The Coming Recession

Seven observers debate the (sorry) state of the economy.

From the June 2008 issue

As this issue of reason goes to press, the dollar is at a record low against the euro, oil is more than $100 a barrel, consumer prices are up 4 percent from a year ago, and Federal Reserve Chairman Ben Bernanke is cutting interest rates so often that the guys at the office have taken to calling him Edward Scissorhands. The subprime mortgage fallout has yet to finish wreaking its havoc, Bear Stearns is holding on by the skin of its teeth, and the government’s bucket may not be big enough for all the bailouts under way. Gloomy faces dominate CNBC and the Fox Business Channel, muttering long-forgotten terms like inflation and recession.

President George W. Bush, by contrast, is relatively cheery, conceding that we are in “challenging times” but arguing that “our financial institutions are strong” and the capital markets “functioning efficiently and effectively.” “In the long run,” Bush said in a March 17 White House address, “our economy is going to be fine.” And some statistics back up the sunny view: Unemployment is still at a low 5.1 percent, and productivity remains high.

Presidential hopefuls are offering a variety of explanations and possible solutions for what 42 percent of voters say is the most important issue to them, according to a recent CNN poll. At a March 20 rally, Sen. Barack Obama (D-Ill.) suggested the problem was a combination of “special interests” and war: “At a time when we’re on the brink of recession, when neighborhoods have ‘For Sale’ signs outside every home, and working families are struggling to keep up with rising costs, ordinary Americans are paying a price for this war.” Sen. Hillary Clinton (D-N.Y.) took a different tack: The “economic crisis is, at its core, a housing crisis,” she said in a major Philadelphia address on March 24, but she cited other factors as well, including Bush’s “brain dead energy policy.” Sen. John McCain (R-Ariz.) won the Republican nomination without really talking much about the economy.

How will we know when it’s fair to speak the dreaded r-word? In general, a recession is defined as a decline in a country’s gross domestic product for two or more successive quarters. In the United States, an official pronouncement is required from the professional doom diagnosticians on the business-cycle dating committee of the National Bureau of Economic Research, who often take other aspects of an ailing economy into account. GDP growth slowed dramatically at the end of 2007 and is projected to be zero in the second quarter of 2008, so we look to be well on our way.

As oil prices continued to climb and housing prices continued to slide, Reason assembled a panel of economists and other market watchers to help make sense of the headlines, point some fingers, figure out how we got where we are, and offer advice about how to get out with our wallets intact.

Blame the Fed
Gerald P. O’Driscoll Jr.
The U.S. economy is in the midst of an old-style credit crunch brought on by a combination of bad policies and incredibly lax underwriting standards at financial institutions. The biggest policy failure was the decision by Alan Greenspan’s Federal Reserve to hold interest rates too low for too long. That led to a tsunami of credit that inundated the economy with cheap money. Mortgage lenders in particular were flush with funds and searched for deals wherever they could be found. Heretofore unqualified borrowers suddenly “qualified” as underwriting standards relaxed and then disappeared.

Egged on by statements from Chairman Greenspan, market participants came to believe the era of low interest rates would last indefinitely. But the era did come to an end as the Fed was forced to begin raising interest rates. Faced with the prospect of paying higher rates on their mortgages in the future, borrowers began defaulting. First home prices stopped rising, and then home prices began dropping—precipitously in some overheated housing markets. Now we are approximately six months into a new cycle of lower interest rates, but with no end in sight to the crunch.

At least two other factors stoked the crisis. First, many exotic financial products were issued whose value was tied in one way or another to home prices and the value of the securities into which home mortgages were bundled, such as collateralized mortgage obligations. The pricing of these financial products was the product of complex economic models, not the outcome of market transactions. As the value of the underlying homes and mortgages declined, pricing of the financial exotica became nearly impossible. As we learned in the collapse of Long Term Capital Management, these pricing models fail precisely when their accuracy is most important—in times of financial turbulence. The inability to price the financial products has exacerbated losses among the firms holding them.

There is a wonderful parallel here to the collapse of the Soviet Union. As the great Austrian economist Ludwig von Mises argued almost 100 years ago, central planning inevitably fails because there are no market prices to allocate resources. Market prices can only be the outcome of actual market transactions among buyers and sellers. Planners used mathematical formulas to value resources, especially capital. Now Wall Street wizards have imported Soviet thinking to allocate financial capital. Is it any wonder that it failed?

The second factor contributing to the housing market collapse was the federal government’s commitment to “affordable housing.” Lenders, especially Fannie Mae and Freddie Mac, were pressured into promoting housing to low-income groups that could not qualify for normal loans. That policy is predicated on the belief that there is an underserved group of people who, but for economic discrimination or some other market failure, would be homeowners. That social goal and the credit-driven desire for more deals merged into mortgages made without adequate collateral.

