The long hangover

America's economy is in recession. Don't expect a quick recovery 

If the IMF is right, weakness will last longer this time. America's new president will be elected against the backdrop of a shrinking economy and on taking office will face months of economic malaise.

THE ECONOMIST 

IT MAY not be official but it is increasingly obvious: America's economy has slipped into recession. The latest labour-market figures—a jump in the unemployment rate to 5.1% and the loss of 98,000 private-sector jobs in March, the fourth consecutive month of decline—point to a shrinking economy. So do surveys of manufacturing and services. So does Ben Bernanke, chairman of the Federal Reserve. On April 2nd he told a congressional committee that output was unlikely to “grow much, if at all, over the first half of 2008 and could even contract slightly.”

The official judges of American downturns—a group of academics at the National Bureau of Economic Research (NBER)—define a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production and wholesale-retail sales.” (Contrary to popular belief, recession does not require two consecutive quarters of falling output.) Though the NBER's wonks will not pronounce for many months, their criteria look increasingly likely to be met. 

The question now is: what kind of recession will this be? Shallow or deep; short or long? So far, it seems remarkably gentle, given that many think America is suffering its worst financial shock since the Great Depression. Since December the economy has shed an average of almost 80,000 jobs a month. In most recessions a rate of 150,000-200,000 is normal.



To be sure, this downturn has only just started. The labour market will surely worsen as firms cut back in the face of weaker consumer spending. But a buoyant world economy is still boosting American exports; a fiscal stimulus is on the way; real interest rates are around zero and likely to fall further; and, with the rescue of Bear Stearns, the Fed has given an implicit guarantee to Wall Street. So few forecasters expect outright slump. A liberal enough loosening of fiscal and monetary policy can stop recession turning into depression, and American policymakers have left little doubt that they will use their recession-fighting weaponry freely.

More controversial is the question of how long the weakness will last. Not very, Mr Bernanke told Congress. Growth will strengthen in the second half of the year, nourished by lower interest rates and the fiscal package. In 2009, he suggested, the economy would be growing “at or a little above” its trend rate, which the Fed is thought to put at around 2.5%. Many investors seem to agree that the downturn will be short as well as shallow. Share prices have recovered since the Bear Stearns rescue, even as economic statistics have been gloomy. The S&P 500 stockmarket index is around 5% higher than it was a couple of weeks ago and is still only 13% below its all-time high. 

Others are more pessimistic. In its latest World Economic Outlook, published on April 9th, the IMF slashed its forecasts for America's economy both this year and next. It now expects GDP to shrink in every quarter of this year. By the fourth quarter the economy will be 0.7% smaller than a year before. (Only three months ago the fund expected a rise of 0.9%.) Nor does the IMF expect 2009 to be much better: GDP will grow, but at well below its trend rate.

Such a dramatic divergence of official economic opinion is rare. And it matters. Recent recessions, as defined by the NBER, have been both short and shallow: those of 1990-91 and 2001 each lasted eight months, below the post-war average of ten. If the Fed is right, the 2008 recession may be shorter and shallower still. That would be remarkable, given the extent of the housing bust and credit turmoil.

If the IMF is right, weakness will last longer this time. America's new president will be elected against the backdrop of a shrinking economy and on taking office will face months of economic malaise. That in turn will imply bigger budget deficits, and redefine next year's big domestic policy debates: whether to roll back George Bush's tax cuts for the wealthy, for instance, and how ambitiously to reform health care. It could fuel protectionist and populist sentiment, particularly since Americans are already unusually fed up. A new CBS/New York Times poll finds that eight out of ten people think the country is “on the wrong track”, the most since the question was first asked in 1991.

The hangover's duration will depend on many things, from the strength of foreign economies to the degree to which American firms cut jobs and investment. But top of the list, given the recession's origins in the property bust and the credit crunch, are the fate of the housing market and the resilience of consumer spending. On both counts, the odds are against catastrophe but on a lasting headache. 


By many measures the news from housing is still getting grimmer. Housing starts are at less than half their peak, and builders are continuing to cut back. Although this has begun to reduce the stock of unsold new homes, the frailty of demand means that supply still vastly outweighs sales. At 9.8 months' worth of sales, the stock is at a 26-year high. The official overhang of existing homes (which excludes those repossessed) is not much lower. The excess of supply over demand means that the fall in house prices is accelerating. According to the S&P/Case-Shiller index, house prices are 13% off their peak. They fell at an annual rate of 25% in the three months to January.

