Road to Ruin? America Ponders the Depth of its Downturn
By Krishna Guha in Washington
Published: April 21 2008 18:16 | Last updated: April 21 2008 18:16
What will be the shape of the US economic downturn? In recent months, the debate among economists has shifted from whether the US will have a recession to how deep and how long it will be.
Will it be a V-shaped recession – short, shallow and followed by a rapid return to normal rates of growth? Will it be U-shaped, in which the initial downturn is followed by a protracted period of weak growth and a slow return to the trend rate? Or could it even be an L-shaped recession – with economic weakness lasting for many years, as in the US during the Great Depression or Japan in the 1990s?
The answer will have enormous significance for the world economy and is likely to determine whether the recent improvement in some financial markets marks the beginning of the end of the credit crisis, or simply another false dawn.
The Federal Reserve believes the single most likely outcome is a V-shaped recession, though it sees significant risks of a deeper and more prolonged downturn. Fed staff expect economic activity to contract in the first half of this year, with a pick-up in growth beginning in the second half. They predict growth will be above trend – more rapid than normal – in 2009, when measured from the final quarter of 2008 to the final quarter of 2009.
This month Ben Bernanke, the Fed chairman, told Congress that the US was going through a “very difficult period” but said “much necessary economic and financial adjustment has already taken place” and policies were in train “that should support a return to growth in the second half of this year and next”.
Until recently, this was also the near-unanimous view of private-sector forecasters. These experts highlighted the absence of excesses in the corporate sector outside housing and finance. Most companies did not invest heavily or hire aggressively during the economic upturn, and so are unlikely to cut back deeply on investment and staff as they did in the last recession in 2001.
This theory is consistent with the data so far. Private-sector employment has fallen for the past four months but at a modest rate compared with past recessions, while hours worked have held up quite well.
Miles of unoccupied new homes on the edges of Las Vegas and half-built condominiums in Miami demonstrate that there were big excesses in the building industry. But the adjustment in housing is well under way. Home starts are still falling at a precipitous rate but the Fed expects that the rate of decline of residential investment will slow from the second half onwards, reducing the drag on growth.
Moreover, there is a double boost in the pipeline from the fiscal stimulus and aggressive interest rate cuts by the Fed early this year, which typically effect the economy with a lag. The first tax rebate cheques will be sent out next month.
Brian Sack, chief economist at Macroeconomic Advisers, estimates that consumers will spend about 40 per cent of the rebate cheques of up to $1800 (£907, €1,132) per household. “We expect a sizeable contribution to growth from the fiscal stimulus package in the middle two quarters of this year,” he says. There would be some “payback” later but by the time the stimulus fades, “the economy will be getting itself on a better underlying footing”.
In this scenario, exports continue to be strong, the drag from housing declines and reasonable income growth enables the economy to return to trend growth quite quickly, even allowing for a moderate increase in the household savings rate. The relatively benign forecast assumes that stresses in financial markets gradually ease, reducing pressure on the economy and amplifying the effect of interest rate cuts.
A V-shaped recession is certainly quite possible. But top Fed officials acknowledge that, while we know that the first half of this year will see either a shallow recession or very little growth, and that there should be some support from fiscal and monetary stimulus around the middle of the year, the outlook is quite uncertain from there onwards.
These officials believe that the great unknown is what will happen to the housing sector (see below). As long as house prices show no sign of bottoming out, it will be difficult for financial markets to return to normal and consumer spending will remain under severe pressure.
Other experts – including some top central bankers in Europe – think there is a significant risk of a sharp rather than a gradual increase in the household savings rate in current conditions, even if house prices do begin to bottom out.
In recent weeks a number of private-sector economists have moved to more of a U-shaped outlook, forecasting an extended period of tepid growth and a sluggish recovery. Some believe that tax rebates will be used almost entirely to pay down debt, while others offer the notion of a W-shaped recession in which a bounce from the stimulus is followed by further weakness.
The International Monetary Fund, meanwhile, has gone still further in forecasting an extended period of economic weakness in the US, with growth of minus 0.7 per cent on the Fed’s final-quarter-to-final-quarter measure this year, and only 1.7 per cent next year. The IMF believes that US growth will start to recover only in 2009, not in the second half of this year as the Fed expects, and will only return to at or above trend in 2010. The forecast is an outlier from the consensus but its assumptions are not particularly radical.
Alan Blinder, a professor of economics at Princeton and a former Fed vice-chairman, says the economy will struggle to return to normal growth in the face of “super-headwinds” emanating from the financial sector.
With banks under balance-sheet pressure and the financial system as a whole deleveraging, the credit squeeze on the real economy could continue even after the risk of a systemic crisis in the banking sector recedes.
