Bearing Down - The coming recession

Desmond Lachman doubts that monetary policy can stem the looming recession.

by Desmond Lachman

Wall Street estimates that bank losses stemming from bad lending behavior will range anywhere from $500 billion to $1 trillion. These numbers dwarf the losses from the savings-and-loan crisis of the 1980s.

Until very recently, most Wall Street analysts were in denial about the prospect of even a mild economic recession, let alone a serious and prolonged one. Ever optimistic, they turned a blind eye to the onset of the worst U.S. housing bust since World War II. They also minimized the gravity of the subprime mortgage crackup, the subsequent credit crunch (which has been plaguing the U.S. banking system since mid-2007), and the approximate doubling of global oil prices to around $90 a barrel.

Now that practically every economic indicator is signaling recession-from rapidly falling home prices to abysmal Christmas spending figures to declining employment growth to tightening bank lending standards-Wall Street analysts are conceding, reluctantly, that America might experience a recession in the first half of 2008.

However, they are all too quick to reassure us that this recession will be short and shallow, with a slowdown in the first half of the year to be followed by an early and vigorous rebound in the second half of the year. In making that forecast, they are pinning much hope on two things: the Federal Reserve’s recent decision to slash interest rates aggressively and the $168 billion fiscal stimulus package announced last week on Capitol Hill.

It would be wonderful if the Wall Streeters were right this time in their sanguine prognostication. The sad truth, however, is that all the important clues are pointing in the opposite direction. The main forces driving us toward a recession-high oil prices, a serious credit crunch, and the bursting of a major asset price bubble-are operating in combination with each other. At the outset of America’s three previous recessions-in 1981, 1990, and 2001-these forces were operating separately. Therefore, it seems reasonable to expect that a recession today will be longer-and more painful-than the postwar average (around nine months).

Steven Roach of Morgan Stanley argues, correctly, that the present housing market bust is affecting a very much wider swath of the U.S. economy than did the dot-com bust (which led to the 2001 recession). After all, the combined output of the housing sector and housing-related industries accounts for roughly 10 percent of the total U.S. economy-a considerably larger share than technology investment. And there is every reason to believe that national home prices will fall by at least another 10 percent in 2008, under the weight of record inventories of unsold homes, the scheduled resetting of adjustable rate mortgages, and a severe tightening of mortgage lending standards. These facts alone suggest that a 2008 recession will be more serious than the one in 2001.

In a similar vein, the present credit crunch is far more debilitating than was the savings-and-loan crisis of the mid-1980s. For while the credit woes of the 1980s were largely confined to the savings-and-loan sector, today’s credit problems seem to be much more pervasive, going well beyond subprime mortgage lending. Indeed, Wall Street estimates that bank losses stemming from bad lending behavior will range anywhere from $500 billion to $1 trillion. These numbers dwarf the losses from the earlier savings-and-loan crisis.

The optimists are hoping that the 2.5 percentage point cut in interest rates over the last few months, coupled with the recently announced fiscal stimulus package, will soon turn the economy around. But they choose to forget that interest rates had to be cut by 5.5 percentage points (to as low as 1 percent) following the dot-com crash before the economy began to recover. They also choose to overlook the troubled state of today’s banking system, which may reduce the efficacy of interest rate cuts this time around.

The good news is that both the Bush administration and the Federal Reserve have finally (if belatedly) grasped the urgency of the present situation. This indicates that they will do whatever it takes to prevent the U.S. economy from succumbing to the sort of vicious cycle that crippled the Japanese economy after the bursting of its asset price bubble in 1990. Yet monetary and fiscal policies often take a long time to have their full effect on economic activity. Indeed, at this late stage, it’s doubtful that either the administration or the Fed can prevent a nasty recession.

About the author: Desmond Lachman joined The American Enterprise Institute after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney. He previously served as deputy director in the IMF’s Policy and Review Department and was active in staff formulation of IMF policies toward emerging markets. Lachman has written on topics such as economic policy, fund arrangements, monetary reform, import restrictions, and exchange rates.

Reprinted with kindly permission of The American Enterprise Institute.