Business News: The Economy of Fear

Why this recession is going to hit particularly hard--and last longer than you think.

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Illustration by: Brian Rea

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Citigroup to Harry Macklowe to the Metropolitan Museum of Art, the list of the credit crunch's victims grows by the day. So how bad will it get? If Federal Reserve chairman Ben Bernanke and former Treasury secretary Lawrence Summers are to be believed, the answer is not too bad. Bernanke recently predicted "a period of sluggish growth followed by a somewhat stronger pace of growth starting later this year as the effects of monetary and fiscal stimulus begin to be felt." Summers said a recession is likely, but it will be a relatively mild one that lasts a year or less. "Everybody needs to take a deep breath and recognize the resilience, the potential, and the competitiveness of the American economy," he declared.

Whenever Bernanke or Summers talk about economics, my advice is to sit down and listen. Bernanke left his childhood home in South Carolina for M.I.T., Stanford, and Princeton, where he headed the economics department. Summers, if anything, is even more formidable. In the 1980s, when I was visiting Harvard, I attended a series of lectures he gave to first-year Ph.D. students. Whereas other professors turned up with pages of typewritten equations, which they then copied onto a whiteboard, Summers came in with a few notes scribbled on a piece of paper and started talking. He could see the algebra in his head; he didn't need to write it down.

Yet when it comes to this economy, Bernanke and Summers, for all their brilliance, may well be mistaken. The economy is most likely spiraling down, with unemployment rising, the stock market tumbling, and corporate losses mounting. In economics, as in quantum physics, nothing is certain, but falling housing prices and slumping consumer confidence point to a deep recession that could last for two or three years. Psychology is critical in economics, and right now it is battered. Until we get through this period, it might be worth keeping in mind the words of another famous economist, Adam Smith, who said that in every great nation "there is a lot of ruin."

Unlike some past recessions, which were rooted in inflation problems, this one has been triggered by credit and real estate—both of which have a lot to do with how people perceive their financial well-being and, in response, how they adjust their spending. (View a tally of recent recessions and their causes.) For what is probably the first time since the 1930s, home prices are falling sharply. Nationwide, housing prices have slipped about 10 percent in the past year, and the decline is accelerating, according to the S&P Case-Shiller home-price index. As prices drop, more and more homeowners discover that they owe more than their property is worth, at which point they experience the temptation to hand the keys back to the bank or mortgage company. Jan Hatzius, an economist at

Goldman Sachs, estimates that by the end of 2009 up to 15 million households could be in a position of negative equity. If Hatzius is right, the glut in houses for sale will only get larger, and prices will fall a lot further. Just how low they could go is anybody's guess, but a reading of data compiled by Yale economist Robert Shiller, which show the evolution of inflation-adjusted home values since 1890, suggests an overall drop of 30 or even 40 percent.

When property prices fall, homeowners feel poorer, which prompts them to spend less and save more. Gross domestic product falls and unemployment increases. A slide of 25 percent in home prices would wipe out about $5 trillion in household wealth. Coincidentally, this is roughly how much was lost when technology stocks collapsed in 2000 and 2001. Given that some predictions have home values falling even more steeply, the pain could be severe.

In addition, homes are more widely owned than stocks, and they have a bigger effect on spending. Simulations carried out by Frederic Mishkin, one of Bernanke's colleagues at the Fed, imply that the typical American family will cut its spending by up to 7 cents for every dollar in housing wealth it loses. Given a 20 percent fall in prices, this adds up to a nationwide reduction in consumer spending of about $350 billion a year, or 2.5 percent of the U.S.'s gross domestic product. That's a big number—more than big enough to tip the economy into recession.

Just as consumers are hitting the panic button, companies also are being squeezed, with many of them unable to access money precisely at a time when they need it. It has been nine months since the subprime crisis began, and it is now affecting virtually all credit products, including two of the safest of all: municipal bonds and corporate bonds issued by blue-chip companies. Now that the credit bubble has burst, even some perfectly reputable and solvent businesses are struggling for access to funds. Unless something happens to reverse these trends, a big drop in G.D.P. is inevitable.

