Sustainability of the on-going recovery of the American economy has been an issue since the lapse it suffered after the eruption of the European crisis earlier this year.  Ben Bernanke on the TV show "60 Minutes' said that the recovery is "sustainable". Nevertheless, It became obvious to many people that not every economic recovery is sustainable, particularly the current one that came after a serious financial crisis. It will be useful to look for early signs of sustainability of the current recovery. Credible indicators of sustainable recovery from the2007-2008 Great Recession can be “real” in nature such as declining unemployment rate and accelerating GDP growth, and “financial” which may precede the real ones. Thus, I am now interested in the financial indicators.

Many economists believe that there is some resemblance between what caused the Great Depression in the 1930s and  the Great Recession in 2007-2008. This common cause is the perspective of dearth of liquidity in the eyes of banks, investors and corporations. Rightly or wrongly, this perspective generates a defensive behavior that tries to deal with the fear of insolvency and even bankruptcy. Under such a circumstance, the behavior of these corporations, banks and financial players titles heavily against risk, all kinds of risk, and toward safety. This behavior materializes in three steps. In the first step, investors, corporations and financial players, banks in particular, will want everything they have or tough to turn into cash, regardless of return. Never mind that cash brings zero returns and has a high opportunity cost!  This explains why U.S. corporations are setting on two trillion dollars of cash and do not want to invest. Time in this step is not ripe for real investment. It also explains why banks have been sitting on $2.5 trillion of excess reverses at the Fed and have no desire to make loans.

In the second step, and after feeling less nervous about insolvency and bankruptcy, banks, investors and corporations look for safe ways to use their cash.  Safety becomes the name of the game. They look for risk-free and low risk assets. This explains the rush behind buying gold and the risk -free Treasury bills, particularly those of shorter maturities. Gold price topped $1425 per ounce and the three- T bill rate touched the zero lower bound.

The third step sets the stage for the new normalcy of financial indicators of sustainable recovery. Banks will start turn their excess reserves at the Fed into loans and credit. The monetary base morphs into rapid increases in money supply. Currently, money supply grows at an annual rate of 6%, while at this time of the recovery from previous recessions money supply grows between 10-15%.  Investments in Treasury bills will move toward the risky corporate investment grade and high-yield bonds. A credit risk measure such the corporate default risk, which is the difference between Baa corporate rate and 10-year government bond rate, will commence its way down steadily. To noone surprise, the price of gold will turn south as investors, hedgers and speculators will short gold and long more risky assets such as stocks and corporate bonds. Cyclical commodities such as oil, copper and aluminum will divorce themselves from the shiny yellow metal which will not have many friends at that time. Life in derivatives will also come back from the back of the investments line. The financial Sun will start to shine!

Fear of lack of liquidity is a long-lasting shock that takes several years to get over. It may take the Fed several rounds of QEs to address this shock and when it succeeds it will write the book on how to deal with stubborn liquidity shock s whether in terms of size, pace and timing of the QE process. Investors, banks and corporations have not yet made strong strides toward this third step of overcoming the fear of dearth of liquidity. But those financial indicators which are related to liquidity shortage are worth watching now to judge the pace of sustainability of the on-going weak recovery [1]. They should flash green long before the real indicators boom.  We are not there yet but we are not far from there, though [2].  I think Bernanke fast-forwarded the recovery sustainability on "60 Minutes"!

[1] For a graphical representation of the current movements of the U.S. monetary base and the M2 money supply, click on this link:

http://krugman.blogs.nytimes.com/

[2] Here is a chairman and CEO of an important bank that foresees " much more lending in 2011". This is one of those financial precursors for the recovery sustainability.

http://finance.yahoo.com/tech-ticker/bank-ceo-%22quite-optimistic%22-about-2011-%22i-think-you%27ll-see-much-more-lending%22-535742.html?tickers=HBAN,XLF,KRE,FAZ,FITB,KEY,RKH&sec=topStories&pos=8&asset=&ccode=