The drop in house prices so far has left some 9m people, or 10% of all those with mortgages, owing more than their houses are worth. Among all mortgage borrowers, 6% are behind on their payments; among subprime borrowers, 17% are in arrears. Lenders are already foreclosing on more than 1m homes. The pessimists expect these figures to climb much higher, adding to supply and further depressing prices.  


 


In the short term that is likely. But there are some signs of hope. Demand seems to have stabilised: since November total home sales have been running at an annualised rate of 5m or so (see chart 1). Lower prices have made houses a bit more affordable. And government action may help to ease the drought of mortgage finance stemming from the collapse of the subprime market and the contraction of the market for large (“jumbo”) mortgages, and to limit foreclosures. 

At the height of the housing boom in 2006, non-traditional loans, such as subprime and jumbo mortgages, backed nearly 40% of home sales. Some $750 billion of financing disappeared as they shrank. Fannie Mae and Freddie Mac, America's government-backed mortgage behemoths, will fill part of that hole. The Bush administration recently announced changes to these institutions' capital rules, to let them buy up to an extra $200 billion of mortgages. Political momentum is also building to prevent a surge of foreclosures. For now Congress is debating some modest tax incentives. But a more ambitious idea is gaining support: to allow the Federal Housing Administration to refinance troubled mortgages at a discount. 

Hit from all sides

Despite these hopeful signs, house prices will continue to fall until the excess inventory is worked off. Even the cheeriest analysts expect that average house prices will continue to fall this year. Worse, house-price deflation is only the first element of a quadruple whammy that is thumping American consumers. The other three elements are tougher credit conditions; a deteriorating labour market (with unemployment on the way up and wages slowing); and high commodity prices pushing up the cost of fuel and food.

Weekly private-sector wages rose by 3.6% in the year to March, the slowest pace since mid-2003. Headline consumer-price inflation is likely to have topped 4% in the same period, so for many real pay is falling. Economists at Goldman Sachs reckon that consumers' real discretionary cashflow—their income plus any new credit minus debt service and spending on essentials—has been shrinking since late last year.

Faced with all this, no wonder Americans are glum. The forward-looking bit of the Conference Board's measure of consumer confidence is at depths not seen since the recession of 1973. Indicators of financial stress outside housing, such as delinquencies on car loans and credit cards, are rising. And consumer spending, after years of resilience, has finally cracked. Not all economists share the IMF's view that spending is actually falling, but none doubts that it is at best barely growing. Because it makes up 70% of total demand, its feebleness does much to explain why the economy has tipped into recession. 

On all four counts—house prices, credit, the labour market, and fuel and food prices—the consumer's position is likely to worsen in coming months. Granted, the imminent fiscal stimulus should help. Between early May and mid-July $117 billion will be paid out in tax rebates. The average American household with two children will get a cheque from Uncle Sam for up to $1,800 and will spend at least some of it.

Unfortunately, most of the forces dragging down consumer spending are likely to persist long after the cheques have been banked. Even with stronger exports, growth is likely to be too sluggish to raise incomes by a lot or offer much support to employment. Looser monetary policy will cushion but not avert financial deleveraging. Lending standards are usually tight for years after credit busts, not months. And by most estimates less than half the likely losses in America's financial sector have been written down. Meanwhile, lower house prices will reduce both homeowners' wealth and their potential collateral.  


 


Even when house prices eventually stop falling, they will not suddenly soar. After years of tapping rising housing wealth to finance their consumption, Americans will need to build wealth the old fashioned way, by saving more. At 0.3%, the household saving rate is above its all-time nadir, but not by a lot (see chart 2). 

No one knows by how much, or for how long, America's economy will be weighed down. The IMF's gloom is based in part on its reading of history. An analysis by the fund of post-war housing busts in rich countries, written in 2003, suggests that crashes typically last about four years and are often accompanied by banking crises. Economies end up 8% smaller, on average, than they would have been had they carried on growing at pre-crunch rates. Perhaps this time will be different, and the hangover will soon be gone. But given the scale of America's housing binge and of the financial crisis the bust has spawned, that seems unlikely.