Spotting Signs Of Economic Recovery

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When it comes to issuing gloomy warnings about the U.S. economy, I’ve established myself as something of an authority (or bore). Ten years ago, I was much exercised about the threat of a stock market bubble; in 2002, I wrote a piece saying that the next crash would come in real estate. Since then, I’ve produced numerous jeremiads, including ones for this column. But for the first time in my memory, I am less pessimistic than the conventional wisdom.

I wouldn’t say that I’m a heady optimist, but I think there is a danger of repeating the mistake that many of us made during the boom: extrapolating current trends to make decisions about the future, failing to take into account how rapidly economic circumstances can change. There’s a risk that we may again overshoot the mark: As the economy goes down, we could be overemphasizing the negative just as we exaggerated the positive on the way up. (View a graphic showing analysts' predictions for 2009 quarterly G.D.P. growth.)

Yes, the short-term outlook is dismal and will remain that way for months. On top of a slumping housing market and credit crunch, we have soaring unemployment, an unprecedented fall in consumer confidence, daily corporate retrenchments, and a dramatic slowdown in the world economy, which is affecting even India and China. The U.S. recession, according to the National Bureau of Economic Research, began in December 2007, which means it’s already the third-longest downturn since 1945. Come May, barring something completely unexpected, this recession will become the longest in postwar history.

So where’s the good news? In any serious downturn, a number of self-reinforcing processes—economists call them adverse feedback loops—start to take hold. To prevent a recession from turning into a depression that lasts for years and years, these feedback loops have to be thwarted on as many fronts as possible, with a variety of policies. Fortunately, these are now being put in place.

In the U.S., we have an energetic new president with a mandate to expand government spending and cut taxes. Equally important, we have the Federal Reserve, chastened by earlier errors, injecting money into the financial system at a rate never seen before. Overseas governments also are busy introducing stimulus packages, slashing interest rates, and propping up their banks. It’s possible the pessimists are right, and all of these initiatives will fail to halt the downward spiral. But that would go against historical precedent. And during the most catastrophic slumps of the past—the Long Depression of 1873 to 1879, the Great Depression of 1929 to 1933, Japan’s “lost decade” of the 1990s—policymakers failed to act decisively until it was too late.

The most visible adverse feedback loop is in the financial industry. Faced with mounting losses on housing-related securities and loans, banks and other institutions are curtailing their lending to preserve capital. Initially, the Fed responded to this problem by cutting interest rates and expanding its role as the lender of last resort to encourage banks not to sit on their capital. This strategy, which amounts to a finger in the dike, prevented a rash of collapses but did nothing to repair the financial industry’s capital base, which has been massively impaired.

By injecting taxpayers’ money into big banks on generous terms and agreeing to have the government take the hit on many of Citigroup’s junky securities, Ben Bernanke and Hank Paulson are well on their way to addressing the problem; in essence, they’re socializing the private sector’s losses. From a political and philosophical perspective, this is an ugly process to behold—who likes bailing out Vikram Pandit and Robert Rubin? Nevertheless, it is probably the only way for the financial industry to move beyond the credit crunch and start over. The Obama administration is likely to expand assistance to the banks, possibly through the creation of a new Resolution Trust Corp., which would take on distressed assets from many financial institutions, perhaps in return for stricter limits on executive compensation and bigger equity stakes than the Bush administration demanded from Citigroup.

In addition, the Fed has agreed to purchase hundreds of billions of dollars’ worth of such dubious securities as “triple-A”-rated mortgage bonds and credit-card receivables and allow financial institutions to swap even trashier paper for cash or Treasurys. The financial crisis is far from over, but with the federal government guaranteeing bank debts, dispensing practically unlimited amounts of credit at close to zero percent interest, and acting as the junk purchaser of last resort, it may well have seized the initiative.

Similarly aggressive moves may soon be under way in the housing market, where the self-reinforcing cycle is continuing into its third year. As prices keep falling, the number of foreclosures increases and abandoned homes flood the market. At the same time, home loans become more difficult and costly to obtain for almost all kinds of borrowers, so potential buyers decide to stay put, and prices fall further. The good news is that Obama appears to be serious about preventing more foreclosures.

One option is to follow the advice of Sheila Bair, the departing head of the F.D.I.C., and restructure millions of delinquent home loans, reducing the principal and lowering the interest charges. For this to happen, changes will need to be made to the bankruptcy code and laws regarding the disposition of securitized mortgages. A more radical approach would be to have Fannie Mae and Freddie Mac, the two government-sponsored mortgage companies—now effectively government agencies—offer refinancing to any homeowner with negative equity, that is, anybody with a home loan bigger than the value of his or her property. And to encourage home buying, Allan Meltzer, an economist at Carnegie Mellon University, has proposed making some down payments tax-deductible.

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