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Worries That the Good Times Were Mostly a Mirage
By DAVID LEONHARDT
23/01/08 "New
York Times" -- -
- So, how bad could this get?
Until a few months ago, it was accepted wisdom that the American
economy functioned far more smoothly than in the past. Economic
expansions lasted longer, and recessions were both shorter and
milder. Inflation had been tamed. The spreading of financial
risk, across institutions and around the world, had reduced the
odds of a crisis.
Back in 2004, Ben Bernanke, then a Federal Reserve governor,
borrowed a phrase from an academic research paper to give these
happy developments a name: “the great moderation.”
These days, though, the great moderation isn’t looking quite so
great — or so moderate.
The recent financial turmoil has many causes, but they are tied
to a basic fear that some of the economic successes of the last
generation may yet turn out to be a mirage. That helps explain
why problems in the American subprime mortgage market could have
spread so quickly through the world’s financial system. On
Tuesday, Mr. Bernanke, who is now the Fed chairman, presided
over the steepest one-day interest rate cut in the central
bank’s history.
The great moderation now seems to have depended — in part — on a
huge speculative bubble, first in stocks and then real estate,
that hid the economy’s rough edges. Everyone from first-time
home buyers to Wall Street chief executives made bets they did
not fully understand, and then spent money as if those bets
couldn’t go bad. For the past 16 years, American consumers have
increased their overall spending every single quarter, which is
almost twice as long as any previous streak.
Now, some worry, comes the payback. Martin Feldstein, the
éminence grise of Republican economists, says he is concerned
that the economy “could slip into a recession and that the
recession could be a long, deep, severe one.” In Monday’s
Democratic presidential debate, Barack Obama made the same
argument: “We could be sliding into an extraordinary recession,”
he said.
In the next breath, of course, Mr. Obama suggested that the
right policies might still help, while Mr. Feldstein has said
that a recession isn’t yet a sure thing. And much of the great
moderation is real. Computers allow managers to run their
businesses more efficiently and avoid some of the wild swings.
The Fed and central banks in other countries have learned from
their past mistakes.
But a recession is now more likely than not. It may well have
started already. The Philadelphia Fed reported Tuesday that the
economy shrank in 23 states last month, including Ohio, Missouri
and Arizona, and was stagnant in seven others. California and
Florida, with their plunging home values, may soon join the
recession list.
The bigger question is how severe the recession will be if it
does come to pass. The last two, in 1990-1 and 2001, have been
rather mild, which is a crucial part of the great moderation
mystique. There are three reasons, though, to think the next
recession may not be.
First, Wall Street hasn’t yet come clean. Even after last week,
when JPMorgan Chase and Wells Fargo announced big losses in
their consumer credit businesses, financial service firms have
still probably gone public with less than half of their
mortgage-related losses, according to Moody’s Economy.com.
They’re not being dishonest; they just haven’t untangled all of
their complex investments.
“Part of the big uncertainty,” Raghuram G. Rajan, former chief
economist at the International Monetary Fund, said, “is where
the bodies are buried.”
As Mr. Rajan pointed out, this situation is more severe than the
crisis involving Long Term Capital Management in the late 1990s.
That was a case in which a limited set of bad investments,
largely at one firm, had the potential to drive down the value
of other firms’ holdings in the short term. Those firms then
might have stopped lending money because they no longer had the
capital to do so. But their own balance sheets were largely
healthy.
This time, the firms are facing real losses, which will almost
certainly curtail lending, and economic growth, this year.
The second problem is that real estate and stocks remain fairly
expensive. This shows just how big the bubbles were: despite the
recent declines, stock prices and home values have still not
returned to historical norms.
David Rosenberg, a Merrill Lynch economist, says that the stock
market is overvalued by 10 percent relative to corporate
earnings and interest rates. And remember that stocks usually
fall more than they should during a bear market, much as they
rise more than they should during a bull market.
The situation with house prices looks worse. Until 2000, the
relationship between house prices and rents remained fairly
steady. The same could be said about house prices relative to
household incomes and mortgage rates. But the boom of the last
decade changed this entirely.
For prices to return to the old norm, they would still need to
fall 30 percent across much of Florida, California and the
Southwest and about 20 percent in the Northeast. This could
happen quickly, or prices could remain stagnant for years while
incomes and rents caught up.
Cheaper stocks and houses will benefit many people — namely
those who don’t yet own a home and still have most of their
401(k) investing in front of them. But the price declines will
also lead directly to the third big economic problem.
Consumer spending kept on rising for the last 16 years largely
because families tapped into their newfound wealth, often taking
out loans to supplement their income. This increase in debt — as
a recent study co-written by the vice chairman of the Fed dryly
put it — “is not likely to be repeated.” So just as rising asset
values cushioned the last two downturns, falling values could
aggravate the next one.
“What people have done is make an assumption that these prices
could continue rising at the rate they had been,” said Ed
McKelvey, an economist at Goldman Sachs. “And that does seem to
have been an unreasonable assumption.”
Certainly, there are some forces to push in the other direction.
Outside of Wall Street, corporate balance sheets remain
remarkably strong, while the recent fall in the dollar will help
American companies to sell more goods overseas.
But it’s hard not to believe that the economy will pay a price
for the speculative binge of the last two decades, either by
going through a tough recession or an extended period of
disappointing growth. As is already happening, banks will become
less willing to lend money, households will become less willing
to spend money they don’t have and investors will become more
alert to risk.
Welcome to the new moderation.
E-mail: leonhardt@nytimes.com
Copyright 2008 The New York Times Company
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