|NY Times, July 18, 2008
L-ish Economic Prospects
By PAUL KRUGMAN
HOME PRICES ARE in free fall. Unemployment is rising. Consumer confidence is plumbing depths not seen since 1980. When will it all end?
The answer is, probably not until 2010 or later. Barack Obama, take notice.
It’s true that some prognosticators still expect a “V-shaped” recovery in which the economy springs back rapidly from its slump. On this view, any day now it will be morning in America.
But if the experience of the last 20 years is any guide, the prospect for the economy isn’t V-shaped, it’s L-ish: rather than springing back, we’ll have a prolonged period of flat or at best slowly improving performance.
Let’s start with housing.
According to the widely used Case-Shiller index, average U.S. home prices fell 17 percent over the past year. Yet we’re in the process of deflating a huge housing bubble, and housing prices probably still have a long way to fall.
Specifically, real home prices, that is, prices adjusted for inflation in the rest of the economy, went up more than 70 percent from 2000 to 2006. Since then they’ve come way down — but they’re still more than 30 percent above the 2000 level.
Should we expect prices to fall all the way back? Well, in the late 1980s, Los Angeles experienced a large localized housing bubble: real home prices rose about 50 percent before the bubble popped. Home prices then proceeded to fall by a quarter, which combined with ongoing inflation brought real housing prices right back to their prebubble level.
And here’s the thing: this process took more than five years — L.A. home prices didn’t bottom out until the mid-1990s. If the current housing slump runs on the same schedule, we won’t be seeing a recovery until 2011 or later.
What about the broader economy? You might be tempted to take comfort from the fact that the last two recessions, in 1990-1991 and 2001, were both quite short. But in each case, the official end of the recession was followed by a long period of sluggish economic growth and rising unemployment that felt to most Americans like a continued recession.
Thus, the 1990 recession officially ended in March 1991, but unemployment kept rising through much of 1992, allowing Bill Clinton to win the election on the basis of the economy, stupid. The next recession officially began in March 2001 and ended in November, but unemployment kept rising until June 2003.
These prolonged recession-like episodes probably reflect the changing nature of the business cycle. Earlier recessions were more or less deliberately engineered by the Federal Reserve, which raised interest rates to control inflation. Modern slumps, by contrast, have been hangovers from bouts of irrational exuberance — the savings and loan free-for-all of the 1980s, the technology bubble of the 1990s and now the housing bubble.
Ending those old-fashioned recessions was easy because all the Fed had to do was relent. Ending modern slumps is much more difficult because the economy needs to find something to replace the burst bubble.
The Fed, in particular, has a hard time getting traction in modern recessions. In 2002, there was a strong sense that the Fed was “pushing on a string”: it kept cutting interest rates, but nobody wanted to borrow until the housing bubble took off. And now it’s happening again. The Onion, as usual, hit the nail on the head with its recent headline: “Recession-plagued nation demands new bubble to invest in.”
But we probably won’t find another bubble — at least not one big enough to fuel a quick recovery. And this has, among other things, important political implications.
Given the state of the economy, it’s hard to see how Barack Obama can lose the 2008 election. An anecdote: This week a passing motorist shouted at a crowd waiting outside a branch of IndyMac, the failed bank, “Bush economics didn’t work! They are right-wing Republican thieves!” The crowd cheered.
But what the economy gives, it can also take away. If the current slump follows the typical modern pattern, the economy will stay depressed well into 2010, if not beyond — plenty of time for the public to start blaming the new incumbent, and punish him in the midterm elections.
To avoid that fate, Mr. Obama — if he is indeed the next president — will have to move quickly and forcefully to address America’s economic discontent. That means another stimulus plan, bigger, better, and more sustained than the one Congress passed earlier this year. It also means passing longer-term measures to reduce economic anxiety — above all, universal health care.
If you ask me, there isn’t much suspense in this year’s election: barring some extraordinary mistakes, Mr. Obama will win. Assuming he wins, the real question is what he’ll make of his victory.