If you're breathing a little easier because the Great Recession seems to be ending, consider this: the U.S. economy may remain in a "contained depression" for months or years to come. That warning comes from economist David Levy, chairman of the Jerome Levy Forecasting Center, an economic research and consulting firm. Levy originally coined the term to describe the recession of 1990–1991 and the subsequent halting, jobless recovery. Earlier this week, he talked with CFO about the prospect of a similar scenario unfolding today. An edited version of the interview follows.

What is the state of the economy today?
We're in for a much longer period of contained depression [than we saw in the 1990s]. The single most overlooked observation about the U.S. economy in the postwar period is that balance sheets grew faster than incomes, decade after decade, both assets and liabilities. The problem is that asset values have to be justified by returns they can earn — or by expectations of future capital gains, and that's where you get into bubbles. What went on in the postwar period couldn't go on indefinitely. We were able to make it go on longer by dropping interest rates in the last two recessions, but we can't do that anymore. We have to shrink the value of assets on balance sheets and shrink liabilities. And that makes it very difficult for the economy to operate.

In fact, without the government sector, the economy would collapse. If you look at the second and third quarters of this year and analyze the sources of profits in the economy — and if you take government out of the picture — everything added up to a net loss, for the first time since the 1930s. But because we had an enormous injection of monetary wealth into the economy by the federal government, we were able to pump up profits and help them climb back to a much better level than they were at during the worst of the recession.

Fortunately, we're not going to have the 1930s all over again, although unemployment will be very high. The banking system will continue to function. The government at times may try to reduce the deficit, as the Japanese government has tried to do as they have been dealing with their own kind of contained depression. But every time you do it, profits are undermined, things get worse, and the deficit widens anyway — and then you feel pressure to do something to stimulate the economy. It's very hard not to run very large deficits.

In Japan, they wasted a lot of time actually getting to the financial problems and writing off bad loans and cleaning them up. We're doing a much better job, and it won't take us as long. But this is essentially the kind of problem we're dealing with. We're not going to see anything like the bubble-and-boom of the last couple of expansions or what we think of as more-normal business cycles.

It sounds like we could be bumping along the bottom for quite a while.
It's going to be a very difficult time. Unemployment is going to remain a chronically severe problem. We're going to average at least 8% over the next 10 years. And it could be worse. Even if we made progress from this point, we would do pretty well to knock unemployment down a percentage point a year, and we're nowhere near a position to do that. If we can keep the economy growing consistently, it will take at least four to five years just to get unemployment down to 6%.

Do the banks have their balance-sheet problems worked out?
The great majority of bad loans are yet to be recognized. We have seen the problems that came directly out of the structured-finance deals, but the actual defaults on mortgages are going to get much greater as incomes deflate and people are unemployed for longer periods of time. We'll see housing prices resume their decline at some point, and the collateral values are just not going to be there, and the ability to sell will remain compromised.

Are we close to a time when the federal government can stop some of its stimulus efforts?
[Private] investment is almost dead. Net investment in the U.S. economy came extremely close to zero. It had never been below 4% of GDP, and then it was almost zero. That's extraordinary. The government is replacing profits that are missing. That part can't go away anytime soon.

Many of our readers are skeptical or critical of the stimulus. They feel too much money has been spent, and they're concerned about the deficit.
The deficit was going to increase whether on purpose or by accident. Most of the deficit-widening was by accident. About $250 billion of the $700 billion stimulus was expected to be spent in 2009, but the deficit widened by many hundreds of billions, and most of that was as a result of the collapse of revenue. Corporate tax revenue collapsed and personal-income tax revenue collapsed. If we had not had the stimulus, perhaps we would have seen an even bigger decline. That is a part of the story that's not well understood.

People who have spent a good part of their careers concerned about financial management look at the government and say, "All I know is that this is an organization that is putting out debt at a ridiculous rate. When is it going to end?" We're talking about something like 10 years before we clean out these problems. I think [public debt] will break the post–World War II record of 109% of GDP. Maybe it will be 120%; maybe 140%. But we'll manage. This is going to come with a deflationary environment where we'll have very little inflation overall and maybe some periods of modest deflation. In that environment, interest rates are going to remain very low, and the actual debt service will not be that outlandish.

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