Moreover, the impact of the tightening to date is only now beginning to be felt in the economy. Richard Berner, chief US economist at Morgan Stanley, who expects a lacklustre recovery, says that “given the time lags between when financial conditions tighten and when it shows up in the economy we still have a long way to go.”
With the markets for housing finance still dysfunctional, the downturn in both construction and home prices could prove more protracted than the Fed expects. Global growth could also weaken as the effects of the credit crisis are felt in Europe and possibly even in emerging markets such as China.
Yet at the centre of the debate is consumer spending, which accounts for about 70 per cent of the US economy. Consumers are grappling with falling net worth, tightening credit conditions, higher energy and food costs, and a softening labour market.
The Fed forecast assumes a flattening out of commodity prices, which would give consumers over time more purchasing power while easing inflation pressure. But commodity prices keep going up, worsening the growth/inflation mix. The longer this persists, the greater the risk that stagflation – low growth and high inflation – becomes embedded in the expectations of workers, companies and investors.
The inflation risk means the Fed will now have to moderate or even soon pause its interest rate cuts. Moreover, while the US corporate sector generally looks in good shape, some analysts see huge excesses in the household sector that need to be worked out, including record levels of debt relative to income and a savings rate that is close to zero.
Others dispute that US households are badly overstretched, noting that household net worth is still close to record levels. Wealth, though, is unevenly distributed, and could fall sharply if the worst-case scenarios for house prices prove correct.
“The trillion-dollar question is what happens to consumption – is the US household going to rein back its spending?” says Raghu Rajan, a professor at the University of Chicago’s Graduate School of Business. As results from US retailers indicate, the consumer is already pulling back. “But the real question is has it got much further to go?”
Mr Rajan says economists do not fully understand why the savings rate collapsed from the early 1980s, making it hard to be sure at what rate it might rise again. Most explanations suggest some combination of increasing wealth (first from equities, then housing) and financial innovation, which made it easier to access the wealth represented, for instance, by home equity.
Kenneth Rogoff, a professor at Harvard, says US consumer spending would have to adjust following the reversal in house prices, even if there had been no accompanying credit crisis. As things stand, “even if we take away the immediate financial crisis, we are still left with a story where the whole credit structure that propagated the housing boom and credit boom has been seriously compromised,” he says.
Most experts believe the US savings rate will rise as households start to repair their balance sheets, but that this will happen gradually, muting rather than derailing economic recovery. There is a risk, however, that under stress this adjustment could be more abrupt.
Moreover, the longer an economic downturn lasts, the greater the strain on the financial system. The IMF already estimates that losses and writedowns on all debt and securities – not just subprime mortgages – could total $945bn.
Nouriel Roubini, a professor at New York University and chairman of RGE Monitor, an economic research firm, argues that underwriting standards deteriorated across a wide range of credit products during the boom, and that economic stress will result in a sharp rise in defaults and delinquencies on non-mortgage debt such as car loans, credit cards and leveraged loans.
The ultimate losses could turn out to be much lower than the IMF and others estimate. But the potential losses in a protracted downturn are of a size that could impair the capital base and functioning of the US financial sector. This could create an L-shaped recession, in which an anaemic economy and a damaged financial sector transmit weakness to each other, resulting in an extended period of stagnation like that of Japan in the 1990s.
Yet while the risk of a U-shaped recession has probably risen in recent weeks, the worst-case scenario is looking less likely thanks to policymakers’ activist response. A number of experts see the rescue of Bear Stearns, the investment bank, by the Fed and JPMorgan Chase as a watershed. The US authorities showed they were willing to deploy public money to prevent a systemically important institution from defaulting on its debts. Congress, meanwhile, is considering plans to provide between $300bn and $400bn in credit guarantees to allow lenders who agree to write down home loans to refinance these mortgages.
Robert DiClemente, chief US economist at Citigroup, says that the problem for the pessimists’ analysis is that “the stark seriousness of where we are” galvanises an aggressive policy response. For this reason, even the arch-bear Mr Roubini says: “This is not going to be like Japan – it will be U-shaped, not L-shaped” – though Mr Roubini’s idea of a U-shaped recession still involves 12 to 18 months of economic contraction.
Policy activism is not a guarantee of success. The US’s large current account deficit increases the risk of a dollar crisis and a sudden pick-up in inflation expectations – a threat that has looked worryingly real at moments in recent months.
Moreover, there are some financial risks – such as multiple ruptures in the credit default swaps market, which banks and other financial institutions use to trade and hedge credit risk with each other – that would be very difficult for the Fed and Treasury to contain even if they wanted to.