We learned two lessons from the drive to make home ownership available to the heretofore underserved. First, many of these were not homeowners because they could not afford a home. Only under the temporary “hothouse” conditions in mortgage markets did they seem to qualify. Second, people who have no equity in their homes cannot meaningfully be said to be owners. When times turn tough, they will walk away. They were effectively renters, not homeowners.

The crisis will end when housing markets hit bottom and the prices of mortgage securities stabilize. Banks also need to unwind their positions in exotic financial derivatives.

The Fed needs to understand it is facing a capital crisis, not a liquidity crisis. The very low interest rates on safe assets show there is ample liquidity in financial markets. The Fed should not supply capital. That is the job of markets, and they are doing it.

Gerald P. O’Driscoll Jr., formerly a vice president and economic adviser at the Federal Reserve Bank of Dallas, is a senior fellow at the Cato Institute.

No Hoofing to Hooverville
Megan McArdle
Just one thing puzzles me about the race to the White House: Why would anyone want to get there? I know that being crowned prettiest girl at the prom is the great lasting rejoinder to everyone who made fun of you in middle school, but given the economic condition of the country, the next four years seem like a rotten time to reign.

Ignore the econopundits making comparisons to the 1930s. While the parallels are striking, we are missing the key ingredient in the onset of the Great Depression: tight Fed policy that caused the money supply to shrink by 25 percent. You can put away that bindle and push the apple cart back in the garage.

Comments

Grand Poobah|5.5.08 @ 12:23PM|#

You forgot the requisite reference to those dastardly newsletters. How can you mention Ron Paul without dragging out the mythical LRC KKK hood?

Cosmotariat|5.5.08 @ 12:34PM|#

Grand Poobah | May 5, 2008, 12:23pm | #

Did you not see him talk about the Fed? Scary stuff...what a loon...you know when somebody mentions banks they mean "the jooos."

frankstallone|5.5.08 @ 12:59PM|#

Well, according to forbes I live in the country's most recession proof city (OKC). But good luck to the rest of you.

|5.5.08 @ 1:21PM|#

Urged on in part by the example set by their profligate leaders, Americans wallow in a huge pile of private debt as well.

I never quite understood statements like this. Does anyone really base their personal financial decisions on how much debt the federal government has? "Well, Honey, I was going to put this extra $2000 we have in a Roth IRA, but I just looked at the latest federal budget and said 'Screw it! Let the good times roll...'"

The Democratic Republican|5.5.08 @ 1:36PM|#

Hey frank! I don't live too far from you. Ya, it's good living in Oklahoma right about now!

Naga Sadow|5.5.08 @ 1:43PM|#

NAL,

I do. Also, some use it to judge loan timing. A set 160,000 dollar loan looks better if you anticipate inflationary pressures kicking your wages up due to "high cost of living increases".

Brandon|5.5.08 @ 1:53PM|#

Poobah said, "How can you mention Ron Paul without dragging out the mythical LRC KKK hood?"

This article wasn't compiled by David Weigel.

David Weigel|5.5.08 @ 2:10PM|#

This article wasn't compiled by David Weigel.

But I talked to him for the article, JUST BECAUSE I HATE HIM SO MUCH.

|5.5.08 @ 2:10PM|#

I never quite understood statements like this. Does anyone really base their personal financial decisions on how much debt the federal government has? "Well, Honey, I was going to put this extra $2000 we have in a Roth IRA, but I just looked at the latest federal budget and said 'Screw it! Let the good times roll...'"

Probably not literally. But in a broader sense, we now live in a society where debt is no longer a four-letter word, so to speak. Our ancestors were terrified of indebtedness, and rightfully so. But so many Americans today live in a dream world of thinking that they can always buy everything today and pay tomorrow. And the federal government's profligate nature sets a very bad example, to say the least. It's not enough to say that we get the government we deserve. We ARE the government, so it will always reflect us as we really are.

BTW, kudos to the Reason folks for this roundtable. A welcome relief from all of the Obama/Clinton crap that has dominated H&R lately.

PC|5.5.08 @ 2:22PM|#

David Weigel | May 5, 2008, 2:10pm | #

I don't think you hate him. You probably love him the same way Obama loves his racist evil grandmother.

Invisible Finger|5.5.08 @ 2:30PM|#

Does anyone really base their personal financial decisions on how much debt the federal government has?

No, but it IS based on the government's attitude toward debt versus savings. If the government goes deeper into debt, and the government is much smarter than me, then debt must not be a bad thing. So gimme that 120% LTV mortgage, please.

Plus, capital gains and savings are taxed up the ass, so it's not like the government rewards you for saving. Whereas there's always another debt bailout just around the corner.

Sam Grove|5.5.08 @ 2:31PM|#

Another thing that is different now is the proportion of people working in agriculture is much lower and most people are now dependent upon 'the system' for their daily bread.

