The odds of economic meltdown
With interest rates and oil prices rising and consumers spending beyond
their means, we may be headed for recession -- and worse.
By Brad DeLong
Aug. 03, 2006 | FORECASTING RECESSIONS IS A fool's game. If there is enough
solid economic information to make it appear highly likely that a recession
is coming -- that production, unemployment and consumer demand will
actually fall -- then it is highly likely that there already is a
recession. Businesses are not stupid, and they don't have to wait for
economists to tell them what they already know. By the time a gloomy
forecast has been issued they've probably already noticed a drop in
consumer demand and responded by firing workers and reducing production.
So: Never say that a recession is coming. Say only that a recession is
here, or that there might be a recession on the way. Which, in fact, is
what I'm saying today. As of the beginning of August 2006, a recession is
not here, and I'm not going to violate my own rule by saying one is coming.
But there is a good chance -- for the first time since 2003 -- that there
might be a recession in progress six months from now.
Why? Three factors: 1) A Federal Reserve that finds itself with less
inflation-fighting credibility than it thought it had; 2) upward pressure
on inflation from rising energy and, perhaps, import prices; and 3)
millions of middle-class homeowners who for too long have treated their
houses as gigantic ATMs, using home equity loans and refinancing to
generate extra spending money.
First, the Federal Reserve, now chaired by Bush appointee Ben Bernanke. The
Federal Reserve sets interest rates, and when it does it tries to hit the
economy's sweet spot: that point that produces maximum employment,
purchasing power and growth without generating enough upward pressure on
prices to produce expectations of inflation. The Federal Reserve does this
by pushing interest rates up and down. Push interest rates up and
businesses find it more expensive to expand capacity and production,
causing them to cut back on investment spending. Push interest rates up and
households' balance sheets deteriorate, causing them to cut back on
consumption spending. Push interest rates down and firms find it cheaper to
expand capacity and production, and so they ramp up investment spending.
Push interest rates down and households find their balance sheets looking
better and feel flush, expanding consumption spending.
There is one major complication: what Milton Friedman calls the "long and
variable lags" in the system. Every action the Federal Reserve takes now
affects production, demand and inflation roughly 15 months in the future.
What the Federal Reserve has done in the past 15 months has not yet had a
chance to affect the economy.
This leads to the Federal Reserve's current dilemma. The last two
percentage points' worth of increases in interest rates -- increases in
interest rates that will in the end make businesses cut back on investment
spending and households feel pinched -- have not yet had a chance to affect
the economy. Because of "long and variable lags," they are still "in the
pipeline." When they emerge from the pipeline they will slow the economy
further. By how much? Nobody is really sure.
In this situation it seems reasonable that the Federal Reserve should stop
raising interest rates. Waiting to see what the interest-rate increases of
the past couple of years will do to the economy would be a prudent
strategy. Indeed, since last December the Federal Reserve has been quietly
signaling that it is about to "pause," to adopt such a wait-and-see
strategy. Yet so far it has not done so. Why not? One important reason is
that the Federal Reserve is scared that if it pauses too soon it will
convince many observers that it is not truly serious about fighting
inflation -- and a central bank has a hard time fighting inflation if
businesses, speculators and workers ever conclude that it is not truly serious.
The Federal Reserve is also unwilling to stop increasing interest rates
because it is afraid of recession risk factor No. 2: a rise in oil and
import prices. Those fears are justified. Remember how the invasion of
Iraq, besides bringing a golden age of democracy to the Middle East, was
also supposed to produce $15-dollar-per-barrel oil? Oil is now at $75 a
barrel, and this rise in oil prices is putting upward pressure on prices in
general. As for import prices, they are vulnerable to a U.S. dollar that
has been weakened by the Bush budget deficit and massive borrowing from
China. Suppose the dollar declines suddenly, which is not a far-fetched
possibility. Should the dollar fall by, say, 30 percent, and should
importers raise their dollar prices in proportion, then the one-sixth of
U.S. spending that is spending on imports will see prices rise by 30
percent. Because 30 percent times one-sixth equals 5 percent, that would
boost U.S. consumer prices by 5 percent nearly overnight.
Thus there are two big reasons for the Federal Reserve to keep raising
interest rates, in spite of how much downward pressure on demand is still
in the pipeline. The Federal Reserve thinks it needs to do so in order to
establish its long-term credibility, and there are the twin dangers of oil-
and import price-triggered inflation to guard against.
Most likely the Federal Reserve's continued raises in interest rates will
not send the economy into recession. But there is that chance, and the
chance is raised from a low-probability possibility to a serious worry by
the third factor: that home-as-ATM problem. The unprecedented use of home
loans to squeeze cash out of equity has allowed middle-class consumers to
spend well beyond their means. Someday this spending spree has to come to
an end. If it comes to an end suddenly, at a time when the Federal Reserve
has raised interest rates a little too much, then we have our recession.
Make no mistake about it: The U.S. economy is close to the edge. Retail
sales in the second quarter were rising at only a 2.1 percent annual pace.
Business investment in equipment and software was falling. Residential
construction was falling. Either households will continue spending beyond
all reason, or businesses will start boosting investment, or exports will
start booming, or there will be a recession sometime in the next year.
Figure the odds at 3 out of 10.
What can be done to head off the danger? Unfortunately, very little. The
bag of macroeconomic tricks is empty. In 2000-2001 the Federal Reserve
could lower interest rates to the floor, boosting residential construction
and consumer spending to offset the decline in high-tech investment, and
turn the 2001 recession into a very small event indeed. In 2002-2003 the
short-run stimulative effect of the Bush tax cuts came online at exactly
the right moment to offset fears of a deflationary spiral. But today
further fiscal stimulus would increase global imbalances -- meaning, raise
the trade deficit -- and do more damage to confidence than it might do good
in curing a recession. And sharp reductions in interest rates would lower
the value of the dollar and increase inflationary pressures from import
prices in a way that the Federal Reserve does not dare allow.
The past 24 years have been an amazing run as far as the business cycle is
concerned. There have been only two recessions, and both of those were
short and shallow. But Ben Bernanke and Co. are now at real risk of
presiding over the third.