Bernanke and Summers know this, of course. They are relying on the stimulus package signed by President Bush in February and lower interest rates to boost demand. From September through January, the Fed cut the federal funds rate from 5.25 percent to 3 percent. Cheaper borrowing costs make it attractive for families to refinance their mortgages and take out home-equity loans. In the boom years of 2004 to 2006, refis and home-equity cash-outs boosted consumer spending; the Fed is hoping to restart this game. Lower interest rates also bring down the value of the dollar, making American goods such as

Boeing airplanes and

Apple computers more competitive in world markets. In recent months, the one economic bright spot in the U.S. has been a surge in exports.

I doubt whether these policy changes will be enough to offset the slumping housing market and its psychic multiplier. But a bigger weakness in the optimistic view is its failure to fully address the crisis in the financial system. In the mild recessions of 1990-91 and 2001, we didn't see anything like the dislocation we are now witnessing. In some ways, the current situation more closely resembles the ruinous credit busts of the late 1800s, which shepherded in lengthy periods of economic contraction in that century's last three decades. According to the National Bureau of Economic Research, the U.S. was in recession from October 1873 to March 1879, March 1882 to May 1885, and January 1893 to June 1897 (with a brief respite from June 1894 to December 1895). The slump of the 1870s, which was precipitated by a collapse in the value of railway bonds—the era's subprime securities—and the ruin of banker Jay Cooke, lasted even longer than the Great Depression.

For those who prefer more-recent analogies, the relevant episode is the Nordic banking crisis of the late 1980s and early 1990s, which afflicted Norway, Sweden, and Finland, three highly developed countries that hitherto were considered exemplars of financial stability. In each of these cases, a lending boom that revealed poor risk management, ill-advised deregulation, and irresponsible macroeconomic policies preceded the financial blowup, and a severe recession followed. In Sweden, for example, banks were left with bad loans that came to more than 10 percent of G.D.P., and the economy went into a slump that lasted three years.

In all three countries, the initial reaction to the banking crisis was to try and drum up private-sector solutions for stricken institutions, such as new injections of capital or takeovers. But as panic spread, consumer psychology worsened, and G.D.P. growth turned negative, the authorities had little choice but to step in. The Norwegian government took over the three largest banks in the country, wiping out their shareholders. The Swedish government seized control of two of the biggest banks and split off their troubled assets into a state-owned company. The Finnish government took over more than 40 savings banks and combined them into a state-owned Savings Bank of Finland. Stefan Ingves, a senior official at the International Monetary Fund, was working for the Swedish government at the time. In a speech, he said that the principal lesson he learned was "that you cannot rely on the private sector or markets alone to solve systemic banking problems."

On this side of the Atlantic, we are still looking for market solutions to the credit crisis. First, there was the idea of setting up a privately funded "super" investment vehicle to digest the mess. In that scenario, bailout money would come from the banks themselves. Then came the sovereign wealth funds, with their injections of Middle Eastern and Asian cash into Citigroup and

Merrill Lynch, and then a "voluntary" rate freeze on subprime mortgages. Now the big banks and Warren Buffett are vying to "rescue" the municipal-bond insurers. Behind the scenes, the Fed and the Treasury Department have been quietly orchestrating a mortgage bailout, using the Fed's lending facilities and other government-sponsored institutions, such as

Fannie Mae and

Freddie Mac, but even these efforts are too opaque and indirect to restore confidence, which is their ultimate goal. Lost trust takes a very long time to recover.

Until the solvency of the financial system is confronted head-on, with realistic write-offs and large-scale recapitalizations, there is little prospect of an economic recovery. Ask the Japanese. Back in the early 1990s, at the same time that the Nordic governments were recapitalizing their banks, the crony capitalists who ran Japan's financial system, which had undergone a similar boom-and-bust cycle, were busy trying to disguise the losses they had suffered. The result: an entire decade in which the Japanese economy hardly grew at all.

Bernanke, Summers, and other leading economists spent years studying how the Japanese got it so wrong. It is past time for them to read up on how the Scandinavians got it right.

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Sunday, April 13, 2008

The Economy of Fear

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