As long as people keep going to work, we'll be able eat and maintain comfort. And they will keep going to work because they have to.

Brandybuck|5.5.08 @ 2:33PM|#

OMG! Two, not one, but two Austrian economists! Reason may have to turn in its Cosmotarian card, and Lew may have to tone down his snark!

Kolohe|5.5.08 @ 4:11PM|#

"There is a wonderful parallel here to the collapse of the Soviet Union. "

I'm only up to here so far, but this a crappy parallel.

What the big brains on wallstreet were trying to do was get towed into Jaws during a winter swell. Most get wiped out, but a few are able to surf it through a combo of prep, skill, and luck.

What the soviet union was trying to do was build a wave machine.

|5.5.08 @ 4:42PM|#

There is only two things wrong with our economy.

1. Gas prices. These are the fault of the environmental wacos and the global warming hysterics. They are stopping us from drilling for cheap local oil, building new refineries and changing the number of blends down from 60 to 10 or so, that refineries must produce.

This is mostly the fault of liberal Democrats. It amazes me when Americans think the Democrats will be better on the economy. They will push gas to $10/gallon if allowed to and raise our taxes to boot.

2. The fictional home mortage crunch. Once again it was liberals who said it was racist to give high risk borrowers good mortgage rates. So they gave them floaters and the rate went up a few points. They should never have been given credit in the first place unless it was at a very high rate so they would pay for the defaults of their deadbeat fellow travelers. Yet it was the liberals who presured banks to do this.

Now it is a buyers market. Most of the problems are in over priced California and Florida anyway.

Outside of that our economy is wonderful. The only reason anyone thinks otherwise is because of the propaganda coming out of the leftist press who want a Democrat in the white house. A pack of lies every day fools stupid Democrats.

If the press was fair and accurate none of this would be happening!

|5.5.08 @ 5:09PM|#

"There is only two things wrong with our economy. 1. Gas prices. 2. The fictional home mortage crunch."

Those two things don't bother me. The two that worry me are: 1. Potential for insolvent US Treasury. 2. Potential for hyperinflation.

1. With $9T outstanding UST debt, why does anyone want to buy T-bills anymore? When are bond purchasers going to wake up and think "Gee, I'm standing at the end of a long, long line. How the heck am I ever going to get paid back on these treasuries?"

2. If debt investors _do_ wake up, then what does the US do? Hyperinflate the money supply so that all the treasury-holders can get paid back (albeit in worthless dollars.)

I think these two things are most worth worrying about, since the worst historical economic disasters involved either or both.

|5.5.08 @ 7:03PM|#

The $9.4 trillion Bush debt burden in notes with its requisite vacuum of over $200 billion yearly INTEREST payments is the "main" problem with the economy.

The debt lowers the value of the dollar, ignites inflation via Fed rate cuts and sucks capital out of worthwhile endeavors - which in turn drives up the cost of oil and other commodities.

The Bush/GOP sycophants that make up the bulk of posters here can't get past their Christ-Faggotry long enough to recognize basic economics though.

Oh - and they beat off to the war dead too.... Fascists like TallDave take their perversion to Dr. Strangelove levels.

|5.5.08 @ 7:49PM|#

Sorry, but I will not be joining in the doom-and-gloom (note, traditionally, a great buy signal). With a net worth up 50% since Bush took office (as it is for most long-term, well-diversified investors --check pension funds and university endowments, for example), happy days are here again.

|5.5.08 @ 8:02PM|#

"up 50% since Bush took office" - DP

Pure bullshit.

I do, HOWEVER, believe many institutions are up 50% since the market lows of late 2002. The markets plunged from Inauguration Day to fall of 2002 following the Enron and Worldcom debacles.

Kolohe|5.5.08 @ 8:32PM|#

The Bush/GOP sycophants that make up the bulk of posters here can't get past their Christ-Faggotry long enough to recognize basic economics though.

um, perhaps you are confusing this with redstate? or perhaps townhall? lgf?

There are maybe 3 non-troll 'conventional' right-wing committed christians who post here fairly regularly. (talldave, john, and mad max).


And as another point of order, I propose that using the words 'basic economics' should be part of the drinking rules.

|5.5.08 @ 9:07PM|#

"There are maybe 3 non-troll 'conventional' right-wing committed christians who post here fairly regularly. (talldave, john, and mad max)." Kolohe

Well, there is Neil and Guy - if they count.

You no doubt know the posters better than I do.


I just hate fascists.

|5.5.08 @ 10:08PM|#

Well, there is Neil and Guy - if they count.

No Neil does not count as he is clearly performance art.

|5.5.08 @ 10:09PM|#

And as another point of order, I propose that using the words 'basic economics' should be part of the drinking rules.

