretchen Morgenson reported in the New York Times last week, those talks resulted in an $85 billion bailout of AIG via a government loan, and, oh yeah, the deal may have saved Goldman $20 billion in losses due to its trading position with the insurer."

Goldman poured cold water on that claim saying in a statement it "had no material exposure to AIG.

"Our counterparty risk was offset by collateral and hedges, and that remains the case."

There have been other fortuitous decisions, too. For instance, the Securities and Exchange Commission's ban on short-selling was lifted for market-makers such as Goldman, and U.S. regulators may be willing to back Goldman's purchase of $50 billion in troubled assets from other banks, according to a Financial Times report.

Buffett investment

It was the Buffett investment that was the master stroke. Announced on the same day that President Bush, Congress and presidential candidates worked on the first draft of Treasury Secretary Henry Paulson's bailout plan, everyone hailed the deal as a huge financial gain for Buffett and an expensive vote of confidence for Goldman.

If it were only that, the price was rich. But the investment earned Goldman permanent access to the Federal Reserve discount window, lowered its leverage to just over 18 times equity, brought it closer to its new bank-holding company structure, and, according to Fox-Pitt Kelton analyst David Trone, wasn't costly for Goldman.

"Goldman's raise will simply pad its equity capital cushion to appease the market's recent concern about its model," he wrote. It put "to rest doubts that a company could raise without fundamentally needing it."

Goldman, like its rivals, is on the prowl for deposits, but unlike its competitors, it will be the acquirer. Goldman emerges from this mess essentially the same institution. It has the same lack of transparency. It still manages hedge funds and private-equity businesses. It still has a thriving prime brokerage business.

As former Drexel Burnham Lambert CEO Fred Joseph said last week, investment banking is "not disappearing at all. [Banks] will act more like advisory firms and underwriters and lenders. They'll act a little bit more like banks, and less like hedge funds."

That doesn't mean those enterprises won't disappear. And Goldman will be one of the few left open for business.

David Weidner covers Wall Street for MarketWatch.