From the March 2, 2008 Sunday Times (London)
March 5, 2008
by Irwin Stelzer
The Federal Reserve Board chairman Ben Bernanke gave Congress a briefing last week that was in line with the views of many worried readers who have been advising me that I don't understand just how grim America's economic situation is. So, in deference to their views, and to the need to provide a balanced view of the turbulent economic scene, let me sketch out the worst-case scenario.
The economy is not merely slowing, it is heading towards recession. Sales of new homes are 34% below year-earlier levels, as homes move from builder to buyer at the slowest pace in 13 years. The market for existing homes is no better: sales are down 23%, and the inventory of unsold homes has started to rise again after a brief fall. House prices are down about 10%, and are heading lower at an accelerating pace. Worse still, nonresidential construction, until now holding its own, "is likely to decelerate sharply", says the Fed chairman.
Nor is any relief in sight. "Down-side risks to growth remain," warns Bernanke, frustrated by the inability of the Fed to bring the housing market's decline to an end. Even though the Fed has cut its short-term rate by 2.25 percentage points since September to 3%, rates on the standard 30-year fixed-rate mortgage are stuck at about 6.8%, almost exactly where they were at the height of the credit crunch last autumn. And any hope that the government would intervene directly was dashed when Treasury secretary Hank Paulson announced that he saw no reason for "the American taxpayer to be stepping in with more taxpayer dollars".
Given that houses are most Americans' largest asset, it is little wonder that consumer confidence is at its lowest level in five years, and that consumer spending, which held up in the first half of 2007, "appears to have slowed significantly", as Bernanke put it to the House Committee on Financial Services. That's not news to car companies, which are watching sales shrink to 10-year lows.
More important, falling house prices, rising mortgage (and credit-card) defaults and other problems in the credit markets are shrivelling banks' balance sheets, making it harder for them to lend to even creditworthy customers. There is no question that such credit as is being made available to consumers and businesses is offered on tougher terms – more collateral, higher interest rates, more proof of creditworthiness.
Tighter credit, especially when combined with plummeting consumer confidence, causes the blood to run cold in the nation's boardrooms. Projects are put on hold, investment spending declines and with it the new jobs needed to keep the unemployment rate down. Unemployment rises, consumer confidence and spending drop even more, foreclosures increase, credit tightens even more, and America settles into a long period of sub-standard growth, or actual decline.
Meanwhile, the number of people waiting for the next shoe to drop in credit markets is rising. When Credit Suisse can go from an "all's well" to discovery of a $2.85 billion loss in a few days, investors can be forgiven for wondering what's out there. There is an old saying that you can't make chicken salad out of chicken droppings, and investors have discovered that this applies to the complicated debt packages that were supposed to elevate the quality of dicey loans by bundling them with other dicey loans. You can't make a triple-A credit instrument out of lots of loans that are unlikely to be repaid.
All of this leads most observers to expect the Fed to cut rates even more, which Bernanke is hinting he will indeed do. But further loosening, especially when the fiscal stimulus is about to hit the economy, threatens to increase inflationary pressures, which have already driven the consumer price index up by more than 4% in each of the past three months, forcing the Fed repeatedly to raise its inflation forecast. The oil price seems to be settling at a bit more than $100 a barrel, and food prices are soaring, in part because of demand from increasingly better-off consumers in developing countries, and in part because misbegotten energy policies are diverting land from growing food to growing fuel.
Adding fuel to the inflationary fire is the falling dollar. Every drop in the value of the American currency makes imports more expensive. And now there is a new problem: prices of Chinese goods are rising as Chinese wage levels rise. These pay rates are not rising fast enough to make American workers competitive with their Chinese counterparts, but enough to make made-in-China products dearer in America.
Faced with the risk of a recession, Bernanke has decided that inflation is the lesser evil. Which has brought a furious response from Carnegie Mellon professor Allan Meltzer, America's leading student of the Fed and its history. Writing in The Wall Street Journal, Meltzer excori-ates the Fed for its "unseemly and dangerous response to pressures from Wall Street", where bankers are hoping that lower interest rates will drive up the prices of shares and bonds – not to mention houses.
Meltzer's reasoning reflects my own, and explains why I remain optimistic. Even the Fed is predicting that the economy will grow more rapidly in the second half of this year, bringing the overall 2008 rate to between 1.3% and 2.0%. It expects unemployment to rise to 5.3%, up from current levels, but still below the postwar average.
So, nervous readers, hold off on the Prozac, at least until this summer, when we might just find that lower interest rates and the stimulus package provide that bridge over troubled economic waters that will ease your mind.
Irwin Stelzer is a Senior Fellow and Director of Economic Policy Studies for the Hudson Institute. He is also the U.S. economist and political columnist for The Sunday Times (London) and The Courier Mail (Australia), a columnist for The New York Post, and an honorary fellow of the Centre for Socio-Legal Studies for Wolfson College at Oxford University. He is the founder and former president of National Economic Research Associates and a consultant to several U.S. and United Kingdom industries on a variety of commercial and policy issues. He has a doctorate in economics from Cornell University and has taught at institutions such as Cornell, the University of Connecticut, New York University, and Nuffield College, Oxford.
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