Subject to invocation of DEMAND KURV, or independent?

|5.5.08 @ 10:16PM|#

The $9.4 trillion Bush debt burden in notes with its requisite vacuum of over $200 billion yearly INTEREST payments is the "main" problem with the economy.

The debt lowers the value of the dollar, ignites inflation via Fed rate cuts and sucks capital out of worthwhile endeavors - which in turn drives up the cost of oil and other commodities.

This is what I wrote that matters.

I have been "Wrighted".

Mr. Blather|5.5.08 @ 10:22PM|#

What is the source of the "two consecutive quarters" definition of a recession.?

This seems very odd to me:
Monday: I have $100
Tuesday: I lose $3.
Wednesday: I earn $1.
Thursday: I lose $2.
Friday: I earn $1.
Saturday: I lose $3.
Sunday: I earn $2.

By my math, I've $4 less by the next Monday, but I've never had two days of loss in a row. Isn't that a recession?

|5.5.08 @ 10:37PM|#

Blather, your understanding of economics is a thing of wonder.

|5.5.08 @ 10:47PM|#

Here, in small town, South Carolina, I'd say the economy is really, really bleak. Bush can be as cheery as he wants but the reality is people are actually walking to work here. I mean if they want to lose weight, more power to them, but I don't think that's the case.
Not to mention the price of milk.
And the truckers, some of them aren't moving their trucks cause it's not worth it.
I think we can only deny the inevitable for so long.

|5.5.08 @ 10:55PM|#

Sorry, Jeb.

The Bush fans will argue, but the trend is set.

Oil is going to $150 a barrel before the election. Food is going up 20% too.

Hang in there. The GOP is dying.

George Dubya Bush|5.6.08 @ 12:02AM|#

Recession? What recession? We aren't in a recession - my friends and I have never made so much money.

gmatts|5.6.08 @ 3:11AM|#

"Sen. Hillary Clinton (D-N.Y.) took a different tack: The "economic crisis is, at its core, a housing crisis," she said in a major Philadelphia address"

Nonsense. The housing "crisis" is endemic of our country's overall economic philosophy: "Don't worry about today, tomorrow simply must be better. After all, its America". Consequences of actions taken seem to be pooh-poohed to a bizarre degree nowadays.
IF someone can present a reasonable scenario where the federal governments fiscal house will be in order in the next 10-20 years I'd love to hear it. If not, I don't see how the expenditures that the gov't is on the hook for the next 20 years in anyway leaves the US economy in a strong position.
Odd that a President, when a private citizen, was only able to head oil companies that drilled empty holes and created debt has taken that "expertise" to the federal level.
But he'll be comfortably retired to his ranch with no cattle at that point. Let freedom ring!

Is there anyone here that would base their own personal finances on the model that our federal gov't is basing it's own fiscal policy on now?

Ebeneezer Scrooge|5.6.08 @ 4:07AM|#

Hang in there. The GOP is dying.

Yeah buddy. And the socialist Democrats will be here to stay for GOOD this time.

We'll be so much better off won't we.

|5.6.08 @ 9:40AM|#

America's worst enemy, economic wise, the US Congress. Gone are the days when upstanding men went to Washington because they had a vision to make things better. Today we have a congress of professional con-men whose sole purpose in life is to get re-elected and experience la dolce vida sucking the life out of the taxpayers. We also have embedded in the Washington establishment a powerful group of socialists who have never learned that since the great Socialist International of 1899, socialism has never delivered on its promise, not once.

|5.6.08 @ 10:17AM|#

I meant "la dolce vita".

|5.6.08 @ 11:10AM|#

In regards to Megan's 'big new health care entitlement' comment:

I find the continuing myth that we need to spend more money to get Universal Health Care (UHC) coverage disturbing. There are numerous industrialized countries that provide UHC to their citizens with better results, universal coverage, less medically-forced bankruptcies than the current US system. The kicker is that they all do so, get this, while spending less of a percentage of their GDP than the US currently does. Some cut the inefficiencies by almost a half.

Part of the problem is thinking that every UHC system needs to be socialized. It doesn't. Some are, but others are a mix of private and public institutions, while some are wholly private and are way less expensive (as a percentage of GDP) than the US system.

PBS and Frontline just aired a examination of UHC systems across the industrialized world. It might be worth the effort to be better informed before making the same old argument about health care being unaffordable and a budget buster.

|5.6.08 @ 5:53PM|#

joe sez The kicker is that they all do so, get this, while spending less of a percentage of their GDP than the US currently does. Some cut the inefficiencies by almost a half.

I don't have the reference handy, but I recall a study that indicated that healthcare spending goes up with income. In which case, it isn't a matter of inefficiency.

Kevin|5.14.08 @ 11:41PM|#

Joe, your comment avoids the question of why we would want universal healthcare coverage in the first place, regardless of how much or little it costs. The next question is why we can't make the US system less, rather than more socialistic, and save money that way instead (I would certainly save money).