Henes: Top 5 Questions For the Weekend About the Economy

Just imagine what would have happened to the markets if the debt ceiling wasn't raised. Yesterday, the equity markets fell off a small cliff and gave back the gains for the year. Today, we are watching the markets on a roller coaster rideas investors try to figure out what is really happening in the economy. Europe is in disarray and many are asking whether the United States will experience a double dip recession. As everyone is focused on the markets and the economy, here are five questions to consider over the weekend.

#1 - Is Europe of 2011 Mimicking U.S. of 2008? In the U.S., it started with subprime. The banks held it and it was not worth the paper it was written on. These toxic assets lead to a banking system failure and, as a result, the federal government needed to "invest" money into the banks to save them. In Europe, the banks hold sovereign debt and the sovereigns are insolvent. The ECB is now understanding that sovereigns don't have a liquidity issue but a debt issue. The days of kicking the can down the road are over, yet coming up with a viable solution to allow for an orderly default is difficult. And, the austerity measures being put in place will guaranty that countries like Greece and Italy will not grow. Will the toxic sovereign debt being held by banks push the European banking system to the precipice of failure? It's not unthinkable. In fact, it is fairly easy to imagine.

#2 - Will Corporate Profitability Save the US Economy? In the depths of the Great Recession as earnings dropped precipitously, corporations cleaned up their balance sheets and cut their fixed costs dramatically. This was good for corporations. They began to accumulate cash and, as earnings began to increase, corporate profitability was magnified as the fixed cost cuts remained constant. But U.S. corporations are not hiring and they are not investing (at least not in America). The demand is not there and U.S. corporations realize they can do more with less. As stagnant economic growth will most likely be the norm for the foreseeable future, earnings may not continue to rise. If they do not, then profits will remain flat or, if corporations increase their fixed costs, profits will go down. While the foundations of many corporations are now strong, is the increased profitability for some more of a mirage than a reality?

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#3 - Will States and Cities Stall the Economy? States and Cities make up 12 percent of GDP. (Housing makes up only two percent of GDP.) The majority of states and cities have structural deficits as they have been spending more than they take in for years. In the past, to fill their budget holes and allow them to spend beyond their means, states and cities borrowed, failed to make pension fund contributions and relied on federal aid. Federal aid is ending. Borrowing and the continued failure to make contributions to pension funds will not balance budgets. Consequently, states and cities are cutting spending dramatically, including laying off public employees. In the short term, layoffs are negatively impacting the unemployment rate and spending cuts (austerity measures) are slowing the economy. In the long term, the unfunded pension liabilities will overwhelm states and cities. Public retirees will not receive the total amount of the payments they were promised as pension plans run out of funds. With less money in their pockets, public retirees will not spend as much, dampening any economic recovery. Don't underestimate the economic drag caused by the austerity measures being implemented (due to the requirement of 49 of 50 states to balance their budgets) by states and cities across the nation and the long term dangers of unfunded state and local obligations.

#4 - Will the Federal Government Stall the Economy? The debt ceiling was raised and the federal government took a first step toward implementing a plan to reduce our debt and deficit. Over the next four months, a super committee made up of six democrats and six republicans in Congress will attempt to hash out a long-term debt reduction plan. (Who is betting that it will look a lot like the Simpson Bowles plan?) Then the plan will go to Congress. Of course, this is where we will watch the political finger pointing and fighting (and the holding of proverbial breaths until certain strident politicians refuse to compromise and turn blue in the face or pass out). Whatever plan gets approved (or, if one doesn't, the forced cuts will take place), it is likely that we will face significant uncertainty over Thanksgiving and Christmas. This will negatively impact the markets and freeze decision making by both consumers and corporations. Will a real plan be approved that will fix the structural issues facing our nation? Or, will an inadequate plan be approved requiring more politics and debate both before and after the 2012 election?

#5 - Are We on the Verge of a Double Dip Recession? Does it really matter what we call it? The economy's growth is tepid at best. The federal government is playing politics with the structural problems facing our country and, consequently, creating severe uncertainty. The housing market has never left its recession or depression and unemployment remains stubbornly and dangerously high. Today, the job numbers were "better than expected". But, are the numbers real? Are the assumptions being made accurate? Unemployment dropped from 9.2 percent to 9.1 percent, yet more than 16 percent of our working population is "underemployed." Plus, unemployment insurance is running out. Do people continue to go to the unemployment office to file unemployment claims when their 99 weeks are up? The economy is weak and this should be expected. We just faced the most severe economic trauma since the Great Depression and it took more than 10 years to recover from that and only after U.S. citizens who were not sent to Europe and Asia for World War II were forced to save and pay down debt because rationing didn't let them spend. And, when World War II ended, citizens with savings and no debt began to demand goods and services and spend on those things. We are in the early innings of our Great Recession and we need to have the same kind of deleveraging and savings before we will truly grow again.

It seems that we are in for a bumpy ride. With August upon us and vacations set, we should think long and hard about what is needed to fix our economy for the long term and return to growth and prosperity.

Jon Henes is a partner in the restructuring group at Kirkland & Ellis LLP where he has led some of the most complex restructurings in the United States and abroad across a variety of industries, including media, chemicals, energy, manufacturing, real estate, retail and telecommunications. Jon has also frequently appeared on CNBC's "Worldwide Exchange" as a guest expert on various financial and economic topics, federal, state and local fiscal issues.