Sizing Up The Coming Recession

Image: Brian Rea

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From Citigroup to Harry Macklowe to the Metropolitan Museum of Art, the list of the credit crunch's victims grows by the day. So how bad will it get? If Federal Reserve chairman Ben Bernanke and former Treasury secretary Lawrence Summers are to be believed, the answer is not too bad. Bernanke recently predicted "a period of sluggish growth followed by a somewhat stronger pace of growth starting later this year as the effects of monetary and fiscal stimulus begin to be felt." Summers said a recession is likely, but it will be a relatively mild one that lasts a year or less. "Everybody needs to take a deep breath and recognize the resilience, the potential, and the competitiveness of the American economy," he declared.

Whenever Bernanke or Summers talk about economics, my advice is to sit down and listen. Bernanke left his childhood home in South Carolina for M.I.T., Stanford, and Princeton, where he headed the economics department. Summers, if anything, is even more formidable. In the 1980s, when I was visiting Harvard, I attended a series of lectures he gave to first-year Ph.D. students. Whereas other professors turned up with pages of typewritten equations, which they then copied onto a whiteboard, Summers came in with a few notes scribbled on a piece of paper and started talking. He could see the algebra in his head; he didn't need to write it down.

Yet when it comes to this economy, Bernanke and Summers, for all their brilliance, may well be mistaken. The economy is most likely spiraling down, with unemployment rising, the stock market tumbling, and corporate losses mounting. In economics, as in quantum physics, nothing is certain, but falling housing prices and slumping consumer confidence point to a deep recession that could last for two or three years. Psychology is critical in economics, and right now it is battered. Until we get through this period, it might be worth keeping in mind the words of another famous economist, Adam Smith, who said that in every great nation "there is a lot of ruin."

Unlike some past recessions, which were rooted in inflation problems, this one has been triggered by credit and real estate—both of which have a lot to do with how people perceive their financial well-being and, in response, how they adjust their spending. (View a tally of recent recessions and their causes.) For what is probably the first time since the 1930s, home prices are falling sharply. Nationwide, housing prices have slipped about 10 percent in the past year, and the decline is accelerating, according to the S&P Case-Shiller home-price index. As prices drop, more and more homeowners discover that they owe more than their property is worth, at which point they experience the temptation to hand the keys back to the bank or mortgage company. Jan Hatzius, an economist at Goldman Sachs, estimates that by the end of 2009 up to 15 million households could be in a position of negative equity. If Hatzius is right, the glut in houses for sale will only get larger, and prices will fall a lot further. Just how low they could go is anybody's guess, but a reading of data compiled by Yale economist Robert Shiller, which show the evolution of inflation-adjusted home values since 1890, suggests an overall drop of 30 or even 40 percent.

When property prices fall, homeowners feel poorer, which prompts them to spend less and save more. Gross domestic product falls and unemployment increases. A slide of 25 percent in home prices would wipe out about $5 trillion in household wealth. Coincidentally, this is roughly how much was lost when technology stocks collapsed in 2000 and 2001. Given that some predictions have home values falling even more steeply, the pain could be severe.

In addition, homes are more widely owned than stocks, and they have a bigger effect on spending. Simulations carried out by Frederic Mishkin, one of Bernanke's colleagues at the Fed, imply that the typical American family will cut its spending by up to 7 cents for every dollar in housing wealth it loses. Given a 20 percent fall in prices, this adds up to a nationwide reduction in consumer spending of about $350 billion a year, or 2.5 percent of the U.S.'s gross domestic product. That's a big number—more than big enough to tip the economy into recession.

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