The US government is also in a worse fiscal position than it was in 2001, making it harder to sustain an aggressive fiscal policy such as the Bush tax cuts and increased government spending that helped pull the US out of recession last time. Yet the likelihood is that the US – with even its external debts denominated in its own currency – has both the economic capacity and political will to prevent an L-shaped recession taking hold. In an election year, the pressure is for action.
The US should manage to avoid an L-shaped recession – and may even escape with a short V-shaped recession. The danger is that the extreme measures taken – already including the extension of the safety net to investment banks and the loosening of constraints on government-sponsored enterprises to support the housing market – could lay the seeds for the next financial and economic crisis.
Bleak houses in search of equilibrium
In the end, thinks the Federal Reserve and much of Wall Street, it all comes down to the value of bricks and mortar, writes Daniel Pimlott. How much further will American house prices fall and when will they bottom out? Jan Hatzius, chief US economist at Goldman Sachs, says this is “the most important question in the US economic outlook”.
The extent of the decline is critical both for consumer spending and financial stability. The further home prices fall, the more household wealth declines and the greater the pressure on consumers to spend less of their income. Meanwhile, the larger the fall, the bigger the losses in the financial sector and the greater the likelihood of a protracted credit squeeze as banks seek to repair their balance sheets.
The timing of the decline matters too. Until house prices at least begin to bottom out, it will be impossible to put firm values on mortgage-backed securities and resume something resembling normal business in the credit markets.
No one – including the Fed – has a good sense of how far house prices will fall or when they will stabilise. The US central bank’s base case is that the Office of Federal Housing Enterprise Oversight (Ofheo) index of house prices might fall another 6-8 per cent from current levels. This would imply a larger decline – in the region of 10 per cent – in the more volatile S&P/Case-Shiller index, which reflects house prices in 20 US metropolitan markets.
Yet top Fed officials admit that this is only an educated guess. There is no consensus among economists as to what the equilibrium price for US housing – the price that matches demand and supply – might be. Analysts differ as to whether house prices will undershoot fair value on the way down in the same way they overshot on the way up.
Moreover, just as house prices will affect the depth of the downturn, its severity – in particular the rise in unemployment – will affect house prices. “If we have a deep recession, all bets are off,” says Todd Sinai, assistant professor of real estate at Wharton.
US house prices have already fallen by about 10 per cent from their peak in mid-2006 on the Case-Shiller index. This takes them back to levels that last prevailed in 2005, when the subprime mortgage boom was beginning. Some measures of house prices-to-rent ratios suggest that houses remain as much as 60 per cent overvalued. Others, which allow for an increase in the price/rent ratio over time, still suggest that prices in January were about 30 per cent higher than their trend.
However, various housing affordability measures – which take into account the cost of mid-market mortgages – suggest that prices are either at normal levels relative to income or not much more than 10 per cent overvalued. Goldman Sachs estimates that the Case-Shiller index will fall another 15 per cent from its January 2008 level, for a total peak-to-trough decline of 25 per cent.
Lehman Brothers concurs and both firms see house prices bottoming out late in 2009. Michelle Meyer, an economist at Lehman, says: “The most rapid decline was at the beginning of this year. Next year the pace of decline will be much more moderate.” Merrill Lynch economists think house prices will fall another 20 per cent or so on the same measure, for a total decline of 30 per cent. The futures market is pricing in a further 20 per cent or so decline in the narrower but more actively traded Case-Shiller 10-city index. That has already fallen about 15 per cent, for a total predicted decline, peak to trough, of about 35 per cent.
The larger estimated drops generally include some degree of undershoot below fair value. There are a number of reasons why this might happen.
First, excess supply. While the stock of new homes for sale relative to market turnover has stabilised and inched down, the proportion of existing homes for sale is still rising. “Home prices are now falling at a rapid rate because the overhang of vacant homes has surged to historic highs,” says Peter Hooper, chief economist at Deutsche Bank Securities. A wave of home foreclosures and abandonments – in most cases linked to negative equity – could add as many as 5m homes to the market over the next three or four years, Goldman estimates.
Second, credit conditions. Just as an abundant availability of credit helped push house prices above fair value during the housing boom, the credit crunch could push prices below that level now. Borrowers face higher credit scores and lower loan-to-value ratios.
Third, downward momentum. During the boom people bought houses in part because they thought they would appreciate in value. Now they are holding back because they think prices will fall further.
House prices could end up falling by less than the futures market anticipates. But they could also fall considerably more than the Fed is assuming. The only solace is that price falls of anything approaching that magnitude would likely prompt large-scale government intervention to restore credit supply and minimise foreclosures.
Copyright The Financial Times Limited 2008