How bad is the economy? Don’t jump, but “We’re going to have to redefine what we mean by normal growth”

The government bails out Fannie Mae, Freddie Mac and AIG. Lehman Brothers goes bankrupt and Merrill Lynch is sold. Stocks are tanking with the Dow Jones down by 22 percent over the last year.

How bad is the overall economy, and what’s coming next? I had a brief conversation about those questions today with Christopher Whalen, managing director of Institutional Risk Analytics, whose interview here last fall proved highly prescient. Here’s what he said:

We’re deflating the economy, like we deflated it during the 1920s. In the end we’ll be okay, but there’s going to be a lot of collateral damage. In terms of big numbers, trillions of dollars has been taken out of the economy–it’s gone–and major banks are in a very precarious situation. Retailers are in full retreat and you’re going to see a lot of bankruptcies, because discretionary spending, anything having to do with consumption, is going to drop sharply.

Still, people should not panic. The Treasury is going to stand behind the FDIC (Federal Deposit Insurance Corporation), which insures individual deposits up to $100,000 and IRAs up to $250,000. But if you’re a high-income individual or a small- or medium-sized business owner with large cash balances, you’re going to have to be sensitive to keeping balances above the insured limit. If you’re above that limit, you’re an unsecured creditor of the bank. People have not had to think about that for a long time.

We’re going to have a low-growth scenario for a few years, and we’re going to have to redefine what we mean by “normal growth.” The whole country has gone through a speculative mania, in terms of real estate, the stock market, and risk, and when we come out of it we’re going to have a typical growth rate that’s lower than what we’re used to.