Three-Ingredient Recipe for Recession (re the recession of 2007-08)

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David Wessel, Wall Street Journal

26 Oct 2007 02:08

When we look back next year at this time, it will be clear what caused the recession of 2007-08.

It was basically a triple whammy: Housing prices kept falling, oil prices kept rising and both lenders and borrowers grew more cautious after five years of incaution. The combination was simply too much even for the impressively resilient U.S. economy. The Federal Reserve saw it coming, but couldn't move swiftly enough. Still, Fed Chairman Ben Bernanke's interest-rate cuts helped keep the recession as short and mild as those of 1990-91 and 2001.

There are three rules to keep in mind when reading a recession prediction.

* Rule No. 1: Forecasters rarely call the turn in the economy accurately. Even the wisest business-cycle veterans have a hard time. "There are forecasts of thunderstorms and everyone is saying, 'Well, the thunder has occurred and the lightning has occurred and it's raining.' But nobody has stuck his hand out the window," then-Fed Chairman Alan Greenspan told Fed colleagues on Oct. 2, 1990, transcripts reveal. "And at the moment," he said, "it isn't raining. ...The economy has not yet slipped into a recession." Much later, arbiters at the private National Bureau of Economic Research determined a recession had begun that July.

* Rule No. 2: Once forecasters start shaving their growth forecasts, they tend to keep shaving them. At the end of August, economists surveyed by Macroeconomic Advisers, a St. Louis forecaster, predicted the U.S. would grow at a 2.7% annual rate in the fourth quarter; last week, they were betting on 1.6% growth.

* Rule No. 3: There are always good reasons to argue, "This time it'll be different." But "this time" is usually different in specifics, not in the overall outcome.

The housing story is painfully clear. A June WSJ.com survey found that by a 3-to-1 ratio economists thought the worst of the housing bust was behind us. They were wrong. Housing kept sinking. Housing starts in September were 26% below year-earlier levels. That's a direct hit to economic growth.

Falling housing prices are a second hit. The price of the median existing home sold in September was down 4.2% from a year earlier. That is reducing household wealth, shaking confidence and increasing foreclosures. That's significant because today's recessions are triggered more by collapsing asset prices -- the bursting tech-stock bubble in 2001, for instance -- than by the old cycle of retailers and factories reacting to rising inventories of unsold goods by curtailing orders and production.

"Only twice have we had this kind of housing collapse without a recession, in 1951 and 1967, and both times the Department of Defense came to the rescue, because of the Korean War and the Vietnam War," Edward Leamer of the University of California, Los Angeles, told the Federal Reserve's Jackson Hole, Wyo., conference in August. Mr. Leamer and his UCLA forecasting team say this time will be different. They predict "a near-recession experience," but expect factories, aided by export orders, to avoid recession-inducing layoffs.

The energy story is less clear. Oil and gasoline prices are up and look likely to keep rising. That has hurt, but not crippled, consumer spending on other things. But oil at nearly $90 a barrel -- $30 higher than at the start of the year -- doesn't seem to have had much impact on global economic growth yet. There's good reason for that: Oil prices are up partly because China's growth spurt increases its appetite for oil. You can't have a recession because you have too much demand. And inflation-fearing central banks haven't panicked and raised interest rates in response to higher oil prices, as they once did.

But that was yesterday's story. If oil prices keep climbing because producers can't or won't increase supply or because of recurrent tensions in the Middle East, the effects are unlikely to be as benign. The next $10 increase in oil could hurt consumers more than the last $10 increase.

And then there's the prospect of a credit crunch, the consequence of lenders and investors being burned by mortgages and other loans that turned out to be much riskier than anticipated. As the late economist Rudiger Dornbusch used to say: "The crisis takes a much longer time coming than you think and then it happens much faster than you would have thought." Rudi was right.

Commercial banks, investment banks and the market itself are tightening lending terms. That may, as central bankers argue, be a welcome reaction to excessively generous lending in years past. But coming on top of housing and energy, the understandable desire of lenders to be a bit more tight-fisted is likely to turn what might have been painfully slow growth into recession.

Now, recall Rule No. 1. What could prove me wrong? Mr. Bernanke talks hopefully about a "two-speed economy" in which housing remains weak and the rest of economy remains strong. After all, the best guesses are that the U.S. grew at significantly better than a 3% annual rate in the quarter ended Sept. 30. The continued boost to U.S. exports from a weakening dollar and continued economic vitality in Europe and Asia could yet offset the triple whammy. But global growth prospects, except for China, look gloomier than six months ago. And, at home, the job market could continue to be strong enough to give consumers the wherewithal to keep spending.

But that's not the story I expect to be writing in October 2008.

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