When economic activity declines, business investment declines as well. This makes sense, as people are buying fewer goods and services, so there isn't a need for companies to produce as much.
The problem, however, comes when businesses cut back so much that unemployment skyrockets. Unemployed people have less money to spend, which further reduces economic activity, leading to further layoffs.
That's an ugly, self-feeding scenario -- one we're faced with now, as unemployment remains high and is on track to be more protracted than at any point since the Great Depression. According to a variety of sources, we could easily be looking at another decade of high unemployment.
What's a bear to do?
To break such a cycle, the Federal Reserve ordinarily cuts interest rates to reduce the costs of investment and spur economic activity. But the Fed has already reduced short-term interest rates to 0%, and its ability and desire to provide additional economic relief are limited.
The other way to crack the unemployment/recessionary cycle is to take more direct action to lower unemployment or boost economic activity. All in all, stimulus has been responsible for saving at least two million jobs, according to Moody's economists and the Congressional Budget Office. But it wasn't big enough, and its boost to the economy is now ending.
The bottom line: Unless the Fed or Congress does more to stimulate the economy, unemployment will linger and the economy will remain weak.
That's unlikely to happen
The trouble is, that Washington refuses to help the economy because the economy is weak. I know this sounds stupid, so let me explain.
"Deficit hawks" in Congress are freezing unemployment insurance checks and federal aid to states. Since most state constitutions prohibit budget deficits, the loss of those funds mean that states will begin laying off thousands of workers. Instead of stimulating the economy, we're about to embark on a massive anti-stimulus. Yes, I know there are now finally enough votes in the Senate to pass the jobless benefits extension sometime this week. But it was been pared back significantly, will not cover 1.4 million Americans who have been out of work for 99 weeks, took months to pass, and will be even tougher to extend the next time. Any truly substantial stimulus is likely to be out of the question.
So the deficit hawks will not allow Congress to stimulate the weak economy because of the deficit, while the weak economy is causing the increase in budget deficits. It's a self-perpetuating dynamic, a fact to which Washington is both blind and deaf.
The following chart shows why projected budget deficits for the next decade jumped between 2008 and late 2009. It's mostly because of lost tax revenues due to a weak economy:
Source: Congressional Budget Office, Baselinescenario.com.
A good look at the pie chart will show that all this talk about how fixing the economy would explode the deficit is, mathematically speaking, bull.
In short, this is what's killing the recovery:
Crummy Economy -> Lower Tax Revenue -> Large Deficits -> Congressional Paralysis on Stimulus -> Crummy Economy
A persistently weak economy would hurt most everyone, but who will be affected by it most?
Homeowners: High unemployment is a drag on the housing market. Foreclosures are on track to beat last year's record. The pain for PulteGroup (NYSE: PHM ) and Toll Brothers (NYSE: TOL ) may last longer than expected.
Consumer goods: Unemployed people have less money to spend on luxury and big-ticket items. My colleague Alyce Lomax tells me she would be particularly worried about high-end retailers, including Williams-Sonoma and Nordstrom. Coach (NYSE: COH ) also comes to mind.
Wall Street: The big winner here, ironically, could be the industry most responsible for the recession. Granted, unemployment may not be great for traditional lending; I recently attended an interview hosted by Bloomberg where Citigroup (NYSE: C ) Chairman Richard Parsons said unemployment and a weak economy were the biggest threats to his company. But others have already written the problem off -- Bank of America (NYSE: BAC ) CEO Brian Moynihan recently claimed that his company is aggressively collecting debts and lending more conservatively, so as long as unemployment doesn't grow, persistent unemployment is manageable for Bank of America.
Meanwhile Wall Street's trading arms benefit enormously from the nearly free money they're able to borrow when short term interest rates are close to 0%. For this reason, a protracted recession, which is causing the Fed to hold interest rates low, would be a boon to firms that live off trading, such as Goldman Sachs (NYSE: GS ) , Morgan Stanley (MS), and JPMorgan (JPM). Annaly Capital (NYSE: NLY ) , which profits from the spread between short term rates and mortgages, seems like a great bet too. (I may even buy shares of Annaly sometime after my 10-day lockout expires.)
In short, the failure to stimulate the economy looks likely to prolong the recession. That's good for Wall Street … but bad for just about everyone else.