Wealth of Nations September 2006

Is a Recession Around the Corner?

The chances of a recession appear to be rising, namely because housing prices are dripping in many markets, and household new worth along with them.
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Democrats expect the economy to help them out in November. As The Washington Post put it this week, " 'Mortgage Moms' May Star in Midterm Vote. With Wages Stagnant and Debt Growing, Democrats See an Opportunity." Well, if mortgage moms are already stressed out, you have to wonder how they might be feeling a year from now. By then, the chances are good that they will have a lot more to worry about. If it's true that the economy is going to help the Democrats this year, and it probably is, the boost may be nothing compared with the push it will provide in 2008.

Today, after all, economic growth is steady, unemployment is low, and inflation is subdued. This is not to deny the financial stresses that so many Americans complain about. Median incomes are growing only slowly—more slowly than the prices of health care, a college education, and gasoline, for instance. Still, for now, the overall economic picture is bright.

This may soon change. The chances of a recession seem to be rising. And you could say that mortgage moms—stars of the economic outlook as well as of the forthcoming elections—are the reason why.

Mortgages and other kinds of debt explain how the last recession turned out to be both brief and mild. Alan Greenspan, then-chairman of the Federal Reserve, responded to the bursting of the tech-stock bubble in 2000 with deep and prolonged cuts in interest rates. As a result, consumers kept on spending, notably on houses and on related goods and services—and got themselves deeper and deeper in debt to do it. The Fed's policy worked exactly as it was supposed to, in the first instance, because the economy quickly recovered. But the full story of the tech-stock bubble and its aftermath is by no means over.

During the past five years, encouraged by those post-bubble interest rates, not to mention the tax deductibility of mortgage interest payments, American households have got themselves in debt up to their eyeballs. Mortgage debt alone has approximately doubled in the past six years. While housing prices were rising at double-digit rates, all those loans weighed lightly on households. Net worth was preserved, or even continued going up, despite the burden of increased debt, and despite the fact that much of the borrowing was used to finance consumption, not investment. But mortgage moms and dads are no longer taking it for granted that housing prices will keep rising so fast. Housing prices are now stalling. In many real estate markets, they have dropped, and household net worth is falling along with them. According to the most recent figures, sales of new homes are running 22 percent below the same month last year. Inventories of new homes are up by about the same; inventories of existing homes are 40 percent bigger than a year ago.

Those debts are looking heavier by the week. This would be enough by itself to cause households to cut spending and start saving, thus slowing the economy down. But there's worse. Traditionally, American mortgages have been granted at fixed interest rates. Lately, banks and other lenders have fueled America's appetite for credit with aggressive sales of new kinds of loans. These loans typically have lower payments at the start and higher payments later, and they expose borrowers to greater risk if interest rates rise. These variable-rate and interest-only mortgages are much more hazardous than the old-fashioned kind. The recently popular "option-ARM" (for adjustable rate mortgage) takes it to an extreme. The debt does not get paid down promptly. In the early years, these loans even let borrowers pay less each month than the interest due, with the difference added to the principal. For borrowers who don't know what they are doing—and, to judge by some of the horror stories published lately, that is more than a few—the option-ARM is a formula for financial ruin.

Interest rates have risen in recent months but, in inflation-adjusted terms, they are still pretty low. So far, the housing market has slowed but it has not collapsed. Nonetheless, defaults are already rising, and many borrowers with interest-sensitive mortgages are in trouble.

Apparently a lot of people continue to take comfort in the remarkable fact that median house prices in America have not fallen on a year-on-year basis since the Great Depression. Speaking as the owner of a mortgaged property, I would like that fact to hold as an eternal truth. Unfortunately, I don't expect it to. That is partly because house prices are further out of line with other prices than ever before, and partly because I have seen housing prices crash in other markets—markets, such as Britain's, which have relied more heavily than the United States has, up to now, on variable-rate mortgages. Nothing puts a market into a rapid fall more reliably than homeowners forced to sell. Britain's most recent housing crash, in the early 1990s, was brought on by a spell of high interest rates, which made the debts of many variable-rate borrowers unaffordable. Many chose to sell rather than default. (Those left without equity in their homes as prices fell were ruined in any case.) The recent popularity of variable-rate and other high-risk mortgages has exposed many Americans to this danger for the first time.

But, you may ask, if that is true, why would the Fed raise interest rates any further? If need be, if the housing crunch gets serious, it can lower rates instead.

Yes, in theory. But there are two complications. One is timing: It would be easy to lower rates too late, and a serious housing-price decline would be difficult to cut short once it got going. The other is that housing prices are not the only thing the Fed has to think about. This week, new figures showed that labor costs are rising faster than the Fed and its new chairman, Ben Bernanke, would like. They went up by 4.9 percent at an annual rate in the second quarter, and that followed a 9 percent rise in the first quarter (itself a sharp upward revision). Year-on-year, unit-labor costs are rising at their fastest rate since 1990. Lately, many on Wall Street had begun to think that the Fed's recent tightening of monetary policy had about come to an end, and that Bernanke and the other governors would leave the benchmark federal-funds interest rate at 5.25 percent. They are having to think again.

So the Fed has something of a knife's edge to confront. It has inflationary forces to deal with: Labor costs, and the price of oil, are pushing prices up. No chairman of the Fed—least of all a new one who is still struggling to establish his credibility with the financial markets—wants to preside over a surge in inflation. But at the same time Bernanke knows that the housing market is fragile, and that American consumers are anxious, financially overstretched, and unusually exposed to a rise in interest rates—the Fed's only tool for curbing inflation.

Some economists believe that a housing bust, with a recession almost sure to follow, is coming regardless. Their leading spokesman right now is Nouriel Roubini, a professor at New York University's Stern School of Business and the brains behind RGE Monitor, a closely followed and highly regarded economics Web site. Roubini puts the probability of an imminent outright recession at 70 percent. His reasoning—and it is all too plausible—is that the coming housing bust (which he regards as almost inevitable) will have a much worse deflationary impact than the bursting of the tech-stock bubble. When tech stocks collapsed, a lot of wealth was wiped out, but the effects were confined mostly to a relatively small group of investors. It was within the Fed's capacity to counteract the effect of this reduced wealth on consumer spending by cutting interest rates. Housing wealth, Roubini points out, is more widely held and, through home equity withdrawal, more directly linked to household spending. Moreover, this time around, the stagflationary influence of dearer oil is constraining the Fed's response.

One economics blogger (Tim Duy, at Economist's View) said that reading Roubini had left him wondering about "liquidating all [his] assets and rebalancing into a diversified portfolio of dry goods, gold, guns, and ammunition." That was my feeling, too. Needless to say, recessions have been predicted with high probability before (including in this column) and then have failed to materialize. That cheers me up, but I would be a lot happier if I could see where Roubini's reasoning goes wrong.

The Republicans are bracing themselves for some awful election results in November. Iraq is hurting them badly, they acknowledge, and so is "economic insecurity." Has it occurred to them, or to the Democrats for that matter, that at some point between now and the next presidential election the economic insecurities of 2006 might seem like very small stuff?

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Clive Crook is a senior editor of The Atlantic and a columnist for Bloomberg View. He was the Washington columnist for the Financial Times, and before that worked at The Economist for more than 20 years, including 11 years as deputy editor. Crook writes about the intersection of politics and economics. More

Crook writes about the intersection of politics and economics.

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